Stephen’s Posterous

From Alan Greenspan, former chairman of the Federal Reserve and president of Greenspan Associates LLC.

The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators.

But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions.

For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk-product design were too much for even the most sophisticated market players to handle prudently.

Even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against crisis – our regulatory system – functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”.

US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees.

The UK’s heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened Northern Rock. The Basel Committee, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers.

The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.

What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate.

But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation’s savings into the most productive capital investments – those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism’s great success over the generations.

New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities.

The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals.

Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery.

Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union.

History also demonstrates that underpriced risk – the hallmark of bubbles – can persist for years. I feared “irrational exuberance” in 1996, but the dotcom bubble proceeded to inflate for another four years.

Similarly, I opined in a federal open market committee meeting in 2002 that “it’s hard to escape the conclusion that ... our extraordinary housing boom ... finan­ced by very large increases in mortgage debt, cannot continue indefinitely into the future”. The housing bubble did continue to inflate into 2006.

It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices.

But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar.

The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the “next” crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis.

Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality.

An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.

I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble.

I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus, before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation.

Restoring the US banking system is a key requirement of global rebalancing. The US Treasury’s purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency.

But, starting in mid-January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value.

Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios.

The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury’s most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets.

Mr. Greenspan is the author of The Age of Turbulence: Adventures in a New World. 

Source.

Stephen Roach, Chairman of Morgan Stanley Asia and the bank’s former chief economist, answers questions.

How should capitalism evolve to create a sustainable economy and limit the occurrence of boom and busts and asset bubbles, while at the same time creating opportunities and incentives for innovation and wealth creation?

Stephen Roach: The demise of capitalism is greatly exaggerated. As the free-enterprise system survived the Great Depression of the 1930s, I have little doubt it will reinvent itself and endure the current crisis. Yet we can and must do much better in making market-based capitalism a safer, more stable and sustainable system. There has been a major systemic failure of the model that has held the world together since the 1930s.

Governance, or the lack thereof both within the private sector as well as by those charged with regulation and oversight proved to be the weak link in the chain. As a first priority, that shortcoming now needs to be addressed head on.

In one key respect, that is already happening: Wall Street is being turned inside out right before our eyes. But the new post-crisis regime must also include a revamped code of governance not just regulatory streamlining and reform but also the hardwiring of financial stability into the policy mandates of central banks.

Independent central banks that operate apolitically and free of ideology could well be the most important stewards of a post-crisis capitalism. But they can’t do it alone. Only through better discipline and more effective governance of regulators, rating agencies, and the political oversight function, can the invisible hand of Adam Smith start to work its magic once again.

How should global imbalances, the savings glut in the U.S. funded by China and Japan, be addressed?

SR: The theory is simple: spenders need to start saving and savers need to start spending. Easier said than done, of course. Execution is the problem for a world that simply doesn’t seem to have the appetite, i.e., political will, for the heavy lifting of global rebalancing.

Significantly, powerful market forces have already sparked the early stages of an endogenous rebalancing. In the US, the simultaneous bursting of property, equity, and credit bubbles is forcing households to shift from asset-based saving strategies back to income-based saving strategies. The ageing of 77 million US baby boomers, the first of whom started retiring last year, underscores the urgency of this adjustment, as a large generation of Americans now comes face to face with the imperatives of retirement security.

In China, a massive external demand shock has brought its export-led growth strategy into serious question. If a multi-year compression in US consumer spending growth leads to a protracted slowing in the growth of China’s external markets, Chinese policymakers will have no other choice than to accelerate the transition to a more balanced, and increasingly consumer-led, growth.

Critical in this regard is for China finally to put in place policies that will expand its social safety net, especially social security, private pensions, unemployment insurance, and public support to education and healthcare.

The United States is adding to its already great national debt to fight the recession. Should the US enact laws now, which state that we will raise taxes and cut spending in the future to guarantee that we will stand behind our national debt and prevent catastrophe, e.g. increased interest rates if our debt is considered worthless or has reduced credit worthiness?

SR: The good news is that the coming explosion of federal debt starts from a relatively low base, just 40 per cent of GDP at the end of 2008. The bad news is that open-ended deficit spending seems likely to take the debt-to-GDP ratio toward 60 per cent by 2013 and to over 100 per cent by 2022.

The real problem is the lack of a credible exit strategy from fiscal and monetary stimulus, alike. Post bubble economies are very fragile and not easy to wean from the life support of fiscal and monetary accommodation. Just ask Japan. Twenty years after the bursting of its big bubbles, public sector debt-to-GDP is nearly 150 per cent and the Bank of Japan’s zero interest rate policy is celebrating its 10th anniversary.

While I am not worried about a debt default of the United States government, I am very sympathetic to your suggestion that we codify an exit strategy to the massive fiscal expansion now under way. Toward that end, I believe that the Congress and the White House should collectively declare a formal fiscal emergency and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era, deficits that now look like child’s play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big and the long-term stakes are too high for fiscal sustainability to be entrusted to the oft-politicised whims of the year-by-year discretionary budgeting process.

Given the balance sheet repair needed by the Western consumers, do you see Asia growing at all over the next two years? And more specifically, is there any way that China can juice its economy now that global demand has evaporated?

SR: In light of prospects for a multi-year compression of US consumer demand growth, together with persistent sluggishness of private consumption in Europe, Japan, and elsewhere in the developed world, there can be no mistaking the challenges faced by export-led Developing Asia.

Those challenges are all the more acute in light of Asia’s sharply increased dependence on exports. Over the past decade-plus, the export share of Developing Asia’s GDP went from about 36 per cent in 1997-98 to fully 47 per cent by 2007. This strategy worked brilliantly while global trade was booming. But now that this boom has gone bust, Asia has been hit extremely hard leaving it with no choice other than to come up with a new growth strategy.

The answer for Asia is obvious, to embark on the heavy lifting of structural rebalancing and stimulate internal private consumption. Nowhere is that more evident than in China, where the private consumption share has fallen to a record low of about 36 per cent of its GDP.

In the meantime, Developing Asia will still grow, driven by ongoing infrastructure-led investment and less than optimal growth in personal consumption. I suspect the growth rate for the region over the next few years will average only around 5 per cent about half the pre-crisis norms and not strong enough to prevent unemployment from rising further. For a region that has long worried about social instability, this is a disconcerting outcome, to say the least. It underscores the critical imperatives of Asian rebalancing.

What is the likelihood of Anglo-Saxon-style capitalism morphing toward a more state-involved Chinese approach, along with more draconian penalties for moral lapses?

SR: Your point is provocative and well taken, but I just can’t get on board this ideological spin to the twists and turns of a post-crisis capitalism. The history of capitalism is very much a continuum of tough tests. Yet in the end, it is a system with strong survival instincts, one that periodically reinvents itself. Financial panics, periodic recessions, and even the Great Depression are all part of the stress testing that has long shaped the rough and tumble evolution of market-based capitalism.

Notwithstanding the claims of a sensationalist media, the scale of state-directed intervention in America’s privately-held corporations remains relatively small.

According to US Commerce Department statistics, the value added by banks, securities firms, and other financial intermediaries collectively accounted for 6.2 per cent of the private sector’s gross domestic product in 2007; the insurance sector made up another 2.8 per cent, whereas the share going to motor vehicles manufacturers was just 0.8 per cent.

Private employment shares of these newly protected industries are even smaller, 5.3 per cent for finance and insurance and just 0.7 per cent for motor vehicles.

These figures provide an outside estimate of the US government’s recent intervention share of around 6-10 per cent in the private economy. That means, of course, that more than 90 per cent of the private sector in the United States is still operating largely as a free-enterprise system. That is not exactly consistent with the widely popularised image of a bail-out nation that has been offered up to depict a US economy in chaos and a market-based system on the brink of collapse.

Still, there is good reason to be concerned about the implications of these recent interventions. Emergency government investments in privately-held companies, capital injections as well as backstop financing, have become an all-too-frequent outgrowth of what started out as a mere sub-prime crisis. At the same time, compensation caps, home mortgage foreclosure mitigation efforts, and politically-engineered consumer lending programs all smack of a quasi-socialisation of American finance.

Add to that, Washington’s new-found aggression on trade policy, “buy America” government procurement policies, along with Chinese currency bashing and it seems as if the US strain of capitalism is being turned inside out. The US body politic is rushing headlong toward a very slippery slope!

The intro asks what is to be done to restore ”faith” in the free market. Is anyone using reason to re-examine free-market ideology itself, or considering the possibility that free markets might be less lethal if they were a little less free?

SR: The current mess is deeply rooted in an ideological approach to economic governance, namely, America’s recent penchant for market libertarianism. Alan Greenspan, the high priest of this approach, framed most of the Federal Reserve’s critical policy choices in the context of this ideology.

As seen through this lens, asset bubbles were not judged to represent a dangerous build-up of speculative excesses instead, they were repeatedly perceived by Greenspan as outgrowths of America’s thriving free enterprise system. The equity bubble of the late 1990s was justified by the breathtaking acclaim accorded to IT-enabled, productivity-led advances of a New Economy.

Property bubbles were presumed to be local, not national,  especially in an era of rising homeownership at the lower or subprime end of the income distribution. And the credit bubble, together with the risk bubble it spawned, was offered as testament to the genius of financial innovation and American creativity. Market libertarians simply looked the other way as the US lurched recklessly from bubble to bubble.

Bubbles, of course, are always based on a shred of truth. But the post-bubble wreckage of the US economy begs for a very different interpretation than that which became conventional wisdom over the past decade. So, too, does the Fed’s blatant abrogation of its regulatory responsibilities during the Greenspan years.

Nowhere was that more apparent than in the central bank’s failure to make the distinction between financial engineering and financial innovation. Far from playing the widely popularised role as the ultimate shock absorber, the originate and distribute hallmark of the derivatives explosion became a lethal transmission mechanism of cross-border and cross-product shocks.

Ideology blinded America’s central bank, as well as its political overseers, to the imperatives of discipline. That same ideology let an unregulated and increasingly unstable free-enterprise system veer unnecessarily out of control. I don’t think that markets have to be any less free, as you suggest.

We just need to be more vigilant in attending to their potential for instability and in recognising the repercussions such destabilising adjustments can have on increasingly asset-dependent real economies. Market risk must be taken far more seriously by the Authorities in the future.

Some form of regulation is undoubtedly needed, but it can sometimes be counter-productive, merely adding layers of costs and giving more business to corporate lawyers and auditors. Sarbanes-Oxley is a perfect example of this form of regulation. In light of such issues, what in your opinion is the ideal form of regulation, and do you foresee a return to Glass-Steagall?

SR: While I agree that misplaced regulation can be counter-productive, I also believe that our system of self-regulation failed miserably in an increasingly complex and globalised economy. An important corollary of this failure is the dangerous and destabilising implications of bubble-dependent economic growth.

We must be very careful, however, in rushing to judgment in designing a new regulatory approach in this post-bubble era. The search for scapegoats can become an obsession; in effect, a lightning rod for national angst. But scapegoating can play an even more destructive role as it can bias and eventually undermine the re-regulatory fix that invariably follows any crisis.

Therein lies one of the greatest potential pitfalls in the post-crisis backlash of 2009. Wall Street has been singled out as the villain in this crisis. On one level, this is understandable. Financial service firms did make many serious and regretful mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. But they were hardly alone.

The modern US financial system has long been under the purview of an institutionalised network of checks and balances controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment. Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess.

The task ahead is to pick up the pieces, learn the lessons of this crisis, and take actions to insure these types of problems never occur again. The post-crisis fix can succeed only if it is grounded in the premise of shared responsibility. A targeted politicised fix is not a solution to a systemic problem. Fix the system that gave rise to the crisis not just the banks that have defined ground zero of a wrenching credit crunch.

It is hard to know where the re-regulatory fix will end up. I would not be surprised if new Glass-Steagall-like regulations were enacted in order to shield the credit intermediation function from riskier activities. Moreover, a much broader umbrella is likely, covering banks and non-bank financial institutions, alike.

In the face of government picking winners and losers both of businesses and individuals have we had a free market in reality during the last 40 years? Isn’t it correct to state that what we have had is a hybrid economic system that depended on government manipulation of the financial system to exist?

SR: To the contrary. During the Era of Excess, market libertarians were in charge, embracing a regime of self-regulation and unbridled free-market capitalism. Led by Alan Greenspan, there was very little of the manipulation you seem to believe in.

Those days appear to be over at least for the time being. With many of the once proud icons of Corporate America now on the skids, emergency government intervention has become the norm in this crisis. That is closer to the hybrid system that you seem to be alluding to. As I noted above, the real trick will be to wean the patient from the life support measures of such interventions without triggering a relapse.

To what extent might governments try to influence the business strategies of the financial institutions, which agreed to state aid?

SR: That is a little close to home. The words “might” and “try” should be stricken as this train has already left the station. The feeding frenzy of US Congressional bonus bashing has taken on a life of its own with extreme “clawback” legislation having already passed the House of Representatives and now working its way through the Senate.

If signed into law, these draconian measures would severely impact talent retention, as well as the willingness of any financial institution to accept government “assistance” in the future. Your choice of the word “influence” is a massive understatement of the destructive intent of America’s increasingly vengeful body politic.

Personally, I am sickened by the hypocrisy of the blame game that has been spawned by this wrenching crisis, a politically inspired witch-hunt that has now singled out Wall Street as the villain in this mess. While our industry is hardly blameless for developments that gave rise to the so-called sub-prime crisis, it is dead wrong to lay it all on Wall Street.

Yes, we made many serious mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. I personally have great regret for these errors, honest mistakes that were made by a few but with implications for far too many.

But the verdict must be rendered in context. Governance of the modern US financial system has long been relegated to an institutionalised network of checks and balances, controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment.

Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess. In short, the system failed. And in this new era of responsibility, as President Obama calls it, all of us must accept shared responsibility for that, from Wall Street to Washington to Main Street.

America’s politicians, the stewards of a system that went to excess, apparently can’t stomach the possibility that they, too, played an important role in shaping the endgame. They prefer, instead, to opt for the blame game, in particular, singling out Wall Street as the major culprit in this devastating crisis.

Focusing on the fall guy deflects attention away from the tough choices that ultimately must be made by elected leaders to avoid the repetition of a crisis like this in the future. Never mind the hypocrisy. It is as if the people’s representatives were innocent passengers on a runaway train.

The blame game is the darkest side of any crisis. The search for scapegoats often becomes an obsession, in effect, a lightning rod for national angst. And it brings out the very worst in an otherwise great nation. Accountability is, indeed, a critical issue in any post-crisis debate. But it must be adjudicated objectively and fairly.

Capitalism is failed in the form it is in and will fail again. If the only target of a system is to accumulate wealth for the minority, it is a worthless system. What do think about the ideas of Mahammad Yunus and his Grameen Bank?

SR: I stand by what I said above. The failure is not capitalism but the system of governance or should I say, the non-governance of self-regulation, that was put in place to manage the capitalist system. Fix that, and capitalism will be fine.

No one could reasonably have expected the boards of directors of major financial institutions to foresee the devastation caused by the financial crisis, but was it not reasonable to expect them to be much more effective in forcing their chief executives to protect against the demise of their banks? If not, what real value can boards play in a governance system if they cannot be relied on to do the right thing when it is most critical?

SR: It is premature to judge the most critical failures in the system of corporate governance that guided financial institutions into the eye of this storm. Was it directors, senior managements, risk managers, credit departments, incentive systems or a lethal interplay between all of the above?

Or was it a siloed decision making process and a related failure to communicate effectively across these different constituencies? Getting to the bottom of these concerns is an urgent matter for every financial services firm.

But there is a very human piece to this sad tale, as well. Call it greed, blind greed, for that matter. Like it or not, booms, artificial or real, distort incentives. Booms also warp values and blind us to downside risks. And denial, that most powerful of human defenses, leads us to dismiss the tough questions that might draw the staying power of a boom into question.

In the now-ended boom, there was everything to gain from keeping the magic alive. And much to lose by drawing it all into question. But it wasn’t just Boards of Directors that failed. It was the American body politic – from Wall Street to Main Street to Washington that was consumed by the hopes and dreams of a bubble-induced boom.

As long as the music kept playing, went the painfully accurate metaphor, no one wanted to stop dancing. We even found heroes to worship: Alan Greenspan, anointed as the Maestro, knighted by the Queen, lionised by US Congress, and yet derelict in his responsibilities as a tough and disciplined central banker was the champion of the Era of Excess.

In the end, the ultimate seduction came from the appearance of unbridled wealth accumulation, soaring stock prices, surging home values, and the ultimate in retirement security. But it wasn’t just us. The rest of the world was delighted to go along for the ride, especially export-led developing economies whose newfound prosperity was built on selling anything and everything to over-extended American consumers. Literally, no one, not even you guys in Shanghai, Peter, wanted this party to end.

If the core reason for the current financial crisis was the failure of the American consumer to save, how will policies designed to simulate spending massively at a time when the consumers’ financial position is even more precarious be conducive to the long term change in behaviour needed to really solve this crisis?

SR: There is enormous push-back to my pro-saving prescription for a saving-short US economy. “America needs to spend,” is the increasingly desperate cry of the born-again Keynesians steeped in fear of the dreaded “Paradox of Thrift.” Greg, you have your finger on one of the biggest issues of this crisis: do we want to go back to the failed macro of bubble-and debt-driven consumption that got us into this mess, or do we have the guts to try and break the mold of years of excess?

The answer is clear to me: the US needs to shift its growth dynamic away from excess consumption and de-minimus saving toward enhanced saving and increased investment. The surplus savers of the world need to do the opposite. To do this, we need to rethink our views on the “paradox of thrift”, viewing this phenomenon in the context of an open global economy rather than something as seen through the lens of a closed domestic economy.

I am not suggesting that the world boost its saving rate. What I am suggesting is a critical shift in the mix of global saving with the US doing more of it and Asia doing less of it. As Developing Asia moves to more of a consumption-driven economy, its currencies should also appreciate, allowing the US dollar to work its way lower and helping American boost its export competitiveness.

If the Obama Administration delivers on other aspects of its competitiveness agenda, namely, infrastructure, educational and healthcare reforms, and energy independence, the excesses of bubble-dependent consumption growth should give way to increasing support from export-led growth.

If, however, the US backtracks and goes back to the well for another dose of excess consumption growth, imbalances will only build again, culminating in an even more treacherous endgame. The ever-expedient quick fix must be avoided at all costs. It is a recipe for disaster.

What would be the very first sign that you will be looking for to tell you that this crisis has come to an end and recovery should begin soon? Do you think there will be a long gap between the end of this crisis and the start of recovery?

SR: I wish it were that easy, one magical indicator turns and the end would finally be in sight. This is a lethal and very complex crisis, with many moving parts. The first stage was the credit market contagion that started with the bursting of the subprime bubble in the summer of 2007 and then spread like wildfire in a cross-product contagion that engulfed the remainder of the capital markets.

Moreover, courtesy of the “originate and distribute” technology of the derivatives explosion, toxic instruments found their way all over the world. This interplay between cross-product and cross-border contagion has created a crisis of truly epic proportions.

The second stage of this crisis is the impact of the capital markets contagion on the real side of asset-dependent economies. The asset-dependent American consumer has been first to tumble. But quick to follow has been export-led economies elsewhere in the world – especially in Asia, Europe, and now Latin America. The decoupling dream was just that – actually a bad dream, bordering on a nightmare.

The third stage of this crisis involves the adverse feedback loop between a deteriorating real business cycle and the loan quality of the same financial institutions that bore the brunt of the credit market contagion in the first stage. That stage is now unfolding with a vengeance. Unfortunately, these stages tend to feed on each other – creating the true vicious circle that is exceedingly difficult to break.

Politicians, policymakers, media pundits, and many business leaders have argued for quite some time that this is mainly a crisis of confidence. If only we all just started smiling more and spinning the good news, then the vicious circle would magically turn virtuous and the worst would be over. As I said, I wish it were that easy.

What will be the global consequences of the Fed’s decision to buy US government bonds and bad bank debt on such a massive scale? Will we see hyper-inflation in the US, and will the creditor nations in Asia now want to stop lending them money? What strategic opportunities/risks do you see as a result of this situation?

SR: For a world in recession, the immediate impact of Helicopter Ben’s unconventional monetary easing is not nearly as problematic as you seem to imply. Given the slack in the global economy, together with its still massive imbalances, it is highly unlikely that inflation will spontaneously ignite or that the world will stage a buying protest against dollar-denominated assets.

Keep in mind that trend growth in the world economy has been about 3.7 per cent per annum over the past 35 years. That means if global GDP contracts by over 1 per cent this year as many, myself included, now suspect, such an outcome will open up about a five percentage point gap relative to the global economy’s longer-term growth potential. Given the multi-year sluggishness I envision, I suspect that the global output gap will expand further in the years immediately ahead, possibly peaking at around 7 per cent to 10 per cent of world GDP.

Such a huge global output gap implies a lingering risk of deflation rather than the immediate risk of an outbreak of inflation. If, however, the gap starts to narrow and the Authorities have been unable to develop effective and credible exit strategies for their massive monetary and fiscal stimulus campaigns, then there will be good reason to worry about inflation. Those worries are distant, however, at least three years, and maybe even five years out in time.

In the meantime, I doubt if the export-dependent surplus savers in Asia would stop lending capital to the US. If they did, their currencies would appreciate, undermining their export competitiveness and thereby threatening a key source of their economic growth.

However, if Asia is successful in migrating to more of a consumption-dependent growth strategy, it will start to absorb its surplus saving and have less capital to send to the US. And then, Asians can truly afford to be far more demanding in seeking better terms on dollar-denominated assets. Doesn’t sound very symbiotic to me.

If banks are too big to fail,  too important to our economy, are they not also too important to be owned and managed by capitalists alone? How can we have smart and well-paid bankers and traders make the right decisions for the long-run benefit of their organisations, and not just churn and burn for short-term bonuses?

SR: Having worked for one firm on Wall Street for over 26 years, I am obviously biased in attempting to answer this critical question. But I believe very strongly that financial institutions are too important to be turned back into state-owned public utilities. In an era of globalisation and interdependent markets, financial intermediation and capital allocation have taken on new dimensions of complexity and risk. These are critically important functions in any economy’s quest for prosperity.

Alas, as we have painfully learned, that quest can cut both ways. That provides one of the most important lessons for the financial services industry, the need to redress the asymmetries of reward and compensation. Remuneration, in my view, can no longer be paid out on a point-of-sale basis. It must be aligned with the longer-term risk-adjusted returns of individuals and their companies. Only then, can we avoid the distorted incentives that encouraged short-term payouts from bubble-driven momentum in trading and banking activities.

Of course, in the Era of Excess, we ended up with a very different system. The profusion of bubbles distorted everything, from the financial system to the real economy. If we do a better job in containing the excesses of asset and credit bubbles in the future, I think we will go a long way in establishing a stable and secure market structure that will force the financial services industry to adopt a more reasonable and equitable system of incentives and rewards.

This critical adjustment can not be taken for granted. The trick will come in aligning a new financial system with the industry’s contribution to broader measures of national prosperity. That is a very contentious point.

Former Fed chairman Paul Volcker put it all too well in an April 2008 speech to The Economic Club of New York when he said, “It is hard to argue that the new (financial) system has brought exceptional benefits to the economy generally. Economic growth and productivity over the last 25 years has been comparable to that of the 1950s and 60s, but in the earlier years the prosperity was more widely shared.” Volcker concluded that. “The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place.”

If the next financial system fails the Volcker-like test of the market place, its rewards, or lack thereof, should be aligned with its failed returns. If, however, the outcome is more favorable, remuneration to its workforce, and presumably to its shareholders, should follow. This is the crux of the challenge for our industry and for those charged with its governance. It is an especially critical challenge for the central bank, an institution, which owes its very existence to the crises of yesteryear.

The role of the central bank is, in fact, testament to one of capitalism’s most important covenants, that finance cannot be entrusted to self-regulation. That is the most painful flaw of the Greenspan era. Never again should we let ideology guide central banking and its regulatory responsibilities.

Central banks need new mandates that explicitly tie their policy targets to the requirement of containing the excesses of asset bubbles and the severe economic distortions they spawn. Then, and only then, can the new financial system be on much sounder footing than the old one. But that’s not to say that we in the industry shouldn’t take a long and hard look in the mirror before we embark on our own Herculean task of attempting to rebuild a failed financial system.

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China is cooling on Western capitalism. Look at the rough treatment meted out to Coca-Cola, the US drinks giant, and a group of foreign bondholders in Asia Aluminum, a Guangdong-based metals group. Pragmatism and self-preservation are taking precedence over free-market ideology.

China’s monopoly watchdog rejected Coke’s $2.4bn bid for fruit-juice maker Huiyuan on March 18, 2009. It probably feared the loss of a big Chinese brand, and domestic jobs. Over at Asia Aluminum, non-Chinese bondholders face losing all their investment after a local government reneged on its offer to buy them out. Pressure from Beijing provoked the change of heart, according to a person familiar with the situation.

Direct foreign investment into China is falling, despite government assurances that barriers for overseas cash are coming down. Approvals for foreign purchases fell by 37% in January and February, versus the same period in 2008. The amount of US capital put to work in China over the two months fell by half. That may reflect in part the crisis taking place in investors’ home countries.

But foreign investment isn’t just diminishing in value, it’s also diminishing in importance to China. Most historic investment went into low-value added manufacturing business destined for exporting, 54% of it in 2008. As exports dwindle, to be superseded, eventually, by home-grown consumption, restoring that flow of capital isn’t a priority. China can be pickier.

Even plans for a Rmb4 trillion ($585bn) stimulus doesn’t put China under much pressure to keep its doors open. Prodigious savings, $1.9 trillion of foreign reserves and a wall of money held by pension funds and insurance companies, should make that easy enough to finance. Direct investments from foreigners in 2008 were just $28bn, a pittance in comparison.

A full move to Chinese autarky, shutting off flows of everything but what China can’t make itself, would be counterproductive for the country. In the long run, openness to foreign capital builds up skills, wealth and welfare.

But China, unlike the US, Europe or Australia, is in a position to pick and choose where that capital goes. In pharmaceuticals and green technology, foreign research and expertise is still indispensible. In fruit juice, probably not. Until the global imbalances that filled China’s pockets are unwound, expect more protectionist spats.

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Jeremy Darroch is in many ways the opposite of James Murdoch, his predecessor as BSkyB chief executive. He describes his background as working class and while Mr Murdoch had an Ivy League education, he studied economics at Hull University in the UK.

Mr. Darroch's career has led the 45-year-old from Procter & Gamble to retailer Dixons before he arrived as finance director of the UK pay-TV company. Mr Murdoch has been groomed by his father Rupert for a role in his media empire and is now non-executive chairman at Sky.

Sky has just celebrated its 20th birthday and has succeeded not only in establishing itself as the main pay-TV brand in the UK but also after a hesitant start as the fourth-largest provider of broadband. Its subscriber numbers are still rising in spite of the recession. But it faces challenges ranging from its stake in poorly performing broadcaster ITV, which it is being forced to sell, to how it can perform in online television.

In this interview, Mr Darroch talked about why shareholder value needs reforming, how pay-TV has proved remarkably resilient and about the Murdochs, father and son.

The Financial Times has just started a series on the future of capitalism. Is it a bright outlook?

If we stand back from the pressures we are seeing now, which are very acute, I think that, by any benchmark, capitalism has been fundamentally good in terms of economic development in societies and all it has brought. That is not to say that it doesn't need to move on.

What kind of changes would you like to see?

How we think about shareholder value probably needs some reappraisal. It has been too narrowly focused around short-term financial returns. It seems to me that really effective wealth creation comes not purely from short-term financial return, albeit that it's very important, but also from how we position our business for the communities and societies in which we work.

We are seeing some extraordinary measures such as quantitative easing and de facto bank nationalisation. Is it enough?

From where I stand, it's difficult to predict. We have to be cognisant that, as we push more and more public money into the private sector, that ultimately has to be paid for.

How deep will the recession be?

Again, it's difficult to predict exactly. 2009 is going to be a difficult year for the consumer environment.

The G20 are meeting next month in London. Should they focus on stabilising the system in the short term or on longer-term regulation?

We have to avoid too much long-term structural thinking without having got through the short term [first]. That said, we can't go too far the other way. So, getting a clear direction around where we want to come out of this and then being able to take short-term decisions through those optics are important.

Is pay-TV, which is dependent on subscription, showing that it is recession-proof?

So far it has proved pretty resilient. In fact, through 2008, we grew at a slightly faster rate than in 2007.

Are customers going for lower-value packages?

A bit. Right across our business what we are seeing are more marginal pressures and we are certainly seeing more customers come in at a basic level and a bit more pressure in terms of downgrades. Conversely, though, we're also seeing customers taking more services from us.

How do you see consumer spending developing?

I think 2009 is going to be difficult in terms of the consumer environment, but . . . in the short term one thing that has surprised me has been the performance of the consumer in areas like retail, which has typically done better than most expectations.

Has this recession changed your long-term assumptions about the penetration rates for pay-TV?

 If anything, it is the opposite because one of the things we are seeing is that TV remains central to people's lives. They are consuming more TV than ever before.

Online TV is all the rage. Do you need to buy another internet company?

No, we've worked hard over the past few years to assemble the distribution assets we think are going to be competitive for the long term, and that is why we acquired our own broadband network three years ago. If there are opportunities we will be open-minded, but there is not really anything we feel we need to do.

The latest thing is super- fast broadband. Would it be better and cheaper for you to go with BT's own network rather than set up your own?

There are a number of options and BT is certainly one of those . . . We've got a good relationship with BT . . . so if we can get to a sensible solution then we'll be pretty open to that.

Can you do anything as a shareholder in ITV to salvage your investment?

With the right strategy that pushes into new areas there's no reason why ITV can't be successful. And we, alongside other shareholders, look for the management team to deliver on that.

James Murdoch is now your chairman. How does he differ from his predecessor, his father Rupert?

We all have different styles. James is different to Rupert in that sense. His style as CEO was a bit different to mine. What characterises the whole management team at Sky is that we have a belief in output and results.

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The black holes of US capitalism are multiplying and growing larger. American International Group's quarterly loss of $62bn may be the largest in history, but the firm is hardly alone in its extraordinary ability to destroy capital. When large complex financial firms grow unstable and start to collapse, the implosion is nearly impossible to stop. Gigantic amounts of financial matter are being sucked in, maybe never to be seen again.

Outside viewers cannot directly see the tremendous capital destruction – many assets within these firms have no observable price. One must rely on indirect signs such as managerial estimates or governmental bailout packages to gauge the size of losses.

They are huge. Three governmental aid packages totalling $150bn haven’t proven sufficient for AIG. The government was forced to pony up another $30bn worth of aid Monday and there’s little assurance this will be sufficient.

Mortgage agencies Fannie Mae and Freddie Mac are equally impressive. Fannie just reported a $25bn loss for the fourth quarter, and says this year’s results may be worse than 2008. The government has pledged up to $400bn to prop up the two.

Other collapses may prove equally difficult to halt. The US injected $45bn into Citigroup, converted its preference shares for common equity while strong-arming other investors to do the same and guaranteed more than $300bn of its assets, yet the company’s $1.50 stock price suggests more is needed.

Bank of America boss Ken Lewis recently claimed that the Countywide and Merrill Lynch were “stars” in the troubled company’s firmament. An odd, but perhaps apt, word choice if the additional mass from these bodies pushes BofA beyond critical mass. The continuing slide in its share price suggests there’s more bailing out of BofA to come.

The Milky Way of American capitalism has so many black holes because complex financial firms clustered in centers like New York and grew large on cheap monetary fuel. But they exist elsewhere. Indeed, they are also common in the British Isles sub-galaxy, where RBS and Northern Rock have sucked in tremendous amounts of financial matter.

Of course, not every star has the needed mass, leverage or complexity to become a black hole. Yet the future of many firms that avoid falling over the edge is hardly bright. Investors’ distrust of leverage, stricter governmental regulation, and slower economic growth mean they may be doomed to red dwarf status.

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Peter L Bernstein is the founder and president of Peter L Bernstein Inc, economic consultants, and author of 10 books on economics and finance.

The “long run” used to be one of the most popular topics among investors, particularly institutional investors. In recent months, discussion of the long run has disappeared  from view. Indeed, the possibility the long run has run away is one of the few pieces of good news I have been able to find in the financial and economic turmoil of recent months.

The cold statistics have hardly been encouraging for the traditional view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts. These data are not to be taken lightly.

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent  a year.

But does this history really tell us anything about what lies ahead? Neither the awesome historical track record of equities nor the theoretical case is a promise of a realised equity risk premium. John Maynard Keynes, in an immortal observation about the future, expressed the matter in simple but obvious terms: “We simply do not know.”

Relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny? Trends bend. Trends break. Today, in fact, we have no idea where any trend lines might begin or end, or even whether any trend lines still exist.

As Lord Keynes in one of his best known (and wisest) observations, reminded us: “The long run is a misleading guide to current affairs. Economists set themselves too easy, too useless a task if in the tempestuous seasons they only tell us that when the storm is past the ocean will be flat.” To Lord Keynes, the tempestuous seas are the norm. We cannot escape the short run.

There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance.

Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.

Recent experience raises a different but perhaps an even more serious question relating to the long run. How do you frame a view of the long run from early 2009? The world has a ruptured financial system showing only fragile signs of recovery. The economic recession now encompasses the whole world.

The speed of economic decline is without precedent. Government intervention is also without precedent, in its magnitude, depth, and complexity. Fiscal deficits are reaching numbers no one dreamed about even 12 months ago, yet they will have to be financed.

What kind of a long run is this mess going to produce? Was Bill Gross correct when he wrote for the December 2008 issue of Pimco’s Investment Outlook that “capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it?”

Can capitalism remain “a going concern” after an extended period characterised by massive government intervention into the economy – and bail-outs of firms that would otherwise have failed? To what extent will the “going” in Mr Gross’s vision be tied to government intervention in these forms and magnitude? Or is Mr Gross’s optimism justified? Will we be able to unwind the role of government in the capitalist system as we know it and go back to the status quo ante?

Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.

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President Barack Obama's plan to limit executive pay to $500,000 a year -- plus restricted stock -- for institutions that get government funding is understandable. Still, salary caps are only a stopgap measure that fails to address the root of the problem.

The real problem is that many corporate managements operate with impunity -- with little oversight by, or accountability to, shareholders. Instead of operating as aggressive watchdogs over management and corporate assets, many boards act more like lapdogs.

Despite the fact that managements, albeit with some exceptions, have done an extremely poor job, they are often lavishly rewarded regardless of their performance.

We must change this dismal state of affairs if we are to rebuild our economy in a sustainable way that restores confidence. If we don't, these problems will keep recurring as investors pile into the next Wall Street innovation or asset bubble, enabled by the kinds of managements that nearly sank Wall Street.

The problem, as I have long maintained, is that boards and managements have been entrenched by years of state laws and court decisions that insulate them from shareholder accountability and allow them to maintain their salary-and-perk-laden sinecures.

What we need are fewer government rules at the state level that protect managements. We need to return capitalism -- our great national wealth machine -- to its roots, where owners call the shots to managements, not the other way around.

Currently, corporate law is largely the province of state governments, not federal. As a result, most corporations migrate to, and incorporate in, states that offer the most protection for managements.

Management-friendly states have a vested interest in attracting these companies because hosting them generates a substantial portion of state revenues. It's a symbiotic relationship: The state offers management protections and, in return, receives much-needed tax revenue.

However certain states, like North Dakota, offer many more rights and protections to shareholders. Because shareholders own companies, they should have the right to move a company to a state that gives shareholders more protections.

What is needed, therefore, is a federal law that allows shareholders to vote by simple majority to move their company's incorporation to another state. That power is currently vested with boards and management.

This move would not be a panacea for all our economic problems. But it would be a step forward, eliminating the stranglehold managements have on shareholder assets. Shouldn't the owners of companies have these rights?

Now some might ask: If this policy proposal is right, why haven't the big institutional shareholders that control the bulk of corporate stock and voting rights in this country risen up and demanded the changes already?

This is because many institutions have a vested interest in supporting their managements. It is the management that decides where to allocate their company's pension plans and 401(k) funds. And while there are institutions that do care about shareholder rights, unfortunately there are others that are loath to vote against the very managements that give them valuable mandates to manage billions of dollars.

This is an obvious and insidious conflict of interest that skews voting towards management. It is a problem that has existed for years and should be addressed with new legislation that benefits both stockholders and employees, the beneficiaries of retirement plans.

I am not arguing for a wholesale repudiation of corporate law in this country. But it is in our national interest to restore rights to equity holders who have seen their portfolios crushed at the hands of managements run amok. The suggestions above would do a great deal to change the dynamics of corporate governance in this country. Such a change will make us more productive as an economy, generating more wealth for everyone.

The Wall Street bailout and economic stimulus packages may be unfortunate and necessary steps to revive this flagging economy. But it is important to attack the real problem by demanding more management accountability.

I have initiated United Shareholders of America to empower shareholders to institute changes, and I encourage you to join our cause. A majority of the U.S. population owns shares. Their voices need to be heard -- now -- on Capitol Hill and in the boardrooms of corporate America.

Mr. Icahn is chairman of Icahn Enterprises, a publicly traded diversified holding company. Visit Mr. Icahn on the web at IcahnReport.com.

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