Stephen’s Posterous

Karl Rove writes in his weekly editorial in the Wall Street Journal that President Obama inherited a set of national-security policies that he rejected during the campaign but now embraces as president. Mr. Rove calls this a "stunning and welcome about-face."

Mr. Rove writes:

For example, President Obama kept George W. Bush's military tribunals for terror detainees after calling them an "enormous failure" and a "legal black hole." His campaign claimed last summer that "court systems . . . are capable of convicting terrorists." Upon entering office, he found out they aren't.

He insisted in an interview with NBC in 2007 that Congress mandate "consequences" for "a failure to meet various benchmarks and milestones" on aid to Iraq. Earlier this month he fought off legislatively mandated benchmarks in the $97 billion funding bill for Iraq and Afghanistan.

Mr. Obama agreed on April 23 to American Civil Liberties Union demands to release investigative photos of detainee abuse. Now's he reversed himself. Pentagon officials apparently convinced him that releasing the photos would increase the risk to U.S. troops and civilian personnel.

Mr. Rove writes that throughout Obama's presidential campaign, he excoriated Mr. Bush's counterinsurgency strategy in Iraq, insisting it could not succeed, and he promised to end the Iraq war by withdrawing all troops by March 2009. But as President, President Obama has set a slower pace of a drawdown Iraq and still plans to leave 50,000 troops there while also applying a counterinsurgency strategy in Afghanistan  .

Mr. Rove calls these reversals praiseworthy as President Obama realizes that the realities of governing trump the realities of campaigning. But Mr. Obama is also reversing himself on the domestic front and possibly causing more harm than good.

Mr. Rove writes:

Mr. Obama campaigned on "responsible fiscal policies," arguing in a speech on the Senate floor in 2006 that the "rising debt is a hidden domestic enemy." In his acceptance speech at the Democratic National Convention, he pledged to "go through the federal budget line by line, eliminating programs that no longer work." Even now, he says he'll "cut the deficit . . . by half by the end of his first term in office" and is "rooting out waste and abuse" in the budget.

However, Mr. Obama's fiscally conservative words are betrayed by his liberal actions. He offers an orgy of spending and a bacchanal of debt. His budget plans a 25% increase in the federal government's share of the GDP, a doubling of the national debt in five years, and a near tripling of it in 10 years.

On health care, Mr. Obama's election ads decried "government-run health care" as "extreme," saying it would lead to "higher costs." Now he is promoting a plan that would result in a de facto government-run health-care system. Even the Washington Post questions it, saying, "It is difficult to imagine . . . benefits from a government-run system."

Mr. Rove says that Mr. Obama's flip-flops on national security have been wise, but on the domestic front they have been harmful. He says that we have learned something about Mr. Obama and that is that what animated him during the campaign is what historian Forrest McDonald once called "the projection of appealing images."

Mr. Rove says that all politicians want to project an appealing image, but Mr. McDonalds warns when an appealing image "becomes a self-sustaining end unto itself."

Mr. Rove concludes:

Mr. Obama's appealing campaign images turned out to have been fleeting. He ran hard to the left on national security to win the nomination, only to discover the campaign commitments he made were shallow and at odds with America's security interests.

Mr. Obama ran hard to the center on economic issues to win the general election. He has since discovered his campaign commitments were obstacles to ramming through the most ideologically liberal economic agenda since the Great Society.

Mr. Obama either had very little grasp of what governing would involve or, if he did, he used words meant to mislead the public. Neither option is particularly encouraging. America now has a president quite different from the person who advertised himself for the job last year. Over time, those things can catch up to a politician.

Mr. Rove is the former senior adviser and deputy chief of staff to President George W. Bush.

Source.

The financials sector has surged in recent weeks but investors still remain cautious. Still, Kenneth Mertz, manager of the Forward Banking and Finance Fund (ticker: HSSAX), is upbeat about the smaller regional banks that constituted 62% of the fund at the end of 2008.

The fund didn't have a prosperous 2008, as total return was down 21.4%, according to Morningstar. Yet that was still 22.5 percentage points better than the average among its specialty-finance peers. Also, the 10-year annualized return through Feb. 28, 2009, was 4.72%, placing Forward Banking in the top 3% of its category.

While no one can be sure when the economic recovery will begin, Mertz expresses confidence in his long-only portfolio and the role that small-bank stocks play in it. "The banks are going to participate in any recovery that we have on a longer-term basis," he reasons.

Barrons.com: What do you see in store for financials?

Kenneth Mertz: We are in a transition year. We are going to be concentrated on cleaning up any loan problems that are out there, and that would apply to the community banks that I follow. Once the investing public gets comfortable that the bank community as a whole has enough capital to fulfill their business plans, I look for financials to be part of any economic recovery.

We don't see an economic recovery until late in 2009. But we all know stocks are going to move before you see an economic recovery in terms of positive GDP [gross domestic product] growth.

Q: I'm looking at your top 10 holdings list, and I'm not seeing any household names.

A: We do small-cap investing, so there are not a lot of others in my peer group of financial-services funds that do what we do. There are several very good ones but most people that manage a financial-services fund would buy Citigroup (C) and Bank of America (BAC) -- that's not what we do.

Q: Tell me about your top holding [as of Dec. 31], Texas Capital Bankshares (TCBI).

A: Texas Capital is a businessmen's bank based in Dallas. They have a very fine management team, and we think they have historically showed great underwriting skills, have low nonperforming assets on their books. They take market share away from their bigger competitors. They do banking in a relationship manner with their borrowers. That keeps their deposit levels quite high and gives them some nice spread business. So their whole business is a spread business on that lending relationship that they have.

Q: What do you like about PrivateBancorp (PVTB) [second-largest holding as of Dec. 31]?

A: PrivateBancorp is headquartered in Chicago. It's very much a bank that, again, deals in relationships with high-net-worth individuals. Management changed within the last year when they brought in the executives from LaSalle Bank, which was taken over by Bank of America, and really created a middle-market-geared institution.

They have to continue to raise capital to support growth, and they've run into a little bit higher nonperforming [assets] than we would have liked to see. The bullish case that we have for them is that they are going to be able to outgrow some of their problems.

Q: Regional banks' dividends are definitely a lot more secure than the bigger institutions. Are dividend yields a barometer for you?

A: No, not really. Texas Capital doesn't have a yield. They are using all their capital to continue to grow the bank in terms of growing their assets, so they have adopted a model that doesn't pay a dividend. I think the nature of your question is correct that these institutions are probably not that vulnerable to dividend cuts because they have the adequate capital right now.

But we are in an environment where the very largest and much-respected companies out there were able to drop their dividends. That may happen to some of these regional banks across the country, but with the smaller ones I don't think you will probably see that. If you don't need TARP [Treasury Department's Troubled Asset Relief Program] you are probably not cutting your dividend, either.

Q: What have you bought recently?

A: A small company in South Dakota, HF Financial (HFFC). It is an S&L [savings and loan institution] with less than $100 million market cap. They are doing business in their community, which is very sound. Low nonperforming assets. The negativity around the group has caused some banks and thrifts like this to present themselves as higher-quality, good institutions to hold.

Q: What names have you been selling or trimming back on?

A: Affiliated Managers Group (AMG). It owns a bunch of asset managers. The fourth quarter was obviously devastating across all asset classes as the market was going down we didn't want exposure to market assets. That was the reason why we were trimming ourselves out of that. We still have some exposure though.

We also trimmed back in the fourth quarter in Sterling Bancshares (SBIB). It's a Houston bank. It has a lot of exposure to commercial-real-estate lending. Just from a risk perspective, we were trimming out of that. I think that is probably still the remaining overhang on regional banks across the nation.

A: Thanks.

Source.

FT: Thank you for doing the interview Mr President.

Obama: My pleasure, I read the Financial Times before other people read the Financial Times. Now it’s trendy and everybody carries around a Financial Times.

FT: Let’s talk about the G-20. What will be your benchmarks for success?

Obama: The most important task for all of us is to deliver a strong message of unity in the face of crisis. There’s some constituent parts to that. Number one, all the participating countries recognise that in the face a severe global contraction we have to each take steps to promote economic growth and trade; that means a robust approach to stimulus, fighting off protectionism.

Next, we have to make sure that we are all taking serious steps to deal with the problems in the banking sector and the financial markets and that means having a series of steps to deal with toxic assets and to ensure adequate capital in the banking sector.

Third, a regulatory reform agenda that prevents these kinds of systemic risks from occurring again and that requires each country to take initiative but it also requires coordination across borders because we have a global, we have global capital markets, and that will include a wide range of steps, additional monitoring authority coordination of supervisors and various countries dealing with offshore tax havens. Making sure that…

FT: Is that a problem? Offshore tax havens.

Obama: Well, its something that is going to be discussed. I know that in my discussion I think there is a concern that we don’t want people to be able to game the system or circumvent regulated capital markets and making sure our regulations are targeting not just banks but any institution that could pose a potential systemic risk to the system.

A final area of concerted action involves international financial institutions and their capacity to assist emerging markets in developing countries at a time when those markets could be under even more severe strain then some of the more wealthy nations and I think making sure that institutions like the IMF have the resources to provide such assistance that world food supplies are not imperilled as a consequence of the break down in global trade, those are all issues that I think have to be addressed.

Now, I’m confident based on conversations that I have this week with Angela Merkel, Sarkozy, as well as with Kevin Rudd as well as conversations that I have had previously with Gordon Brown and others, that there is already a rough consensus there that by the time we arrive in London we will have taken, we will have made significant progress in moving in the right direction.

FT: Let’s just talk about the stimulus for a moment. At the moment there has been a 1.8 per cent GDP boost in 2009 by the G20 nations. There are concerns among economists that you need a sustainable stimulus and therefore 2010 is key. Will you get secure commitments from say, the Europeans, for action if necessary in 2010?

Obama: Two points I want to make on this, Number one: The press has tended to frame this as an “either or approach”. There are some G20 participants that are arguing fiercely for stimulus, others for regulation. What I have consistently argued is that what is needed is a “both and approach”.

We need stimulus and we need regulation. We need to deal with the problems right in front of us and we also need to make sure we’re taking steps to prevent these types of breakdowns from happening again.

With respect to the stimulus, there is going to be an accord that G20 countries will do what is necessary to promote growth and trade. I think there is a legitimate concern that, would most countries already having initiated significant stimulus packages that we need to see how they work.

Obviously I admire economists. I have a bunch of them on my staff. But to start making a whole host of plans about next year, without having better information on how the current stimulus efforts are working, is something that I think is of concern.

So what we are going to see is what the United States has led on this. We have been very aggressive in terms of our recovery package. The way our recovery package is structured, money is going out both in 2009 and 2010.

But each country has its own constraints, its own political rhythms and what we want to just make sure is that everybody is doing something, everybody recognises the need to make progress on this front and that we are prepared to step into the breech should current efforts prove to be inadequate.

FT: I mean that is really the great challenge, in managing this crisis - bridging the gap between what is economically absolutely necessary and what is politically possible. How do you bridge that?

Obama: That’s one gap. Then there’s a gap in ideas about how to approach a crisis like this, especially among economists - although on the issue of the stimulus there seems to be much broader consensus among both conservative and liberal economists that stimulus is appropriate.

You know, the financial crisis hit the United States first; it is now being experienced around the world. Not surprisingly we took some very aggressive action earlier than some other countries because its impact had been felt most immediately on Wall Street.

As other countries start experiencing these drastic declines in GDP and in their exports I think that the sense of urgency has grown and you are going to start seeing a convergence.

In all countries there is an understandable tension between the steps that are needed to kick start the economy and the fact that many of these steps are very expensive and tax payers have a healthy scepticism about spending too much of their money, particularly when it is perceived that some of the money is being spent not on them but on others who they perceive may have helped precipitate the crisis.

So that is always going to be a challenge and what’s also difficult is the fact that the policies we initiate all take time to take effect and by its very nature politics looks for more instantaneous gratification.

But I am confident that the American people, and I think people around the world, are looking to its leaders to lead and that some of the steps we have already taken are starting to bear fruit. We’re seeing glimmers of stabilisation in the economies and we haven’t yet seen…

FT: Glimmers of stabilisation?

Obama: Here in the United States for example, you’re starting to see pockets of stabilisation in the housing market. Our housing plan has led to the lowest interest rates, mortgage rates in a very long time and you are starting to see a huge number of refinancing in the banking sector.

In certain select markets, like the market for auto loans or the market for student loans, Secretary Tim Geithner’s efforts to provide a market for asset-backed securities has helped and so we still have a long way to go, but I am confident that if we are persistent and we don’t approach this with a thought that there is a silver bullet out there but instead are willing to try a range of methods to deliver on the economic growth in jobs that we will get out of this current crisis.

FT: You mentioned the risks and dangers of protectionism. 73 separate measures have been identified by the World Bank since the last G20 summit so what again in practical terms can your administration do at the G20 to stop this - and I’m thinking to whether there are real risks that people worry in Europe a lot about what is going on, on Capitol Hill, with “Buy American” provisions.

Obama: Well first of all I think it’s important to note that here in the United States, despite some protectionist rhetoric and very real economic frustration growing out of the collapse of the financial markets and the huge rise in unemployment that the “Buy American” provision that was in the stimulus package was specifically written that had to be consistent with WTO. That the Mexican trucking provision is now subject to negotiations to ensure that we don’t see an escalating trade war.

I have sent a very clear signal that now is not that time to offer hints of protectionism and I will continue to discourage efforts to close off the US market. I think that in a democracy, there are always going to be some loose ends out there.

That’s true here, that’s true around the world but overall I don’t think that we’ve seen a huge rush to protectionism that that isn’t the rhetoric that is emanating from the leaders that will be gathering in London.

And to the extent that the American people or Europeans or Asians, Africans, Latin Americans all feel confident that their leaders are doing everything that they can to encourage and promote economic [..] and that they have their populations interests at heart, I think we are going to be able to hold the line on any significant slippage.

FT: I wondered Mr President whether you’re concerned that, particularly following the AIG bonus controversy, there’s some danger that confidence that business has in the rule of law in the United States has been shaken and that could hinder some of these recovery measures?

Obama: I think it is a source of concern in some quarters. To the extent that the captains of industry recognise very legitimate frustrations that the American people feel when they read about huge bonuses going to members of firms that are receiving large tax payer bailouts.

I think they can take steps to lessen that danger and I met with some bankers today and it was a constructive conversation but one of the points that I made is that a time when everybody is needing to sacrifice there has to be a similar sense of sacrifice on the part of those various sectors of the economy that helped to precipitate this crisis and to the extent that they’re showing restraint that compensation packages are structured so that there is some deferral until money is returned to tax payers and the economy recovers that will be good for everybody. That will put [...] in a stronger position to help them.

But you know, keep in mind that although there are going to be, I think, emotional reactions to and legitimate grievances around some of these issues, the United States has been the world’s most successful economy precisely because of a long standing respect for legal contracts and orderly transparent and open market operations and that’s not going to change.

FT: Mr President, given the rising tendency to populism on Capitol Hill and elsewhere, do you feel confident that at a time like this you can go to Congress and ask for the kind of backing of capitalisation that most economists say will be required in the near future?

Obama: I think it is very important for us to show that the money that has already been authorised is being well spent. That it is helping to result in loans going to small business and large business that are in turn investing and creating jobs. If voters perceive that it’s a one way street that we are just pouring more and more money into institutions and seeing no return other than avoiding catastrophe then it’s harder to make an argument for further intervention.

If on the other hand people start saying that they can refinance their house, and their child can get a student loan and that small business is able to retain its credit line, so that there is a tangible and meaningful result from our measures, then I think we can win back the confidence of the American public.

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.

Source.

From Roberto Barr, Professor of Economics at Harvard and a Fellow at Stanford University's Hoover Institution

Central questions these days are how severe will the U.S. economic downturn be and how long will it last?

The most serious concern is that the downturn will become something worse than the largest recession of the post-World War II period,1982, when real per capita GDP fell by 3% and the unemployment rate peaked at nearly 11%. Could we even experience a depression, defined as a decline in per-person GDP or consumption by 10% or more?

The U.S. macroeconomy has been so tame for so long that it's impossible to get an accurate reading about depression odds just from the U.S. data. My approach uses long-term data for many countries and takes into account the historical linkages between depressions and stock-market crashes. The research is described in "Stock-Market Crashes and Depressions," a working paper Jose Ursua and I wrote for the National Bureau of Economic Research last month.

The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.

Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870.

Our conjecture was that depressions would be closely connected to stock-market crashes at least in the sense that a crash would signal a substantially increased chance of a depression.

This idea seems to conflict with the oft-repeated 1966 quip from Paul Samuelson that "The stock market has predicted nine of the last five recessions." The line is clever, but it unfairly denigrates the predictive power of stock markets. In fact, knowing that a stock-market crash has occurred sharply raises the odds of depression. And, in reverse, knowing that there is no stock-market crash makes a depression less likely.

Our data reveal 251 stock-market crashes defined as cumulative real returns of -25% or less and 97 depressions. In 71 cases, the timing of a market crash matched up to a depression. For example, the U.S. had a stock-market crash of 55% between 1929-31 and a macroeconomic decline of 25% for 1929-33.

Likewise, Finland had a stock-market crash of 47% for 1989-91 and a macroeconomic fall of 13% for 1989-93. We found that 30 cases where there were both crashes and depressions were also associated with wars. In fact, World War II is the worst macroeconomic event of the period, with strong U.S. wartime economic growth as an outlier.

In the post-World War II period, the Organisation for Economic Co-operation and Development (OECD) countries were strikingly tranquil up to 2008. The worst macroeconomic event in that period came in Finland in the early 1990s. Sweden also faced a financial crisis in the early 1990s, though it reacted quickly and is now being touted as a possible guide for leading the U.S. out of its current economic crisis.

Outside of the OECD, there have been many linked stock-market crashes and depressions since World War II -- including the Latin American debt crisis of the 1980s, Mexico's financial crisis in the mid-1990s, the Asian financial crisis of the late 1990s, and Argentina's financial turbulence that lasted until 2002.

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a "minor depression," macroeconomic decline of 10% or more will occur when there is a stock-market crash.

There is a 9% chance that a "major depression," a fall of 25% or more will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes, our data show the probability is 92%.

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war. The Iraq and Afghanistan conflicts are not comparable to World War I or World War II. Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing.

In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes, 69% for minor depressions and 83% for major ones.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

The bright side of a 20% depression probability is the 80% chance of avoiding a depression. The U.S. had stock-market crashes in 2000-02 by 42% and 1973-74 by 49% and, in each case, experienced only mild recessions. Hence, if we are lucky, the current downturn will also be moderate, though likely worse than the other U.S. post-World War II recessions, including 1982.

In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.

Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions -- including several pursued by Franklin Roosevelt during the Great Depression -- can make things worse.

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Source.

With the Dow Jones Industrial Average below 7,000 at 6,763, the US stock market is well below its early 1995 level, adjusted for changes in nominal GDP. That suggests it’s cheap, if growth prospects are as good as they were back then. The risk, however, is that too much fiscal and budgetary stimulus will bring on growth-stultifying inflation.

On December 5, 1996, the Standard and Poor’s 500 Index closed at 744.38. That evening, Fed Chairman Alan Greenspan decried the market’s “irrational exuberance”. At its March 2, 2009, close of 700.82 S&P 500, the market is clearly exuberant no more.

It is not, however, exceptionally low. Greenspan announced a new easier monetary policy to Congress on February 23, 1995, the day the Dow Jones average, which had been generally rising since 1990, first reached 4,000. Adjusting for the 95% increase in nominal GDP since that time would give an equivalent Dow level today of around 7,800. That suggests that current levels are only somewhat below their long term trend, and that the 1996-2007 period represented a lengthy bubble.

Standard and Poor’s currently projects 2009 earnings on the S&P of $48.10. Over the 20-year period to 2008 the index traded at an average of 19.4 times earnings. That would give a current value of 933.14. That 20-year period however includes the 12-year bubble; taking a longer-term average of around 15 times earnings gives a valuation of 721.5, again, just slightly above the current level.

So, based on 1995 stock prices and long-term earnings considerations the market is just below a middling valuation. However, that assumes US growth and earnings prospects are as good today as they were in 1995, or over the long-term average. That’s where doubts creep in.

If the exceptional monetary stimulus since September produces inflation, which needs to be squeezed out, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 “crowd out” private investment, then growth and earnings prospects for the next few years would be below average.

In that event, the market as it stands today would be overvalued. Bailouts and stimulus can thus produce long-term uncertainty as well as short-term uplift.

Source.

If size is the measure of achievement, then President Barack Obama has outdone every one of his predecessors since Harry Truman. Setting out spending plans for the next decade on Thursday, the administration announced that the US government would run a $1,750bn fiscal deficit this year. Equivalent to 12.3 per cent of gross domestic product, the gap between tax receipts and spending is at its greatest since the second world war.

The ambition inherent in the plans is similarly large – to stimulate the economy out of recession and transform the healthcare system while (and here’s the tricky bit) returning the public finances to a reasonable footing. It is hard to square the last of those, shrinking the fiscal deficit to $533bn by 2013 (then expected to be a mere 3 per cent of GDP), with the rest.

To do so requires the assumption that the economy will return swiftly to 5 per cent nominal growth a year by 2011 and 6 per cent thereafter. Questions about the effectiveness of the current stimulus package aside, the assumption is that such spending will be temporary, with private demand emerging on cue to fill the hole as the economy recovers. The lesson though from Japan’s lost decade is that the economy falters as soon as government support is withdrawn.

Structural changes in the US economy may make this feat even harder. At the peak in 2007, finance contributed fully one-third of domestic corporate profits. Chastened, and soon to be heavily regulated, assumptions for tax revenues based on the recent past are likely to prove optimistic.

It would be remarkable if the gap can be paid for by greater government efficiency and higher taxes purely for the rich. If the president can resurrect the economy and rapidly bring the deficit down at the same time, he may want to try walking on water next.

Source.

Paul Krugman is in his element. The Nobel Prize-winning economist in December put out an updated edition of The Return of Depression Economics, his prescient study from 1999 in which he laid out the risks to nations when recessions spiral into long-term malaise.

Timely reading, indeed, and worth picking up. Krugman was kind enough to expand upon his thoughts regarding President Obama's stimulus package and what changes may be in store for the U.S. and world economies in coming years in an e-mail exchange with Barrons.com.

Barrons.com: What's the stupidest thing you've heard said about the current economic crisis and how to solve it? What's the smartest?

Paul Krugman: The stupidest is a very tough competition; I tend to think of whichever mind-numbingly stupid thing I've just heard, like [U.S. House of Representatives] Minority Leader [John] Boehner's statement that we shouldn't "reward" Fannie and Freddie by increasing their resources (he apparently doesn't understand the meaning of "government owned.") But I guess the statements from many players that the Obama plan is a spending bill, not a stimulus bill -- when spending is the whole point -- top the list.

The smartest thing probably comes from Richard Koo, [chief economist for Japan's Nomura Research Institute, part of Nomura Securities] who was one of the first to point out that this isn't just a housing crisis, or even a banking crisis -- it's a balance sheet crisis.

Barrons.com: You've written that the gap between the economy's potential shortfall in production over the next three years -- $2.9 trillion -- and the $800 billion in economic stimulus is a big problem. Why does this gap between production and bailout matter so much?

Krugman: My big concern here is that the economy digs itself into a deflationary hole, which is what can all too easily happen if you have a large, sustained output gap. Once prices start falling, and people start to expect continuing deflation, the balance sheet problems will become much worse than they already are, and much harder to resolve. Watching that happen in Japan is what led me to write the original, 1999 version of The Return of Depression Economics, and now the same thing is all too possible here.

Barrons.com: What's a worst-case scenario if this stimulus fails to kick-start a recovery, as you've argued?

Krugman: A lost decade or more. I don't think, even now, that we're headed for 20+ percent unemployment, Depression-style. But I can see a strong possibility of an economic and political trap: low investment and high savings thanks to deflation and a depressed economy, with effective government action blocked by a combination of concerns about debt and the widespread belief that we tried stimulus and it didn't work.

Barrons.com: Will the $80 billion in aid to holders of underwater mortgages make a material difference?

Krugman: It depends on the meaning of the word "material." It will help millions of families, and somewhat reduce the financial system's losses. It won't revive the housing market, nor will it end the banks' problems.

Barrons.com: Will we ever become a nation of savers again?

Krugman: Actually, we ARE becoming a nation of savers again -- which is part of the reason GDP is plunging. I think the asset wipeout will have a long-term impact on consumer behavior; remember, we had a 9% savings rate as recently as the 80s.

Barrons.com: There's been a dramatic collapse in asset values in the stock market, as measured by the decline in the P/E of the S&P 500. Do you think asset values will bounce back with an economic recovery, or has there been some fundamental long-term shift in asset values that will linger even after recovery?

Krugman: Believe it or not, housing prices are still above-normal, as measured either by the price-rent ratio or the price-income ratio. So housing prices won't bounce back. As for stocks, when I take [Yale University economist] Bob Shiller's data, which give prices relative to a long trailing average of profits, and update, I get a P/E right now of about 13, not so far from historical norms. So it's not clear how much bounceback we can count on, if any. Maybe the bull market was the aberration.

Barrons.com: You've advocated a stimulus for the U.S. along the lines of the Public Works project during the Depression. Assuming such a thing could produce another economic boom, what are the downside risks to a massive infusion of public money?

Krugman: Well, large-scale government borrowing does pose long-term fiscal risks; the U.S. has substantial room for additional borrowing, but it's not unlimited. Aside from that, I don't see big risks.

Barrons.com: One of the themes you explore in your writing is the notion that world economic relationships can change over the course of decades (e.g., from globalism to nationalism to globalism). What are a couple of the biggest economic changes you see playing out over the next ten years, and what might be their social impact in the U.S. and abroad?

Krugman: I think we're heading for a new regime of financial regulation, which might significantly reduce financial globalization, for both good reasons and bad: the good reason is that a lot of what looked like globalization was actually regulatory arbitrage, the bad reason is that governments that are bailing out financial system will tend to insist that the benefits stay at home. I don't think this will affect most Americans' lives much; but a lot of the highest incomes have come from finance, and the Masters of the Universe will definitely end up less masterful.

We're also, I think, going to see some significant reindustrialization, because the conveyor belt moving Chinese and other funds to America will be slowed if not shut down. This will mean a greater reliance on domestic production.

Mainly, though, how society changes will depend on the political response -- whether this really ends up being a new New Deal or just a slight course correction.

Barrons.com: What great books have you read recently that you can recommend?

Krugman: I just reread a good part of John Maynard Keynes's Essays in Persuasion, especially "The Great Slump of 1930," which is awesomely relevant right now. And while it has nothing much to do with the crisis, I'd highly recommend Dan Koeppel's Banana: The Fate of the Fruit that Changed the World, which tells you a lot about the history of globalization along the way.

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Based on the costs of fiscal stimulus and the bank bailout, the US’ federal government debt to GDP ratio is heading much higher. While other factors are important, that suggests the credit quality of currently top-rated US Treasury debt may trend down. That’s not a complete disaster, but it means Treasuries won’t really be a safe-haven investment either.

Assuming deficit projections by the Congressional Budget Office for the 2009 and 2010 fiscal years are right, and adding in the cost of the stimulus plan, the bank rescue plan and borrowing costs, US public debt would rise from 41% of GDP in September 2008 to about 70% of GDP in September 2011.

After 2011, the US debt-to-GDP ratio is expected to decline again. The CBO projects deficits of less than 2% of GDP after 2012, and the capital injected into the banking system under the government’s bailout plans should start to produce some returns for taxpayers around that time.

There are considerable downside risks. The CBO projections are based on optimistic assumptions: that growth averages 4% annually between 2011-14, that the Bush tax cuts and Alternative Minimum Tax relief all expire in December 2010 and that discretionary spending only increases in line with inflation after 2010.

The falling debt scenario also assumes that none of the expenditures under the stimulus plan migrate into annual spending after 2010. Should the recession deepen, or persist beyond the end of 2010, higher budget deficits could become entrenched. Finally, the projection assumes US interest rates remain low. With Treasury bond maturities now averaging only 48 months, higher interest rates would rapidly feed into higher borrowing costs and budget deficits.

Source.

Léo Apotheker describes himself as a "citizen of the world". Born in 1953, the son of Jewish parents who fled their home on the Polish-Ukrainian border to escape the Nazis in 1942, Mr Apotheker spent his formative years in Germany, Belgium and Israel before finally settling in Paris, where he still lives.

He is co-chief executive of Germany's SAP enterprise software group, a role he will share with Henning Kagermann until Mr Kagermann retires in May. When he takes over, he will be only the third boss of the software giant since it was founded in 1972 and, as someone who has spent most of his working life in sales, its first non-techie leader.

Mr Apotheker has worked for SAP since 1988 and joined the SAP executive board as head of sales in 2002, a job he did while being charged with turning round the US operation, which was haemorrhaging staff and clients who complained that SAP had missed the internet bandwagon.

What has been the impact of the recession on IT spending?

IT spending correlates well with GDP, so like anyone else we have been affected as well. Fortunately, IT has become a very mission-critical part of this world, so IT spending is resilient but it is still affected by the global economy.

Do you worry that this slowdown will hurt innovation, which has been so important for the IT sector?

I hope not. We will continue to focus very much on innovation. It's actually very important to innovate, particularly in hard times, because you might actually find a way out of this crisis through innovation.

You have had to cut jobs. What is it like to do that in a company that has always experienced growth in the past?

It has been a gut-wrenching decision for SAP. We had to make this adjustment because we have always been hiring ahead of the curve, and we had 19 quarters of consecutive double-digit growth.

Will this recession make Europe less innovative?

I think [the recession is being] felt equally around the world. The real question is how do we come out of it? And coming out of it is going to be dependent on the capacity of each part of the world to adjust fast and take the right decisions. In Europe we have a tendency to try to make these things happen in a certain way, which is not necessarily conducive to speed but ensures social stability. I guess you probably have to find a way that tries to balance economic efficiency and social responsibility.

Many on Wall Street see the Lehman bankruptcy as the moment when the recession became a once-in-a-century event. Do you agree?

I would share that opinion. When Lehman was allowed to go bankrupt and AIG was saved at the very last minute the system just froze over . . . I was in Moscow at the time and I could see it happening in real time in front of my eyes. The stock market was closed for three days. They tried to open it a few times and it crashed, so they had to close it again. My meetings with many people became almost tragedies in a sense that people were on the phone during the meeting trying to pay margin calls. You could see it unfold. Yes, Lehman was a watershed event.

Has the use of technology in financial services helped fuel this crisis?

I think technology by definition is neutral. You can do great things with it. You can do horrible things with it, like anything else. It's just technology. The problem was that people started to view money as a virtual thing. When you're a young trader in a bank and the only thing you see is digits on a screen the money becomes, you know, a video game. That's not good. But you can't blame the technology for that - you have to blame the system that allowed people to reason like that.

From a European perspective, is this a Made in America economic disaster?

No. This is a Made in the World disaster. There's no point blaming anyone. I think it's something that will go down in history . . . as a phenomenon of society. We are going to have to learn again that a house is not an ATM machine, and that a mortgage is not a financial instrument or an option, it's something that you have to pay, and that saving money is not a disease.

Is there a danger that this crisis will discredit free-market capitalism?

Well, that discussion is raging as we speak, and I hope we will be able to put some rationality back into the discussion. I think we need to find a fair, reasonable middle ground. Many Europeans can tell you what it means to live under a system that does not have a free market. So, I think a free market with some regulation is probably a very good compromise.

Within Europe, are you worried about beggar-thy-neighbour policies being pursued?

I'm hopeful that we don't come to a point where protectionism is going to take the upper hand, not only within Europe, but in particular in the world at large. Protectionism is a recipe for failure.

Is this a systemic crisis or a short-term one?

I'm not a prophet. I'm a realistic person. I'm trying to adjust to the environment. My personal opinion is that things will probably start to stabilise [in the] second half of 2010. Up to now people have been using a lot of inventory and capacity is being adjusted. That will take some time. In the meantime, the stimulus programmes have been launched but they take some time to trickle down.

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