Future of Finance Conference

March 25, 2009 The Who’s Who of finance descended upon Washington, D.C. Monday for 24 hours of policy
analysis, complete with presentations from Treasury Secretary Tim Geithner, Kevin Rudd
Dr. Sherry Cooper (Prime Minister of Australia), Meredith Whitney (the bank analyst who first called the
Executive Vice
President, demise of Citigroup), Professor Robert Shiller, Larry Summers (Assistant to the President for
Chief Economist Economic policy), Nobel Laureate Myron Scholes, CEO of TIAA-CREF and former Fed
Governor Roger Ferguson, and former Fed Chairman Paul Volcker, among many others.
1-800-613-0205
Assembled were senior leaders in investment banking, commercial banking, hedge funds,
pension funds, derivatives trading, market exchanges and so on. The Wall Street Journal,
sponsor of the by-invitation-only forum, is covering the formal proceedings of the meetings
so I will share some of the informal discussions. Having the opportunity to just chat with
George Soros or Nassim Taleb (of Black Swan fame) as well as with my friend and former
boss, Paul Volcker was fascinating. The cocktail and table chatter confirmed what many of
us are thinking, that no one really knows how and when the crisis will end, but many are
now looking over the valley to the economic and financial risks in the recovery period.

My overall impression is just how concerned many leaders are about the prospects of
forthcoming inflation and a plunge in the dollar. Volcker commented that his hard-
won battle against inflation is at risk if the current Fed is willing to accept inflation rates
that “best foster economic growth and price stability in the longer term”. This is a quote
from the March 18 FOMC press release, taken out of context, that the former Fed
Chairman fears might indicate that the current FOMC is less committed to inflation control
than he feels they should be. The fear is that the Fed would tolerate some inflation to get
the economy going and the debt repaid.

To be sure, the Fed is flooding the system with liquidity; M2 has been growing at a 15%
annual rate in the past three months, and once the velocity of money picks up, the rebound
in economic activity (sooner or later) will lead to inflation. This worry presumes that the Fed
will not or can not reverse the growth in money in sufficient time to preclude this from
happening. Chairman Bernanke, on the other hand, points out that many of the measures
he is currently taking to boost the flow of credit are short-term in nature and that the Fed
can drain reserves when necessary. As well, the Treasury and the Fed believe they can
sterilize their actions (use open-market operations to counteract the effects of loans to
financial institutions or capital injections on the country’s monetary base). Some have even
suggested that the Fed could issue its own bonds to drain liquidity when necessary.
The counter argument is that the Fed will err on the side of easing (for too long) for
macroeconomic reasons, and that with the budget deficit rising explosively, running the
printing presses and allowing a “bit of inflation” makes it easier to repay the debt. Many
point out that it is a natural tendency of over-spending governments to shy away from
sufficiently tight monetary policy to avert or reduce inflation as we saw in the ‘60s and ‘70s.
This is why Volcker is so concerned that if we let the inflation genie out of the bottle, the
degree of tightness required to reverse the process could well be political untenable. It was
Volcker who took the political heat in 1979 through 1982 for driving the economy into
recession to break the back of inflation. (Remember 15% Treasury bills?)

The issue of the dollar is very troubling and is highlighted by China and Russia raising
the prospects of reduced Treasury buying and substitute reserve currencies. Volcker went
as far as to say that we are in a dollar crisis, as well as a credit crisis, banking crisis,
economic crisis, and so on. (However, he also suggested that other currencies are in crisis
as well.) There is a crisis of confidence, and the shocking development that the
financial system is government dependent. The U.S. dollar is falling, undoubtedly
reflecting, at least in part, the excessive spending and borrowing of the government. The
feared inability of the U.S. to finance the debt without much higher interest rates is
underlined by today’s weak five-year Treasury note auction, with a lack of foreign investors
coming to the table. This came after a sale of U.K. government debt Thursday failed. It was
the first failed auction of conventional U.K. government bonds since 1995. If the Treasury
continues to have difficulty funding the deficit, rates will rise returns will fall; even
quantitative easing by the Fed cannot fully offset reduced foreign demand.

Clearly, no one forces China to buy Treasuries, they do so to keep a lid on their own
currency. If they remain unwilling to revalue the renminbi, then they are forced to buy U.S.-
dollar assets. Those purchases could shift more towards real assets, equities or other
dollar-denominated investments. No wonder the Chinese would like to see their currency
pegged to SDRs or another synthetic currency, reducing their need to buy dollars,
presuming the hegemony of the dollar is declining. The Treasury and the Fed are well
aware of these risks. Tim Geithner asserts his belief that the dollar will remain the global
reserve currency.

Judging from these concerns, many of the financial participants seem to take economic
recovery for granted even though they have their doubts about the current bank bailout
programs. I was surprised by an informal vote that showed that most participants (by far)
believe the Public-Private Investment Program (PPIP) to buy legacy assets from troubled
banks will not work as currently devised because banks won’t sell enough of these toxic
assets at prices that private purchasers would offer; these prices, presumably below
current marks, would lead to further write-downs, which require banks to go into the TARP

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for more capital. Some suggested the amortization of the loss or some other capital relief
for banks.

Another issue, the cleavage of Wall Street and Main Street and the resulting rush to
judgment by the House to tax bonuses is a concern. Lynch-mob populism is dangerous.
Larry Summers suggested that the U.S. middle class feels squeezed. They are losing their
jobs, their homes and their wealth and they are angry. In the past, they have directed their
anger downward, resenting that welfare and social assistance programs were available for
the poor but not for them. Ronald Reagan tapped into this sentiment in 1980. Some of that
still exists manifested in the immigration debate. But now, the middle class is also directing
its anger upward, hence the executive compensation furor. There will be a continuing
firestorm towards Wall Street (in its broadest sense) and towards the business elite in
general. (Just last night the home of the CEO of RBS was vandalized.) President Obama
successfully tapped into that sentiment in his campaign. Seeing the danger of the mob, the
President now is quieting his rhetoric. The Senate will provide the sober second look.
House bills often die in the Senate and the recent House bill on an executive compensation
claw back of 90% will likely die a quiet death. One Goldman Sachs executive at the
conference quipped that being paid in stock was claw back enough.

There is no returning to the norm of the past 30 years. While the goal is the return
to fully functioning private credit markets, we are never going back to the credit and
spending excesses of ‘03 and ‘04.

The global imbalances created unsustainable U.S. overspending and

undersaving, financed in large measure by China and the petro-countries of the Middle
East. America is now painfully deleveraging, which portends slower average growth and
lower rates of return in the future. Ultimately, the 30%-to-40% household savings rates in
China will wind down creating a more buoyant domestic buying market there.

Meanwhile, in the U.S. banks must return to banking the old-fashioned way: knowing their
customer, strengthening their underwriting standards and limiting leverage. More lending
will be financed by deposits and fewer loans will be securitized. Nonbank financial
institutions will come under more scrutiny and there will be greater price and volume
transparency and capital and collateral requirements on credit default swaps and other
derivative products. Financial regulatory oversight will be consolidated and reformed.
Consideration will be given to reducing the procyclicality of capital requirements. It looks
like the Fed will be tapped as the Systemic Risk Regulator, although what exactly that
means is uncertain. Paul Volcker believes there should be a commercial-bank centred
approach to regulation and supervision. Commercial banks have a fiduciary responsibility to
serve the public, business and government. Their deposits are guaranteed. The rest of the
financial system falls into the category of capital market institutions, which don’t need as

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tight regulatory oversight because there is no presumption that the government protects
them or their investors. Having said that, though, the nonbank FIs should be monitored
requiring reporting and transparency rather than regulation.

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