OPERATOR:   This is a recording of the Michael Safianik Teleconference with The Atlantic Council of the U.S. scheduled for Wednesday October 29, 2008 at 11:30 a.m. Eastern.

Excuse me everyone, we now have The Atlantic Council President and CEO Fred Kemp, and Financial Times Chief Economic Commenter, Columnist and Associate Publisher Martin Wolf in conference.

Please be aware that each of your lines is in a listen-only mode.  At the conclusion of Mr. Wolf’s presentation, we will open the floor for questions.  At that time, instructions will be given as for the procedure to follow if you would like to ask a question.  You will be asked to
press star one to line up to ask a question.

I would now like to turn the conference over to Mr. Fred Kemp, Atlantic Council President and CEO.  Mr. Kemp will be followed by a presentation from Mr. Wolf.  Mr. Kemp, you may begin.

FRED KEMPE:  Thank you very much Wendy.  It’s my honor to welcome you all to this installment of our Atlantic Council teleconference series.  We launched this series during the Georgian crisis in August as a means of reaching out to our influential Atlantic Council membership directors and friends in a timely fashion to events of particular importance.  The one thing that has happened in the last couple of years at the Atlantic Council is our membership has become increasingly global, and it’s increasing – it’s difficult to put everyone in a room in Washington to talk about these events.  And on top of that, it just takes a lot of logistics for people to take time out of their day to get here.  We found this a very good way to operate.

Our speaker today, and we are continuing it because of the positive response we’ve had from all of you.  Our speaker today is Martin Wolf, Chief Economics Commentator and Associated Editor of The Financial Times.  I’m sure most of you on the phone, probably all of you like myself are regular readers who have been impressed for many years already with Martin’s brilliant insights and often irreverent approach to critical issues.  We were just talking on the phone before you all came on, and I told him not only that he was at the top of his game with this crisis, but in a funny, sad, tragic sort of way, this is the perfect crisis for Martin’s talents.  It really has all the aspects that he writes about best.

So one can honestly say, one receives a regular diet, his rich expertise, original thought that one doesn’t get in so many columns in the press right now, where the expertise is deep and also the originality.  So with that, let me pass the portent.  Martin, now that I’ve set such a high bar for you.  He’ll talk for about 10 minutes or so and then will have question-and-answer.  Martin.

MARTIN WOLF:  Thank you very much.  That’s an impossibly generous opening, so I will ignore it.  It just makes one frightened other ways.

I have been doing a number of presentations recently on what’s going on, how we got here, why it is so bad and so forth, but what I’m going to do now is essentially give the second half of those presentations, which focuses on where we are now.  So, I’m going to ignore how we got here, why it’s such an extraordinary crisis.  I think everybody understands that.  So, I’m going to focus on what’s going to happen now in my view, what are the likely developments in the next year or two in the economy.  Then I’m going to talk about some of the policy implications, which actually I have been discussing the last couple of weeks.  And finally, I’d like to touch on, sort of what are the lessons for the future from the crisis and how we should – whether we should start thinking about that.

So, what is going to happen now?  I should stress that most of what I have to say, you will be familiar with, I’m afraid.  I don’t have so many ideas.  If you’ve read my columns, there will be a fair amount of repetition.  I apologize for that.

So first of all, it seems to me that in the aftermath of Lehman bankruptcy, we were really watching something like Armageddon, when many of the world’s, perhaps most of the world’s premier financial institutions, certainly all those to any degree reliant on markets for funding were increasingly funding a sizable part of their balance sheets overnight.  This was an impossible situation.  And, when they met in Washington, the leaders of the G-7 were really made aware of this, and they took decisive action, really both in the U.S. and Europe, I still think the American plan and the Polson plan is pretty muddled and confused, but it’s got a much better, with a much stronger element of straightforward recapitalization.  I’m not going to talk about the differences in terms across countries, but the commitment of the G-7 countries to recapitalize their institutions, to guarantee at least marginal lending, to provide liquidity generously as say the core banking system.  And, in that sense, we’ve got to where the Japanese were after about eight years within a year, so because the crisis became so incredibly severe.  And by the way, I should say incidentally, much that we may hate it, mark-to-market has accelerated the recognition of the need for recapitalization, for that at least we should be I think grateful.

However, while that’s very important to prevent, what I think what otherwise has been a truly horrendous meltdown of the financial system and within the economy, the recession reports is now working the world economy are incredibly powerful, and in the short term, surely irresistible.  We continue to have largely dysfunctional credit markets, lending is returning very slowly.  You can see this in all sorts of ways.  The flight to safety is still continuing.  You can see this in currency markets, you can see it dramatically in all bond markets, you see it into bank markets, so we still have a very dysfunctional credit system, both short and long term.  The so called shadow banking system, I believe this is a brave invention by Pinco but I may be wrong.  Anyway, the financial system that evolved and became so immensely important outside the conventional banking system responsible for at least half of the intermediation in the U.S. is continuing to implode as far as I can see.  So, credit will remain incredibly tight.

The second associated with that, also to some degree preceding it, asset price collapses have been enormous.  As I had pointed out this morning, we’ve lost about half the value of the global equity markets in the last few months.  This is about $25 trillion from the mark-to-market basis.  The loss in the sort securities, which remain particularly important for core financial institutions, secured high mortgages and so forth, the losses are now about $2.8 trillion, and as the Bank of England financial stability report points out.  So, we’ve got enormous continuing pressure on the banking system and enormous losses on asset markets.  And of course, housing markets are not really continuing to decline but if anything, declining at an accelerated rate everywhere where they are vulnerable, even in the U.S. and of course elsewhere, in Europe, particularly in the UK.

Basically, all risky borrowers now including a vast number of emerging market borrowers and particularly corporate, I was particularly struck by this morning’s chart showing the explosion, an unbelievable explosion upward of interest rates to emerging market corporate who have borrowed quite extensively in many cases in foreign currencies.

And over above these effects, we are seeing also something I’ve long been worried about that the Anglo-Saxon economies, to the English speaking countries in particular would start seeing a rapid rise in household savings when prices hit.  And, given the enormous dependence of demand on household spending in the U.S., household spending is about 70% of GDP, that itself will be enough to trigger a very deep recession.

I noticed that JP Morgan most recently is predicting an annual rate of decline of 4% in this quarter in the U.S.  That looks very plausible to me.  It could well be worth and it’s going to be at least as bad in the UK and possibly even some continental European countries.  The whole developed world is in recession and is going to remain in recession for at least a year or two.

I think that we should expect both deep and probably prolonged recessions in the U.S. and Europe, prolonged above all because there is no locomotive to pull these countries out.  Domestic demand – domestic private demand, both consumption and investment are bound to be week.  There is no external demand that’s going to be strong.  We’re really going to be relying on the fiscal system to a large degree.  I’m going to come to that in a moment.

There are – there is however one really important bit of good news, at least for the developed world and ultimately I think for the world which is collapsing.  Commodity prices, the oil prices which will eliminate the concern about inflation.  It’s basically going to liberate central banks to be very, very aggressive everywhere.  I expect them to be very aggressive everywhere.  It will shift income to consumers, get rid of the squeeze on consumer income that we’ve seen, and that should help support consumer spending in time, but I think given the shock, it’s going to take quite a while for that to filter through.

I’m not suggesting that the works will suffer a lot of decays like Japan.  I think action has been taken relatively quickly and adjustment will be relatively quick, but we could have, it seems to me at least a couple of years which are really very grim.  So, that’s where I think we are for the next couple of years on the basis of what I see.

What are the policy options?  Well, first and most obviously, monetary policy is going to get very aggressive.  I think it’s now overwhelmingly probable that we bend the tool box for the zero bound is going to be used.  It’s going to be very interesting to see it.  I wouldn’t be terribly surprised if the same happened to the UK.  I would be really surprised if we saw it in the euro zone, but interest rates are going to go to incredibly low levels.  And, that’s the first point.

Second point, the governments are supplying the one asset everybody wants and they’re going to go on supplying it.  So, we’re going to have enormous expansion of fiscal – of public sector debt.  This is partly debt for a debt swap, effectively public debt to private debt, but it’s also going to involve enormous fiscal deficit that’s offsetting the move, the whole private sector of the developed world into circulars.  And, that move is well underway.

There is going to be a need, and I think we’re at just the beginning of this, for a very generous finance of a lot of emerging economies which are in this situation.  All the vulnerable ones are going to be in great difficulty, particularly Central and Eastern Europe. I think some are rushing to the euro or trying to for that reason.

It’s very important but it probably won’t happen for the surplus, the surplus countries to increase their spending.  In the case of oil surplus countries, of course they are going to lose income, so it’s less of a big problem, but the – it would be really wonderful if China realized what effect this is and started taking very, very serious action now to expand demand.  The same should be happening in Japan.  It should be happening in Germany.  These are the huge surplus countries in the world.  I don’t expect it to.  It’s one of the reasons I’m concerned about the depths of the recession.

Two more issues which I think are very important which I’d like to mention.  Restructuring the balance sheets of households, very many of whom are going to be effectively bankrupt, and of course, restructuring the balance sheets of intermediaries that are non-bank intermediaries.  We’re not going to say.  That’s a very big issue in seems to be the U.S. to get these institutions restructured and back in business as quickly as possible.  And, there’s going to be a big issue about frankly compelled banks to lend in return to government money.

Now finally, just – I know I’ve run through time so I will just say this very quickly.  It’s obvious that this crisis raises profound questions for the future about the international machinery, the role of international institutions, the size of the IMF and its lending capacity, about the management of global imbalances, about the regulation and capitalization of banks, and indeed the structure of the banking system.  All of this is going to have to be considered.  The only point I would make now, I’ve been trying to make in the last two weeks is, first we’ve got to get through this.  Second, it really is too soon to tell, it seems to me, how deep those reforms will be determined in very large measure by how deep the crisis now turns out to be.  A lot of the thinking there was a few months ago about regulatory reform and the financial stability forum seems to me, at least in part, neither here or there.  It was tinkering with a model that now looks to me hopelessly exploded in many different directions.

So, I think we’ve just got to get through this and then we’ve got to – as we are getting through it, I’m confident we’re getting through it, we’re going to have to settle down and say, well, how different should the global institutions environment be?  And, how differently should the financial system be structured to at least avoid a return of this sort of thing with a single future?  I actually have to say, I suspect this is a once in a lifetime event for the simple reason that nobody who has been through it will ever want to see anything like this again, and experiences itself will be the best protection against the repetition anytime soon.

So, that’s all I have to say as opening remarks.

FRED KEMP:  Thank you Martin.  I’m going to pass – I think we have a couple of people lined up to ask – I have my own questions as well, but let me hold that in reserve and compliment what’s coming from others first.  So, let me go back to the operator.

OPERATOR:  At this time, we will open the floor for questions.  If you would like to ask a question, please press the star key followed by the one key on your touchtone phone now.  Questions will be taken in the order in which they are received.  If at any time, you would like to remove yourself from the question in queue, press star two.

FRED KEMPE:  And, let me just say that Martin, like all good commentators has been talking on the record, which means you can tell all your friends whatever he says and tell them he said at The Atlantic Council.  But, if at any point, Martin, you do want to say something sensitive that you would rather not put on the record, just go ahead and say it.  We’ve been very fortunate in these calls not to have any confidence broken.

OPERATOR:  Our first question comes from Jacob Frenkle of AIG.

JACOB FRENKLE:  Hello Martin and thank you.  Am I connected?

MARTIN WOLF:  Yes, I can hear you.

JACOB FRENKLE:  Okay.  First, thank you very much for your remarks, wisest ever.  When you started by saying that you really preferred today not to talk about how we came to where we are and how we are going to solve the long-term problems, I can see the rationale but I’m a bit concerned, because as you know and as you have argued, some of our problems today emanate from completely blacked of imbalances that have been working in the system for long times.  And, the question is, if the solutions in quotation mark will generate further imbalances, how are we going to plant the seeds for the next crisis?  And let me just pose it in a bit of a different way.  In your previous book, which is really, I recommend to everyone, Why Globalization Works by Martin Wolf, you say in the process that, and I quote, the problem today is not that there is too much globalization, but that there is far too little.  And I agree with you, and you say that what we need is in quotation, more cooperative global governments.

Now you know, we’re going to have a conference next month in Washington.  Whether you want it or not, they will discuss the system beyond the short term solutions, and this call for the new route is in the air.  I think it would be worthwhile to highlight some of the principles that should drive such a conference beyond the extinction of the existing file.  Thank you.

MARTIN WOLF:   Do you want me to respond to that now Fred?

FRED KEMPE:  Yes.  Let’s take them one by one.

MARTIN WOLF:  Okay.  I mean, it really was lack of time, 10 minutes is a very short period Jacob, as of course you know very well, not lack of interest in these issues.

Let me make just two sort of comments.  First, you know, I agree very passionately with this view.  As you also know and perhaps some of you know, I very recently published a book called Fixing Global Finance, which is really largely about the role of global imbalances and the savings surpluses of many large countries in generating these very strange conditions, because effectively I’ve written in many different ways, the only way the world has actually practiced bound to use these vast saving surpluses in the last eight, six, seven years has been to encourage extraordinary household borrowing booms in a very small number of countries, all of which had huge housing bubbles.  So, about two thirds of the world surpluses have been absorbed back to about four countries, the U.S., UK, Australia and Spain, all of which had huge housing bubbles.  And basically, all of which to a greater or less extent now hit very significant house price collapses and debt problems, both particularly in the U.S. in the UK  It’s pretty obvious, this is an unsustainable way to run the world system and it creates very profound questions for those of us who want an integrated global capital market.

The fundamental point, I think that I was trying to make and that I would make is that, what you would want to see is excess savings go into investment, not into consumption, and ideally, they should go into the countries which have the best investment opportunity.  It so happens instead that many of the countries, and above all China, with exceptional investment opportunities are also savings surplus countries in significant measure, I think, but precautionary reasons, they’re worried about the consequences of importing capital.  This is a fundamental issue I address in my book.  And, if we don’t fix that problem, I’m not sure that this sort of integrated global capital market would prove sustainable at all.

Conceptually – and that’s the first one.  The second point is, well, what might one do about it?  Conceptually, one could think of one way out as being essentially to encourage people to pursue policies, which ensure pretty close to current account balance.  One can envision what those policies might look like.  Certainly, they would not include the scale of foreign currency intervention we’ve seen to keep exchange rates down, but they would have to go probably a long way beyond just having floating currencies.  One would actually have to think about the structure of savings and investment in the economies, and would probably demand really quite active government policies to deal with these sorts of excess savings positions.

The – an alternative way of thinking about it, these are not mutually exclusive, does bring us back to the IMF.  I argue in my book that one of the reasons that so many countries, other than the oil exporters, have a very good reason for saving a lot.  One of the reasons they saved a lot, and this doesn’t apply just to China, is essentially that the great many countries decided that they needed to self-insure because the risks are becoming substantial importers of capital, had proven so large in so many emerging markets crisis in the 80’s and 90’s.  They came to mistrust the IMF, they’ve mistrusted its conditionality, they thought it had inadequate funding, they never wanted to rely on it again.  So, they went into this massive self-insurance program.

Now, there are two ways one can envision getting out of this.  At one is to say, well, the self-insurance is now adequate, so policy can change and wouldn’t allow liberalization of various kinds, which would reduce the surpluses.  All you can say, and I think this is very relevant to rethinking the global order that the IMF and self has to be made a much more credible credit collective insurance arrangement, which means that – which is very much close to what John McCain wanted.  They will be much larger than what it is now, and a great deal of its lending would be much less conditional.  So, in the present circumstances, that would imply an IMF, which would simply cement many emerging economies through the crisis without heavy conditionality.  That might again encourage countries to be more relaxed about running deficits than they’re now likely to be.

On alternative way of thinking about this, which I discuss in my book is further developments of local currency bond financing and equity financing, which eliminates the incredible dangers associated with large scale foreign currency borrowing and currency mismatches when currencies collapse, recipe for mass bankruptcy.

But, the essential point that Jacob is making is, I think is really important.  That it does seem that we have got a very unfortunate and as it turns out, with the case unsustainable sort of way of disposing of excess savings in the world, and right now today, it has implications because if it seems likely, the countries that have been borrowing so much are now going to cut back dramatically on their borrowing, because savings are going to rise, household savings only partly offset by fiscal deficits, of increased fiscal deficits.  Then, if there isn’t an offset to that, a sort of spontaneous offset to that somewhere in the world, we can expect a cumulative global recession, and that would be sort of the worst possible outcome.

So, if they start thinking about these questions and what sort of institutional arrangements we need to encourage a more stable transfer of capital across the world towards countries with good investment opportunities, then that will be incredibly desirable.  But it seems to me, and this is my very last comment, that the ground has not really been prepared for that discussion, that policy makers aren’t really thinking about that discussion, at least not coherently, and therefore it is very unlikely that anything useful will come out in the next month or so on these topics.

FRED KEMPE:  Thank you Martin.  Let me just throw in one question before we go back to the queue.  Since you touched on in your opening comments, the question of surplus countries, I know you are an economist but perhaps I’ll ask something that’s geopolitical.  You’ve read and all the talk about the rise of authoritarian and capitalism, this financial crisis, does it accelerate this trend because we are the Atlantic Council?  What does this do to U.S., European economic leadership going forward?  Could this be an inflection point?  Not just economically, but also geopolitically?

MARTIN WOLF:  Well, I’m sure you’ve all read, if you have not I recommend the column in The Financial Times this morning.  Further as it were, heralding the arrival of the Asian century and praising Asian stability, and certainly the Asians are at this time bystanders to some considerable degree, so though they are all of course going to be significantly affected by it.

The way I report this is something like this.  The credibility of the West economic and financial model, and particularly the U.S. model, after all, the hegemonic Western power and the one that has been most forward in sort of presenting the liberal market model, the credibility of that is obviously self evidently very, very seriously damaged and, in many many different dimensions.  That seems to me completely obvious.  And also, that this array in the U.S. will itself reduce U.S. credibility as the leader.  So, the damage is clear.

At the same time, I would stress something that I’ve been thinking about writing but I haven’t gotten around to, that the – the circle of authoritarian capitalists do not offer a model of the global economy at all.  They have no global economic vision of how that might work, different it seems to me from broadly what we have.

Second, they’re all incredibly deeply concerned with domestic challenges, which are overwhelmingly large, which will continue to require all of their attention.

And third and most important, it is actually in their interest, and I think most of them and above all China clearly recognizes in their interest to have a reasonably successful, prosperous West with a reasonably successful and prosperous world economy.  So, while clearly the West position has weakened in many respects, and for the U.S. position, it’s not as if there is either at the level of ideas or the level of power a replacement, or as the rest of the people who really matter in this context, the other big economic powers on the rise want to see a world in which the West collapses.  It’s far from it and it’s the last thing they want, and it should of course be remembered that while China and perhaps Russia could be described in this capitalist mode, authoritarian capitalist mode, the other great rising power is a completely different kettle of fish.

So anyway, my idea is we should not worry too much about these geopolitical rivalries, because I don’t think they are fundamentally replacements at all.  We should just focus as far as we can on getting our own houses back in order and creating a global system in collaboration with these countries, it’s clearly necessary, which will work better for all of us.

FRED KEMPE:  Thank you Martin.  Let me go back to the questions.  And, anyone on the phone who is dying to ask something, please follow the operators instructions to do so.

OPERATOR:  Again, if you would like to ask a question, press the star key followed by the one key on your touchtone phone.  The next question comes from Hector Schamis of American University.

HECTOR SCHAMIS:  What do I have to do, press the star key?

FRED KEMPE:  No, you’re okay.

HECTOR SCHAMIS:  I’m okay.  Thank you.  Thank you so much.  Nice being here.  I have a question regarding the issue of the IMF.  The conversation of course reminded me of Charles Steimelberger, who we should be reading these days again, and the issue of the restructure in the IMF which appears to be essential.  Basically, the question of the pay of last resort, that the U.S. has allowed the IMF to exist in function.  Could you comment on that issue in light of the idea of restructuring the IMF, given the current difficulties of the U.S. as the payer of last resort?

MARTIN WOLF:  Well, I think we probably have to define two separate things.  First of all, I think actually interestingly, the way this crisis has evolved, has in many ways reemphasized and to some degree, to my surprise, the centrality of the U.S. dollar as a currency.  In fact, I’ve been quite fascinated by the combination of rising dollars, the rising dollar and the falling long-term treasury bond yields at the time when the U.S. is the epicenter of crisis, and what it underlines is that when things go really badly, lots of people want to go the U.S., even if the U.S. is why, at least in part when things are going so badly.  Of course, there are other more technical reasons to do with the imploding which explain these developments, but I think the – we still live in a world in which, and I think this crisis has reestablished that beyond any question, the U.S. is absolutely central for both good and ill.  It has established a principle that nobody can decouple from the U.S. economy in any way, and nobody plausible, and that the American currency and economy is the central currency and economy of course.  The euro down is quite significant, the euro is a very significant currency.  There is sort of a degree of choice here, but it’s not as if the euro zone has been able to – in any way escape this sound turn, and nor is it the case that the euro looks in any way a real replacement, still less the currencies of the rest of the world which are in many cases, after all not even freely tradable.

I mean, China’s currency strength comes ultimately from its holdings of dollars, an asset which the U.S. is actually able to print.  So, the Chinese are working incredibly hard to earn something that the U.S. is able simply to create by a stroke of a pen.  It’s not the position of strength but in important ways, a position of weakness.

So that is, what I think of as the global monetary system in its essence seems still to have many of the features that it’s had really since the 1920’s.  The U.S. remains the core of the core.

Now the second question, which is associated with that is obviously what is the IMF for?  Well, again, this reminds us that the IMF can only work by being able to lend countries the currencies everybody wants, and the currencies everybody wants continue to be essentially the currencies of the G-7, or really I suppose the G-4 or three, or not three or whatever.  Mainly, the major hard currencies of the world, particularly the dollar and euro and yen.  These are the currencies that the IMF needs in order to lend and of course other currencies in smaller quantities, and the IMF really only functions because it has access to those currencies, but unfortunately at the moment in grossly inadequate scale.  And, the total usable funds of the IMF at the moment seem to be about $260 billion.  This is smaller than the foreign currency reserves of a very large number of emerging countries.  It’s really almost irrelevant to anything except second and third tier emerging countries.  No large one could really be saved anymore.  So, we’ve got a grossly inadequate IMF in terms of its insurance properties, collective insurance properties.  It’s almost irrelevant, and it’s not completely so, but many small countries, it’s going to be very, very important as of the limit to what it can do.  It could only do 15 Ukraine’s scale operations, let alone what it would do with a bigger country.

Now, that really has to be rethought, that really has to be rethought after the surveillance function of the IMF, and of course the way in which we bring the rising powers against China into the global discussion.  Those are very big issues there.  But, I think the core point is, to take away from the crisis so far is that we have seen a gain, though in a rather negative way, a powerful reassertion of American centrality and in general, Western centrality as well.

FRED KEMPE:  Ironically, one can almost add to that.  Next question?

OPERATOR:  Our next question comes from Roger Hamberg of Indiana University.

ROGER HAMBERG:  Yes.  I’m probably the one distaffed member of this panel.  I am a retired political science professor who is quickly cramming in economics, and I want to ask Martin a couple of things he alluded to.  The United States keeps being victimized by a credit bubble, the dot com bubble, this bubble, that bubble, and part of that I think is very much generational, and frankly, your comment that people need to save more than the short run, that won’t be good.  What seems to be good for the individual is bad for the macro economy and vice versa.  You mentioned two thirds, 70% is based on consumer spending.  That concerns me.

The other question I think that you raised is important.  I also follow Russian stuff very closely, and I’m not surprised that even Russia is having to bail out Russian millionaires, and I sent an e-mail yesterday, we are all in the same boat.  Russians, Chinese and I believe they understand geopolitical rivalries.  I think it’s an important point, and your point about the centrality of the United States as part of the global economy is essential, and I say this as we face a presidential election in this country in less than a week.

MARTIN WOLF:  Well, we certainly agree on the second point, so I don’t need to add more.  I’ve already spoken a lot about this issue.

On the savings points, and be careful what you wish, it might happen is what comes to mind.  What I’d always been worried about, and I feel I’ve been banging on about this for so many years that it’s became tedious, is that at some moment, completely unpredictable, what seemed to me evidently unsustainable behavior by households in the U.S. and the UK in particular, but also in some other developed countries, would change as it were on a dime.  Instead of being, as I hoped and I constantly say this, smoothly adjusted to more normal levels, these huge financial deficits would instead disappear overnight.  By the way, that’s exactly what’s happening in the U.S.  In the last quarter for which we have information, the second quarter of 2008, the financial deficit of the U.S. household sector just disappeared with a massive shift over in one quarter.

Now, in the long run, nobody would deny that the national savings rate, gross national savings rate and net savings rate, and for that matter, household savings rate, thought that’s just as important of the English-speaking countries, particularly the U.S. and UK needed to rise dramatically if we are to sustain prosperity in the long run, and that’s particularly true as we’re going to export mode, because the export sectors, specifically manufacturing are more capital intensive.  We need more investment.

The trouble is, if these shifts occur very quickly, we get into a tainted sort of world.  It’s not offset in some other way, this is the cycle paradox of thrift, and I think that’s where we are now.  The household sectors are adjusting very quickly.  Inevitably, that always affects corporate investment and corporations will not invest more when demand is collapsing around them.  That’s the last thing they will do.  And so, these huge economies, and I’d like to remind you that the economy with this sort of excess spending pattern and define accounting for well over the third of world GDP, about 35, 36% of world GDP at market prices, much bigger than the emerging economies.

This is going to tip the world into a massive slowdown, unless offsets firmly elsewhere, and I just don’t see where the offsets are coming from.  To one stage, I hope some of the euro zone and some of Japan, which in aggregate almost as big would offset it. That’s clearly not going to happen.  On the contrary, the reverse will happen.  And, most of the emerging economies are going the same way, because the financial crisis is so bad, but the private sectors in these economies, particularly the over-borrowed ones, you’ve talked about that, that leaves us with very little chance of an offset.  That’s why we’re going to have this massive decline.

It’s a great pity that this adjustment now looks as though it’s going to occur overnight as its were, but the credit crisis along with all the other sources, the collapsing asset prices, the collapsing – the incredible destruction of wealth we are seeing, perceived wealth by households, the loss of their housing wealth, the loss of their equity wealth, the loss of their pension is bound to create a massive slowdown, and the real issue to my mind, I mean, I never expected to say this but it’s what I have been writing about is not whether we’ll have a recession.

FRED KEMPE:  We’ll go back to the operator for questions.

OPERATOR:  Again, if you would like to ask a question, press the star key followed by the one key on your touchtone phone now.  Our next question comes from James Joyner with The Atlantic Council.

JAMES JOYNER:  Yes.  We’ve been talking at the global level and at the macroeconomic level, I wonder if we can sort of get it down to the level of Joe the Plummer, who is of course, you know, the most important American at the moment.  And, what strikes me is about 30 odd years ago, Jimmy Carter introduced this, it’s a concept called the misery index, which was obtained by adding the inflation rate, the unemployment rate and the prime interest rate, and as a sort of a measure of how individuals were doing in the economy.  And, it strikes me that the inflation rate is low and getting lower by your prediction, interest rates are low and going to get lower by your predictions, unemployment rates, at least in the States are low by historic measures.  Is the misery index just not an important indicator anymore?  Or, will this have relatively little impact on, sort of the individual level economic of sense?

MARTIN WOLF:  That’s a very interesting question.  We had very similar indices here in the UK  I wasn’t prepared to say where they were invented first.  You’re absolutely right, that inflation is low, at least at the moment, though one can imagine medium to long-term inflation risks associated with the way we deal with this crisis.  The unemployment rate is going to rise, and I would be very surprised in the U.S. and UK, which have relatively flexible labor markets is the unemployment rate didn’t rise very quickly.  So, a year from now or two years from now, we will be looking at a very different unemployment environment.

Maybe we should add a third element, I’m not going to go any further, in the misery index nowadays, because one of the changes from the counter era is, there was in the intervening period, an enormous increase in private sector wealth, household wealth held principally in equities and more recently in appreciated housing, and this increase was absolutely gigantic, many, many trillions of dollars.  And, as the countries have aged, a very significant proportion of the population, the baby boom is my generation, expected to retire on all this.  They were looking forward to actually – until quite recently to a relatively prosperous retirement on this, and then as somebody pointed out, we’ve gone through one bubble and enough to know that how the equity market bubble burst, it was a recovery but it’s now way back below in real terms, where it was in, you know, it’s about the 95 levels, I think in real terms, the stock market perhaps lower than that now.  The housing markets, you know.

So, I would add another element to the misery index, which is sort of wealth lost.  Now, it may seem notional in a way but I think that notion of wealth meant a lot to the people who were about to retire in aging societies.  And, I would suspect that if we understand misery properly in terms of disappointed expectations, there is plenty of misery around and I think that will be shown in the world, I may turn out to be utterly wrong, in the elections which are due very soon in the States.  At least on the basis of what I’m reading about those elections.

FRED KEMPE:  Thank you Martin.  Let me ask you a last question and then we’ll wrap up.  We keep it a tight 45 minutes for people during this time, so that we can do this more often.  China, we watched what the U.S. did through all of this.  We watched the late Sunday night action of the Europeans, which was also critical.  It’s been harder to read the way the Chinese are playing this crisis, and the way they are stepping and the way they are viewing it, both in terms of their action and in terms of their policy.  Can you – do you have some insight into that?  And how are you reading this right now?  Also seeing when Wen Jiabao with Putin on your front page today.

MARTIN WOLF:  Yes.  I’ve actually been in correspondence with a very good friend of mine who is generally very well-informed, and we’ve been asking each other this same question.  I haven’t been to China for a while and I’m not going to until December, so I haven’t spent much time talking to people who are involved in this.  So, any remarks I make are second or third hand, and therefore not in any way to be relied upon.  I think there are two points generally about the Chinese government, with the present Chinese government.  They are very deliberate and they don’t make decisions very quickly, and they think that they, you know, they feel that in general they are the winner in the sense that the economy has been going pretty well.  The problems they have have been manageable, and the right thing is not to change things in any fundamental way.  I think these are sort of two basic features about the system.

And, it is important then if we look out where they are now, that only a month or two ago, maybe three months ago, their main concern was inflation.  So suddenly, in September, that presented with what something that looks a completely different sort of problem from the one they thought they were having to deal with, so they are going to have to reorient themselves.  My guess therefore is at the moment, they have not made fundamental – I’ve been tweaking at the margins, quite clear that they’ve changed their view of the margin on the balance with inflation and recessional slowed down, not recession in China.  They’ve changed their view on this, but this is tweaking at the margin.

So my guess is that what we are going to see instead is a process something like this.  First, I believe that the Chinese will be surprised by how much their economy is affected by the global slowdown, and particularly their exports, net export.  That may turn out to be wrong and so they won’t do very much.  But, if it turns out that they are significantly affected by what’s happening in the world economy, they will then notice that it’s affecting domestic investment as well, and that growth is slowing quite significantly.  More than they want and more than they expected.  Once they realize that, they will change policy, but within the framework we are very familiar with, that is to say, they were going for a whole range of similar programs, mostly with fiscal kind and public investment and various other things of that kind, there won’t be any fundamental policy changes, fundamental reorientation towards domestic demand with associated real appreciation of exchange rate, it’s not going to happen, far from it.  All the evidence is they want to resist that.  So, I expect adjustments at the margin to their policy mix in response, probably a bit too little and too late, and nothing fundamental, at least unless they get into a really big friction with the – really big friction with the developed world.

Now, it is possible that that sort of response combined with a new administration, Democratic president, Democratic Congress, and a year from now, the U.S. is in a very deep recession with little sign of recovery, and still an enormous trade deficit, possibly even increasing as a result of the rising dollar, and the slowing in the rest of the world, then in that context, slow adjustment in China could lead to absolutely enormous friction between these countries.

And, that’s one of the, sort of one of quite a large number of geopolitical dangers, geopolitical economic dangers if this challenge, this enormous challenge is not handled well.  So, I’m concerned that the Chinese will remain internally focused, focused on their model that works, focused on doing as little as possible to shake this, and they will find that the external environment has become the unfriendly politically and economically much more quickly than they imagined with possibly very serious consequences.

FRED KEMPE:  Martin, thank you very much.  You closed with this provocative and insightful statement which – as you opened with.  And so, thank you so much for taking the time out of what I know is an incredibly busy day for you.  Because we can’t applaud over a closed line, I am hearing the applause of the people on the line for your comments, and they are thanks to you.  So, let me thank you on their behalf as well and welcome all of you on the line back to our next conference call.  We’re going to focus obviously on this global financial crisis for some time in these calls.  Martin, thank you so much.

MARTIN WOLF:  It was a pleasure.  Very interesting and enjoyable.  Thank you.  Bye-bye

FRED KEMPE:  Bye bye.