A conversation with the Stanford University Economics Professor.

Question: Why did the asset inflation created by the Fed occur primarily in housing? (Jeffrey Friedman, Causes of the Crisis)

John Taylor: You know, the thing about monetary policy is, just to get to your question about why asset prices were the place where some of the stresses took place, you never know exactly where the impact will take place, sometimes it's in broad measures of inflation, sometimes it's certain sectors first. Energy has been a common place where price pressures first build up. In this case, a lot of them were more in the housing market. I think that was because we already had the beginning of a housing boom going. So in a sense what the low interest rates did was accelerate that. Plus, of course, with the adjustable rate mortgages around and available, though very low interest rate enabled there to be more teaser rates, more very low starting rates, and so that added to the housing boom itself.

As you know, during this period, there was a big increase in the fraction of mortgages that came through the adjustable rate, and so those extra low interest rates affected things there.

But you also had general increase in inflation during this period. It was creeping up each year, 2002, 2003, 2004, 2005, and the acceleration of the housing boom was on top of that.

Question: Is it better to have price level targeting or inflation targeting in a liquidity trap? (Scott Sumner, The Money Illusion)

John Taylor: I think the distinction between price level targeting and inflation targeting, which has had a huge amount of attention in the academic literature and has been referred to in the past, such as Ben Bernanke before he became Chairman. I think those distinctions in practice get blurred by the realities, quite frankly. It of course would be good to have a price level targeting other things equal that would sometimes require deflation, however, and a lot of evidence that that's not such a good thing to have; even occasionally.

So, I've always been of the view that an inflation target makes more sense, it's easier for people to understand, we've had a lot of practice with it. And while there is this problem of lack of a drift, the drift of the price levels sometimes called base drift, overall seems to me if we were able to keep the inflation rate at a very low level, then we would effectively get similar results to price level targeting.

Question: Should the Fed have been more aggressive with monetary stimulus in September-November 2008? (Scott Sumner, The Money Illusion)

John Taylor: I think the Fed cut interest rates during that period just about right. I think it was basically coming down, it could have been a little faster at that point, and of course, GDP did fall tremendously. But I think if they had kept the interest rates along the same path it would have been fine. The problems I see at that period was the tremendous amount of uncertainty added by these new effects, if you like, the quantitative ease, and sometimes I've called somewhat **** mundustrial policy to where the actions went well beyond the usual interest rates. And I don't think they were appropriate. We're still studying them. Some of them were inappropriate. I just finished a study on mortgage interest rates.

So, the question about whether the policy could have been even easier going into the panic, it is certainly something to examine, but I think basically, it's about all it could do at that point. The problems I saw were not so much a monetary policy at that stage, but the really ad hoc chaotic interventions that occurred around the time of the rollout of the TARP, not clear kind of actions with respect to what happened to Lehman Brothers. So, a lot of surprises and ultimately a lot of panic. And I think that panic was induced as I've argued in other places by government actions. I think some of the actions of the Fed after the panic began were constructive to be sure. But I don't see that in terms of a faster reduction in interest rates.

In fact, if I could just add. One thing I think people should recognize is that while the federal funds rate target of the FOMC came down gradually in the fall of 2008, the actual rate came down quite a bit more rapidly. In fact, each of the FOMC decisions effectively ratified what the rate was already at. And that rate came down so rapidly because of the large expansion in the reserves. So, it's hard to see how measured in terms of interest rates policy could be much easier in the October, November, December period.

Question : What is your view on the validity of the 10-plus year projections that the CBO provides?

John Taylor: Well, I was on the CBO Advisory Board for several years, so I have thought a lot about that question about how accurate the CBO projections are over time. I think they do a reasonable job. Of course, focus first on what's happening on the labor force and those growths are relatively easy to forecast that because you know what the population is going to be. The more difficult part of course, is projecting productivity and that's effectively a crap shoot. It's very hard to project it accurately. I think they do as good a job as anyone. But you also have to realize that any long-term projection like that is subject to a tremendous amount of uncertainty. I think basically, what you have to do is take that uncertainty into account.

Now the CBO of course projects much more than ten years they're projecting out many decades in order to get estimates of the cost of the unfunded liabilities. Those are even more uncertain. Frequently they are too optimistic. I think you have to watch for that, but I wouldn't have a general complaint about long-term CBO forecasts, it seems to me their about as best as you can and they're really not challenged much in one direction either way.

Question: What are three things California should do to fix the economy? (Dan Indiviglio, The Atlantic Business Channel)

John Taylor: Three things California should do to fix its economy. I think first you've got to recognize, California has enormous potential. It has -- it's a great environment, it's very open to new ideas; Silicon Valley. It's got great universities; both the University of California and the private universities. So, the potential is tremendous.

What we really need to do in California is to deal with the serious budget problem, which means spending grows too much, and then taxes rise and that tends to drive out businesses and ultimately is harmful to the state. So, I'd say number one in terms of the question is put some limit on the growth of spending; population growth plus inflation is one way to do it. That would prevent the ups and downs, and the deficit spending usually rises when the tax revenues rise and then tax revenues fall off and you've got this huge deficit. So, control the growth of spending is number one.

Number two, put in some tax reforms that prevent the ups and downs in revenues to be so great. And here we've got a huge cyclical performance in tax revenues. So, I would adopt some of the proposals of the recent California Tax Commission that Governor Schwarzenegger introduced.

And third, education; K-12 it’s slipping in California. I think it's not a matter of spending; a lot is spent in California. It's really demanding more accountability. I'd like to see a program where there's more for teachers and less for administration. I think that would do a lot of good.

Question: Do you think the Federal Reserve Board should target asset bubbles like the asset bubble? (Dean Baker, Beat the Press)

John Taylor: No, I don't think they should target bubbles like that. The impacts of monetary policy occur with long variable lags as Norton Friedman showed many years ago and we've seen a lot of evidence of timing to deal with bubbles leave a lot to be desired. But more important, I don't think that has been the problem with respect to monetary policy. Certainly not in this serious crisis. I think to have the interest rates too low for too long in the 2002, 2003, 2004 period was really effectively inducing a lot of the bubbles and asset prices, especially housing.

So, if interest rates were higher, closer to what they would have been under the policy followed in most of the '80's and '90's, then I think we wouldn't have had nearly as much as a boom and bust problem. Not as much of a bubble as we had. So until policy can stop preventing bubbles; it seems to me that’s the number one priority, and the fact that people think they are some how possible to bust them, it seems to me that is not really feasible, and let's get back to the policies of really most of the '80's and '90's that was working without serious bubbles. The bubble problem, the housing problem, this crisis occurred primarily because of policy getting off track, let's get it on track first and then worry about the bubbles.

I think the bubbles will be must less of a problem. They're not going to disappear of course, but much less of a problem if monetary policy followed the kind of actions we had through much of the '80's and '90's.

 Question: Would you advocate an aggressive strategy of quantitative easing? (Dean Baker, Beat the Press)

John Taylor: Well, the question is; given that the Taylor Rule has large negative interest rates right now, would I want more quantitative easing? First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.

So, the question is a good one, and I'm glad it was asked because there is a lot I think, of misinformation out there about what the Taylor Rule says. The Taylor Rule is very simple, as I just mentioned. You can say it in a sentence and you plug in the numbers, you don't get minus five, minus six percent. You get something much closer to zero where the interest rate is now. Now, that of course has implications going down the road because it says, to the extent that real GDP picks up; I hope it does, or if inflation picks up; hope it doesn't. But if either of those occur, then you'd have to see interest rates starting to move above the zero to 25 basis point range. And if we don't then we're going to be back in the same kind of situation we were in 2002 through 2004, and that of course could begin to induce bubbles and we certainly don't want that to happen.

Question: Would quantitative easing speed the recovery? (Mark Thoma, Economist’s View)  

John Taylor: No. I don't think quantitative easing at this point would effectively smooth the recovery. I think right now, based on historical experience, the interest rate is about where it is, it's not that we don't need a lot of quantitative easing. We've had some and I think the job of the Fed now is to bring it back. They're talking about doing that, which is good. But I think, for me, the most important thing now for policy to have a good recover is to reduce this tremendous amount of uncertainty that exists with both monetary policy and fiscal policy and the uncertainty for monetary policy is, we don't know how rapidly the quantitative easing will be reversed. We don't know what's going to happen with interest rates. There is a lot of questions there. So I’d say, get back to the things that were working during the great moderation period, the '80's and '90's primarily, and that means letting interest rates rise appropriately and reducing the amount of quantitative easing; getting back to where it was through most of policy of the '80's and '90's.

Question: What is the most important unresolved question in monetary economics? (Mark Thoma, Economist’s View)

John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford; Girly and Shaw. A lot of it done by Tobin at Yale, Ben Bernacke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by Monica Busasy[ph] and some of her colleagues, that combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?

This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.

So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.

Question: How important is Fed independence? (Mark Thoma, Economist’s View)

John Taylor: I think we need to have both independence and accountability. They go together. It's not one or the other. So, in answer to the question, how important is Fed independence? I say it is very important, but it needs to be matched with accountability.

A lot of the concerns that you're seeing in the Congress, in the country about the Fed; the Ron Paul bill, I think that's a reaction to what looks like a very interventionist action by the Federal Reserve. Not a lot of descriptions of how it actually occurred, there's no reports on what's called a Section 13-3 Intervention. Section 13-3 of the Federal Reserve Act which allows for such actions, but there’s very little reporting on how it actually took place.

So, I think the best thing the Fed can do to get back some of its independence, and quite frankly, I think it's lost a little bit in this crisis. The best thing it can do is be very accountable about some of the interventions in Section 13-3, that's where most of the transparency concerns exist at this point, and then of course to emphasize that the policy that has worked most well was the policy of the '80's and '90's and when we got off track on that, things deteriorated.

I think that some recognition of interest rates being so low for so long in the '02 to '04 period by the leadership would be very important. It’s discussed in the Fed system, is discussed by other central banks, it's discussed quite widely, but some recognition of that seems to me would be important in terms of bringing back some of the independence that the Fed lost.

So, I think that independence, just to summarize, is really important, it's essential, we've seen evidence over time about how it is. But it has to be matched with a strong sense of accountability to the Congress and to the American people of what the Fed is actually doing.

Question: Should the Fed be engaging in purchases of mortgage-backed securities, or is that a role for another government agency?

John Taylor: I think it's not the thing the Federal Reserve should be doing. I think the Fed should be focusing on the overall level of interest rates, not trying to intervene in certain sectors.

 A year ago I wrote a paper and presented at the annual meetings of the economists arguing that this was what I called mundustrial policy. It's using monetary policy to intervene in certain sectors, certain firms of course is part of that as well. So, I think it would be better if monetary policy did not do that. I’ve just completed a study trying to look at the impacts of the purchases of the mortgaged-backed securities by the Fed and I actually don't think there is large – had as large an impact on rates as many people believed. We'll be studying that for a while.

But more important, the impact is quite unreliable. It's very hard to measure. A lot of uncertainties. So, the notion that the Fed could go into business of controlling the mortgage rates as it has effected the funds rate for years I think is really a mistake and wishful thinking. It would take the Fed in the wrong direction.

So, the more we can get back to a monetary policy which is focusing on the overall level of the money supply, the overall level of the interest rates rather than intervene in certain sectors the better. That's not monetary policy. That's the kinds of things that raise people doubts about monetary policy. They question, why should an independent agency of government be intervening in certain sectors like that? The Treasury has bought mortgage-backed securities. That doesn't raise the same independence questions that the Fed has raised by these purchases.

So, it's one of the biggest issues now to address. If you read, for example, Brian Sachs' recent speeches at the New York Fed, he acts as if this is like a new instrument for monetary policy in the future. One of his predecessors, Peter Fisher, who is now at Black Rock, calls this "price keeping operations." And I think there is a huge amount of doubts about this; it's effectiveness, it's reliability, and it raises questions about the Fed's independence.

So, I feel strongly that this is not the kind of thing that we should have the Fed doing in the future.

Question: Should the inflation target implicit in the Taylor Rule change over the business cycle? (Mark Thoma, Economist’s View)  

John Taylor: No. I don't think there is any reason to do that. I always assumed the inflation target should be 2%, some people think it should be lower, let's maybe talk about changing it. But, varying it across the business cycle seems to me to be just an extra element of confusion to people. There's no reason to do that.

So, the question for me is how would you adjust it? I think rather than move it around the business cycle is to do as good a job as possible assessing how you measure the inflation target. There has been a lot of confusion, for example, about using the Poor Inflation Rate. I've always preferred to use as a smoothing device, just average the inflation rate over a few quarters, there's actually four quarters in the Taylor Rule. But the Poor rates, especially if they're consistently higher than the headline rates over several years, then -- or lower the other way around, then they can be misleading. So, for one year or so paying attention to the core and looking at that is important, but ultimately, it's the measured inflation rate, the headline inflation rate that's most important and that's what I would focus on. And again, no reason to be changing that, that would just add confusion, add uncertainty to what monetary policy is doing.

 Question: Was the deviation from the Taylor Rule in the early 2000’s severe enough to lead to the problems we’ve had? (Arnold Kling, Econlog)

John Taylor: I think of these as the original cause, if you like. Really, what got the excesses going. It was a big deviation, 300 basis points, we hadn't seen deviations like that since the 1970's, which of course was another period of lots of recessions, a very severe one in '81, '82. So, I think that there is a lot of evidence that says that this was really the factor that got things going in terms of the excesses, the boom, and ultimately the bust in housing, the search for yield, the extra risk taking. And I think you could have guessed that something would happen based on previous periods where central banks have deviated from the Taylor Rule, or other similar guidelines.

It's amazing to me through history and through time how much evidence there is that when central banks deviate from that kind of policy that things don't work out well. We saw that in the United States in the '70's, a terrible time with high inflation and recessions. We've seen it in other countries, and as countries started to follow those principles, things got better. So in some sense now, unfortunately, have another piece of evidence that when policy deviated, we had a big recession. I actually say that the great moderation was ended by the great deviation which has led to this great recession.

Now, I want to be very clear that other things happened that made this situation worse. I made that clear in my book, for example, Getting Off Track, that there really was three things; the deviation from monetary policy rules, the second was misdiagnosing the crisis in the summer of 2007 as a liquidity problem rather than a problem in the banks, and the third was this panic in the fall of 2008, September/October, which I think was largely the result of the rather chaotic government responses to the crisis. So, the deviation was part of it, but there in some sense there are other deviations from policies. Deviations in directions of very interventionist policies to misdiagnoses which is really why this one has been so severe, unfortunately.

Question: What do you think of Goodhart’s law, which suggests that targeting variables for the purpose of policymaking leads to those variables becoming misleading?

John Taylor: Well, Charles Goodhart makes a good point with that, that the policy responses actually affect individual behavior. I think it's what makes policy difficult. I think you can take account of those and be wary of them and still have conducted policy.

I'll give an example. I think when bond traders, people in the markets have a sense of what monetary policy is going to be like, then they will price securities, long run securities and medium run securities based on that. If the policy moves to something else, say for example, deviates from had been working, then it takes them a while to figure out what's going to happen, but they will adjust. They will adjust their forecasts, their procedures, their rules of thumb, sometimes indirectly, sometimes somewhat inadvertently they'll do it. So, that's the adjustment.

But, that's why we like our policies to be as predictable as possible sot hat people can make these adjustments. So, I would say, this is to me Goodhart's Law is another reason not to be changing from a policy that's worked well. I'd say not to do too much fine tuning. In a way, what Goodhart's Law shows you is that efforts to fine tune can actually be something that's harmful. In fact, I think the period in the early, say 2002-04 period, that could very well be explained by an effort to make policy even better than it was during the great moderation, if you like. Trying to fine tune an extra way, bring rates below what had worked before. But those are all fine tuning things and I think what messages such as Goodhart's Law show you is that the reaction to those can sometimes be hard to predict. People will begin to see that there's another target, there's another idea. You're moving away from the equilibrium and that's a reason, I think, to keep it simple, if you like. Keep the policy as simple as possible, keep the regulations as simple as possible, and that's true of both monetary policy and fiscal policy.

Question: In what ways could policy measures have been more predictable in this crisis?

John Taylor: There's several ways policy could have been more predictable in this crisis. I think first of all, by sticking to the predictable policy that worked well in the '80's and '90's with respect to the setting of interest rates. That's something that I think we have a lot of evidence for, it was unpredictable, a surprise if you'd like, to take rates too low for so long even though there was an effort to explain it, it was hard for people to understand how long that was going to be. Was it a new policy of actual low interest rates, or not. So that's an element of unpredictability that I think has caused damage.

I think a second thing I would stress is the response to the problems in the financial institutions. First of all, misdiagnosing it as a liquidity problem, so more liquidity was pumped into the economy, new facilities were set up. That added unpredictability rather than looking at the evidence that there was a problem in the banks due to the mortgages and the other toxic assets.

And then I'd say the third element of unpredictability, and probably the most important for the severe panic. And I would go back to, for example, the Bear Sterns intervention. Let's just take as a given, although it is debatable that that was the right thing to do in the heat of the moment, very difficult under pressure. I have been in policymaking jobs. I know what that's like. So, the decision was to intervene and bailout Bear Sterns creditors.

 It seems to me that that was the moment, as clear as possible, about what would be the policy in case another institution had some problems to articulate it, but there was very little description of it and in fact, policies tended to vary from case to case. You had the Indymac, you had WaMu, you had of course the Lehman Brothers, AIG, Fannie and Freddie, and in each case there was a difference and each one seemed to be approached independently, if you like, ad hoc without an overall strategy.

That's probably the biggest degree of unpredictability. Equity holders, preferred equity holders, debt holders, bank holding company versus bank, various kinds of senior creditors, counterparties, there was a huge amount of uncertainty about how they were going to be treated. And of course, when the ultimate policy was port forth, the so-called TARP was put forth in a way that was quite confusing. The Treasury Secretary just had 2 ½ pages , testified with the Chairman of the Fed of the Banking Committee, and couldn't answer, in my view, the questions very well. A huge irate response from the Congress at that point and it really then became very clear, I think, that there wasn't really policy. They had not been thinking about it, at least as evidenced from the testimony and the other actions. And so, that was probably the most unpredictable, most damaging part of this whole episode.

Question: Did the financial panic come about because of the Lehman Brothers’ bankruptcy, or was it the government response?

John Taylor: This is a question about the timing of the panic and whether it was associated with the Lehman Brothers bankruptcy, or with the responses of the government more generally. Basically, as soon as that occurred, I looked at the data and I saw much more evidence that the panic in the markets were associated with the government's responses a week or ten days later. That's the time that say, the S&P 500 fell by nearly 30%, 10 times greater than what happened at the time of Lehman. The S&P 500 was higher the Friday after the Lehman bankruptcy than the Friday before.

And there's lots of other data to look at to show you that. There is much more investigation. For example, not one counterparty, derivative counterparty to Lehman, filed for bankruptcy after the Lehman case. The major creditors who did not fail. So it's hard to find a direct knock on effects from that in the data. The more I look at it, the more it seems to me the other explanation makes sense.

Now, I'd say, now you need to think about what the counter factual would have been. And I guess I'd go back to something I've stressed before that if there had been a clear policy put forth whereby people could have expected the possibility at least of Lehman being put through bankruptcy, then there could have been some preparation. There wasn't any. The day of the announcement in September, 2008, people were just beginning to think about how it works. It was really, I think, a surprise that had been no preparation. And so, it was a jolt. Let's be sure, it was a jolt. But it seems to me that the direct connections that people talk about with expect a cascading and domino effects were not there and it really occurs later. There's more evidence for this. John Cochran, Louie ***** in Chicago have put more out. I think the former FDIC Chair, Bill Isaac has studied it and has come to the same kind of conclusion.

So, while it was originally controversial when I put this idea forth, over a year ago actually in a speech at the Bank of Canada, in November, 2008, was viewed as controversial. But I was just looking at the data then, but more and more you look at what happened, internally talk to people, and study the aftermath, it seems to me there is at least as much -- let me put it evenly, at least as much evidence that the panic was caused by the response as distinct from that particular event at Lehman Brothers. And I think it is more evidence, it's actually becoming overwhelming, but this is still controversial, and it will be looking at it more and more.

Looking at the data carefully, at spreads in the markets at what's happening to the equity markets and also looking at what's happening in the aftermath of the bankruptcy of Lehman Brothers, those are the kinds, if you like, nitty gritty details that we need to be studying to understand what happened. We're doing that work here at Stanford at the Hoover Institution. A lot of focus on, we have a whole working group that's delving into it. We've talked to people, former policymakers, and also people in the private sector to try to understand this and match it up with the data. And I think that's the most important thing to do now. Come to some conclusion about what actually happens so that we can then take the appropriate remedies, reforms, to make sure it doesn't happen again

Question: Why have you disapproved of the stimulus of the large counter cyclical Keynesian policies?

John Taylor: Why have I disapproved of the stimulus of the large counter cyclical Keynesian policies? Because I don't think we have ever had much evidence that they work. So, let me try to be specific. The first stimulus was in early 2008, and that was largely in the form of one-time rebate checks sent to individuals. A lot of money went out and basic economic theory would tell you that that would not jump start consumption. People would save most of that.

So, unlike what was advertised, it shouldn't stimulate the economy and in fact, if you go back and look at it carefully. Look at the numbers as I have done, you don't see an impact. You see that big rebate just went into people's pockets and didn't touch on jump start consumption. In fact, consumption is going the other way at that point.

And then you had this stimulus of 2009 to the extent that that was based on sending checks to people. You see exactly the same thing happening. One-time payments, temporary tax cuts don't stimulate spending or consumption. And again, we knew that for years and years. That's why policy in most of the '80's and '90's didn't take those kinds of approaches.

And so that brings you to the question about government purchases, can that be more effective? Well, yes, in principle, it can be if it's timed right, if it's done in time. But this stimulus package of 2008, the government purchase is part of it, is spread out over a long period of time, most of them haven't even come in line yet. The government purchases side. So, I don't see that that's stimulating the economy. The rebound in the economy has been due to things like inventory changes, recognition that the panic is over in investment side, and so you can't find the impacts of it.

And it's unfortunate because that means that we’ve got a huge increase in our debt and that's ultimately harmful. We didn't get much out of it in terms of stimulus. So, I'm convinced -- what I like to do is not just look at the models. I looked at a new Keynesian model, I looked at a model I built many years ago, I looked at other people's models. And they're good for assessing impacts, but ultimately what we need to do now that we've had these packages, is to look at what happened. You go away from the models, look at what happened, did jump start – did consumption get jump started, I say no. Was the recovery due to the stimulus? It seems not because it was in the form of investment.

So, I think, ultimately, we can learn from this experience, I don't know exactly why we moved away from the policies that were working, which is really aversion to these large countercyclical policies. It began in early 2008 and has continued and it may continue further. And I think let's start learning from what happened and not be ideological about this. Not consider what school went in, but look at the facts. When I look at the facts, I don't see much impact of these policies.

Question: How responsible is Wall Street for the financial crisis?

John Taylor: I'd say the responsibility of Wall Street in this crisis, and it still hasn't been resolved is the dependence of the financial institutions on the government for bailouts and interventions. In other words, the institutions had become large enough and complicated enough that at least that led people to say we needed to have these bailouts, these interventions. Each time it was –people said there would be systemic risk it was like saying there was fire in the theater, crying fire in the theater, and it led to these responses which I say were quite chaotic and not systematic. They really led to problems.

So, I think what has to happen in the future is, Wall Street, the large firms, have to find a way to say, "We are not going to depend on the government for bailouts." Just like a startup firm out here in Silicon Valley, if it fails it's not going to be bailed out by the government. The same should be true for the large financial institutions. They should find a way to do that. It seems to me that in some sense they are responsible for doing that. They want to be responsible citizens.

But I think, in the meantime, government needs to find a way for it to get out of this bailout business. There's an example I would point to where there has been a change. In the 1990's, the IMF did a lot of bailouts. The United States participated in some of those in the case of Mexico. But it got quite chaotic in the case of the Southeast Asia crisis. They were sometimes in and sometimes not in. In the case of Russia, they were in for a while and they pulled out and, of course, we had a lot of contagion globally. But it wasn't until maybe 2002, 2003 that the policy became more predictable and more understandable. The IMF led out some procedures called The Exceptional Access Framework. It clarified what their operations would be. So, the expectation of a bailout of a country in this case, sovereign debt, was reduced substantially. And I think you saw a huge improvement in the emerging markets. Some of them made an extra effort to build up their reserves, some of them reduced their deficits, they made the adjustments and they've been stronger as a result. And that shows you what can happen if the policy become more predictable and less expected bailout there are in the system.

Recorded on December 21, 2009