November 23, 2012 5:36 pm

Onwards and upwards

In a world without innovation and without expansion, it will be much harder to keep democracy going
An illustration by Shonagh Rae
©Shonagh Rae
What do you need to make democracy work in the modern world? That is something many Americans might be asking as they digest the results of the latest $6bn election. From Plato on, there has been no shortage of ideas: an educated population, rule of law and civil society are all key ingredients – and, of course, a reliable system to count votes (ie no hanging chads).

But is another ingredient also required: namely, a healthy pace of economic growth? That is the issue I have been pondering after I attended a debate in Oxford earlier this month with Peter Thiel, the American entrepreneur-turned-investor. In the past decade, Thiel has shot to fame and fortune by creating companies such as PayPal and cannily investing in Facebook. As such, he epitomises the sunnily optimistic, wheatgrass-juice-fuelled culture of Silicon Valley.

But these days Thiel-the-entrepreneur is worried. In particular – and as he wrote in a recent column for the Financial Times, co-authored with Garry Kasparov, the former chess champion – he fears that the pace of innovation in America is slowing down. To be sure, he asserts, the country produced plenty of innovative ideas after the second world war; but in the past 30 years, this creativity has withered, sapped by the financial boom, and the rise of a newly risk-averse culture. “You cannot compare the iPhone 5 with Apollo 5,” he laments. “Innovation has declined.”

Not everyone accepts this gloomy view. On the contrary, during the Oxford debate the American economist Kenneth Rogoff retorted that what has hurt America’s pace of growth was the implosion of the debt bubblenot lack of innovation. And Mark Shuttleworth, another fabulously successful entrepreneur, declared that there was still as much innovation as beforeif not more, since “today is an extraordinary time to be a scientist, researcher, explorer, academic and entrepreneur”.

But if you think that Thiel is even half correct, it begs another question: what does this mean for the political culture? For what makes Thiel really concerned about America today is his belief that a world without innovation will also be a place with dramatically slower growth. And without expansion, it will be much harder to keep democracy working, even in America. “Democracy works where voters think that things are getting better,” he argues. “It is an open question whether you can have a democracy in a world with zero sum growth.”

Is this true? Part of me would love to shout no”. After all, the whole point about democracy is that it is supposed to be capable of making tough decisions in tough times, and formulating trade-offs. If democracy only works in fair weather, then to my mind it is doubtful whether a system should be labelled as a functioning, grown-updemocratic state at all.

And yet what I find fascinating – and unnerving – about Thiel’s comment is what it may reveal about the underlying political culture in America. For whether you agree with his assertion or not, it does appearnot least from the recent election campaign – that modern American political rhetoric is peculiarly addicted to the presumption of permanent growth.

Those early pioneers founded the country with an optimism that anything could be done, and had precious little sense of resource constraint: if you ran out of land in the east, you just moved west. Ever since then it has almost always been presumed that it is possible to make the economic pie expand, either through conquest, entrepreneurship, immigration – or, more recently, innovation.

This attitude is very different from the cultural vibe seen in a crowded country such as Japan, where there is an overwhelming sense of limitation and constrained resources. And that has a powerful secondary implication: precisely because the Japanese perceive resources as finite, they have developed extensive cultural mechanisms to divide up their economic pie in a manner that maintains social harmony. Sharing pain – and gain – is instinctive.

In America, however, there has hitherto been less cultural imperative to develop ways to share constrained resources. If you think the economic pie will always grow, you do not need to worry as much about how to divide it up. Hence my fascination with Thiel’s point.

Most American politicians continue to insist that their economic pie will grow in the future: it would have been suicidal in the recent election campaign for anyone to mention the wordstagnation” or “zero sum growth”. And for my part, I dearly hope this American political optimism is correct. In theory, a combination of favourable demographics, entrepreneurial zeal and energy resources should indeed give America a growth edge.

But what if Thiel and Kasparov are right about innovation slowing down? Will this strain the political system to breaking point in the years ahead? It is a sobering question, and doubly so in a week when Washington is enmeshed in yet another bout of debilitating gridlock about tackling its debt. It must share out economic pain, in a country where the word is still all but taboo.

Copyright The Financial Times Limited 2012.

23, 2012 6:01 pm
The population conundrum
By Norma Cohen, Demography Correspondent

They were the decades that gave us Gordon Gekko and the Big Bang. The 1980s and 1990s were the boom years for stock-market investors, with globalisation, deregulation and rising productivity driving double-digit market returns.

Yet, just as the financial crisis has unravelled previous assumptions about free market economics, an FT analysis shows that perhaps the most significant driver of those equity returns was something else entirely: demography.

Click to enlarge

The 1982-1999 bull market was driven by the post-war baby boom, which resulted in a bulge in the numbers of working-age adults and the core savings group.

That has ominous implications. Facing current trends in birth rates and rising life expectancy, a growing body of economic research suggests that the rates of stockmarket growth enjoyed by investors during the 1980s and 1990s are gone for at least a generation - and possibly forever.

But another factor was at work, too: demography. The 1982-1999 bull market was driven by the post-war baby boom, which resulted in a bulge in the numbers of working-age adults. Those adults are now retiring, having spent too much time working and not enough time procreating.

Falling birth rates and rising life expectancy have left the industrialised world with a demographic profile very different from that of the 1950s. There is a growing body of evidence to suggest that sharply ageing populations will weigh on both economic growth and asset values for years, if not decades to come.

A growing body of economic research suggests that the rates of stockmarket growth enjoyed by investors during the 1980s and 1990s are gone for at least a generation, and possibly forever.
Such high returns were frequently attributed at the time to factors such as globalisation, deregulation, rising productivity through the widespread use of technology and the taming of inflation. All were important. But there was another far more significant factor at work: demography.

Demography is also the key to understanding why such times may never return. In the last four decades of the 20th century, there was an unprecedented rise in life expectancies and a concurrent drop in birth rates. This has left the industrialised world with a demographic profile very different from that of the 1950s. There is a growing body of evidence to suggest that sharply ageing populations will weigh on both economic growth and asset values for years, if not decades to come.

Populations in most of the major industrialised nations are ageing rapidly, which means the numbers of those saving for retirement – generally the ones investing in equities – are a diminishing percentage of investors as the baby boom generation grows old. As those boomerspeople born in the years immediately after the end of the second world wargrow older, their investment preferences tend to favour safer assets such as bonds. This demographic pressure follows a regulatory drive to push banks and insurance companies into “saferassets and is driving yields on those assets ever lower, the research suggests.

The shift from a predominance of younger workers to a growing number of older and much longer-lived adults is confronting policymakers with increasingly unpalatable choices about how to pay for pensions and healthcare in economies where workers simply cannot provide enough tax revenue to maintain decent standards for those too old to work.

The figures are stark. The percentage of the UK population that is 65 and older rose from 15 per cent in 1985 to 17 per cent in 2010, and would have been much larger had it not been for a surge of working-age migrants over the past decade. Even allowing for that, by 2035 those over the age of 65 will be nearly a quarter of the total UK population.

Nor can the asset markets save us from the inevitability of more old folk. The double-digit rates of return that today’s baby boomers have come to think of as “normalmay already be beyond reach of those who will come after them. This trend has enormous implications for the millions about to begin pension saving for the first time through auto-enrolment.

Purple patch

“The 1980s and the 1990s have to be regarded as an anomaly,” said Michael Gavin, managing director and economist at Barclays Capital. Gavin works on the bank’s annual Equity-Gilt study, which highlights the role that rapidly shifting populations have on investment markets. “It is very hard to see how you get a replay.”

Data from the 2010 edition of the Equity-Gilt study, and updated to 2012, shows a clear correlation between the percentage of the UK population aged 35 to 54considered a prime age group for pension savings – as a percentage of the total population and that of price/earnings (p/e) ratios of UK equities.

The p/e ratio measures what investors are prepared to pay for companies’ past or future earnings, and so acts as a proxy for supply and demand. A higher p/e suggests demand is greater than supply, pushing prices – the numerator in the ratio – higher.

In 1982, as the last great equity bull market was beginning, this age group accounted for 22 per cent of the population and the cyclically adjusted p/e ratio – which attempts to smooth out the effects of the economic cycle – averaged 8.5 times.

By 1999, the p/e ratio had soared to a record 44.2 times earnings. The conventional explanation for this is that the boom in technology and media shares massively distorted the market, enough to overpower the smoothing effect of the cyclical adjustment.

But there is an alternative explanation: the proportion of 35-54 year-olds had soared to 29 per cent of the UK population. It continued to rise marginally for a few years, while p/e ratios subsided.

Come 2012, the 35 to 54 age group had eased back to 27 per cent of the population, and p/e ratios fell back to 21.4 times earnings. This core savings age group is set to fall back to 25 per cent of the population by 2018, a smaller percentage than it has been at any time since 1989 – and their real incomes are being relentlessly squeezed by stagnant growth and above-target inflation.

An international issue

Nor are Britain’s stock markets likely to be unique in this respect, economists say. Indeed, much of the research about the link between stock price performance and demography has focused on the US, a nation with similar population trends to those of the UK.

A study in 2011 from the Federal Reserve Board of San Francisco, entitled “Boomer Retirement: Headwinds for US Equity Markets?,” studied US stock market performance from 1954 to 2004, a period long enough to be statistically robust. In particular, it looked at the ratio of those in their peaksaving for retirementyears to the number of those who are around retirement age.

As the proportion of those at peak savings age roseit more than trebled up until around 2000 – so did the average price/earnings ratio of the stock market. In fact, it broadly trebled, too. But after that, as boomers began retiring in large numbers, both the proportion of peak savers and the p/e ratio fell sharply.

Mark Speigel, an economist at the San Francisco Fed and co-author of the report, said the research focused on savers aged 40-49 because workers younger than that are assumed to be saving for housing, not retirement, and will not be investing for the long term. What the research showed, he said, is that although it is too early to prove that an ageing population causes weaker stock markets, there is clear evidence of a strong correlation. “It is a pattern in the data that seems to have held up for quite a long time,” he said.

“This evidence suggests that US equity values are closely related to the age distribution of the population,” the paper concluded. Moreover, Speigel and his colleague Zheng Liu went on to project how the domestic stock market might perform through until 2024, given what is known now about how the nation’s population will age. The findings don’t make palatable reading; even the p/e ratios seen in 2010 are too generous, the study concluded.

An FT analysis of UK census data that replicated the methodology of the San Francisco Fed research found a similar pattern. Although the percentage of those aged 40 to 49 continued to grow relative to those between 60 and 69 in the early years of the 21st century, by 2007 that trend had reversed. So, too, did p/e ratios on UK equities.

The decline in the UK stock market might have been more precipitous but for two factors: monetary easing by central banks, and inflows from foreign investors snapping up stocks. Foreign investors owned 30.7 per cent of the UK stock market as early as 1998, and over 41 per cent by 2008, according to the Office of National Statistics. Prior to the liberalisation of UK markets in 1986, UK shares were predominantly owned by UK individuals. In the US, foreigners own only 11 per cent of the market.

It would be unwise to count on such support in future, because populations are ageing in much of the rest of the industrialised world too. While those over 65 accounted for 12 per cent of the industrialised world’s population in 1982, that has risen to 16 per cent today and is projected to reach 25 per cent by 2042. The working age population within the European Union is expected to decline by 2060 to 56 per cent of the population, from 67 per cent today.

False hope

Some look east for salvation, towards the massive pools of surplus saving in Asia, particularly China. But China’s population over 65 is projected to rise from 8 per cent of its population today to about level with that of the rest of the industrialised world by 2042, partly because of the one-child policy that has been in place since the early 1980s. Its working age population is set to peak in 2020 and begin to fall quickly thereafter.

Russ Koesterich, chief strategist at iShares and author of a recent report on demographic change and stock markets, noted that although there may be many other factors that affect stock prices, there is by now a compelling body of evidence that suggests demography is a key driver. “The burden of evidence seems to be fairly clear,” he said. “The mechanisms by which demographics affect growth are fairly common sense. The great bull market in equities has been over for some time.”

Research from iShares found that as US workforce participation rates peaked at the end of the 1990s at over 67 per cent, just as stock market prices peaked. Moreover, as the ratio of those aged 15 and under in the US population declined relative to the number of those aged 65 and over – a ratio which fell steadily between 1981 and 2011, yields on US 10-year Treasuries fell, too.

The reasons why stock prices and bond yields fall as the proportion of older adults in a population rises probably has to do with the relative appetite for risk at different ages, economist say. Indeed, in the UK, the most commonlifestylefund for pension savings – and the default investment choice for most employees saving via workplace pension schemesinvolves a gradual shift away from equities into bonds as the individual approaches retirement age. Upon retirement, savers buy annuities and insurers who sell these policies buy bonds to make sure they can deliver promised cash payments. That suggests that even if the Bank of England reverses its current easy monetary policy, there will be a natural brake on rates.

In considering the predicament of Japan, Shiri paid tribute to the foresight of Swedish economist and Nobel laureate Gunnar Myrdal, who saw that falling fertility rates posed a threat to economic growth as long ago as the 1930s.

If higher rates of investment return are not going to rescue our retirement systems, what will? Most of the solutions being considered by western governments - later retirement ages, greater compulsion to save, higher taxes - are politically tricky, and will not in any case fully fix the system. The same goes for allowing greater levels of immigration.

Some economists believe that enduring solutions need to be “cradle-to-grave”. They favour policies that maximise each nation’s human capital, as well as relying on longer working lives and higher savings rates, and point to the Swedish social model which encourages women to both have children and pursue careers. In a part of the world with limited immigration and a small population, social policy has acted as a bulwark against the worst effects of demographic drift.

Land of the rising age profile

Japanese flag with a money bill

If one wanted to look at asset values in the industrialised economy most representative of population ageing, that would be Japan. It has sharply declining fertility rates, net immigration of virtually zero and the longest-lived population of any large economy. Its stock market peaked in the late 1980s – at about the time the size of its working age population did – and has atrophied ever since.

In a recent speech, Sayuri Shiri, a member of the Bank of Japan’s Policy Board, spelt out the challenges of managing an economy with both a shrinking workforce and a shrinking population. Already, those over 65 are nearly a quarter of the population.

Shiri noted that stock prices are not the only affected asset class, pointing out that the bursting of Japan’s real-estate bubble also coincided with the peak in the working age population. Citing earlier economic research that suggests risk premiums rise as a population ages investors are prepared to pay less when they are asked to take more risk – he pointed to the excessive cash holdings of Japanese savers.

“Despite nearly zero-interest rates, the share of deposits (and cash) accounts for about half of total assets,” which, in Japan, amount to about $19tn. “As they become older, they (households) may gradually shift their financial asset allocation toward life insurance and securities, setting aside housing investment.”

As they age even further, he noted, households with financial resources tilt even more heavily towards “safe” assets, such as deposits and bonds. “This makes sense since elderly people are more concerned about the the stability of the valuation of their financial assets and thus tend to be more risk-averse than younger people,” he said.

Copyright The Financial Times Limited 2012.

Top Culprit in the Financial Crisis: Human Nature
Kenneth Rogoff and Carmen Reinhart, who wrote This Time Is Different, say coming up with regulations to ward off financial disasters is a lot easier than getting people to keep them in place as years pass.




Carmen Reinhart and Kenneth Rogoff have spent countless hours studying financial crises and debt bubbles. And unfortunately for those with an upbeat economic forecast, their news is not good.



For one thing, they expect growth to remain challenged for a long time, thanks in part to the aftermath of the debt binge of the 2000s. "In the advanced economies, think of trend growth being a percentage point lower for a decade more, possibly even two decades more," says Rogoff, a Harvard economics professor who in 2009 co-authored This Time Is Different, with Reinhart, who teaches about the international financial system at Harvard's John F. Kennedy School of Government.



The two recently came to Manhattan, where they had a lively discussion with a Barron's editor. They agree that the proper regulatory framework to prevent another severe crisis is achievable. "But can we stay there?" Reinhart asks. For the answer to that question and many others, read on.

Barron's: How does the recent financial crisis compare with others throughout history?

Reinhart: The advanced economies, the United States included, really have not seen a crisis of this depth and breadth since the 1930s. In terms of its onset, it harks back to a lot of the liberalization of the financial systems in the advanced economies that enables a lot more risk-taking. And part of that risk-taking gets reflected in significant private-debt buildup.

When we talk about having a debt overhang, it is not just about public debt, but also significant private debt, household debt, bank debt, domestic debt, and external debt. So this buildup began to show itself as an asset-price bubble, importantly in real estatethough that is not unique to this crisis. This is something that culminates with a lot of poor lending decisions, which became a banking crisis.

Rogoff: We circulated a paper in 2007 that plotted some of these key macroeconomic indicators, and we said, "Here are the worst financial crises since World War II." We said it was clear that the U.S. would be lucky, given all of the indicators, to escape having a deep financial crisis. So, compared with other post-World War II financial crises around the world, this one is very typical, regardless of whether you compare it with the very small number of advanced-country crises or to the broader number of emerging-market crises. When it comes to this kind of a financial crisis, we as a country are not so different [than other countries]. That was a shock to us, because we are used to seeing emerging-market data be wildly more volatile than advanced-country data.

Gary Spector for Barron's
While doing their research, Rogoff and Reinhart were shocked to discover how similar financial crises were, regardless of where in the world they had erupted.
What are some common themes you saw?

Reinhart: No two crises are identical. Policies differ, and political systems differ. But the common thread is this sustained buildup in a period of really bold optimism, often predicated on the expectation that if asset prices have gone up today, they are going to go up tomorrow and, therefore, we can borrow fairly indiscriminately without a problem. What was also very illuminating was that the U.S. wasn't alone. You saw Ireland, Spain, Portugal, Greece, and the U.K. with a very similar pattern of debt buildup. In all these cases, the U.S. included, they were fueled not just by borrowing domestically, but by borrowing from the rest of the world. All these countries have been running current-account deficits.

What are some of the key lessons from the financial crisis and the recovery?

Reinhart: The U.S. recovery very much fits the mold of those following any severe financial crisis. The U.S. did not have as sharp an initial decline in output as what you have seen in emerging markets or, in effect, as what you saw in prior crises in U.S. history.—not just the Great Depression, but in the crises of 1907 and 1893, as well. In all of these, there were years where you had massive initial declines in GDP [gross domestic product] of 10% or 12%. In the Depression, it was 30%. We did not have that this time. But all the other developments were the same, including the failure to regain what was lost in income and employment, and how long it has lasted.

Post-war recessions, on average, barely last a year. And here we are having these conversations five years after the onset of the subprime crisis. It attests to the long duration of this type of systemic crisis. In the historical context, the U.S. has had, overall, a pretty good track record in the latest crisis. In terms of income per person and in comparison with other countries that are having similarly severe crises, we are doing pretty well–but not so hot in terms of unemployment.

Rogoff: We have always argued that the right metric for thinking about deep financial crises is to compare the current conditions to where you started. It is a much more robust method, particularly because there are false starts, and you don't know when the recovery starts. It is really getting into semantics to say, "Well, we are not racing ahead that fast." But the flip side of that is that a lot of effort was made to have the economy not fall that fast. There is basically fiscal stimulus being taken out of the economy, for example, as we are consolidating from the initial $800 billion stimulus in 2009. And if we hadn't done that, there would be more room to make the economy grow faster now. But that doesn't mean we would be ahead.

So where is the economy now, compared with when the financial crisis started in 2007?

Reinhart: We are almost caught up.

What are your thoughts about the steps taken to foster fiscal and monetary policy?

Reinhart: We can always go back and figure out a way in which the fiscal and monetary policy could have been made sharper, to do more. But the thrust in a deep financial crisis, when you throw in both monetary and fiscal stimulus, is to come up with something that helps raise the floor. That's why the decline wasn't 10% or 12%. However, one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish.

Rogoff: Again and again, policy makers, Wall Street economists, and world leaders have all been overly optimistic about how fast things are going to go. If you think that we are about to get a V-shaped recovery, then you talk yourself into forbearance. If you think, "My gosh, this is going to last 10 years, but how can we make it last seven years?" you say, "This is really painful, but we've got to do it." But they've been very slow coming around to the view that this downturn isn't ending soon, and they can't just hold their breath and have it go away.

Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine."

What kind of policy makes sense in the U.S.?

Reinhart: On the monetary side, which for me is the least ambiguous right now, this is not the time to be an inflation hawk. I would rather see the margin of error favor easing too much, rather than too little, for many reasons. The frailty of the recovery is still an issue. The amount of debt that is still out there for households, the financial industry, and the government is still large.

The fiscal side is more complicated, because the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle. However, over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing.

But getting back to the earlier point about helping the deleveraging process, we have a credit system that is still working very poorly. It is very difficult for households to refinance. So we are not actually talking about taking on new debt, but re-contracting to get the benefits of lower interest rates. The whole approach of Fannie Mae and Freddie Mac right now is to have caution, which was thrown out the door during the boom.

Rogoff: There is overshooting now in the other direction, through regulation.

Reinhart: Right, and so getting the refinancing process under way would actually help a great deal.

But you do see reports in the press about a lot of refinancing going on, don't you?

Reinhart: You do, but there could be a lot more of it. For example, if you look at the prerequisites for refinancing, the credit scores basically shut out a huge chunk of the population.

In the 1982 recession, there was high inflation that lingered from the late 1970s, and a lot of the mortgage debt was variable-rate. So, as soon as the Fed eased, the benefits were transmitted to households in the form of a lower mortgage payment. That helped enormously. Now what we have inherited is basically a lot of fixed 30-year mortgages, so anything that can be done to loosen up the clogged credit wheels merits quite a bit of attention.

Rogoff: It is important to have an independent central bank that can resist, when necessary, short-sighted political pressures for lower interest rates, even if that's at the cost of higher inflation. At the onset of this crisis, informed by my work with Carmen, I started writing that this is a once-in-a-100-year event. And, yes, there are a lot of clever ways to try to clean things up, but I'm pretty cynical that we will be able to do it. But having some temporarily elevated inflation would not be such a bad idea for many, many reasons. Of course, it means there will be a transfer of wealth from creditors to debtors. But some of this is inevitable anyway, since not all of the debt is going to get paid.

Even then, we will need more restructuring [of debt]. Second, on fiscal policy we have struck a middle ground because we are running a 7% deficit [as a percentage of GDP], and the situation is comparable in the U.K. And there are voices that say, "Well, the deficit should be much higher." Our work suggests caution on that front. There can be very-long-term costs, in terms of growth, to having such elevated debt.

And then if you didn't just raise taxes or cut taxes but actually fixed the tax system, that would be very important. There are very good ideas out there on how to accomplish that. The baseline is a flat consumption tax of some form with a high deduction. The Simpson-Bowles plan takes the political middle road in trying to reach that. It's a great idea. You can have more revenue and keep incentives and maintain growth.

And, lastly, other things, like infrastructure and education spending, are important. This isn't all about austerity versus no austerity. Countries that are successful in dealing with these crises, such as Sweden, sometimes take them as an opportunity to change. We haven't.

Reinhart: You go through history and, in good times, the tendency is to liberalize. Then a crisis happens, and you retrench. But the retrenchment lasts only as long as your memory does, and memory is not that great. Not the memory of the policy makers and not the memory of the markets. So as you start putting time in between where you are now and your last crisis, complacency sets in, and you begin to be more cavalier about what your indicators or warning signals are showing.

That's the essence of the this-time-is-different syndrome. The debt ratios are X, but we really don't have to worry about that; the price-earnings ratios are Y, but that's not a concern.

And so, given that this is so grounded in human nature, I'm extremely skeptical that we will overcome financial crises in any definitive way. We may have longer stretches [without a major crisis], as we did after World War II during the era of financial repression, which grew out of the crisis of the early 1930s. Back then, you had a lot more regulation and clamps on risk-taking, both domestically and cross-border. But then we outgrew it. It was passé. Who needed Glass-Steagall?

So you're not optimistic that financial crises can be avoided?

Reinhart: No, no.

Rogoff: When we started writing our book, we thought we would find that there were financial crises in Asia, Europe, the U.S. and elsewhere. What we hadn't quite anticipated was how similar these crises would be. It just shocked us, because these areas have different legal systems and different institutions. Carmen mentioned human nature. It is almost as if these institutions and these legal systems were forms of clothing and makeup, but inside the person is the same.

Is there a regulatory framework that would prevent severe financial crises?

Reinhart: Of course there is. But can we get there?

Rogoff: And stay there?

Reinhart: That's the question. Getting there is one thing, staying there is a different matter. And that's where the memory, or the dissolution of memory, kicks in. This comes out very clearly in our chapter in the book about banking crises.

Devastated by what happened in the 1930s, the architects of the Bretton Woods System at the end of World War II, including John Maynard Keynes, were very leery of financial markets. This was an era of financial repression. Trade boomed. Not trade in finance, but trade in goods and services. And this very tight system, with all its distortions and problems, still delivered decade after decade of no systemic crisis.

Between 1945 and 1980, it was an unusually quiet period. But then, by the late-1990s, the regulations seemed passé. The financial system found ways of circumventing regulation. It was outmoded. It was discarded, and we started anew.

Rogoff: It's important to channel some financing into safer instruments. If banks were to finance themselves like normal firms by raising a significant share of their lendable capital through issuing equity or retained earnings, we would have much, much safer financial system. So that's a very simple change.

In closing, what's your assessment of the financial crisis in Europe?

Reinhart: The short answer is that it is a lot worse there than it is in the U.S. in terms of the financial crisis morphing into an immediate sovereign crisis with a very deep, double-dip recession. But [European Central Bank President] Mario Draghi has tried to be much more accommodative with regard to purchasing the debt of periphery countries. That's a very big step in the right direction.

But it's very clear that the euro zone needs higher inflation. The orders of magnitude are such that fiscal austerity, together with the ECB easing, won't be sufficient to deal with the extreme debt overhangs in places like Spain and Ireland. And so, bottom line, we expect to see more credit events, including the writing off of senior bank debt.

Credit events don't end with Greece. This is not a Greek problem. This is a European problem. So be prepared for a lot of volatility surrounding future credit events.

Thanks very much.

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