International Affairs Forum:: What do you view as the successes and shortcomings of the Fed and ECB’s policies in addressing the economic recovery? Dr. Laurence J. Kotlikoff: The ECB and the Fed have created a huge amount of money to stabilize their economies and the financial sector. In the process, they've also created the potential for very high inflation if not hyper inflation. I think they’ve succeeded so far in restoring economic growth, although it's not yet very significant, and they've also succeeded in stopping the failure of major financial institutions. So this can be judged to be a success. But, as I said, the ECB and Fed have created a lot of money. In the case of the U.S., by the end of 2011, we will have more than tripled the base money supply compared to 2007. That lays the foundation for more than tripling the price level. There is a real danger from these banks that are now holding all this money that's been printed, as a large part of their holdings are in the form of excess reserves. If the banks begin to lend out those excess reserves, which are massive, we could see prices take off quickly. The other major concern is that the financial problems that were there and caused the crash in 2008 haven’t really been addressed. We still have a highly leveraged “trust-me” banking system, providing no real disclosure as to what the financial intermediaries are doing with our money. For all we know, they may be investing in assets that are even more toxic than those they fraudulently produced prior to the crash of 2008. When people got a whiff of that fraud, they quickly ran on these institutions and they would have kept running had the Fed and ECB not stepped in. You’re talking about a situation where only a handful of people at the top of these huge institutions have access to the true financial picture of those companies. In the case of Bear Stearns, there was Jimmy Cayne (a college dropout, who sold Xerox machines and scrap metal), who got a job at Bear Stearns on the basis of his excellent bridge game and then ended up being the head of the firm. At some point, when the public looks at someone like that, who's purported to be smoking dope and was off playing bridge or playing golf during critical times when the bank needed supervision, they say forget it and all withdraw their money in a rush. Then, when you’re highly leveraged, the bank doesn't have the equity to cover the run. You could have a 10%, 20%, 30%,… capital ratio -- it still wouldn't be enough if there's a fraud run. We need to move from “trust-me” banking to “show me” banking and take the leverage out of the financial intermediaries. That’s where my limited purpose banking proposal discussed in Jimmy Stewart is Dead comes in. IA-Forum: Turning back to the ECB, what are your thoughts on their steps towards addressing the sovereign debt crisis? Dr. Kotlikoff: The US and Europe both have major long term fiscal problems. I think the US fiscal ones are much more severe than those of Greece, Portugal, Ireland, Spain, and Italy, because we have an out-of-control healthcare spending problem. We have a sovereign debt problem as well. But the vast majority of our debt is implicit. It's in the form of unofficial IOUs, obligations to pay Social Security, Medicare, and Medicaid benefits as well as the new health exchange benefits. We also need to make defense spending and other discretionary expenditures. While the Europeans also have a lot of implicit debt, I think it's smaller as a share of GDP than ours, in large part because they have more control of healthcare spending than we do. Whether here or in Europe, there is a real risk that fiscal problems could lead to another major meltdown of the financial sector. If countries start to default on the bonds they’ve issued, the banks holding these bonds may go under water. In this case, the countries will have to print money to try and shore up these banks on top of the money they've already printed. Then people will become worried that there will be very high inflation or even hyperinflation. If you expect to see high inflation or hyperinflation and you're holding deposits in the bank, what you want to do is take your money out of as soon as possible and buy something real, like a new sofa or television or car. So money becomes a hot potato when people get the idea in their head that there's going to be inflation. My concern about the sovereign debt [issue] in these European peripheral countries is that if they do formally default, the banks will be forced to take explicit write downs. Then these banks could be formally declared insolvent and need to be bailed out. That could just trigger further expectation of inflation. I think very shortly we're going to see something happen. I think the Germans' appetite for printing a lot of money to bail out Greece and these other countries is limited, and I think they're likely to say no more. In this case, Greece is likely to formally default or restructure its debt. If that happens, Greece could decide to go off the euro but then everybody who had money in Greek banks would run and try to get their euros out because they won’t know what will happen with their euro accounts. That in itself, could trigger a run on the Greek banks. And a default could put the German and French banks holding Greek sovereign debt, under water. So you have risks either way. I think there is a way for Greece to proceed, but it’s more likely they're going to do one of two things: go off the euro and, in effect, default; or just default directly and stay on the euro. Dr. Laurence J. Kotlikoff is a William Fairfield Warren Professor at Boston University, a Professor of Economics at Boston University, a Fellow of the American Academy of Arts and Sciences, a Fellow of the Econometric Society, a Research Associate of the National Bureau of Economic Research, and President of Economic Security Planning, Inc., a company specializing in financial planning software. Professor Kotlikoff publishes extensively in newspapers, and magazines on issues of financial reform, personal finance, taxes, Social Security, healthcare, deficits, generational accounting, pensions, saving, and insurance. His most recent book is Jimmy Stewart Is Dead.

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