UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 615-ii

House of COMMONS

MINUTES OF EVIDENCE

TAKEN BEFORE

TREASURY COMMITTEE

Banking Crisis: International Dimensions

Tuesday 16 June 2009

PROFESSOR WILLEM BUITER, DR JON DANIELSSON, PROFESSOR JOHN DRIFFILL and PROFESSOR MARK TAYLOR

Evidence heard in Public Questions 59 - 122

USE OF THE TRANSCRIPT

Oral Evidence

Taken before the Treasury Committee

on Tuesday 16 June 2009

Members present

Mr John McFall, in the Chair

Nick Ainger

Mr Graham Brady

Mr Colin Breed

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

John Mann

John Thurso

Mr Mark Todd

Mr Andrew Tyrie

Sir Peter Viggers

________________

Witnesses: Professor Willem Buiter, London School of Economics and Political Science, Dr Jon Danielsson, London School of Economics and Political Science, Professor John Driffill, Birkbeck College, and Professor Mark Taylor, Warwick Business School, gave evidence.

Q59 Chairman: Welcome to this Banking Crisis inquiry. Can I ask you, starting with Professor Buiter, to introduce yourselves for the shorthand writer, please?

Professor Buiter: I am Willem Buiter, Professor of European Political Economy at the London School of Economics.

Dr Danielsson: Jon Danielsson, Reader in Finance, London School of Economics.

Professor Taylor: Mark Taylor, Professor of International Finance, University of Warwick.

Professor Driffill: I am John Driffill, Professor of Economics at Birkbeck, University of London, and Director of the ESRC's research programme on World Economy and Finance.

Q60 Chairman: You are all welcome. We hope to finish this session by 11.30 at the latest, so not everyone needs to jump in to every question; you play to your strengths. Can I start by looking at the issue of what the Governor of the Bank of England called "an unprecedented and synchronised downturn in business and consumer confidence around the world"? Was it synchronised? Or was there a decoupling? What were the reasons for it?

Professor Buiter: It was pretty synchronised, as global cycles go; every country in the world, except North Korea, underwent a downturn. It started in the US, but the UK and then the rest of continental Europe followed soon after, and then the emerging markets chipped in. So it was triggered by the financial crisis that had a common cause, but I think it was primarily a fall in investor confidence rather than in consumer confidence.

Q61 Chairman: Perhaps we can talk about the decoupling issue. Will the present crisis provide the stimulus for decoupling to begin? Was there a decoupling?

Professor Driffill: There has been a lot of talk about decoupling. It is a kind of mysterious business because the way in which the world has been changing you would have thought would have led to exactly the opposite phenomenon from taking place; more and more trade and more and more financial and investment linkages between the developed and the undeveloped world, and on the developing world the emerging markets, and you have seen more coupling, I would have thought, rather than decoupling. The synchronisation has been the exact opposite of decoupling. So it has really affected, to a greater or lesser extent, all of the emerging markets in Asia, Africa and South America.

Q62 Chairman: The New York Times described it as: "A true decoupling may not be so much between the United States and the rest of the world as between segments as the global economy cater to the burgeoning nouveau riche of emerging economies, on the one hand, and most other commercial sectors on the other". Would you agree with that?

Professor Buiter: In part, yes. Those countries, regions, that (a) have not had their financial sector destroyed, (b) are not too dependent on external finances and (c) are not dependent on internal trade will lead the recovery, and the downturn could indeed be v-shaped. We are seeing that, probably, in China, India and, possibly, in Brazil, but that is about it at the moment. There are many nouveau riche who are not doing too well at all; the Middle East, by its standards, is doing very poor.

Dr Danielsson: I would think that the crisis demonstrates how integrated the world is and how synchronised everything is except for North Korea, Cuba and a couple of other countries. I would tend to disagree with the statement in the New York Times.

Q63 Chairman: On to Eastern Europe. I note recently (12 June) that the Latvian Prime Minister said that he had saved the country from bankruptcy, but the cuts he will impose will include reducing old age pensions (and I quote this from the BBC) by 10% and cutting public sector salaries by 20%. However, the Latvian Government have decided against increasing income taxes. What lessons should we learn from the problems that have hit Eastern European countries such as Latvia and Hungary?

Professor Driffill: They have grown very, very rapidly, partly on the back of somewhat speculative investments, and they have relied heavily on external finance, and when that has been pulled out the whole thing has gone pear-shaped very, very quickly.

Professor Buiter: Latvia was a country that was going to go off the cliff for domestic reasons; it had the most unsustainable boom I have ever seen anywhere - 9-10% growth for seven or eight years, and enormous appreciation of the euro exchange rate. The current deficits are larger than Iceland's - it was unbelievable. Of course, it was enabled and facilitated by the willingness of the rest of the world to throw very cheap capital at it, but the problems of Latvia are primarily found inside Latvia - they were grotesquely mismanaged.

Professor Taylor: I think it is worth noting that the problems in Eastern Europe, to some extent, mirror the crisis that occurred in East Asia in 1997/98, and what is striking is the failure of those Eastern European countries to see that parallel, and the rest of the world also to see that parallel.

Q64 John Mann: Senior people in the Home Office and the police warned of social unrest in Britain (which we have not seen) because of the economic crisis. It is not just Latvia that has seen major social unrest; we have seen riots and near-riots in a number of European countries, all in Eastern Europe, in very recent times. How important is membership of the eurozone to avoiding such crises?

Dr Danielsson: I do not really see membership of the eurozone as being very helpful. You might see riots in countries that are within the euro; we do see Greece suffering bad problems; we do see Ireland suffering bad problems. The countries that have seen these riots are countries which have unsustainable economic growth fuelled by the inflow of hot (?) money without the institution in the background to sustain it and without, really, the economy developing to accompany it. In a country like the UK, which is a much more solid economy, I would not expect to see anything either of the economic downturn nor of the unrest.

Professor Driffill: Membership of the eurozone would help a country like Latvia but using the euro would obviate the chance of a catastrophic collapse in the exchange rate, which hits very heavily a country that has large external borrowings in foreign currencies. So the Swedish banks have invested heavily in Latvia and Latvia has a lot of external debt in foreign currencies. Then devaluation of the currency becomes very, very expensive, and being a member of the eurozone would cut that out.

Q65 John Mann: It is very easy to analyse currency and exchange rates in those statistics, but there seems to be no ease of monitoring mass movements of people which we appear to have witnessed in different directions in the last two to three years, including, since the economic crisis, people moving in large numbers within the European Union. How much of a factor is that, and is it a positive or a negative factor in terms of labour market flexibility or in terms of creating further instability?

Professor Taylor: Typically it is a positive factor in the sense that within a common currency area you can adjust or you can compensate for the lack of monetary instruments being the same across a country which may be accelerating different phases of the economic cycle, typically, by capital and labour mobilities - classic criteria. So it does not count as much with mobility to the UK, of course, because we are not part of that common currency area.

Professor Buiter: Labour mobility has always had bad data (?) in Europe as anywhere else, because so much migration is illegal or, even when it is legal, it is just not registered. Within the EU there is no longer a need to register but even across the border the massive flows have certainly increased the flexibility of the labour market but, also, made social tensions, and that is true everywhere in Europe; it is true in this country (that is when British workers objected to Polish gas workers on various sites); it is true in the Netherlands. So migrants, immigrants, are always an easy group to blame for either feeding off the public purse or taking your jobs in a downturn, and those sentiments we hear loudly and clearly now.

Q66 John Mann: I am not interested so much in the question of blame; I am interested in the economic consequences. Let me put a proposition to you: there appears to have been a significant move of East Europeans from this country back to countries such as, particularly, Poland but, also, to the Baltics, in quite huge numbers because they are the most flexible within the labour market here. That appears not to have significantly registered in terms of economic analysis in this country. Yet, those countries do not appear, despite being in a worse recession, to have been negatively impacted by this movement back. Is that because these people are highly skilled and are contributing more? Are they part of the potential salvation or are they an additional burden on those countries? Normal economic analysis would suggest a sudden movement back at times of recession of a huge number of people without work would further worsen an economic downturn.

Dr Danielsson: It will really depend. Many of these countries did employ also substantial amounts of labour from places further east; labour that has been displaced and has gone back to its own countries. Also, many of these people who come back to Eastern Europe tend to be fairly low-skilled labour but they have developed skills in this country; they have learnt how to operate in an internationally developed economy and that will enable many of the very same people to survive in the economy back home. So they are, in many respects, better placed than they would have been before, so I would probably think it is a net benefit to those countries to have these people coming back.

Professor Buiter: It will be a benefit, because in a synchronised downturn you are simply redistributing the misery. Clearly, if Latvia were booming this would be a great time to go back, but it is not so great a time now.

Q67 Chairman: On the issue of economic consequences, there are still economic consequences for Europe. As a Committee we visited Sweden 18 months ago and they learned from the banking crisis of the 1990s and the difficult liquidity problems they had; they were fairly exposed to Latvia and the Baltic States, and Austria is very exposed to Hungary and elsewhere. The issue at the time for our Committee was the cross-border relationships, and those do not seem to have moved. Is there a possibility of a big problem coming our way which Europe itself has to get to grips with on these issues?

Professor Buiter: You are talking about the exposure to Eastern Europe?

Q68 Chairman: Yes.

Professor Buiter: It is not really big enough, relative to the size of Western Europe, to constitute much of a problem. It certainly is a huge problem for the countries in question. If Austria, Italy and Germany decided to pull the plug on their banks or their subsidiaries in Eastern Europe (they have promised not to do so but a promise is worth just that) then there would be a real disaster for these countries. The total exposure of a country like Austria, for instance, to Central and Eastern Europe is much smaller than the headline 67% of GDP that you hear because that assumes that the parent stands behind the whole balance sheet of the subsidiary, and if you are lucky you are only exposed for the equity, which has probably gone already, and any inter-parent/daughter loans you may have. So the actual exposure is much less than the numbers. They could bring down a few banks in Austria, but nothing that the Austrian Central Bank and the Austrian authorities could not live with.

Q69 Mr Todd: Can we explore the function of savings in the macro-economy. First, the exceptional level of savings in the Asian economies. What role did that play in providing a platform for some of the excessive credit expansion that led to this crisis? Then I am going to ask what is going to change in the future.

Professor Taylor: I think it played a key role in terms of building up reserves both as a buffer or as an insurance policy in the 1997/98 East Asia crisis and, also, because of the exchange rate policies pursued by some of these East Asian countries.

Q70 Mr Todd: Particularly China?

Professor Taylor: Particularly China. Of course, those savings were held in currency reserve, the currency being the dollar, so it was recycled back to the United States, and then created a financial market awash with liquidity that was simply returned.

Professor Buiter: I do not think it was the savings themselves that were a problem; that just lowered the worldwide interest rate, which is not something I necessarily frown upon, but the fact that they decided (not for a saving decision but for a full allocation decision) to hold China and the Gulf States - this increased wealth in ultra-safe and liquid form created this totally artificial demand for treasuries everywhere, including American treasuries, and allowed the US to continue on this low-interest, high-liquidity asset boom. So it was more, I think, an unusual portfolio choice than excessive saving, in a way, that was the cause of the problem.

Q71 Mr Todd: So we are agreed on that. What is going to change?

Professor Buiter: They have to change - they have to.

Q72 Mr Todd: Are they changing?

Professor Buiter: Yes, certainly at the margins they are allocating their funds, their wealth, to riskier assets. The wealth firms are not there to invest in treasuries; they went into Black Rock, which was not a terribly wise move, just to show that they were willing to consider risk, and they are going to become normal investors, but that is a question of time.

Q73 Mr Todd: Greed.

Professor Driffill: There have been some recent movements, have there not; I think some diversification of portfolios; the Chinese Government exchange reserves have been shifted away from US treasuries to some extent in the last few months. However, whether or not the enormous savings are going to continue is a more difficult question to answer; I do not think we can give a confident response to that. I guess the Chinese Government will want to engineer more domestic spending and a smaller current account surplus in the coming years because if they do not their growth is going to falter very badly because the demand from North America and Europe is not going to be there. To what extent they can do that ----

Q74 Mr Todd: Do you think we are better prepared? Obviously, this happened over a very long period of time with the effects that you have set out. Do you think we are better prepared to deal with how the Asian economies choose to allocate their savings and the consequences of that, which I think we agreed were deleterious?

Professor Taylor: The answer is probably no. There have been moves, as John Driffill pointed out, to diversify those reserve holdings, both in terms of assets and, also, in terms of currencies - a move to holding euros. However, it is relatively marginal. Of course, if it were China you would think: "If I switch out of the dollar too quickly that will precipitate a fall in the dollar and devalue my reserves". So it has to be slow, in any case. So I would say we are not desperate yet.

Q75 Mr Todd: Okay. It is a fair assumption now, of necessity, that Western economies will also have to increase their saving rates as well in the next few years. What effect is that going to have? How is that going to impact on the way in which the global economy works?

Professor Buiter: If you have a universal stimulus to domestic saving rather than public in the West without offsetting policies to reduce the saving investment surplus in the rest of the world, we are going to have a period of global stagnation - demand stagnation. I see the Chinese as being rather keen to move to a domestic consumption-driven boom. They have a very rapidly growing population and they can still (and are in the process of trying to do so) use unfunded social security, which would stimulate domestic consumption demand and the government has, for a long time, tried to get its hands on the surpluses of the state corporations and may finally be about to do so. So I think there is both a desire and a possibility to tackle really excessively high savings rates. A nation that saves between 45 and 50% of its GDP must be doing something wrong. However, there are reasons for that: the one child policy, the absence of unfunded social security, very bad publicly funded health care, increasing lives, private spending to top up education - all these things are amenable to policy and the Chinese are aware of this, and they are moving, but the question is can they move fast enough to offset the need for the West, especially the US and the UK, to increase their savings? I do not know the answer to that.

Q76 Chairman: The Chinese Central Bank Governor has suggested using Special Drawing Rights as a global reserve currency. What would be needed to achieve such an operationalisation of the SDR and what are the benefits to having SDR as a global reserve currency rather than the euro or the dollar?

Professor Driffill: Someone would have to issue the SDR, like the IMF creating Special Drawing Rights, and then there is the question about how you allocate them and what would happen to the revenue from doing that, because in a sense what has been happening over the last 50 or 60 years is that the US has been providing the world's reserve currency and it has been collecting the seniorage revenue from doing that; it has been printing money on the basis of getting goods and services in exchange. So you print money at no cost and get the value of that in terms of goods and services in exchange. So it would mean a redistribution of the seniorage revenue from creating the global reserve currency away from the United States, and it could be redistributed to emerging markets and developing countries.

Q77 Chairman: Is that just an academic discussion, Professor Buiter?

Professor Buiter: No, I think the problem is that, as John says, somebody has to issue it and that somebody or something has to be credible. Historically, reserve currencies have been provided by present or past world hegemon - economically, politically, militarily. The IMF is an office of 1500 people in Washington DC; they just cannot do this. I would love to see it because I think it is very desirable that there not be a single fiscal authority such as a country standing behind the issue of the world reserve currency because the risk of it acting irresponsibly is far too great - exactly one argument in favour of the euro because it does not have a single sovereign standing behind it, it has 16, and before they agree on anything, as you know, it takes a long time. So even the chances of abuse would be lowest. I do not see, therefore - nice as it would be - the Special Drawing Right playing any role as a global reserve currency. It may, at the margin, help provide some aid for deserving developing countries but it is not a solution to the world's currency problem. We are going to move to a multi-polar world; there is a shrinking share of the dollar because America is losing its hegemon status and it has acted systematically irresponsibly, so the two criteria for being an effective issuer of global currency, being a hegemon and being responsible, are not satisfied. It is very hard to shift reserve currencies but it has been happening, and will continue to happen; in the short run the euro will gain and in the long run the ruon (?) and the rupee.

Q78 Mr Breed: Can I ask each of our witnesses to give a brief comment on the UN Panel of experts' suggestion that there needs to be a global fiscal stimulus to tackle what is the global problem?

Professor Driffill: We sort of have a global fiscal stimulus in the sense that everybody who has changed anything has been increasing public spending relative to taxation. So there has been a kind of unco-ordinated, global expansion. It is better to have a global expansion rather than a local one because if one country expands and everybody else does not, as is well known, a lot of the benefits leak abroad, and one country's increase in demand leaks out into the demand for imports, and that stimulates demand elsewhere. It is better if everybody does it at the same time, so that we all benefit from each other's expansion of public spending.

Professor Taylor: I think it is important to think about what the fiscal expansion and what the fiscal stimulus is doing. What makes this recession different from previous recessions in the US and the UK is the very large amount of debt overhang. Usually, recessions are caused by governments applying the brakes too hard because you are in a boom and then you go into recession, whereas here it was really precipitated by a collapse in asset prices, which has led to very large debt overhangs, which means that when there is a fiscal stimulus - when there are tax breaks or increases in spending - the people receiving that extra income may not spend it all; they may just pay down some of their debt, so one would expect the usual fiscal multiplier effect to be much less in those economies. If we contrast that with Japan, Japan went through a similar process in the "lost decade" ten years ago, it was just emerging from that and then was hit by an actual loss in exports markets to the West. That is more of a traditional type of downturn where fiscal stimulus is likely to have more impact in Japan. The fact that the fiscal stimulus may not have a strong impact in those countries where the debt is being repaid by the private sector does not mean it should not take place because then what it does is replace or compensate for private sector demand that otherwise would not be there. So, yes, I would be in favour of a global stimulus but for different reasons for different economies.

Dr Danielsson: The countries in the world that are able to provide that stimulus have been quite impressive in how they have stimulated their economies, and that, of course, has spill-over effects to the rest of the counties in the world because those countries have not been providing a stimulus as those who can afford to do so. However, if you are referring to this new report from the UN that is coming out next week, I think they are mixing a lot of different things into that proposal; some of them are wise and some of them are less wise. That report is confusing development aid and is confusing our responsibility to emerging markets with a global stimulus. I thought that document was more political than economic, at this time.

Professor Buiter: I agree that was definitely a Curate's egg. A global fiscal stimulus, since the world is going through a period of weak demand, would be helpful because, as my colleague pointed out, it internalises, basically, the import leakage it would otherwise have, but it would have to be modulated according to ability to put in place a stimulus, and that depends on the underlying fiscal position and according to the domestic effectiveness of the policy, which depends on the debt position, as Mark pointed out. I think, at this stage, a further fiscal stimulus is the last thing that is required, except possibly in a very few countries. Germany, clearly, looks a candidate for additional expansion of fiscal action and, possibly, France, but it is hard to think of many other places. Indeed, a number of countries like the US and the UK may have gone well beyond what is fiscally financially sustainable, and may wish to think of bringing in a measure of intelligently designed fiscal tightening, or at least an explicit commitment to do so in the near future, rather than considering an additional injection. It would help to have the Jubilee. That would take out Mark's problem, but I do not think that is likely.

Q79 Mr Breed: Nor do I. What they did say was that rapid recovery depends on there being no free loaders or free riders. Everybody can put their hands up and say: "Great idea; let's have a global stimulus" and then a few countries will sit back and let the rising debt of other countries provide this stimulus so that they can ride on the back of it. To what extent do you think that is a problem?

Professor Buiter: It has not happened a lot. Everybody that could has really done so. There are a couple of countries, Germany and France I can think of, that could do a little bit more, but nobody has free-ridden; everybody has been desperate to hand out the fiscal cookies (?). This is a theoretical problem that turned out not to have materialised in practice.

Q80 Nick Ainger: Can we talk about the role and performance of the IMF? We had Peter Chowla, from the Bretton Woods project before us earlier and he was quite critical of the IMF performance in terms of the differential way that they were applying conditionality to different economies and he put it down to there were some at the top in the IMF that were recognising that their performance had to change in the way that they assisted countries but that perhaps those further down were still operating in the same way that they were operating ten or five years ago. Do you think that these twin roles the IMF has of surveillance and lending are compatible in one organisation? Secondly, particularly, in relation to surveillance, how do you rate their performance and whether they should continue with that role?

Professor Driffill: It would be difficult to see how an international institution like the IMF can lend without carrying out surveillance of who they are lending to and whether it was likely to get the money back. I think they are bound up together. I cannot see how you can separate them. It is a sort of due diligence aspect of global lending. Arguably, the surveillance and the research that the IMF does and the information it produces has been far more valuable than its lending activities because of the heavy conditions attached. The IMF recently seems to be in a position where nobody wanted to borrow from it at all; everyone has been paying back money as fast as they possibly can. They have massively cut down on staff and their budgets have shrunk enormously. Increasingly, their resources for lending have shrunk relative to the size of the problems that they might be asked to lend to support. It is only in the recent crisis that there has been a revival of interest in borrowing from the IMF. Part of this great global expansion of reserves that we have seen over the last few years has arguably been an attempt by emerging markets to make sure that they never ever have to fall into the arms of the IMF again. So, in a sense, the IMF's conditionality has had the beneficial effect of discouraging countries from wanting to borrow from it.

Dr Danielsson: We can add that the IMF is the only organisation we have which is capable of doing the surveillance we need. If you did not have the IMF you would have to create something in its place. They have the expertise and experts for every country in the world; they have extensive databases and monitoring, and they are looking at economies. They are the only organisation we have to do so.

Professor Buiter: The IMF has two different roles: one is to look after basket cases and to lend to them. Generally, these countries come to the IMF when they are broke and facing insolvency, not fiscal problems or cyclical problems. This complete but very tough conditionality is unavoidable because nobody else will lend to them and these are countries on the edge of systemic breakdown. Then they have this surveillance role, which I view as a way of internalising global action. It is a systemic role. That does not require lending, of course. They hear the question but why should anybody pay attention? If you are not lending any resources all you are doing is presenting advice. Advice is nice but it is not very compelling unless it is backed by teeth. I agree that the IMF is the only organisation we have on a global scale; we could abolish it and reinvent it but I wonder what the role of surveillance is if it cannot be backed by instruments to exercise pressure to get incentives for the large countries that are not on the edge of insolvency to pay any attention to whatever advice they give.

Q81 Nick Ainger: Coming back to performance, Pieter Bottelier, who worked for the IMF for 28 years and is now a lecturer at Harvard, said that we need to have a way of knowing when things are going wrong; we need to know when bubbles are being created and when they are becoming dangerous. We need a warning system and there is no better institution set up to do that than the IMF. I think you all agree with that idea, but what about its performance in terms of the commodity bubble between mid-2007 and mid-2008? I do not recall much being said by the IMF about that particular bubble. Were they commenting? How effective as a surveillance tool is the IMF? Is it their problem or is it that people do not listen?

Dr Danielsson: The idea of an early warning system for the global economy is an idea that sounds great in theory but does not really work in practice. We have tried to develop these kinds of systems for the past 30 years and, by and large, those early warning systems have failed completely. We seem to be unable to predict any future uncertainty, and unable to figure out if you are in an asset-price bubble or where asset prices are at the appropriate level until it is too late. So on that score the IMF has failed, just like anybody else who has tried to do the same.

Professor Buiter: There is a further problem, at least historically, that beyond the IMF not "calling the boom", so to speak, and the imminent collapse, and the fact that people do not listen, is that the IMF is often not allowed to speak. It has been gagged, mainly by Washington, but also by other countries. That fact that it was never able to do a financial sector assessment of the US, which it wanted to do - and of the UK for that matter, which it wanted to do - is, I think, testimony to the fact that countries do not want to be told by the IMF that something might be less than blissful. So that has to change if the IMF is going to have a more significant role - it is not even teeth, it is a necessary condition for having teeth.

Professor Taylor: I think there are two problems; one is the inherent difficulty of recognising and forecasting economics, which of course is well known, and the other is, as Professor Buiter pointed out, the problem of regulatory and political capture; that politicians do not like, generally, to be told that there is a boom and that brakes ought to be applied.

Q82 Nick Ainger: Can I ask one more question, which is a hobby horse of mine? Please accept my apologies to the rest of the Committee. There is a concern that the oil price, which has now gone from $35 per barrel to $70 per barrel in the space of a few months, means we are seeing another bubble in commodity prices, particularly in the crude sector. Do you think that there is a risk that if it continues, with rising energy costs as a result of that, we will actually see a delay in the recovery?

Professor Driffill: Low energy costs would undoubtedly help move things along more quickly, but who knows whether $70 is the fundamental equilibrium in the long-term or a medium-term right price for oil or not? It is very, very difficult to see certain factors impinging on the oil market. That bedevils the whole business, really, of spotting bubbles in advance and nipping them in the bud or doing anything about them; there is just huge uncertainty surrounding any of these estimates for estimating the fundamental equilibrium exchange rate, or figuring out whether there is a bubble in commodity prices or oil prices - extremely difficult to do. You get one group of experts who will give you an authoritative explanation for why there is a bubble and another will give you a compelling argument as to why there is not. Identifying bubbles is an absolute nightmare to do, without the benefit of hindsight. Once they have burst, of course, we can all agree, but without the benefit of hindsight it is totally different.

Professor Buiter: If you are going to have a world recovery oil prices will go a lot higher than this. It is not at all clear that what is going on at the moment is a bubble. There has been very little investment over the last few years in exploration and increasing extractive capacity. Supply has also been shrinking because of exhaustion of previous fields. So I am not surprised that oil prices are rising and I hate to think what is going to happen with commodity prices generally as and when we get a global recovery, with a potential automatic dampener of quite major proportions for the West.

Q83 Nick Ainger: Just a final point on that: there was a lot of conjecture around the amount of speculation on the commodity markets; that commodity index funds, university endowment people were pushing money into the commodity markets because equities were not giving the returns that they had hoped for. I asked this question in New York about the actual flows of volume of trading - not the trading of the physical oil but the actual volumes of trading in futures. Do you know of anyone that has done any serious research on this, because nobody seems to be able to answer whether there were, if you like, spikes in the amount of volume of trading?

Professor Buiter: There was quite a bit of research at the end of the last big spike when oil hit $145 a barrel. People looked at whether speculative action in the futures market has any systematic relationship, and it was basically impossible to do so. The reason that this is so hard is that if you have all the futures market information you can spread bet on the price of oil and that does not show up in anybody's records. This is interesting research generally but not something that I think is going to give you results any time soon.

Q84 Mr Love: I wanted to ask one question going back, actually, to a comment that Professor Buiter made earlier on about a more significant role for the IMF, taking into account all the difficulties there are for the IMF, which we have gone into. What should be the more significant role for the IMF?

Professor Buiter: To me it is not short-term macroeconomic cyclical advice but it is exactly the stuff that it is stopped from doing for the big countries: do an impartial assessment of macro-prudential institutions - FSA-plus - and publish it. This is the key thing. Do it without interference; not a document that goes through the board and is vetted by 27 cardinals; it has to be an independent, professional view of the board, and out in the public domain. I think that would do more for systemic stability, even if you cannot call bubbles, than anything they have been able to do so far. If they cannot criticise, implicitly or explicitly, the big countries they might as well pack up.

Professor Taylor: I would echo that. One way to think about it would be to think of the IMF as playing a role that is parallel to the role the World Health Organisation plays in health; to be the world finance organisation in that sense.

Q85 Sir Peter Viggers: I would like to ask about the link between macroeconomic and regulatory policy. Worldwide macroeconomic policy allowed conditions to develop where there was wide liquidity and low interest rates, and of course regulatory conditions allowed dangerous exploitation. What do you think the present crisis has taught us about the link between the worldwide financial system and the worldwide real economy?

Professor Buiter: You can have a collapse of most of the world's financial system and only have, by most standards, still a quite modest collapse of the real economy. That is sort of the good news. However, I would have expected that the magnitude of the financial disaster that we have seen would bring down the real economy much further. It is bad enough as it is - I am not minimising the depth of the recession - but most of the Western world's cross-border banking system is only standing because of past, present and anticipated future government financial support. New lending flows are low, capital markets are only just reviving, so it shows you that there must have been a lot of stuff that went on in the financial system that did not touch on anything real - as well as some bits that really did impact on the real economy. We have to find out which bits are the ones that matter for transmission of policies and other shocks to the real economy and which ones are, really, in some sense, macroeconomically irrelevant - we are not clear on that yet. I suspect that hedge funds are under the "macroeconomically irrelevant" category.

Professor Taylor: Interpreting your question as asking about macroeconomic policy and the shift towards some kind of inflation targeting or perhaps de facto inflation targeting in many countries, which apparently for a time did appear very successful and led to low, stable inflation and low interest rates and the role that played in talking about global imbalances being recycled, and need to be recycled and search for higher rates of return led to, if you like, a generation of various forms of financial assets and derivatives which could generate those apparently higher returns. So, in some sense, it did have a role to play there. The key issue is really not about the macro policy so much as it not being coupled with an appropriate macro-financial regulation to try and dampen some of those asset market bubbles that occurred.

Q86 Sir Peter Viggers: Following that point and following the point made by my colleague, Nick Ainger, it is commonly agreed (I am quoting from the High-level Group on Financial Supervision, chaired by Jacques de Larosière) "that monetary authorities cannot avoid the creation of bubbles by targeting asset prices and they should not try to prick bubbles. However, they can and should adequately communicate their concerns on the sustainability of strong increases in asset prices and contribute to a more objective assessment of systemic risks." So who is "they"? Who do you think should lead us in this search for communicating their concerns about the sustainability of strong increases in asset prices? We have referred to the IMF and rather put the IMF on one side as not being the lead body. Bearing in mind that it is international bodies led from the United States and from Europe with no accountability through to the third world, who should we be looking to to give the lead in this to carry us through this search?

Professor Driffill: I read that as a suggestion that the bodies like the Bank of England and the European Central Bank and, also, the regulators - the FSA and others - ought to be making statements of that kind; that there are big downside risks to asset prices and that they should have been speaking up a lot more loudly in the run-up to the present crisis.

Professor Buiter: Open mouth operations are only, I think, useful at the margin, and it is clear that central banks should be doing it. If it is a national problem it should be through the central banks; if it is a global problem it should be through all of them together at the VIS, which represents them, but I think it is much more important from the point of view of global stability that regulatory instruments be allocated or necessarily designed to control credit growth; not target asset movements directly but simply to, basically, tax credit growth that becomes, simply by historical standards, abnormally high through countercyclical capital ratios and other requirements like that. That, I think, is rather more attractive than expressing one's deep concern, which may have some effect but fundamentally is cheap talk.

Q87 Sir Peter Viggers: As to standards, do you share the concern of the Bretton Woods Project which points out that the Financial Accounting Standards Board and its international counterpart the International Accounting Standards Board have no public accountability and that third world countries are not represented in this view? Do you share that concern?

Professor Driffill: It is certainly true that in the formulation of the Basel capital requirements the third world emerging markets were shut out of the negotiations that led up to that, and the Basel itself took no account of their needs.

Dr Danielsson: I would tend to disagree with that, both on the Basel Committee and also on the issue of accounting. I would rather think that the accounting norms are rather universal and the same rules will apply in the most developed countries and the least developed countries, and the countries that have the most experience in running an advanced economy are probably best placed and the most expert to develop these accounting standards. So I would not see this as a serious worry that the less developed countries are not represented on those bodies.

Professor Buiter: I have the opposite problem that I think the accounting standards boards - both the ISB and the FASB - have become too political and too lobby-able; that it made bad mistakes during this recession in response to political pressures emanating, in the first instance, in the United States but then, also, spreading over to Europe to allow banks to basically mess around with market-to-market and move things between different categories of their balance sheet in order to hide the true state of the balance sheet. I think that has prolonged the uncertainty about the true state of the bank balance sheets. So by all means let us have accounting bodies from developing countries represented on the FASB, but I would not want governments to have, in a sense, day-to-day political influence over the accounting standards. It would be a nightmare; we have far too much of that.

Q88 Mr Fallon: That is, in fact, what has happened and that is what did happen in Europe. Perhaps we could turn to the issue of international financial regulation more generally, Professor Taylor and Professor Driffill. We have seen the counter proposals now being published and the European Union has suggested colleges of supervisors. How close are we to a system of global regulation? Would we miss - should we miss - a degree of regulatory arbitrage if we got there?

Professor Taylor: I think what is missing from the current financial regulatory system is a system of countercyclical charges so that during the boom when banks' capital grows in value they can basically lend more and more, as there is more liquidity in the system, so it becomes fuel for the cycle. In contrast, when there is a collapse and the capital shrinks in value they have to shrink liquidity, shrink lending and it exacerbates the downturn. Clearly, there is a case, I think, for having some kind of countercyclical capital charges and the capital charges vary over the business cycle. That comes back to this point we raised earlier about trying to pursue two targets with one instrument; you cannot pursue asset prices and inflation with just interest rates, so a second instrument would allow us to effectively target both of those. Even at the moment we have had this global shock, the economy is in different phases of the cycle even now. In more normal times the cycle varies enormously across countries and, therefore, that countercyclical regulation should vary across countries. So what I would certainly be in favour of would be some global type of regulation that is applied by the host country in a countercyclical fashion.

Q89 Mr Fallon: Changes to the Basel framework have notoriously taken years to achieve. Do you really see that being put in place reasonably quickly? Everybody now seems to be in favour of it but getting it in place may take some time.

Dr Danielsson: I would think that most of the proposals on a global regulator either within Europe or even across the world, they sort of do miss the point, which is that what this crisis has shown is that we are further away now from having a global regulator today than we were two or three years ago. Tow or three years ago we had the idea that you could have the function of a central bank separate from the treasuries and separate from the regulator, and you could somehow get the regulators to co-operate internationally, but then leave serious financial matters for the home country. What the crisis has shown is that one of the most important institutions is the treasury and the least important institution is the regulator. Very few countries are willing to give up that power; very few countries are willing to face the possibility of saying, if a bank in a different country blew up: "I should be paying for that" or "I should contribute to that or deposit insurance or provide lending capacity for it". At the end of the day, it comes back to the national treasury, and countries are now much more jealously guarding their control over financial regulation than they were two or three years ago. What we are, I think, more likely to see - and this would be a positive development - is a discussion with the college of regulators, whatever that means. Basically, it is an entity that is designed to share information so that the regulator in this country facing a bank that operates across Europe would have a clearer idea of what the bank is doing everywhere and, therefore, they would spot immediately if that bank is committing fraud or is taking on too much risk, or whatever. So it is the information sharing and the co-ordination that Basel takes as a possibility, but regulation is going back to the home country and not to global regulators.

Q90 Mr Fallon: That does not get you round the issue of fiscal burden sharing, does it? It still separates the regulation from the fiscal responsibility.

Dr Danielsson: What the crisis has shown is you cannot really separate financial regulation away from fiscal policies. If you use public money to rescue or intervene in financial institutions it becomes a national matter immediately, and we are not going to get away from that.

Q91 Mr Fallon: So you do not see any hope for the ECOFIN proposal that there should be from the college of supervisors some kind of binding mediation that involves some loss of sovereignty?

Dr Danielsson: It depends a little bit on how you define the scope because there have been various proposals and they are often contradictory. There is considerable scope for co-operation. What we have seen in the crisis is that the banks have been able to operate across Europe without any regulator really understanding what they were up to, and that contributed to these banks collapsing afterwards. That is something people want to avoid. So the regulators do need to co-operate more; they do need to share information and they do need to co-ordinate the responses, and we do need to have the same sort of regulators across all countries. At the end of the day, it is the treasury that pays and they are going to decide.

Professor Driffill: I guess the global regulatory design is to prevent a kind of regulatory race to the bottom; perhaps one saw something of that over the last 20 years, with Britain as one of the winners. It now appears that is a much less attractive type of race to win because Britain led the way and the whole thing blew up in its face. At the moment I do not think it is a very good incentive.

Q92 Mr Fallon: What is the point of all the extra transparency and information sharing between supervisors if, in the end, there is no blight on, say, what is happening?

Professor Buiter: We are not going to get a global regulator; we may not even get an EU regulator in any meaningful sense because, as Jon pointed out here, to have even a college of regulators that means anything you need a college of fiscal burden sharers to accompany it - either that or something rather close. We have just had quite a kerfuffle about Britain objecting to the new-fangled micro-prudential council, the ESRC (not the economic and social issues council but the other one) being able to basically mandate the use of national fiscal resources to recapitalise the bank along the lines recommended or required by this European regulator. That clearly is a non-starter in the current EU competences, because there is no fiscal Europe. You could do something very similar, simply by mandating recapitalisation; and then whatever way you do it, if you cannot do it fiscally then you call on your unsecured creditors of the banks to turn their debt into equity and recapitalise that way. There are ways I think of having a European-wide college of regulators that would have teeth without being able to impose certain recapitalisation, for instance, without it necessarily meaning mandating the sovereign to do anything on the fiscal side. Could I also say, it is not clear that a single regulator globally would be necessarily the optimal thing: it would be in a "Philosopher King" world but in the real world it is certainly possible with a single global regulator we would over-regulate. Therefore regulatory arbitrage - it is indeed a race to the bottom and I have written that myself - could start not from the right position but from a position that has too high a level of regulation and therefore could bring you closer to the optimum. One has to be careful - it is like tax competition: it can be nefarious; but without tax competition within countries, if the tax burden were to be excessive, it may be a second best mitigation of the problem. I think the reality will be, except possibly in Europe if we get a cross-border college of regulators with teeth, we are going to see a major retrenchment of cross-border banking. London will be the first victim of that, because this is the home of cross-border banking.

Dr Danielsson: I would disagree with that actually. To take up the last point, I think one of the things we can see out of the crisis is the re-emergence of securitisation and London is going to benefit from that. Financing will remain high tech, and replacing Europe as opposed to exploiting the high tech finance in London. I would agree with Willem's statement that banking is going to become much more national. One thing that we will see coming out of this is that countries will want banks to be capitalised in the host country; that the branches be capitalised and regulated in the host country. The accusations that have been levied at some of the European banks - like Austrian banks, that they are taking money away from Eastern Europe and taking it back to Austria, Sweden or wherever - that this is something countries object to, and they will safeguard against that. We will see banks be much more autonomous in the various countries: but, at the same time, I would also expect to see the emergence of even more securitisation, more insurance within the more high tech finance, and that always benefits the most advanced, which today is London.

Q93 Mr Brady: Can I pursue that point a little further. Professor Buiter, on 23 April in the Financial Times you wrote that you cannot have a single European regulator without having a fiscal Europe. Am I understanding you correctly today that you are saying actually there is a halfway house?

Professor Buiter: You need to be able to mandate. For certain things you could have. Certain things require fiscal resources. For recapitalisation it is not actually necessary. As long as there are unsecured creditors you can through a special resolution regime - with prompt corrective action of the kind that this country now has; it would simply tell the unsecured creditors, "Congratulations, you are now shareholders".

Q94 Mr Brady: So there is a halfway house?

Professor Buiter: Yes.

Q95 Mr Brady: That presumably could apply to countries that are not members of the Eurozone?

Professor Buiter: For this particular action; for not necessarily everywhere. If you want to recapitalise the central bank, for instance - which maybe needs to be done because central banks are taking on very large amounts of credit risk; the ECB always has; even though it is only just beginning to purchase outright, they have got a lot of rubbish assets on their balance sheet; and if they were to blow-out in a major way then to meet its price stability objectives they might require recapitalisation; and that requires a fiscal Europe. You cannot tell the senior unsecured creditor of the ECB to take a more equity.

Dr Danielsson: I will disagree with that last statement because the way the ECB is providing liquidity is they are taking a lot rubbish assets on the books, but it is the national treasury that backs it up. If a Spanish bank blows up and defaults on its obligation to the ECB, the ECB will call the Government of Spain and say, "Give us our money bank".

Professor Buiter: No, this is not how it works.

Dr Danielsson: It is how it works.

Professor Buiter: It is very simple: if the Eurosystem as a whole makes losses for any reason during the implementation of its monetary policy, including debt liquidity operations, credit enhancements, then these losses are simply shared according to the capital shares by the members of the Eurosystem. There is no new money coming in from the outside. If a national central bank is asked by its national minister of finance to act as a lender of last resort - this is not monetary liquidity or a credit operation - and bail out a domestic institution that loses money, it has to be done indeed against a full indemnity. They cannot even do it without an indemnity. That is different for the operations. You can look at the balance sheet of the Eurosystem. The ECB is a pawn shop and is very small; the Eurosystem is huge. With the Eurosystem you have about €600 billion, which is assets corresponding to monetary operations which are not guaranteed by any authorities and there are separate (but on the same balance sheet) assets that are indeed effectively guaranteed by national treasuries because they have been incurred as a result not of Eurosystem operations but of the central bank of a country acting as a fiscal agent for a particular operation, separate from the Eurosystem.

Q96 Mr Brady: Professor Buiter, can I just pursue you specifically on one point arising from that. The balance of payments facility of the €25 billion, which category does that fall into or is that something which the United Kingdom might share some liability for, or is that something which would be backed up only by Eurozone?

Professor Buiter: This is the EU facility?

Q97 Mr Brady: Yes.

Professor Buiter: No, they doubled the EU facility from 25 to 50. Yes, I think some of it could in principle be used by the UK. Nothing can be used outside the Eurozone, of course; there is no balance of payments. Some of it can be used for EU members if they are not Eurozone members.

Q98 Mr Brady: We would contribute to that?

Professor Buiter: Yes. That is an EU thing; nothing to do with the ECB.

Q99 Mr Brady: Can I ask this end of the table: do you agree with that balance? Is it possible to have a European regulator without having a fiscal Europe?

Professor Driffill: I am thinking about it! It is true; someone has to pick up the bill if institutions are being bailed out. You need some method of allocating the cost across countries. Would you call that a fiscal Europe - I am not sure. It may be very limited to fiscal powers at the European level.

Professor Taylor: I would agree with that.

Q100 Mr Brady: Do any of you then think that the movement towards greater regulatory harmonisation is going to provide a motor towards the creation of a fiscal Europe?

Professor Buiter: Yes.

Dr Danielsson: No!

Q101 Mr Brady: Yes, but that would be within the Eurozone?

Professor Buiter: In the first instance, yes; but since I expect all EU members in due course to become members of the Eurozone, it should not make a difference in the long run.

Q102 Mr Brady: If it is a fiscal Europe does that not make it less likely rather than more likely that the United Kingdom would join?

Dr Danielsson: The way you ask the question is regulatory harmonisation. Regulatory harmonisation simply means you have the same rules operating across Europe. Those rules can easily mean that everything goes back to the home treasury. They do not by themselves mean any fiscal harmonisation. They could mean that, but in principle they do not.

Professor Taylor: I would agree. The point is about regulatory harmonisation but implemented at the host country level.

Q103 John Thurso: Professor Buiter, you wrote an article that appeared in the Financial Times on 26 May which contained the statement, "The damage caused by financial sector excesses is way out of proportion to whatever gains from financial innovation may have accrued to the wider economy in the last couple of decades". Would you agree with the view that financial innovation has actually been a costly diversion away from the true purpose of capital, which is to invest in commerce and industry; and has therefore been unhelpful? First of all, could I ask you: do you concur with that view?

Professor Buiter: Not quite in that form. I would agree with a weaker version of it, that there has been an enormous amount of financial innovation that has been both pointless, and there has been a fair amount that has been actively harmful. It does not mean that there has not been financial innovation that has not been useful even for the so-called real economy. All I would suggest is that financial innovation, like pharmacological drugs (not the legal variety), is re-regulated, rather than invented today, sold tomorrow. That would solve the problem.

Q104 John Thurso: The thrust of your article was that you do not mind if we have too much regulation now because it is easier to wind-back later than it is to, in boom times, add regulation. Do you think that the regulations that are being considered should actually look at, as it were, the end result of what is happening to capital, and regulate in such a way that more of it goes directly into investment in commerce and industry and less of it into speculation?

Professor Buiter: I do not believe that regulators can really foresee all the possible consequences of financial innovation. Much of financial innovation is driven by tax arbitrage and regulatory arbitrage, and so that is almost, by construction, socially unhelpful. A lot of the rest is organising more and more complex ways of betting on other asset price movements through derivatives. Sometimes that can be socially helpful. Much of the time, I think interest swaps by and large have been a useful invention. In the case of CDS, it has become a deeply destabilising instrument that should be regulated to within an inch of its life. I think one should look at proposed new instruments and have them tested again in little laboratories of this kind before they are let loose on the markets. I am sure that the sub prime mortgages if they had been vetted properly would not have flown, because it was clear that the derivatives based on them only had value on the assumption that house prices would forever rise faster than the interest rate on the mortgage.

Q105 John Thurso: Do you think there is a danger throughout the world with all the different regulators, given the shock and fright that everybody has had, that we will end up, as it were, regulating to solve the last crisis and we will miss whatever is going to come down in the future?

Professor Buiter: That always happens; that is a given. We are going to have over-regulation; we are going to have the wrong regulation; and we will be winning the last war. I am sure we will never have a sub prime disaster again. That would be nice. Hopefully people will try to look at risk generically, rather than at the most recent manifestations of particular kinds of risk when they design regulative frameworks. I think the Financial Stability Board may not be a good vehicle for assuring that we do not just re-fight the last war.

Professor Taylor: The thing about regulation is that it is important to distinguish between regulating products and regulating behaviour, in the sense that, we thought the products themselves generated the problems but actually it is in fact the behaviour and what you do with those products. It turns out you can do a lot of damage with a simple mortgage, for example. The point is that what is necessary to regulate is appropriate recognition of the different kinds of risks that prevail in financial markets and how those different kinds of risks ought to be regulated, rather than trying to regulate individual products; because markets are always capable of generating other products that look very much like the one you are trying to regulate. It really needs to get back to incentives and appropriate classification and regulation of risk.

Q106 John Thurso: At the heart of regulation has to be a more conservative approach to how we look at risk; a precautionary principle with regard to risk, which is that if something looks great fun but clearly there is an unknown quantity of risk, it should not be allowed to fly until it has been worked through. We have seen some products which, with hindsight, you think: how could anybody rationally believe that that product was ever going to do anything other than self-implode? Back in the day, when this Committee was in Washington two years ago, we had Hank Paulson and Ben Bernanke telling us not to worry about sub prime; it was going to be a small matter in a couple of states. With the value of hindsight those look like modest under-estimations of the problem.

Professor Taylor: If you were to identify, for example, different kinds of risk institutions face and distinguish between credit risk, liquidity risk and market risk for example, and then apply different kinds of capital charges according to the different kinds of risk, and look at perhaps what kind of maturities were being matched within an institution's portfolio, then you may effectively be able to regulate those more exotic instruments without regulating them directly; that is what I am thinking; looking more at the behaviour and the incentives for holding them than actually trying to regulate the individual product itself.

Q107 John Thurso: Can I perhaps stick with you, Professor Taylor, and move on to something slightly different but part of the same thing which is the so-called shadow banking system, which has seemed to be very much a part of the transmission mechanism, if you like, within the current crisis. What do you think might be the appropriate international action to be able to counter that? Do you think that the shadow banking system is an important part which, by operating in a different way, can add value?

Professor Taylor: I agree, I think it probably does add value. I think it needs to be an increased umbrella in terms of regulation in order to cover that shadow sector, quite simply.

Dr Danielsson: I would think that shadow banking - I would define that as what is outside the regulatory umbrella - is a good and positive thing to have. Take, for example, perhaps the biggest part of the shadow banking system, the hedge funds. Before the crisis the current view was that what would blow up the financial system would be hedge funds. It turned out to be they were completely benign. What the hedge funds have done, by virtue of being unregulated, they are the entities able to buy the distressed assets. When a big bank needs to sell assets to raise capital because of high risk, to have somebody come in and buy that from them is a positive thing to the economy; it is a positive thing to the bank; and it is a positive thing to the taxpayer. We all have benefited quite considerably by the presence of shadow banks and by the presence of hedge funds, in particular, in the crisis. Trying to regulate those entities out of existence or bring them under a regulatory umbrella, which basically means the same thing, would be a huge mistake.

Q108 John Thurso: Some of the hedge funds have blown up pretty spectacularly and an awful lot of investors who relied on them lost a lot of money?

Dr Danielsson: The investors in hedge funds tend to be two types of entities: either wealthy individuals; or institutions that can afford to hire financial advisors. I do not really feel sorry for those entities; and I do not think it is the public role to protect them.

Q109 John Thurso: It is good idea to redistribute some of the wealth?

Professor Buiter: Unlike the banks - when a bank gets into trouble it runs to the Treasury to hold out its hand - the hedge funds just implode. The population of hedge funds has been decimated. They are the raw face of capitalism but they take the downs and they do not lead to this loss of being socialised. I think they are much more honest institutions than the banks, which try to have it both ways.

Professor Taylor: It is of course true that, so-called, sophisticated individuals, sophisticated entities must be clients of hedge funds, but some of those sophisticated institutions are pension funds and when they suffer in fact ordinary people do suffer, so I do have sympathy with some people that actually have lost money in hedge funds. Secondly, the words "hedge fund" cover a multitude of sins and virtues. Some hedge funds have fared very well, reasonably well or in fact have suffered much less of a downturn during the crisis than a standard long-only-type investment policy would have - the global macro hedge funds especially, for example. Thirdly, in terms of saying "I would like to bring that under the regulatory umbrella", there can be differences in regulation; there can be lighter touch regulation certainly; but certainly it does not make sense to me to have a regulatory structure where you be outside of it in a safe haven.

Q110 John Thurso: Do you think there is a need for more transparency in the shadow banking area? We have had evidence - particularly with regard to not so much the classic long/short fund but the short-only and using the short process to actually drive the price - that more transparency would be helpful.

Professor Taylor: I think more transparency, yes, obviously would be important. There has been talk, for example, of having a clearing house which would look at the net positions of hedge funds in various assets. I do not know how feasible that would be to implement. Certainly some more transparency would be welcome, yes.

Q111 Ms Keeble: I wanted to ask about the impact of the banking crisis on developing countries, which has not been discussed much. Perhaps Professor Buiter and Professor Taylor could give me their experience of the IMF and Barclays Global as well. What do you see as the impact of the current crisis being specifically on developing countries; and do you think that separate or extra instruments or mechanisms are needed to resolve those difficulties?

Professor Taylor: I think the answer is in two ways: it impacts on developing countries because of a global downturn in demand and therefore a loss in their export markets; it is also because of a drying-up in capital that hitherto flowed to those economies. Clearly there is an immediate impact on the developing world. In terms of how you develop a regulatory framework -----

Q112 Ms Keeble: If you need separate mechanisms or additional ones to the ones that have been discussed so far to actually deal with those kinds of difficulties, particularly perhaps access to capital.

Professor Taylor: Certainly where countries are suffering loss of access to capital through no great fault of their own and they have not been pursuing profligate borrowing, as in some cases in Eastern Europe for example, it would make sense to have some sort of facility in order to alleviate those problems, I agree.

Professor Buiter: The poorer developing countries have really just been at the receiving end of this recession: in terms of trade, commodity prices have collapsed; and the export market has been hit through remittances, which is very important for many of these countries; since there is forced re-migration, people have gone abroad; and even through reduced aid flows, because aid is a residual in most government budgets and, despite protestations to the contrary, it tends to be cut during a downturn. As capital flows they were not very much part of the poorer developing countries at all. That was not one of the channels through which they suffered particularly severely. It is really through the trade and remittances side that they have suffered most, and some counter-cyclical facility with the fund, not the kind that they have, could be enhanced to allow countries to borrow their way and smooth their way through what for them is just a big commodity cycle.

Q113 Ms Keeble: The recent Global Witness report highlighted the very destructive consequences of some of the international financial systems on developing countries, in particular on quite dysfunctional economies. Do you think that some of the increased financial regulation that is being discussed at the moment would help to tackle that in terms of transparency, tracking of funding and other scrutiny measures?

Professor Buiter: I am not familiar with the Global Witness report so I cannot comment on that.

Professor Driffill: In terms of the effect of this crisis on developing countries, it is noticeable looking at the IMF world economic outlook in April that their forecasts for the real GDP growth in a lot of African countries do not look as bad as you might have thought. They all remain positive. There is quite a substantial dip in a lot of concern about these countries; but they actually have not had a dramatic collapse in growth that there has been in the US and Europe.

Q114 Ms Keeble: They have to achieve 7% year-on-year to be able to tackle some of the commitments that had been made through the international system, do they not, and they are not achieving that?

Professor Driffill: They are starting off from a much lower level.

Q115 Ms Keeble: There has been quite a lot of discussion around tax havens and increased regulation or transparency for this. Do you think that discussion was justified from the point of view of financial stability?

Professor Driffill: I am not sure that tax havens are that important quantitatively from the point of view of global financial stability and so on. They are sort of objectionable to some people. From the point of view of interfering with the flow of finance around the globe, I cannot believe they are that important.

Professor Buiter: The tax havens are regulatory havens. A lot of financial activity goes through banks and those are lightly regulated territories, many of which are actually Crown versions. That does not help because there is a lack of transparency as well as a lack of revelation of whatever income is being earned. Tax havens as simply places with low taxes I think are fine; that is the way you are going to make a living. Tax havens as ways of buying anonymity for ill-gotten gains are not a good thing; but I do not think it is a major contributory factor to this financial crisis.

Q116 Ms Keeble: How do you draw the distinction between the two then? Can I point you to the Stickler report - and it is a very interesting discussion about the need for equal rules to be applied both to the developed countries and also the smaller international financial centres - and its conclusion that, for instance, for foreign investors the US is effectively a tax haven. Where do you draw the distinction between natural competition, as it were, and unfair competition?

Professor Buiter: I do not try to make the distinction because I cannot make it. For me a tax haven is something which gives you anonymity; not something that gives you low taxes. That defines a tax haven. Basically it allows you to hide your assets or your income from the assets. Tax competition healthy/unhealthy - the UK is a tax haven for many; the Netherlands is a tax haven if you want to look at the tax rate story, but that is not what we mean here. The fact is as a US citizen you have to pay taxes on your worldwide income no matter where you live. Tax havens, in my sense of giving you anonymity, allow you to hide assets and income, and that I think is criminal and it should be banned; but I think in this particular crisis it was not a major factor.

Q117 Ms Keeble: Do you want to see the transparency dealt with rather than the aligning of the regimes? That is your concern.

Professor Buiter: If you hear how much support there is, even this country, for federalising at the European level any aspect of taxation, the notion that we are going to get a global agreement on tax rates, you cannot get global agreement on that; it is not permissible to allow citizens of other countries to hide assets from their tax authorities; that is a separate issue.

Q118 Ms Keeble: Professor Driffill, I wanted to ask you a bit more about the international systems and in particular issues around debt of developing countries; because there is concern about the increasing debt levels and the fact that some of the previous international mechanisms for dealing with this perhaps have not been adequate, or they might not be adequate for what is coming in the future. Are you concerned about the increasing debt levels; and do you think that new mechanisms are needed to deal with those?

Professor Driffill: Again, the growth in debt of a lot of developing countries does not look as dramatic as the growth in debt of a lot of the highly developed countries. It is true; I think the main problem is the real GDP growth is slowing down. As they are so poor it is a good argument for the rich countries to continue to provide aid or increase it rather than reduce it at the present time. It may be the problem is that there is a retreat from obligations towards looking at dealing with debt in poor countries.

Q119 Ms Keeble: Have you seen the recommendation in the Stickler report about having an international debt restructuring court to deal with some of the issues? What is your comment on those proposals?

Professor Driffill: That sounds like an attempt to make more systematic the kind of things that have been happening in a fairly piecemeal way under these previous initiatives for dealing with debt in poor countries, and to redistribute burdens of high-class borrowing - sort of globally socialising these debts. In terms of redistribution it would be a good thing; but in terms of incentives that is less clear.

Q120 Ms Keeble: Dr Danielsson, I wanted to come back to one point that you made earlier in response to one of the earlier questions that, when we look at the revised structures for international finance, the developed countries should set the rules because they have the experience of running the bigger economies. What do you think then the role is for the developing countries and, in particular, how should their very specific issues, concerns and difficulties be dealt with?

Dr Danielsson: I think I made a point that was slightly narrower. The point I made was when it comes to accounting standards. The accounting standards are more or less universal and we do not see different accounting standards in different countries. It is however clear that the same type of regulatory structure that is appropriate to the UK, Europe or the US is not going to be appropriate for countries with a non-existent or financial system at very low development levels. You do need a separate regulatory structure for those countries; but when it comes to designing international financial regulations, of course the Basel regulations were decided by the Basel committee - and it is a committee of the biggest financial centres in the world - to suit their own purpose: how to regulate their own economy. They were never designed or meant to apply in other countries; in fact those countries chose to adopt them; they did that of their own volition; they were not designed for them. This is an important distinction. They were not designed to set an international standard of anything; but only a standard for member countries. On that, the emerging market countries, led by China and followed by India, they have chosen to implement something called Basel 1A, which is a version of the Basel regulation more appropriate to the development status and a lot of emerging market countries have then adopted a form of that.

Professor Buiter: I agree, there has been a problem that developing countries have either themselves gold-plated the banking and other regulations, or have been pressurised into doing so. The Basel regulation is really just for cross-border banks even - the Basel 2-type stuff. As I have experienced at the EBID - to have micro finance banks and banks for lending to small and medium-sized enterprises - to have the Basel 2-type requirement imposed upon them is lunacy. There is a problem that things become standards even if they do not set out that way. It can become difficult to attract capital, certainly from abroad, unless you are up to the AAA standard for regulation, and you just have to get more sensible about that. I think that is a job both for advanced countries and for developing countries in the regulatory field.

Q121 Chairman: Could I thank you very much for your evidence. There have been two issues we have focussed on this morning: the international macroeconomic environment, including the global imbalances; and the international regulatory environment and the global financial regulatory system. On both those points, do any of you have any final comments to make to us as we take this inquiry forward?

Professor Driffill: One of the lessons that strikes me just listening to the conversation this morning is that although there is much emphasis on the need for more and better systematic and global regulation, it seems that much of the crisis was due to a misapprehension of the risks that were being taken. You could argue that it was not a regulatory problem at all - simply that nobody understood the risks. If the banks knew what they were doing they might well have done something different.

Q122 Chairman: The Governor of the Bank of England made that point to us a number of months ago when he said that no regulator in the world caught that problem.

Professor Taylor: I would partially agree and partially disagree with Professor Driffill. I agree that a lot of the crisis was caused by misunderstanding of the appropriate risks; but that went down to regulation as well. A lot of regulation in force did not distinguish between the different kinds of risks that different institutions were facing - the liquidity market, credit risk and the appropriateness of all kinds of forms of regulations to address those, or maturity risks for example. In terms of regulation, I think the point I would stress, which I have mentioned before, is that one should try and regulate behaviour and effect incentives rather than trying to regulate products, which would be ultimately futile. I would draw the Committee's attention to the view that has been put forward concerning the macro-prudential regulation - the idea of dynamic provisioning and altering capital adequacy ratios in a pro-cyclical fashion - as one worthy of investigation.

Dr Danielsson: I would think that regulation did fail but the question is: did we not regulate enough; or do we not really know how to regulate? I would rather go to the second point. We do not really understand how the financial system works. We have plenty of regulations; but the regulations failed because I think we do not really know how to regulate. Therefore, trying to rush into a world where we try to regulate everything that moves, as some people have proposed, would be exactly the wrong way to go about it. The next crisis is not going to come for the next 20 or 30 years. If you implement financial regulations, they tend to stay in place for a very long time - 10, 20, 30 or 70 years; they are difficult to eliminate once you have them. If the problem is caused by the fact you do not know how to regulate, I think the appropriate response would be to try to figure out what went wrong and try to decide on appropriate regulatory mechanisms, taking any time we have and have it ready before the next ten years because the crisis is not coming tomorrow. At the same time, there are things we need to do today to try to mitigate the crisis and they are part of the regulatory sphere we have to address - for example, putting CDSs onto exchanges and issues like that. We need to separate out the future from dealing with the current crisis.

Professor Buiter: Cross-border banking and financial mediation generally is under threat, and it is valuable. We should make sure that we save as much of it as we can, subject to adequate controls being exercisable. I think the position of London is really at stake more than any other place. 90% of the regulation of the financial sector for the UK comes from Brussels and we should never forget that. It is very important that whatever is decided - it does not mean you cannot have influence here, but you have to have influence through Brussels and persuading Brussels to do certain things. Then they have to find a way of addressing the "loan is too big to save" problem for banks and other financial institutions. The obvious solution to me is to stop them from becoming too big. The obvious way to do that is to tax size through, say, capital requirement. That alone would make a repeat of similar problems less likely.

Chairman: The issue of too big to fail, our Committee's last report mentioned that. I feel that this could fall off the agenda if there is not the focus kept on it. We look forward to your regular articles to keep us reminded of that, Professor Buiter. Can I thank you all for your attendance this morning - it has been very helpful to us. Thank you.