protect themselves. and that bids up these prices and the fed can't do much about that. but it can do a lot about preventing that. that's what we need them to do. we need them to provide stability. not to be ambitious. when it comes to regulation, they're abysmal. >> okay. i'm tempted to keep going. but let's move to the issue of reversing -- of reversing the policies. i mean, we all now understand your view that it was a mistake to build up a balance sheet to this extraordinary extent in the first place. but it's been done. what do you think is the likely course of action now, you know, to reverse this. and what would you do if you were in a position to influence the decision. >> i would start to reverse it. >> straight away. >> i would start to reverse it. i would raise the interest rate slightly to 1%. i would look around and see what happened.

you know, if it was too much, i might back off. but i certainly wouldn't go further. if it didn't create a lot of problems, well, i would go a little further. slowly. working toward some e quill libri librium. there's $15 trillion worth of u.s. government debt. approximately $12 trillion is held outside the government itself. every 1% that we increase the interest rate is going to raise the cost of interest payments by $150 billion. so while we're thinking about congress struggling to cut a little bit off the budget deficit, we're going to be adding with three percentage points in interest rates, we're going to be adding $450 billion or $360 billion, you know. is that good? heck, no, it's not good.

now, you know, people will say, well, you pay it yourself so it doesn't matter. but we don't pay it to ourselves. we pay half of it to the rest of the world. so that's going to have big repercussions on the balance of payments. we have worked ourselves into a terrible position. you know, we're like the guy who says -- i'm like the guy who says, stop digging. >> okay. okay. i mean, what argument -- we're going to talk about europe in just a moment. because i know you've got strong views on that also. but if you -- you know, if you compare the u.s. and europe, if you look at where they are right now, you might conclude there's something to be said both for our strong fiscal stimulus, which the u.s. had by global standards, and for aggressive monetary ease which, again, the u.s. had much more than europe did? because the u.s. is actually seen to be emerging from the recession, does it not?

you don't see those signs of recovery by any means in europe. >> i think the europeans have a mess and they're making ae inin bigger mess. you know, the greek bailout, it is surprising and extremely disappointing to me that when i read the financial times or most of the discussion, never is the word use t about cost of production. but greece has a cost of production, unit labor cost, 30% higher than germany. so every time they make an estimate of what the greek economy is going to do, it's going down. now, they say, well, by 2020, they're going to have a debt to gdp ratio of 120%. don't bet on it. their economy is collapsing. now, what are the solutions being given to them?

they're told -- the ft every day practically has somebody who says let the germans inflate or print money. germany's debt is about 80% of gdp. if it does what the financial times gurus tell it to do, it'll soon be in the same sink that the others are in. and the idea that germany is going to inflate its way out of this is nonsense. it has the highest productivity growth rate of any of them. so the result will be that the others will inflate relative to germany. that goes in the wrong direction. the german response is let them deflate. what are we talking about? for greece we're talking about a 30% deflation. 30% deflation. that's like the great depression in the united states. would you bet a plugged nickel that that's going to happen? the greeks are very, very slow to implement any reforms. 30% reduction in wages? it's just not going to happen. for italy, it's 20% to 25%. for spain, it's 20% to 25%. nobody even talks about cost of

production. but cost of production is the solution to growth. so my proposal is a very simple one which no one in europe wants to hear. and i'll tell you why they don't want to hear it in a minute. what i say is, keep the euro. divide it in two. take the southern countries and have a soft euro. float it against the hard euro. the hard euro can adopt the fiscal restraint. the soft euro will deflate, devalue against the hard euro. when it devalues to a new e quill lib ream, if they join the fiscal responsibility pact, they come back into the hard euro. that would do what the greeks, the italians, the spanish are used to. that is, you solve the problem by devaluing. and that will cut wages without having to go through the massive recession which is being imposed on greece and italy and the others.

now, that would require to do -- to solve the problem that the germans and the french who after all run the eu don't want. and that is they have to fix their banks. because their banks would be, many of them, under water. so they would have to, in my scheme of things, they'd have to lend the money to the banks to keep their capital up when they do this. but that would solve most of this problem and get europe back to growth. they don't want to do that. you know, i have a close friend who is an adviser to the top of the german government. they don't even want to hear about it. because they don't want to do what they have to do for their own banks. >> i'm interested to -- first of all, let me say, i think you might find there's more support for that kind of analysis in europe than you think. i mean, including, actually, in the aft. i'll just say a word for my former employer. i think i have seen the

occasional references to the competitiveness issue within europe. i think the ft is aware of that problem. let me just say that i'm a little surprised to hear you argue -- to hear you say that, you know, your long-term solution for the -- for europe includes the euro. that you're proposing this adjustment which would be, you know, a hell of a -- have a hell of an impact on the european union. i'm not saying it's a small thing. but then you go back to fixed exchange rates. wouldn't -- i think i might have expected you to argue that the fixed exchange rates for europe were a mistake in the first place. >> well, i am not fond of the fixed exchange rate system. i take that as a constraint because everybody that speaks about this says we don't want to give up the euro. so i'm trying to find a way in which -- >> so you do accept some political constraints in your earlier analysis? >> oh, i believe -- i am, perhaps, on the side of saying

that policy and politics have the same greek root, and it's not an accident. >> okay. so you think there is a way to rescue the -- the euro with -- wi with greece in the system? provided they're allowed this sort of one-shot devaluation? >> right, right. that will prolong the it prolon? who knows. i mean, my crystal ball doesn't look that far ahead. >> okay. we're already -- i mean, i'm already conscious that we're running out of time. i feel like we're just getting started here. if people go to the microphones to ask questions, i'll turn in just a few questions. i have another one i want to put to you if i may while people are organizing their thoughts. another very interesting column you wrote just the other day for the "wall street journal" took on another issue which is very saline to american politics

right now. this is the question of inequality. you argued if i understood the column correctly that we're making too much of this issue in the u.s. that it isn't -- it isn't distingtsively american phenomenon. and dealing with the inequality problem, if we have an inequality problem, shouldn't be the organizing principle or shouldn't be an organizing principle for economic policy going forward. just -- i mean, have i got that right? >> you did. >> okay. >> let me say, first, i am a strong believer in the idea that every election and certainly this one is an election about whether we have more spending or more -- or lower tax rates. that's always true. and to pat myself on the back, i wrote the most -- excuse me. the most widely cited paper i wrote is a paper that says -- >> let me get you something to

drink. >> -- exactly that. now, what the column says for the benefit of those people who don't read "the wall street journal" -- thank you. what the column says is, it shows a picture of seven countries, diverse countries, the united states, britain, france, canada, australia. those are among the seven. for 100 years it shows the share of the income going to the top 1%. that's what the people who complain about this talk about. the one in the 99. so it shows it. and what it shows most strikingly is that they all move down together. and they move up after 1980 together. now, there are two very interesting facts in that chart. at least two. the first one i've already told you. they all move together.

the second one is, that during that period in which we had massive redistributions in all countries, all seven countries had very little effect on the share of the 1%. the big fall in the share of the 1% comes as a result of the operation of capitalism. it reduced the real interest rate and, therefore, the income of those in the 1%. now, after 1980 they all turn up. some more than others. the united states, britain and canada turn up the most. sweden somewhat less. france, much less. why do they turn up after 1980? could it have something to do with the fact that 600 or 700 million workers were added to the labor force in china and india and that holds down the incomes of people who are in labor? in low incomes, middle income groups? boy, we've certainly seen the

destruction here. so it's pretty prima facie case that that's the case. what about the top 1% or the top 5%? why are they doing so well. incidentally, it's not my data. it's data i took from two swedish economists. the economist named cherwin rosen wrote a whole series of papers on the super incomes. and he said -- he attributed to and showed that it was pretty responsible idea that these are people with very high skills. who are they? well, rock stars, athletes. no one complains about their getting high incomes. but i suppose there are people who think that it's wrong for alex rodriguez to make as much money as he does. but he gets it because he's a super star. then there are surgeons, trial lawyers, even a few college

professors. and businessmen. now, most of these people have extreme skills. try to think about what it takes to run a company that has branches in 100 different countries. and if it's a bank, that there are 50,000 people every day who are making commitments. it would kill you. that's a big management job. that's why they get these high incomes. are there disparities in the thing? are there injustices in the thing? of course. life is full of injustices. but that's not the main point. the main point is that what's happening here is happening everywhere. so it's not a result of the local political decisions, the bush tax cuts or the obama expenditures. i mean, it may have an effect. but the dominant effect is an international effect. it's something that's going on. like the chinese and the indians

adding enormous number of people to the labor force. >> okay. okay. could you just say who you are as you ask your question? thanks very much. >> i'm jeff cosne terks. kip linger washington editors. i took classes from dr. meltzer in 1978. >> i'm sure he remembers you. >> my question is this. you were describing the banks and their recent efforts which i guess are probably just starting to raise their dividends, buy back stock. in other words, do they want to go back to the days of when bank stocks paid dividend yields twice the s&p 500 and banks were largely run for their shareholders? i mean, it's one thing to say that this is appalling. it's not thing to say where is this going and why? thank you. >> let me just say, your interview is being incompetent

here. we need to keep on a strict schedule. please keep your answer brief. it will have to be the -- >> i'm sorry. what did you say? >> i would stop it. that is i would reverse -- if we're going to bail out the banks, then congress should vote to lend them the money. which they haven't. >> why do you think the banks want to go ahead and do this, then, if it's contrary to good public policy? >> because they -- it's not contrary to their private policy. >> i think we'll finish there. thank you very much, indeed. thanks, allan. >> thank you. >> thank you, clive. thank you, allan. we now move to one of the other iconic players in the financial crisis story. that's sheila bair. sheila and ali velshi, please join me up here. ali shellvy, of course, is chief business koernd at cnn. sheila bair is the -- is now with pew, is the former fdic.

very, very important voice during the housing bubble crisis. and what happened. and all i will say as i leave the two of them to have their discussion is that if ali doesn't mention this question about a bond bubble, one of you should. >> thank you, steve. i want as much participation as possible. so if somebody wants to ask that question, go ahead. i couldn't help but think when we were listening to larry lindsey and he kept referring to the sympathetic media and whether or not i was a part of that mess. i'm going to try to be very hard hitting. sheila bair, good to see you. we've had fantastic conversations today. and there have been a lot of digs, sort of people have been taking digs at the other side idealogically. but we've had no -- no knockout punches. we're hoping to get one of those from you. let's start by talking about the thing that i see newspapers all over the place. obviously everybody is ingesting this information about the bank

stress tests. we -- because you were here today, we decided to move up the results of the stress tests from yesterday. so now they're out. now they're out. when you and i talked about this on tuesday morning, you suggested that not everybody was going to pass with flying colors. generally speaking, it would probably be more good than bad. and a negative result wouldn't necessarily mean that a bank is in trouble. i would suspect you'd know that more than most people. give me your evaluation, first of all, of the stress test. >> so the stress test was to determine what the bank's tangible common equity to risk-based assets would be in a very high stressed economic scenario. 13% unemployment rate. 50% drop in the stock market. i believe 21% drop in moem prices. so that would be a very, very distressed economic environment. clearly not one that anybody is predicting. but a lot of people weren't predicting the 2008 crisis either. so the fed that even in this kind of

distressed environment, banks would have enough capital to keep lending. right? that was the problem in 2008. a o didn't have enough capital to keep lending. they pulled back. they pulmoed back their loan balances. they pulled back their credit lines. that was the big catalyst for the recession. this is a very helpful, very helpful exercise. it began in 2009. it is forward looking in its approach. you know, i think the examination process precrisis was very static. so examiners would go into a bank. is the bank making money right now? the examiner'sevaluation of the financial institution would be pretty much based on current profitability and examiners did not, regulators did not and bank management did not look forward en drop? i've got this adjustable rate mortgage the buyer can't afford if they can't refinance. if home prices are going to drop what's going to happen to that loan? that kind of analysis wasn't done. they're trying to do it now.

that's a very, very helpful thing. it's an evolving process. i think it's getting better. when we first did it in 2009, stressed. i think it was a 10.3% unemployment rate was the stress assumption. of course, unemployment peaked at 10.1%. now 13% clearly is a very so that is good. the fact that they're making the results public for individual institutions, that is also very good. and that means they're differentiating among institutions. they are saying that some institutions are stronger than others. they all are meeting regulatory capital standards. and they're all still solvent after this stress test. go, too. are better than others. i think, you know, during the -- the financial stabilization measures, euphemistically called bailouts, there was a lot of kind of painting everybody with the same brush. i think that was unfortunate. you did what we had to do. you don't want to punish good

bank managemenhe same group. i think the fact that these stress tests differentiate, i and challenge them as to why they're not doing better. those are the positive things about the stress test. so you asked me to take a few punches. i'll tell you what i think the stress test could be better. one area is that the focus is on what we call risk-based capital. so there are two types of capital standards for banks. one is capital based on what's called risk weighted ba can hal if they say their assets are not very risky. there's a lot of subjectivity that goes into how risky assets are. so risked based capital is not always a good barometer of bank

health. a leverage ratio is simply your tangible common equity to your total assets, right? so that is, you don't try to exercise any judgment on how risky the assets are, just leverage the capital as a percentage of total assets. precrisis, we found that there's a lot of academic analysis that showed those banks that reported strong risk based ratios with weak leverage ratios were the ones that got into trouble. when the crisis came, really the market discounted that and everybody looked at the leverage ratio. if you look at the fed's stress test results, and i would encourage you to do so, that you should also look at the leverage number. there are a number of banks that would have capital -- leverage capital ratios below 3%.

if i were a regulator i would be very troubled by that. so i would hope next year the fed will also make decisions about capital -- there are also, i think, there are some questions about how the losses on housing, housing is a big, big question. a big drag on the u.s. economy. a will the of exposure to the mortgage market, either directly with loans and second liens that banks hold. so the losses that are predicted are as robust as they might be, i don't express a view on that. but it's healthy that investors and others are taking the data that the fed has made available and doing their own analysis. because regulators are not infallible. a lot of this is subject to judgment. so the market, taking a look at

these stress test results and doing their own analysis and asking questions is a very healthy process and very good discipline on the banks themselves. also, the stress test focused on credit losses, what happen it is a borrower can't make good on his or her loan. that was the driver of the 2008 crisis. people couldn't pay their mortgages. going forward, though, and this has been addressed by some of your other -- this excellent list of speakers that you have today, what's the future risk, right? and should perhaps interest rate risk be built into the stress scenarios of these stress tests? because interest rates are not going to stay this low forever. and as the economy picks up steam and there are alternative places for investors to put their money, and as europe repairs itself, the interest rates are going to go up. so i think stressing an interest

rate risk would be very helpful. a lot of banks had liquidity problems. they didn't have enough cash to meet their obligations, so doing a little better job of stressing liquidity would be helpful. but overall, you know, i think it was good that we started it in 2009. they've gotten better and i'm very pleased that the fed has been so open about the results. >> one of the issues we talked about with respect to risk based capital ratios is that the things that the bank would determine were safe as few as five years ago were not safe. many of these cases these banks would have held sovereign debt. >> that's right. >> how do we in the world of evaluating banks come to some consensus on how we evaluate what a bank holds that is safe? >> right. i think there will always be

some judgment, which is why you need the leverage ratio and a risk based ratio. we have that in the united states, they did not have it in europe. european banks were able to hold zero capital. and that has been a key part of the problems that the european banks system has now. you will always have an imperfect judgment about how risky bank assets are. i think it's important to have hard and fast parameters. some of you may have heard of the capital standards, which the fdic, which i fought very hard, which allowed very large banks to use their own judgment and models to set risk weights and there was no floor over how safe they could say their assets were. and they did that in europe. we stopped it here. in europe, the european banks, not all of them, a couple of them did better jobs than others, but most of them were

saying, and there's a barclay's report on this that shows the european banks were saying even during the depths of the recession that their assets were getting safer. sorry, that can't just happen. so you really cannot rely completely on bank judgment and models to do this. so we feel strongly there needs to be some hard and fast parameters. your minimum capital on sovereign debt cannot be below x, et cetera. there was another capital frame work stalled the standardized approach that the committee approved several years ago that uses that similar approach of having hard buckets of assets for each category in terms of what the risk weight can be. >> you make a good point that the 19 banks we did these stress tests on, it's necessary for different banks to be measured differently.

if this is important for these systemically important banks, why don't we have a process for all the rest of the banks? and one of the issues we struggle with is the fdic does have a list of banks that are in danger but that's not public usually. >> right. the troubled bank list is banks that are in trouble and that -- historically only about 20% of banks that go on this list actually fail. that's the reason they're put on the list. most are nursed back to health, but the reason for keeping that confidential is to prevent bank runs. so i think contrast that to a stress test that applies to everybody, and really is, you know, i guess theoretically it could show if the bank was insol vent, with the largest institutions. the first year did show some severe capital shortfalls, but

the first year the government said we will come in with capital to backstop the weak banks. and fortunately they've gotten stronger now. so i don't think any of them are on the precipice the way some of them were in 2009. but it's always a delicate balance between the transparency sand protecting stability and trying to guard against bank runs. >> we got to know each other through the worst of times really when things started to go poorly for a number of banks. the fdic developed what seemed in the midst of this crisis a relatively efficient system where many of these banks would announce that they were closing up on a friday afternoon and on a saturday morning people could get their money and looking back on it, are there things -- tell

me what you think worked well and those things that you would have done differently now that you know what you know. >> that's a really good question. i think the first thing, one thing i do regret is when indy mac bank failed. that bank was quickly becoming insolvent, but it had a liquidity run caused by a senior public official questioning its financial stability. that did not give us enough time to find a buyer, so that was in july of 2008, early on. the primary regulator of the bank wanted to close it a few hours before regular closing hours to facilitate calls to members of congress to let them know the bank was closing, which is typically a courtesy extended. so i ti