Donald Kohn speaks out on global economy at International House

This text is taken from the International House website 

Donald Kohn, a senior fellow at the Brookings Institution and former Vice Chairman of the U.S. Federal Reserve, discussed reasons and remedies for the global economic downturn as the 2011 John J. McCloy Visitor at International House. 

Rather than deliver a standard speech from the podium, Kohn sat down for a conversation with I-House Chairman Paul A. Volcker, the former Fed Chair, and covered a wide range of issues surrounding the US and global economies.

Kohn described his 40-plus years at the Federal Reserve and declared that government is a challenging but ultimately rewarding career choice. He urged the residents and guests in attendance to seriously consider public service careers whether in the US or abroad. Governments, he said, are in desperate need of “bright young people” to solve the complex problems facing the world.

I-House resident Diego Ronchetti from Italy, Donald Kohn and resident Peter Vanham from Belgium.

Asked by Chairman Volcker to describe the reasons behind the financial crisis of 2008 and subsequent downtown, Kohn cited what he saw as a growing sense of complacency within both the government and private sector during the period 1982-2007. The Central Bank was focused largely on inflation control, seeing its main purpose as leaning against the business cycle, raising rates when growth was too rapid and lowering them in response to retractions. For almost 30 years the strategy was largely successful, he said, noting that the few recessions which occurred, most notably the one which came after the tech bubble, were short-lived and the recoveries which followed were swift.

Problems within the private sector, rooted in short-term outlooks and skewed incentives for performance, began to emerge in 2000, and the central element, Kohn said, was the housing market. He placed much of blame on the failure of regulators to take a tougher stand, but acknowledged the important roles played by the investment banks and their “opaque and complex instruments.”

At the most fundamental level, Kohn said, the US population, spurred by artificially low interest rates, consumed and invested far more than it produced. Kohn noted that the current debt crisis in Europe arose from similar circumstances and expressed concern that the outcome there could be equally devastating.

Asked for possible remedies by Chairman Volcker, Kohn said that the Central Bank has been using all of the tools at its disposal, but that its ability to create recovery was limited with interest rates near zero for a lengthy period of time. He noted that compared to previous downturns, the Fed has been at its most active in decades but that working through the overhang of debt and excess capacity in the housing market will take time.

Kohn compared the current recession with the1980s downturn which resulted from high interest rates imposed by the Federal Reserve to battle inflation under Volcker’s leadership. The earlier recession created huge pent up demand for homes, automobiles and other products, which, “along with fiscal stimulus in 1982 plus a declining dollar helped turn the economy around.”

The current financial crisis and bursting of the housing bubble has left the US economy with vast excess capacity and a population focused on reducing its household debt, not taking on more.

“In the long term, we need to determine what kind of housing finance system we’ll have in this country,” he said.

Kohn said that a true recovery would require both short and long-term fixes in the housing sector as well as a serious evaluation and restructuring of systemic problems such as entitlements and taxation. Currently both political parties are exploiting these issues for electoral gains, Kohn suggested, adding that politicization has allowed a resolution of these critical questions to be kicked down the road for almost 20 years.

Turning to questions from the resident members and guests, Kohn was asked for his opinion of the so-called Volcker Rule proposed to ban proprietary training by commercial banks. The former Fed Vice Chair said he believes it is a good idea in principal, but feels it may prove hard to regulate and enforce. Additionally, there could be unintended consequences as risky trading activity moves away from the banks. While the banks themselves could be made more secure, Kohn said the risks to the US and global economies may remain or even increase.

Kohn then spoke about the overall effort to address the issues surrounding default on a systemic scale. He said there is a global consensus on the need for a better form and structure of international resolution authority, and that behind-the-scenes efforts are underway to create a workable, organized, and international response to a major sovereign or institutional default.

Other questions involved the threat of income disparity to the capitalist system, the Occupy Wall Street movement (Volcker said he was “surprised this has been so slow to come about”), and odds that the US would experience a double-dip recession (Kohn said a major meltdown in Europe would make the odds “probably higher than usual”).

The McCloy Visitor Program was established in 1989 in memory of John J. McCloy, Chairman of International House from 1954 to 1971 who, as a distinguished lawyer, banker and administrator helped shape the policies of five U.S. Presidents in the 20th century. The McCloy Program gives International House residents an opportunity to hear and discuss significant aspects of foreign policy and the international economy.