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Wall Street Wisdom

One of the world's most widely known and respected economists, Henry Kaufman is almost single-handedly responsible for founding the spectator sport known as "Fed watching." He began a 26-year career at Salomon Brothers in 1962, when he was probably the only Wall Street employee with a doctorate. There he built one of the most prestigious securities research departments and became a senior partner and vice chairman. In the last 30 years, he has been one of the most vocal critics of insufficient financial oversight and regulation, and his pronouncements and prognostications have often moved markets. We interviewed Dr. Kaufman in his New York office, where he heads his own international economic consulting firm.

Amazon.com: In your book, On Money and Markets: A Wall Street Memoir, you warn how heavily dependent our strong economy is on the direction of the stock market. Recently, the markets have gone into something of a tailspin. In your view has the market bubble burst?

Henry Kaufman: It is too early to say that the bubble has burst, but I think within the next year to two there will be declines of larger magnitude than the declines which we've experienced recently.

Amazon.com: You've criticized the Fed recently for missing its timing on interest rates. What are the likely consequences of the Fed's miscalculation and what can we now expect Alan Greenspan to do?

Kaufman: Well, the Federal Reserve only belatedly recognized the importance of the wealth effect, that is, the effect of appreciation in the value of stocks on business behavior and on the behavior of the household sector in its spending patterns. That recognition did not come until the past year or so. The effect was very much in force beginning in '96-'97 and in '98.

The Federal Reserve does not have a specific technique for dealing with the problems of the wealth effect. Considering the importance of the wealth effect, and that the economy is experiencing extraordinary economic growth, with some indications that inflation has bottomed out and is creeping up now, I would expect the Federal Reserve to raise the federal funds rate by a quarter of a percentage point at its next meeting.

Amazon.com: How do you feel about the celebrity status of the Fed chairman?

Kaufman: Well, it's very dangerous for a chairman to be a folk hero, because you become a folk hero by pursuing policies of accommodation, by allowing the stock market to move ahead very vigorously and in a speculative fashion. The ultimate test of a chairman comes when he has to instill disciplining policies and restraining influences into the system. Now, no one likes to be restrained, whether it is in personal life, business life, or in investment decisions. But the role of the central bank and of the chairman of the Federal Reserve Board is what Bill Martin, a previous Fed chairman, said quite a few decades ago--he said that once the party gets a little bit too rowdy or too good, it is the responsibility of the Federal Reserve to take away the punch bowl. That has not occurred yet, but that is the task of this chairman in the period ahead.

Amazon.com: You write of your concern about the increasing exposure of individual investors to stock market risk and their move toward a more short-term orientation. Would you comment on how dangerous this might be and how likely it is to end in a financial panic?

Kaufman: Well, there's nothing wrong with the household sector moving directly into the stock market through acquisition of stocks or by purchasing mutual funds. On the other hand, when households speculate, borrow on their homes or through the use of consumer credit, and put the proceeds into the stock market, that is dangerous. It's also dangerous when many households become speculators, very active participants in the markets with a very near-term trading orientation. That is a development that has crystallized within the last year or so in the United States, and it is completely new through the post-World War II scene.

Amazon.com: How likely is this to end?

Kaufman: Well, we have a bias in our investment and economic thinking, and the bias is, we don't consider sharp movements upward in the prices of securities as being volatile. But we do consider volatility when the movement of prices is sharply downward. We will have periods when there will be a further downward draft in stock prices, and that will then adversely effect consumer spending and consumption by households generally. One of the stabilizing aspects of economic growth in the entire postwar period has been the stability of consumer spending while other types of spending have been more volatile. That is being threatened by the huge participation of households in the equity market.

Amazon.com: It's generally accepted that international diversification of an investment portfolio reduces risk, but you've taken issue with that because of what you call "the force of contagion in the modern globalized, securitized market." Would you elaborate on this?

Kaufman: Well, it has always been part of portfolio theory that diversification has a very good stabilizing influence on a portfolio, particularly if you diversify internationally. The dilemma, however, is that when financial markets in the United States get into great difficulty it also impacts negatively nearly all other major financial markets -- in Europe as well as in Asia. This is because securities are now traded on a global basis. We don't have segmented markets anymore; we have institutions that span the globe. As result, we no longer have a European view, a Japanese view, or an American view. It becomes very quickly a homogenized view. And also, as I indicated earlier, because there is this near-term orientation in the market, in investment behavior, that reduces the benefits of diversification because near-term negative developments here get catapulted into near-term negative developments in Europe and in Asia with very little time lag in between.

Amazon.com: After the orchestrated rescue of Long-Term Capital Management, you called for greater supervision and regulation in all major financial markets and institutions. Have the lessons of modeling risk in the real world been learned and is there greater oversight today?

Kaufman: Actually, I had called for it considerably earlier, prior to Long-Term Capital Management and even prior to the Russian debt problem in July of 1998. The improvement in oversight and in supervision by the official authorities has been there, but it's hardly enough. I think supervision and regulation lag far behind market developments today, and there is not yet a real powerful, contemporaneous insight into what is happening in the markets, or how to really prevent future dilemmas. I think one of the strengths of supervision should be to minimize extreme excesses. There always will be some failures in the financial system. That, after all, is perhaps wholesome. Without some risk there can't be reward, and if you stifle risk taking it's very bad for the system.

What we have to learn here is to have supervision that will cut away the excesses in the financial system, and we haven't reached that either in the United States or in the rest of the industrialized world.

Amazon.com: There's growing public debate about the IMF and the World Bank and many people are calling for their dissolution. In your book you advocate greater supervisory and regulatory roles for these, or for a similar new entity. Can these institutions evolve into what you feel is necessary, and if not, would you describe the scope and role of the new entity you propose?

Kaufman: I have long believed that the role of these official institutions ought to be much more circumscribed and reduced. The IMF should be in the business of helping some countries where it provides funds to tide them over a temporary imbalance, not a long-term structural problem. I believe the IMF should improve its advance warning systems when countries are approaching difficulty. We still haven't attained that. That was the problem in Mexico in 1994, and that was the problem again in 1998 when it came to the Asian countries. The supervision and insight in the advance warning systems have been lacking.

Additionally, I feel that the IMF should be put into the position of having to issue a credit rating for each one of its member countries, and indicate to those countries that the ratings will be changed if the IMF sees that the credit situation is deteriorating, and the IMF without delay would inform the markets. The IMF is nowhere near that now.

The World Bank should become much more of what I would call a mercenary institution. It should not be an important lender to countries that have access to the open credit market. It should focus far more on countries that are poor that have no structure, but we shouldn't give loans to them on the assumption that they are going to be repaid. Those countries don't have the structure or the capacity to do that.

Now, beyond this, I've felt that we should have a new financial institution that would have complete oversight over major markets and major financial institutions. That oversight should rest with a group sitting in Washington, New York, or in Europe, that should be responsible for setting uniform trading standards, accounting standards, and reporting standards to really improve the transparency of the financial markets and financial institutions.

I think what we need are mechanisms that will clearly provide to market participants relevant, up-to-date, and concise information--not delayed information and not information that isn't useful. We have to work towards that goal.

Amazon.com: Are some multinational financial institutions becoming too large to be allowed to fail, and what are the economic implications of bailing them out if it becomes necessary?

Kaufman: Well, first of all, I feel that we are moving toward a far greater consolidation of institutions in our financial markets domestically and globally than at any time in the postwar period. And there is an increasing amount of assets being held now by fewer and fewer financial institutions. That creates the potential that when we get into another problem some time in the future there will be quite a number of institutions deemed to be too big to fail. I think there is a similar situation like that happening in some industries within this country as well as throughout the world.

That has the effect of really decreasing the effectiveness of what I would call an economic democracy, and we are the closest to an economic democracy in the world. Unfortunately, this is a very difficult issue. It's an issue that is going to haunt us in five to 10 years from now, after there are many more consolidations and more concentration of economic and financial power.

And then the difficult question is, how do we deal with these entities that now have such important control over major markets? And it is not an American question; over time, it becomes a global question, and there is no structure available that says, "Well, some of these institutions now have to be dismantled." It poses a serious challenge in the long run to an economic democracy and a serious challenge to the implementation of monetary policy, particularly when you have more institutions that are too big to fail. It creates a moral hazard, and in turn puts much greater pressure during a period of monetary restraint on smaller institutions.

Amazon.com: What are some of the books that have been most influential in your life?

Kaufman: Well, I read Frederick A. Hayak's The Road to Serfdom many, many years ago. That certainly had an influence on me over time. I read Titan: The Life of John D. Rockefeller, Sr., of course, by Ron Chernow, and also his book The House of Morgan … both of which were very instructive and informative as to what went on in the earlier part of the last century and in the lives of those two important people.

There were a number of books that I've read by and about Thomas Jefferson, who I guess has always been an important idol of mine in terms of American history. And I've read many of the books on Roosevelt because he was a childhood idol of mine, in part because I had polio and so did he. I was a very young boy when I came to America, and he was president at the time during a period of economic crisis and World War II.

Copyright © 2000 by Amazon.com, Inc.
The Investor's Library has reprinted this copyrighted article with the permission of the copyright owner.

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