America in the 21st Century: A View from Europe

• Introduction
• Remarks
• Questions

JOANNE MYERS: Good morning. I'm Joanne Myers, director of Public Affairs Programs, and on behalf of the Carnegie Council I'd like to thank you all for joining us, especially those seated up in the boardroom and those watching us on the live webcast.

Although I believe all breakfasts at the Carnegie Council are special, in some ways this morning's presentation should be a bit more memorable than usual.

To begin with, this discussion launches the first in a series of lectures the Carnegie Council will be hosting in the run-up to the 2012 elections. The title for this four-part series is "America in the 21st Century: Views from Around the World."

In introducing this topic, the Carnegie Council is acknowledging what many pundits have been saying for some time now, which is that American economic, military, and geopolitical primacy, which existed between 1945 and 2000, is no longer. Accordingly, in going forward, we are inviting renowned experts to respond to this premise by sharing their thinking on such issues as how they see America in the years ahead, how they would like America to conduct itself on the world stage, and whether they believe it is still feasible for the United States to remain the most innovative and influential nation in the 21st century.

This series is made possible by a generous donor, albeit anonymous, to whom we are especially grateful.

This morning is also noteworthy because the person we have invited to launch this series is someone whom we all admire and have agreed to be the one individual who would best represent the European view on this equation. Currently, he is the associate editor and chief economics commentator at the Financial Times [FT] and writes a weekly column on the world economy. Martin Wolf is often referred to as the world's preeminent financial journalist.

And if you have been reading his columns, especially the op-ed piece in yesterday's FT entitled "What Hollande Must Tell Germany," you will understand why it has been said that no one understands or can explain international economics better than he. Always a writer with the ability to make you think, whether you are in agreement or otherwise, the bottom line is Martin Wolf is always wise, always thought-provoking.

Now, I know you received a copy of his c.v. when you checked in this morning. If you haven't had a chance to read it, please take it with you and do so when you leave.

Today, as many of America's traditional allies in Europe face changes in leadership, rising unemployment, large deficits, and serious debt, there is also an underlying and growing sense that the friction within and among European nations could become unmanageable and, perhaps, even constrain America's ability to shape the world. Given this state of affairs, there is no better time for the clarity of thinking that Mr. Wolf can bring to this muddled state of international affairs.

Please join me in welcoming the person who has the experience and knowledge to prepare us—America, Europe, and the world—for what could lie ahead.

Martin Wolf, it is an honor to have you address us this morning.

MARTIN WOLF: Thank you very much.

First of all, it is a pleasure to be here and an honor to be here. I have to say I still can't quite get used to the enthusiasm with which New Yorkers approach breakfast meetings of this kind. [Laughter] I regard it as entirely uncivilized, and it proves that our cultures remain fundamentally different. You couldn't even wake people up in Britain, other than those of course working for American organizations, at this time. And the idea that one should have a conversation of serious and depressing matters at this time is beyond belief. The most I can normally manage is a few grumpy remarks with my wife. [Laughter]

The second point I wanted to start off with is to correct you on one very important matter, which is nobody in what we think of as Europe, which of course starts in France, would consider that I can speak for Europe. That is essentially because they are very, very unsure that Britain is part of Europe, and they are even more unsure whether Britain thinks it is part of Europe. So I think the best that could be said is, as I said to Joanne when I was asked to make this address or this presentation, that I can speak for myself, and, I suppose, on a good day you could consider me a European.

I have been asked to address the United States in the 21st century. It has allowed me to think about matters I don't normally think about and a time span that I don't often think about, because the 21st century still has about 88 years to go. I am going to treat this as an opportunity to think about some rather long-term questions, not about what is in front of us immediately. I am going even more to venture into areas of politics, culture, international relations, in which my expertise is essentially zero. The responsibility for any consequences rests, of course, entirely with the organizers. [Laughter]

I am going to start with a quote. The significance of this, I think, will become obvious to this audience and in this context. It really is about the view in the previous superpower to the present one and relates to the future. I'll tell you about the time, the significance, after I have given you the quote.

The quote is as follows: "It has been through the peaceful victories of mercantile traffic, and not by the force of arms, that modern states have yielded to the supremacy of more successful nations."

This quote—first of all, the date, 1835. Second, it is from an essay called "England, Ireland, and America," and really educated people here will already know who the author was. But in case there are one or two who don't, it was Richard Cobden.

Richard Cobden is a very important figure in British history. He was the father of the Anti-Corn Law League, and therefore the progenitor of English free trade, an idea that the Americans have never fully embraced. He was a successful textile manufacturer who became an important policy intellectual and political actor in the formation of what was later to prove the Liberal Party in the great formation of the modern British party system.

The reason this is interesting is he was engaged—and the relevance to the present debates will become obvious to you—in a long-running intellectual war, among other things, with Lord Palmerston, who later became prime minister, one might say the father of gunboat diplomacy, who believed very strongly, as certain forces in your country have believed, that the essence of English power rested in its naval supremacy and imperial might.

Cobden's view was that this was absolutely the wrong way around, that the power that Palmerston enjoyed wielding so much was a consequence of England's power, not a source of it. England's power rested on its overwhelming at that time—we are talking about 1835—economic dominance, the beginning of the Industrial Revolution.

Now, the reason this is interesting is that the essay in question followed a long visit he took, in a time when his political career was relatively fallow, to the United States and particularly to the Ohio Valley.

The essay I recommend basically said: "You in Britain are only interested in how you are doing against the European powers, how successful you are in extending your empire or maintaining your empire in your naval power and all the rest of it. None of this has any bearing on the future status of Britain as a world power. What will determine the future status of Britain as a world power is its economic position, and it is going to be replaced by the United States."

He said this in 1835. And, of course, he was right on every single point.

I thought about this very much at the time when you will remember, about 10 years ago, the United States under President George W. Bush put forward its security doctrine for the next half-century—and I wrote about it at the time—which basically said: "We are going to remain overwhelmingly the dominant military power over the next half-century, as if (1) that had nothing to do with what others did, and (2) as if that was the only thing that mattered about American power." It is exactly the same debate.

I am going to concentrate on the United States in the world. I am not going to focus on the United States at home except to the extent that it bears on the United States in the world, not because that's not important but because that is not my focus.

If you look at the future of the United States in the world, it is going to depend on how successfully it manages, first and foremost, its economic and social challenges; and, second, what happens in the rest of the world relative to the United States.

Now, in the 20th century, as Cobden foresaw, the United States became a uniquely dominant world power. It had, from about 1880 or so—we don't need to be that precise—the world's largest economy, as it still has today.

It has had—and this is very important, I think—the world's highest income per head for a very large country (I am leaving aside one or two tiny countries like Norway and the oil states).

It had—this is more difficult to argue precisely the time, but roughly from the same time on—far and away the world's most innovative economy. The only serious rival, up to the middle of the 20th century, was Germany, and that is no longer true. Interesting point, but I won't go into that.

It has been the provider of the world's principal reserve currency since the First World War. There is a long and futile debate about when exactly the dollar replaced the pound, but essentially it was in the First World War.

It has been capable of providing and, since the Second World War, has been the provider of, the world's largest import market. It was capable before that, but U.S. protectionism in the interwar period made that impossible. Because it was the provider of the world's largest import market, it as a single entity could largely determine the nature of the world trading system.

It was the model of democratic values. It was the model for most people of what cultural modernity meant. That goes all the way back to de Tocqueville; that's his main point. He was trying to identify what a truly democratic, post-aristocratic polity would be, and the United States has defined that for most people for certainly the last 60 or 70 years.

It was the shaper of the world's system. It was a uniquely capable creator of alliances.

And, of course, but not entirely least, despite my opening, it was the dominant military power.

Those assets together have allowed the United States to shape the world in an enormously large number of different ways to a quite extraordinary degree. I think it will be fair to say that in very large measure it has created what we think of as modernity.

In the process, of course, though it is a sideline to this, it won its wars, hot and cold, over its principal rivals to date, namely, Germany, Japan, and Russia.

So this is a story of a quite extraordinary success.

Now, this is not to ignore the long list of blunders, mistakes, follies, and crimes. But I don't think I need to go through these because you are probably all perfectly well aware of them yourselves.

Now, the question that I want to address is how much of this can plausibly survive in the 21st century, and what the United States and what the rest of the world are likely to do about it. That is what I would like now to continue to look at. Let me go through these various elements with a little care.

First of all, these are the things that the United States is really quite unlikely to retain of that list in the course of this century, and possibly rather sooner.

First, it is quite likely—nothing is certain in economics, but it is really quite likely—that the United States will cease to be the world's largest economy on any measure, either PPP [purchasing power parity] or conventional market prices, by not later than the 2020s. It could well be before that.

Their replacement will, of course, be China, unless it blows up. We can discuss that in questions and answers. I wasn't asked to address the question of China in the 21st century, so I will skip that.

But I have a basic, fairly simple view of what is going on here. China's population is going to peak at about five times America's. It will then shrink relative to the United States very slowly. So the United States may actually reverse all this in the 22nd and 23rd centuries, when the United States has a population of 800 or 900 million and China has a population of 800 or 900 million. But you didn't ask me to discuss the 22nd century, and this is not going to happen in the 21st.

The Chinese have basically worked out, though not efficiently and not perfectly, with enormous problems, how to industrialize, which is the basis of economic development for the last 200 years. Unless you think the Chinese are five times as incompetent as the United States—and I don't—it is plausible that their GDP per head, which is just their productivity, will converge enough on the U.S. level without catching up—I don't believe it is at all likely that they will catch up, for reasons I don't think I can go into—that their aggregate GDP will be larger than the United States'.

In fact, there is a very simple calculation you can make, which is this: If the Chinese manage to achieve an income per head, which is an output per head, half that of the United States or Europe, they will be as big as the United States and Europe together in GDP terms.

To believe that the Chinese are incapable of managing to get to half our level is, I think, extraordinarily foolish. So, unless there is some extraordinary catastrophe, it seems to me overwhelmingly probable that China will emerge as the world's largest economy.

It will also—and, in fact, it is already very close to being—be the world's largest market, just behind the United States as an importer, largely because the United States runs a large trade deficit and China does not. But it is already the largest exporter in the world in gross terms.

China is a resource-poor, big country. Resource-poor countries have to trade a lot to achieve a given level of income per head. China's trade is extremely high relative to its GDP. In fact, interestingly, it is about three times as high as the U.S. trade relative to its GDP.

Now, even if you assume that China will become less open than it has been—and it is extraordinary, largely of course because of the role of the processing trade and also because of its dependence on imports of raw materials—you have to assume that it is not going to converge on U.S. levels of openness. And, since it is not going to converge on U.S. levels of openness and it is going to have a larger economy, it is going to have a larger market.

So China will increasingly determine the world's pattern of trading relations. I think we have to assume that will happen. And it will become decisive in determining how the trading system works over the next 20, 30 years.

The third area where it seems to me there is a question, but here it is a much more complicated question, is whether the U.S. dollar will remain the world's reserve currency.

Now, I am involved in a bet with a friend of mine, whose work I hope you are familiar with because it is very provocative and interesting, an Indian economist called Arvind Subramanian, who works at the Peterson Institute for International Economics, formerly at the IMF [International Monetary Fund] and the WTO [World Trade Organization], a very rare combination, who wrote a book called Eclipse, which puts very forcefully the views I have just presented on the rapid ascension of China and the rapid relative decline of the United States over the next 20 years. He predicts that the renminbi will emerge as a dominant world reserve currency by the end of this decade.

I think that is almost inconceivable, and I believe that it is almost inconceivable for two related reasons. The first is that the Chinese won't want it. The second is that the rest of the world will not trust it. I will relate these two because they are related.

The Chinese won't want it because they know that to generate a true reserve currency what you have to provide is an open system.

Obviously, if you want to have a reserve currency, it has to be absolutely liquid, and to be absolutely liquid you have to be absolutely convinced you are not going to get caught behind exchange controls. You need, in other words, a fully convertible currency, which means a fully convertible capital account; you need a commitment by the country concerned to that openness, credible openness; you need a commitment, obviously, to preserve the value of that currency, at least no worse than competing currencies; and you need, of course, deep liquid and safe capital markets.

The U.S. Treasury market and U.S. capital markets, the U.S. commitment to an open capital account, and the fundamental trust in the U.S. legal system, at least as it relates to the characteristics of this class of assets, has been, along with, of course, the scale of the United States and all the rest of it, the guarantor of the value of the dollar as a reserve currency.

I don't believe that the Chinese authorities are willing or able to take the gambles involved, and may not be even able politically, to move in that direction in the short run, the next 10 years or so, which is the period over which I have this bet with Arvind.

There is an additional factor here, which I haven't yet mentioned but which is central, which is once your currency is owned on a gigantic scale abroad, as the U.S.'s is, you lose control over your own capital markets. There is a fundamental loss of control over your own capital markets and financial system if an enormous proportion of the assets in play in that market are actually foreign-owned, unless you want to break that link and so destroy the credibility of the reserve currency.

My view is that loss of control will be truly terrifying to the Chinese. The control over the financial system is the most important economic lever they have over their economy, and they will not risk it.

Therefore, I believe that the move towards the openness on the capital account and all the other things I have talked about that would make the renminbi a genuine rival to the dollar are not on the near-term horizon. By that I mean certainly not in the next 10 years, possibly not in the next 20 years.

So I think there is a reasonable chance, a pretty good chance, that the dollar will remain the dominant reserve currency over that period. I wouldn't dream of predicting what could happen thereafter. Maybe the United States manages a hyperinflation—there's lots of discussion of that. I'm not too worried about it, but who knows?

You will notice I haven't discussed the possibility that the euro will replace it. It's not inconceivable, but a hell of a lot has to happen in Europe in the way of turning Europe into a genuine polity with a fiscal system to match, fiscal centralization, in fact a federal system to make that possible. At the moment that doesn't look terribly likely.

So my conclusion, then, on the straight economic issues is that the United States will cease to be the world's largest economy, it will cease to be the world's largest market, but it may for a very long time continue to provide the world's reserve currency.

Providing the world's reserve currency when you are a declining part of the world economy can be a very, very uncomfortable position to be in, as the British know. So I'm not sure that this should be all that welcome a fact, but I think it is a fact and it will maintain the United States, I think, as a center of the world's financial system.

Again, whether that is an entirely desirable state of affairs is another matter, but I think it is likely to be the case that the United States will remain the center of the world financial system.

All this means, of course, that for the foreseeable future the United States has an extraordinary amount of rope in terms of managing its own monetary and fiscal affairs. As long as that is the case, and I think it plausibly is the case, that is an opportunity to make big mistakes as well as an opportunity to have freedom.

I should perhaps, before I left the last thing, actually just give you a little bit of numbers about the decline in the relative scale of the U.S. economy in the world.

The IMF helpfully provides figures on the shares of economies in the world economy, purchasing power parity. I am not going to get into here the debate about how useful a measure that is. But the shift for the shares in market prices is roughly the same. Basically, what it shows is that between 1990 and probably the middle of this decade the U.S. share will have fallen from about 25 percent of world GDP to about 18 percent. Eighteen percent in 2016 of PPP will be the same as China, and Europe will be also the same share. Europe will have fallen more.

It is an important point here—and that is the last point I will make in this—that while the United States and other developed countries are shrinking as a share of world GDP, as you would expect as others rise, the United States is shrinking much more slowly than other developed countries because it has consistently grown faster than the other old developed countries.

The main reason for that is demographic. The U.S. demographics are more favorable than those of other developed countries, Japan or Western Europe. But it is also because productivity growth has been somewhat higher in the United States.

So it is a general story of Western and Japanese decline in which the United States is actually a relatively successful, or least unsuccessful, part. Nonetheless, as I said earlier, unless you are incredibly pessimistic about the prospects for China—and of course I have not mentioned, simply because of lack of time, India and other emerging countries, Brazil, Indonesia—unless you are very pessimistic about their prospects, relative decline is where the West is going to.

The reason, again, is very, very simple: 12 percent of the world's population is not going to generate 70 percent of world output and dominate the entire economic system, which is where we were in 1990, forever. It was unnatural what had happened. It was the product of historical events of great significance—the Industrial Revolution and thereafter—but that lead is being eroded, and we have to accept that is inevitable and natural.

Now let me turn to the other areas of where the United States I think still has the potential to remain extraordinarily potent.

Whether or not the United States remains a center of world innovation, for example, is up to the United States. It is clear that other countries, particularly China, are investing massively in building up their research capabilities, their university systems, and so forth. But the United States has a very large and effective entrenched system of research; it has the world's dominant universities, of course, and continues to do so; and it has historically had an extraordinarily successful capacity to import the world's talent, in that regard I think much more capable of doing that than China would be, for example, for very obvious reasons.

So if the United States wishes to invest in and retain that lead and wishes to retain its openness to the world, and therefore remain a center of world innovation both in research and in technology and in business, I see no fundamental reason why it should fail to do so. These are policy choices that the United States itself can largely make.

Of course, relatively there may be a decline, but the advantage that the United States attained by the middle of the 20th century, partly of course because of the Second World War and its impact on where the world's most brilliant people were located, remains.

The cultural influence of the United States, again, is I think potentially very, very powerful. The one thing that is pretty clear, it seems to me, is that the basic assumption of most Americans in my lifetime—indeed, most Westerners—that the democratic model based on individualism, a market economy of some kind, and a democratic political culture retains extraordinary attractiveness in the world, and there is no serious ideological rival, in my view. I think the events in Europe in the late 1980s and early 1990s, again in the Arab world today, in Russia now, in China in addition, indicate that that cultural influence, that broad set of values, remains extraordinarily potent.

My view on this throughout my entire lifetime has always been that as long as we retain our fidelity to these fundamental values, they will retain their influence on the world. But, of course, the more hypocritical we are about it—and not infrequently we have been very hypocritical about it—the greater the danger that the values will retain their potency but our influence will be seen as malign. That is a big set of choices for the United States in relationship to the world.

That, of course, links to my next and closely related aspect, the attraction of the U.S. political model, by which I mean the model of democratic political discourse. There is no great secret that a lot of people around the world look at China and think, "These guys know," in the famous quotation about Mussolini, "how to make the trains run on time."

I have always taken the view that, in the long run, democracy is the most effective system. But the long run at the moment looks rather long. [Laughter] I'll come back to this issue in a moment, towards the end of this discussion.

I think there is every reason to expect, certainly compared to China, that the United States has the capacity, again if it wishes to, to retain and develop a working system of alliances built on reasonably deep trust with other countries. This is not just Western countries; it will include many Asian countries.

The most interesting future alliance by far, which again I won't have enough time to discuss but which I think has tremendous hope though great difficulty, is of course between the United States and India.

The ability of the United States and India, both prickly countries, very well aware of their present and future status, to retain such an alliance based on shared values is going to be, in my view, as important for the 21st century as the alliance between the United States and Europe was in the 20th century.

Provided the United States maintains its innovative capacity in business and science and technology, in culture, the credibility of its political model, its political alliances, I think it has the capacity to remain the single most influential, although not absolutely dominant, shaper of the world system in the 21st century. Those are big provisos, but they are important ones.

That leads me to how much of this is in the U.S. control and how much of it is not. I will conclude with that.

The United States, obviously, can control what it does itself, but it cannot control what is done by others. I am taking for granted the assumption that the United States is not about to start preemptive wars against countries that seem to it to threaten its future status. Although there are one or two voices that suggest this is a bright idea, I am assuming that the United States can control itself and not do anything as insane as that. So assuming that, how much of this is in the U.S. control?

China's performance is not in the U.S. control, nor for that matter is India's or really anybody else's. They can't prevent it, short of madness. So the rise of China is going to be largely determined by what decisions the Chinese people themselves make, on the assumption that the world system as a whole does not collapse.

But, of course, the United States does have a large number of areas of policy which it can determine for itself. The nature of its culture, the nature of its openness to the world, its support for its own innovative system, its openness to ideas, the preservation of a stable and workable democratic political system, its role as a leader of alliances, its credibility as a moral force in the world, are all areas of policy, values, and society that are for the United States alone to determine.

In this regard, it seems to me as an outsider that a lot is going to be determined by the outcome of the following three related things:

• First, how the United States manages to get out of what I have referred to as its current contained depression, which is where I think the economy now is. I believe the adjustment process is required to get to a more balanced economy which is not dependent on massive fiscal and monetary support is going to be long and difficult. But they are manageable for the United States, much more so than for the Europeans.
  
  
• The second issue, absolutely core, is how the United States manages what I will refer to—and I hope you will accept this description—as something close to an internal civil war on the question of what is the nature and the role and function of the U.S. state itself within the United States, which obviously is related to profound transformations of the economy: the extraordinary growth in inequality, the relative failure to improve the lot of a vast proportion of the American people, the associated decline in the educational system, and so forth. It seems to me that this is a long-running civil war—and I am using civil war in quotes—and the resolution of that will largely determine the nature of America as a country in the next half-century or so. I am, obviously, far too inexpert to comment on that.
  
  
• Related to that, of course, is the workability of the democratic system itself and its ability to resolve the obvious problems it confronts in terms of managing the public finances while preserving what I see as the essential infrastructure of a modern state in the areas that I have referred to; for example, the ability of the United States to retain a world-class infrastructure and to preserve a world-class support system for its scientific research community. Those things will all depend on the nature of the resolution of this question of the legitimacy and effectiveness of the U.S. state itself, which was a main product of the crises of the 20th century, was an extraordinarily effective product of the crises of the 20th century, and has clearly fallen into moral and practical disrepair.

Ultimately, therefore, the status of the United States in the world system, viewed from the point of view of this European, despite the extraordinary transformations which are inevitably going to occur in the world as a whole, are going to be for Americans themselves to decide.

Thank you.

QUESTION: Thank you for that remarkably insightful presentation.

Today the American mindset seems to focus more on consumption at the expense of savings and investment. How significant do you feel that imbalance is, and is it likely to change?

MARTIN WOLF: This is obviously something I could talk for 20 minutes on, or even an hour.

Very briefly, yes, this is clearly correct. Consumption as the share of U.S. GDP reached extraordinarily high levels before the crisis, as did consumption as a share of household disposable income. Neither was sustainable. The main reason for what I call the contained depression is that it is normalizing. I am not going to get into the issue of what the normal will be because I don't have the time, but it is clearly lower than it was.

That raises two big questions: What fills the hole? The answer at the moment, by the way, is quite clear—it's the fiscal deficit. And what should fill the hole? The answer to that is clearly investment.

If you look at the United States compared to its peers, it is not so clear that private corporate investment is, at least on a structural level, unreasonably low. If you look at the rise of productivity in this economy and the capacity to generate and remain at the frontier for the private, nonfinancial corporate sector, it is not clear to me that much more investment at home would benefit them.

Now, that raises a demand question, which is very profound, because their profits are enormous and they are investing rather little. But I think it is actually rather difficult to see how you would raise that dramatically, though I think it will be interesting to discuss at another time what sorts of changes in the tax and other systems would encourage corporations to invest more at home. But, at the best, I don't think we are talking about more than a couple, two or three, percentage points of GDP, maybe four, not more than that.

I actually think that—and it's pretty obvious to me, and the same applies to Britain—the crying mission is public investment, that what is needed is a higher level of public investment in infrastructure or public investment coinciding with private investment in the research system and all the rest of it. And I would like to see a higher share of investment in public spending and a lower share of consumption in public spending.

That I think is a shared problem of both the British and the American political systems, and the crisis and its aftermath have made that problem much, much worse. So I would emphasize private investment, but even more public investment.

The shortage of savings problem has just been solved. The crisis has solved the problem. There is an enormous level of private savings in this economy now. Unfortunately, it is not matched by private investment. It has been matched by and absorbed by the fiscal deficit, which is largely going on consumption. So I don't think I would focus on the savings problem at the moment; I would focus on the investment problem.

QUESTION: Thank you. James Starkman.

Today is a good day and I would like to divert your views back toward your European analysis, which was so artfully expressed in yesterday's Financial Times, which I have in front of me.

First of all, most analysts, including yourself, I believe, feel that the European experiment lacked a political union and a fiscal union to accompany the monetary union, from which there have been many benefits. You list five possible outcomes to this situation, none of which are painless.

I would like to elicit your views on the fifth outcome which you mention, which would be a selective dropping out of the southern-tier countries, enabling them to sharply devalue their respective currencies, à la Argentina, with the proviso that the European Central Bank [ECB], and possibly the IMF, give a guarantee to the deposits in the banks of those countries to avert the effects of a massive run on the banks which that would accompany. How would you see that as a possible solution?

MARTIN WOLF: I think the latter part of your proposal wouldn't work, and the reason is fairly straightforward. That's why the breakup is a nightmare from this point of view, or one of the reasons. I'll just focus on that.

Let's take a very simple example. I'll take Spain, for example. It's not because it's an obvious possible case. I'm not predicting anything, very, very clear, at least not for this purpose.

Let's assume that we were to see an exit and Spain restored the peseta. It could not guarantee the deposits—nobody could guarantee the value of the deposits—of the Spanish banking system in euros. The reason, fairly obviously, is by now—this is not so true of the big Spanish banks, the two really big ones, Santander and BBVA; they might make their own arrangements, and possibly could, because they are genuinely global banks.

But for the domestic banks, which is everybody else, they own domestic assets. By now, their assets are essentially in large part Spanish real estate-related and the Spanish government. Those assets' value would clearly be redenominated in or valued in pesetas. They cannot guarantee euros liabilities in this situation without bankrupting themselves completely.

So it is not just a matter of having an IMF guarantee or an ECB guarantee. It's about filling up what would then be a gigantic capital hole, a gigantic negative net worth position for the banks. So if they were to redenominate their assets into pesetas, they would have to redenominate the liabilities at the same time.

This was, more or less, exactly the problem Argentina faced, you will remember, when the dollarization was ended. It was a mess, because they did it partially in an incredibly complicated way.

One of the really big obstacles to doing this is you would have to, at the moment that you are doing an exit—and it's one of the reasons people will be incredibly unwilling to contemplate this—is that you would in fact have to change the currency of denomination, I think, of the liabilities of the system, because there is no other way of ensuring that the financial system after you have done this is still viable.

Ultimately, that is because—and it's an incredibly important point—the European banking system remains national. It wouldn't be a problem if all these banks were European banks. There would be large losses in this one bit, but they could manage it. But, by and large, they are not European banks, they are national banks, and, unfortunately, one of the consequences of the crisis is they have become more national. The financial system has become increasingly disintegrated across Europe, with most or a very large part of the cross-border flows going through the ECB.

If you are a depositor in a Spanish bank, or any other country, where such redenomination is threatened, the rational thing, as soon as you believe this is likely, is to run, and there is nothing in the system that allows you to stop that because there are no exchange controls. And there is nothing to convince you that you wouldn't lose, because you would. That is one of the reasons why, as I frequently remarked, it was much easier to create this than to break it up. Or to put it another way, it is very difficult to unmake an omelet, and this is a monetary omelet.

QUESTION: Robert Smith.

What about the cracks in our armor that we are seeing? The United States is the largest debtor on the planet, huge budget deficits as far as the eye can see, of course our trade imbalances, a weak dollar albeit we are the biggest ant in the tall grass, a lack of effective infrastructure investment, the gradual loss of our middle class, our dependence on oil imports still, and, the last point, our leadership paralysis.

How do you address this?

MARTIN WOLF: Well, the latter two I tried to touch upon, perhaps not adequately, in my remarks about inequality, the nature of the state, and what I referred to as the consequent tacit civil war about the future of the United States. A lot will depend on how those political—which are obviously related to economic—stresses are resolved.

It seems to me this is obviously—and I'll come to the others in a moment—at the most fundamental level. Something quite strange has been going on, obviously—strange to me as an outsider—because it has always seemed to me that once we have got into this age of global catch-up in which the know-how of the Western world was essentially disseminated throughout the world by Western corporations and by other means, which we have, I think rightly, accepted, even promoted, that this would create—and it was one of the themes of my book on globalization [Why Globalization Works], though I think I underestimated the extent of the significance—it would inevitably create very large internal political pressures.

The reason for that, which I don't have time to go into in detail—and here I think the United States and Europe are not fundamentally different—is that we created a sort of political settlement in the middle of the 20th century, which was based on certain ideas about the relationship between the citizen and the state, the supportive state, with varying degrees of activism, from the Scandinavians at the one end to the Americans at the other, but nonetheless a much larger and more active welfare-providing, insurance-providing state. That went, of course, along with and coincided very happily with a period of very successful postwar industrialization and a wide share of the economic fruits.

Now, when we moved into this new era, the logical thing to my mind, given that there were going to be some very large winners from this and a lot of losers, that you had to actually think intelligently, in my view, of a more active state to make sure that the benefits of this enormously potent globalization force were not merely widely shared on the current basis but you did everything in your power to ensure that future generations will be equipped, through infrastructure, through education, and all the rest of it, to share in those benefits.

Otherwise, there was a very large danger of creating within our society a relatively small number of immensely successful people who had very little interest in and engagement with the majority of the people who were actually getting worse off. That was a likely outcome of this stage of development.

What never occurred to me—and I was clear also there are fiscal stresses which are relevant to that, but I'll come to this in a moment—what I had not really expected is that a very large proportion of the middle class would apparently, for whatever reason, in the United States agree that the sensible thing to do in this situation was to dismantle the state. That never really occurred to me.

And of course, the consequences of that are going to be, without the slightest doubt—we know this; we can see it in southern Europe—the rise of populist politics. The populist politics will be xenophobic in many different ways. So I think the rise of this sort of politics in the United States, what you might call very broadly Tea Party politics, has been to me both a puzzle and it is clearly a danger.

Now, could there be an alternative to this? That relates to your other issues. My view is yes. The striking feature of the United States to any outsider is—I'm sorry to say this—that you don't pay any tax. The federal income tax at the moment generates about 6 or 7 percent of GDP, which to a European is a joke. Now, even if you throw in all the state and other taxes, the United States is taxing itself at way below 30 percent of GDP. That's not enough to support anything like a modern state in current circumstances, in my view. And of course, it does so through a wildly, insanely inefficient tax system on so many different levels, I can't even begin to talk about it.

That is, of course, related to the structural budget deficits, which are essentially a function of the fact that you have legislated some extraordinarily expensive welfare programs, including open-ended support for the most inefficient medical system on earth, without being willing to raise the taxes on the people who have the money to pay for it. This is a reflection of a political dysfunction of a high order, all of which is incredibly easy to resolve technically and, obviously, politically impossible.

Technically, since the United States has a relatively high underlying growth rate, it has the lowest tax burden of any developed country, it has an incredibly inefficient health care system—you pay for your Medicare as high a share of GDP as we do for the entire NHS [National Health Services] which covers the entire country, and I'd like to point out our life expectancy is longer and our infant mortality is lower. So basically nuts.

All this is incredibly soluble. If only other countries had these problems. Will any of it be solved? At the moment I am getting increasingly concerned that it will not be. Then, of course, there will be profound, deep, self-inflicted wounds. The United States will choose to be dysfunctional. It doesn't have to be.

If you talk to moderately sensible professionals on either side of the ideological divide, though not at the extremes, it really wouldn't be very difficult to devise fiscal reforms, expenditure reforms, which provided the necessary ingredients of a modern and successful state, deal at least in substantial part, though not fully, with what is happening with income inequality—you can't deal with that fully—and sustain a reasonably functioning U.S. state. I think all of these are eminently possible, but I am beginning to be concerned that it will not happen.

QUESTION: Robert James.

Would you talk about inequality? You mentioned it once. Is the measurement accurate? Is it true? What is causing the inequality? It has apparently changed. Is inequality bad if we want more investment? Is the solution for Washington and the states to tax rich people and corporations and let the governments give the money out in their way?

MARTIN WOLF: Oh, god! I have five minutes. There are too many questions here.

Some of them I have just dealt with, so I won't go back into those questions, except to say that part of the solution is to have a more efficient tax system, which would certainly raise the average rate on relatively wealthy people. It does not, in my view. necessarily even necessarily have to raise the marginal rate. The system is so inefficient that it wouldn't be very difficult, I think, to raise the average rate without raising the marginal rate.

The determinants of inequality in the United States—there is a huge debate among economists. On the evidence I don't think there is any real doubt. Sometimes it is very, very difficult to measure inequality precisely. It changes. Of course it is.

But (1) U.S. data are better than anybody else's because they are based on tax returns and uniquely good; and (2) the changes are so dramatic. The share of the top 1 percent in U.S. income has gone from 9 percent 30 years ago to 23 percent. It is rather difficult to imagine that there is any measurement error that would eliminate that. It is pretty clear on any plausible measures of inequality.

I refer you to the superb cross-country disciplined research of the OECD [Organisation for Economic Co-Operation and Development] and its massive report on inequality in the developed countries, which was published at the end of last year, about 500 pages worth, and it is perfectly clear that inequality in the United States is higher than in any other developed country and has increased more.

What has caused it? A whole range of things—technological change, which has clearly been skill-biased and has been particularly strong here; declining relative educational standards at the bottom; winner-takes-all markets of very many and different kinds; and, without the slightest doubt, very well-documented, the rise of the financial sector itself and the rewards associated with the financial sector, some of which were probably returns to skill and ingenuity and some of which, in my humble opinion, were rent extraction.

Now, the question of course is what can be done about this, because it is a complex, international trade, globalization. There are five powerful forces.

I think globalization has had a lot to do and the technology has had a lot to do with relative shifts between, say, the bottom 60 percent and the top 10 or 20 percent, but it doesn't explain the upper 1 percent. That is more the financial sector and so forth.

In terms of its impact on growth, I wouldn't say that it has been particularly successful in terms of raising savings. Actually, one of the striking things is how little very rich people in America seem to save. It's rather puzzling. I don't quite get it. I don't know where it is spent, but certainly that would be the national income statistics. But it probably has something to do, though it's immensely controversial, with the innovativeness of the United States.

So I am personally not suggesting that all inequality should be eliminated. That would be insane and couldn't possibly happen. But one has to focus on those aspects of the system that encourage and reward entrepreneurship. That seems to me a core element of the fiscal system in that regard. We could have a long discussion about what that would mean in the treatment of capital gains, wealth, and so forth.

I have already discussed the possibility that there could be a better welfare floor. Believe it or not, you could have a universal single-payer health system with lots of competition among providers and it would cost you much less than your present health system and it would cover everybody. It is not really terribly difficult to do this. It's not rocket science. Your neighbor to the north does it.

But I do think it is a very complicated issue. There are policies that can be designed to deal with some of it. But the fundamental problem is not going to be eliminated. It has to be managed, though, because the danger, as I said, to my mind is this emergence of a dispirited middle class which is prone to really quite dangerous populist appeals and which may destabilize in the longer run the American political system.

JOANNE MYERS: So many questions you raised and not enough time to address them.

MARTIN WOLF: I can't do anything about that.

JOANNE MYERS: No, but we can. We can invite you back to address them at a later time, because hearing from you, a man from Britain, is very valuable. Thank you.