Scheuenstuhl: Gentlemen, thank you for taking the time to discuss some topical pension finance issues so we can better understand what is currently driving developments in these markets. Professor Allen, you’ve published a book called Understanding Financial Crises. Can you provide us with an explanation on how we got into the current situation?

Allen: Well, in my view, central banks bear a big part of the blame. They kept interest rates far too low for far too long. Recent BIS (Bank for International Settlements) reports are also clear in allocating some of the blame there. Excessively low interest rates caused the credit bubble and subsequent inflation.

Munsters: It is curious that the United States, the home of individualism, entrepreneurship and limited government, has recently seen so many statist interventions: Bear Stearns and so on. What happened to laissez-faire economics?

Allen: In the case of Fannie Mae and Freddie Mac, since they are government-sponsored entities, I think the government essentially had to step in. If they hadn’t, there would have been very serious problems. Not only would new mortgages have dried up, housing prices would have fallen even more. As with Bear Stearns, I think it was important they stepped in. Now, whether they have handled those cases in the best way is debatable.

The other area the government has been involved in is regulations. Right now, it is not clear to me whether, if at all, regulations have helped us with the current situation. In many ways, it seems they have contributed to it. Regulation compliance takes a lot of time away from top managers, time that could have been better invested in identifying and preparing for problems.

Scheuenstuhl: So you are suggesting that the public and political outcry for more regulations and tighter risk controls is not the appropriate answer to avoid such crises in the future?

Allen: The current notion we have in the United States that the Fed should be in charge is a little ironic given that, to an extent, it caused the problem. Low interest rates caused a housing bubble. When bubbles collapse, you’ll have a crisis. It doesn’t matter how many regulations you have. The problem is that you can’t avoid the pain, but this is what they tried to do when they lowered interest rates after the dot-com bubble burst. We would have been better off having a moderate recession five years ago rather than the more serious one now. What the Fed needs to do is to stop this activist monetary policy.

Scheuenstuhl: In any case, subprime, the credit squeeze, inflation – the whole litany of woes – have resulted in bad news. Do you see light on the horizon?

Munsters: Well, these are great markets to be investing in. Many people were comfortable a year ago when markets were high and credit spreads low. The numbers looked fine, but I was wary. The situation is reversed now: risk premiums are much higher and a number of institutions are desperately looking for capital – we have that in abundance. We are putting in negative numbers, make no mistake about that. But for long-term investors, this is the moment when you should be laying your bets, when you buy your long-term holdings. This is hunting season.

Scheuenstuhl: That is a strong contrarian statement in a world where, because of regulatory investment guidelines and stress-test requirements, we generally see pro-cyclical, herd-instinct investment behavior. Where exactly is APG looking to invest?

Munsters: Across all asset classes and regions. Everywhere people are in trouble and – importantly – where we understand what is offered in terms of actual and potential risks. If you look at debts associated with subprime, you see the problems that resulted for investors who purchased supposedly triple-A-rated paper. We bought nothing, because our own credit analysts felt we wouldn’t be fairly compensated for the risks and were dubious of the true dynamics. It is important to buy into areas that you understand. That holds true for today, tomorrow and in 10 years’ time.     

Scheuenstuhl: Roderick, you mentioned risk. It seems to me that inflation has the potential to have more impact than people believe.

Munsters: I agree. We have been warning against an unexpected rise in inflation for a while. That has been partly behind our hedging strategy. A lot of people think inflation will fall back, believe that it will return to “normal,” that is to between 1% and 2%. I am afraid that, because of labor shortages, a more expensive manufacturing base in Asia, continuing supply and demand imbalances in raw materials, that inflation may be with us for a longer time than people imagine. I hope the ECB will react accordingly and raise interest rates. But this is a different scenario and may in itself cause problems in that the financial markets become jittery and react in unexpected ways. And that of course leads to questions about the euro.

Allen: Is there an issue? Are you questioning the stability of the euro?

Munsters: It is a question I raise quietly. In Europe, we have one currency, one interest rate policy and various competing national interests. As a result people in Italy currently pay 50 basis points more for credit than Germans, the Dutch or French. How come? What is happening? I would rather not have all of our investments in the euro zone in case, because of competing national interest, something goes wrong. I stress, I am not predicting this, but it makes sense to make sure you are diversified.

Scheuenstuhl: Which means what? Asian private equities? And is it right to expose Dutch members to risks in South-East Asia?

Munsters: Well, that’s diversification. Our expectations are that GDP growth will be higher there than in Europe for the next 10 to 20 years. So, from that perspective, we are keen to be involved there, though being true to diversification, we need to be spread across markets and regions.

Scheuenstuhl: One feature of the current environment is that it has been largely nationally contained. That is, Bear Stearns affected America, Northern Rock the UK and the Landesbanks in Germany. There has been little spillage. What will happen next?

Allen: An interesting question, especially in light of what Roderick said on the euro. Essentially anything could happen from now on, including a run on the dollar, but one of my concerns is that Europe is less prepared for the current crisis than the United States. If a large US bank like Citigroup were to go bankrupt, it is clear that the government could deal with that. It may add another 10% to 20% of GDP to the US national debt, but it could be absorbed. In Europe, you have banks such as UBS and Credit Suisse whose assets are much larger than the GDP of the Swiss government. What would happen if, for example, Fortis or UBS went bankrupt or faced a run? It wouldn’t be at all clear that the governments of those smaller countries could afford to bail such a bank out, due to their proportionate size to the GDP. If that happened, it would be catastrophic for the global financial system, but particularly for Europe.

Scheuenstuhl: So would the EU be pulled in to resolve such a situation?

Allen: The EU could solve it, but they have never actually had the political will to make an agreement on burden sharing. They’ve talked about it, but always backed away, revealing another weakness of Europe. When such events occur, as they have in the United States, you need to find a solution quickly. The structure of the European system invites procrastination.

Scheuenstuhl: Another point Roderick mentioned was competing national interests in Europe.

Allen: Definitely another weakness. I think you saw that with Société Générale. The Bank of France knew that they were liquidating these huge positions, but they don’t seem to have let the ECB and the Fed in on the information, at least not immediately. It underlines how, when it comes down to it, each country in Europe has a tendency to look after its own interests first. That may be not true of Germany, but certainly the tendency is there in other countries.

Scheuenstuhl: Gentlemen, thank you for your valuable contributions.