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Exploding Public Debt: Consequences for Fixed Income Markets and Future Fiscal Policy

John Cochrane Senior Fellow, Hoover Institution
Raghuram Rajan Katherine Dusak Miller Distinguished Service Professor of Finance, Chicago Booth School of Business
Simon Johnson Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan School of Management
Allison Schrager Senior Fellow, Manhattan Institute
Thu, Oct 8, 2020 EVENTCAST

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Exploding Public Debt: Consequences for Fixed Income Markets and Future Fiscal Policy

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Exploding Public Debt: Consequences for Fixed Income Markets and Future Fiscal Policy

John Cochrane Senior Fellow, Hoover Institution
Raghuram Rajan Katherine Dusak Miller Distinguished Service Professor of Finance, Chicago Booth School of Business
Simon Johnson Ronald A. Kurtz Professor of Entrepreneurship, MIT Sloan School of Management
Allison Schrager Senior Fellow, Manhattan Institute EVENTCAST 04:00pm—05:00pm
Thursday October 8
Thursday October 8 2020
PAST EVENT Thursday October 8 2020

In addition to the public health and economic crises wrought by COVID-19, record government debts and long-term uncertainty will soon become pressing issues. The federal government has used fiscal and monetary policy tools to address the immediate damage from the pandemic. As debts mount and central banks take a more active role in managing the crisis economy, what will the future hold for American fiscal policy and financial markets?

There is no consensus about what the spending priorities should be as the economy recovers and what, if anything, must be done about the debt. How worried should we be about a potential debt crisis, and how much debt will fixed-income markets absorb before interest rates increase?

For a discussion of debts, fiscal policy, and the future of financial markets in the aftermath of today’s crises, please join us for an expert panel featuring John Cochrane of the Hoover Institution, Raghuram Rajan of Chicago Booth, and Simon Johnson of MIT Sloan, moderated by Allison Schrager of the Manhattan Institute.

Event Transcript

Allison Schrager:

Hello. Welcome to Exploding Public Debt, consequences for fixed income markets and the future of fiscal policy. I'm Allison Schrager and I'm a senior fellow here at the Manhattan Institute. We are all convened today, I was really motivated to do this because as we're thinking not only about the current stimulus, but on the future of fiscal policy as we come out of the deep recession we're in, we often talk about spending, but don't really think about the impact from financial markets, which is obviously where fixed income prices are set and this really may be truly our constraint on what we can do. It seems that there's a real disconnect going on between when we talk about our fiscal priorities and what will happen for financial markets, what it means not only in terms of investment, but how much fiscal policy we can do in the future.

Allison Schrager:

We are incredibly fortunate today that we have three of the best thinkers on this, all of whom not only have deep expertise in macro policy but also in financial markets. We have John Cochrane, a senior fellow at the Hoover Institution, who's also a research associate at the National Bureau of Economic Research and an adjunct scholar at the Cato Institute. Before joining Hoover, John was a finance professor at the Booth School of Business, and before that in the economics department, University of Chicago. He also authors the wildly popular Grumpy Economist blog and is the co-host of what is becoming my favorite podcast which I look forward to every week with H.R. McMaster and Niall Ferguson called Goodfellows. I highly recommend you check it out. I can't imagine three people any more you'd want to hear making sense of how crazy the world is.

Allison Schrager:

Next, we've got Simon Johnson, a professor at MIT Sloan School of Management. He is also head of the Global Economics and Management Group and chairs the Sloan Fellows MBA Committee. He has been a member of the private sector Systemic Risk Council since it was founded in 2012. And from 2007 to 2008, he was the IMF's chief economist and director of its research department.

Allison Schrager:

Finally, we've got Raghuram Rajan, a professor also at Chicago Booth School. He was also the 23rd Governor of the Reserve Bank of India between 2013 and 2016, and proceeded Simon as the chief economist at the IMF before that. All of whom as well have just a large number of important publications and work and policies. As I said, all uniquely experts in both macro and finance. So I can imagine a better group of people to take on these issues. So thank you all for joining us.

Allison Schrager:

To get started, let's talk about the topic of the day, which is the current relief package which is being hotly debated. It seems the difference is coming down to a trillion dollars, which even during a crisis used to sound like a lot. Now, we have Democrats and Republicans divided over this last trillion. I think we'll kick things off, two questions, which we'll start with Simon, is, do we need to spend more than $2 trillion, and if we don't isn't that last trillion really worth holding up the stimulus over?

Simon Johnson:

That was a great questions, Allison, obviously we're in a very much unchartered waters. I think that the nature of the shock that's hit the American economy and the global economies is obviously unprecedented. And I would suggest we're actually in a phase of economic life that we've never experienced, which is sort of survival economics. And the question is when you think about small businesses, when you think about a lot of the people who have been hard hit, and who've struggled to bounce back, obviously, the credit markets overall on average and for larger borrowers have actually held up surprisingly well perhaps. But for a lot of smaller firms they're being crushed. Now, is it really to the good of the overall economy for these restaurants and small shops, other businesses to go under what are the frictions that are going to impede the recovery if that's the case?

Simon Johnson:

Is there a way to buffer our way through this? It's a very tough set of questions, Allison. I'm on the side of thinking that we should be more generous. I think we should be buffering people more. I really feel that the private sector in this country has taken a beating for no good reason and for no fault of their own. And so I'd like to get as many of those entrepreneurs and their employees through this as we can, but obviously you can't save everyone in an economic sense.

John Cochrane:

Could I take maybe a slightly more critical. So I think we're making a mistake by focusing on how much we spend and not what we spend it on. Simply throwing money out the window doesn't help an economy all right now. So I agree with Simon but let's evaluate our spending as if we had to pay it back, which we will, and that will be costly. So are we spending it wisely? Keeping some small businesses afloat is wise because we'll need those businesses again, they need to reform, but not everyone. There's going to be big shifts, lots of restaurants will not reopen and because lots of cities are going to change. So we don't want to keep every business exactly open that was ever there before.

John Cochrane:

And when you start bailing out businesses, you take on not just their current operations, keep their employees hanging around doing nothing, you also bail out all of their creditors. So the case, for example, for bailing out the airlines seems to me much weaker because you're not bailing out the airlines, you're bailing out bond holders. And bond holders who earned a good rate of return on the way up are exactly the sort of people who should be taking a financial hit right now.

John Cochrane:

Airlines can be reorganized in bankruptcy, they are all the time. So let's focus on what's important. I think Simon's right. What's important is buffering shocks to people who have really been hit hard with less important is bailing out bond holders of large corporations. And less important still simply handing money out the window willy-nilly. $1,200 checks to every registered voter play well. But many of those voters like me don't need it.

Raghuram Rajan:

Allison, I'd like to comment also on this. I think Simon used the phrase, "It's not their fault." And certainly it's nobody's fault. But that's not a good metric, my view of how we decide to spend, because in some sense, who's going to be paying for this its future generations and you can hardly accuse them of it being their fault that we're in this mess. So really, I would agree with both Simon and John, that it makes sense to spend, but it makes sense to spend as wisely as we can. Clearly, no civilized country wants to see poor people go starving. So some amount of support for those who are poor, who are unemployed is actually very sensible at this point. But when it comes to corporations I think certainly airlines need to adjust.

Raghuram Rajan:

You don't want to bail out the airlines, especially their creditors, but many large firms can access financial markets, now don't need help. Many small firms, the tiny ones, yes, it would be great to bail everyone out, but there are limited resources. And the question is, can we start up the restaurant again tomorrow so long as we have enough credit and the answer is yes. Yes, the current owner suffers a big hit, that's unfortunate. But that's a free enterprise. Now, the real problems that need help because they wouldn't otherwise survive and they'd have to lay off a lot of people are really in the middle. Not so big that they can access markets, not so small that doesn't matter if they go bust at least air for everyone except their owner. It's the middle sized firm with 100% ... The firms that employ 100 people who can't get credit from the banks, who can't get credit from the markets, who may go bust with a lot of valuable organization and human capital lost. Those are the ones we need to focus on in this realm.

John Cochrane:

And if I could just emphasize, we centered the rhetoric tends to say the government spends as if there's some huge pot of money there that they can just do a lot to us. The government transfers, every cent that is spent to help one person comes from someone else, taxpayers, future taxpayers, bond holders, who might be investing it somewhere. All the government can do is transfer resources from one place to another. So that doesn't mean don't do it, but that means do it wisely.

Allison Schrager:

So there's this extra trillion dollars. Is this worth holding negotiations over? I mean, is that a meaningful amount of money still?

John Cochrane:

A trillion dollars is a meaningful amount of money. But I think we're losing track in sort of the big headline. I mean, what matters is the details. I haven't read the bill of exactly where this money is going. I hope Raghu and Simon have done some more. But I really think that's the issue. And I think we should get around the political sideshow of one party versus another on this question.

Raghuram Rajan:

Well, some extension of unemployment insurance is certainly warranted how generous it should be, what the top ups should be over that I think one can debate. But in general, the United States has relatively thin unemployment insurance relative to other industrial countries. And if unemployment is really high and the jobs aren't coming back can we find a vaccine and it is widely distributed. It makes sense, at least in areas that are strongly hit to prolong the unemployment insurance for comeback that's just [inaudible 00:14:48] money.

John Cochrane:

Let me too just put a note in there. What we are good at is economics, and there's this problem of help. You want to help people who need help. But the problem with helping unemployment too strongly is then people don't have the incentive to go get a job. So obviously, unemployment insurance, much as I'd like to give everybody something, unemployment, even leaving aside where it has to come from in terms of taxpayers, if you pay people to stay at home, then they stay at home and they don't go back to work, they don't move if necessary.

John Cochrane:

And right now there is not just a lot of unemployment, but there's a lot of businesses who can't get people to take jobs because when unemployment was even more generous than going back to your job, obviously people didn't want to go back. So it's just not an easy question of give more help versus not. If this all unemployment has to be this fine balance of the incentive versus the health. And supposedly socialist Europe is in many cases, much more hard-hearted than we are. They give more money, but they're much more hard-hearted about when your employer calls you back up, you must take the job or you lose it. So they control these incentives in a way that's much harsher than the United States does, even though they offer apparently more money.

Simon Johnson:

Allison, this is a great discussion, and I really commend the Manhattan Institute for putting this out issue out here. And of course, Raghu and John are two of my most brilliant colleagues. But I'd like to ask a question, which is if United States were hit by a large meteor, but not the kind of meteor that ends civilization. But let's say the meteor killed 200,000 people. And let's say further that it damaged consumer confidence in such a way that people were afraid to go out of their houses. They were afraid to have in-person transactions because of something that happened to the atmosphere perhaps. Would we be having the same discussion about, we should really spend a little bit less over here or a little bit less over there. Or would we be saying, "Look, we have to get the economy back on its feet. We're in a massive stall right now. We're losing future output." I would suggest because we're not making necessary investments.

Simon Johnson:

Well, Raghu is right. That in the private sector, we should be very careful, we should differentiate there's a set of firms that are actually doing quite well. They have access to credit, they're run by people who've regained their confidence and they are making investments. So that's the good news. The problem is that there are a lot of people I meet in the smaller business sector are absolutely terrified. They don't know where this is going. The uncertainty, even around the medical testing space, where I do a lot of work with people right now is enormous. And as a result, people just hold back. And I would say we're losing output today, and we're losing output in the future. We're going to have a smaller economy if we continue with the current policies and the current reluctance to really push hard in terms of risks out in the economy.

John Cochrane:

I think in terms of when you bring up consumer confidence, there's this idea of stimulus to stimulate aggregate demand, which is sort of our all purpose economic. When you're a little tired, you need a cappuccino, let's have some stimulus. But when you have a virus, cappuccino doesn't do any good. And you can give people all the money you want to stimulate aggregate demand. They're not going out to restaurants and they're not going on airlines. Half of that is because the government has closed down the restaurants and the airlines, the other half of that is because people are scared to death and they don't want to go in restaurants and airlines. So a lot of what a shut down now is not solvable by lots more aggregate demand. Places where you can buy a house prices are going up, cars are selling well. It's hard to say that this is a Keynesian recession.

Simon Johnson:

All right. Yeah, absolutely no John, I never said that. [crosstalk 00:18:21]. I think it's [inaudible 00:18:21] economics are really bizarre wartime. I mean, it's not World War II, World War II in yours very different. It's not the Great Depression either, that was also very difficult. It's extremely strange, there's a large number of people who need to survive this phase. We want this phase to be as short as possible on your trillion dollars, Allison. The question I would ask is why aren't we spending a lot more on everything to do with testing? Yes, individuals, schools, it's incredible the underspend, because this is not about inventing technology or about waiting for a vaccine to be adopted or proved safe or whatever.

Simon Johnson:

We have the technology, we need to scale it up. The private sector is doing actually a remarkable job. It's the public sector that's really holding us back. And I'm speaking at the local state and federal level to an extraordinarily, I don't need a trillion dollars for testing to be clear, Allison. Okay. But I think this also fits with what John was saying earlier. It's what you spend it on. We have lost sight of, or maybe we never had in this phase a strategy for how we get the economy back on its feet. And then of course, we have to talk about that [crosstalk 00:19:27].

John Cochrane:

I think I will accuse you of Keynesian, but lots of people are in this debate and view this into ... When they say, "We need more stimulus." The word stimulus means, not that we need to spend on things that will help get us over this thing, the word stimulus means Keynesians [crosstalk 00:19:42]. A trillion dollars, $100 billion would pay for tests for everybody every day. And it's criminal that not only are we not spending that money, the FDA is not allowing us to have tests that we can end this thing in a month if the FDA would allow us to have daily testing. And then we can fight about who has to pay for it. But the amount is tiny. We spent $5 trillion on this business, and we're not even beginning to pay for the testing.

John Cochrane:

So on your comment also, you said that there would be uncertainty, where is the uncertainty coming from? A lot of the uncertainty is coming from policy. But the restaurant owners are scared about is not the virus, the restaurant owners are scared about that their local government's going to shut them down for another three months and then they'll be out of business. So there's a lot of policy we could do to remove uncertainty. Raghu, you can just may get a word in there.

Simon Johnson:

They are also a little worried about demand, right? You can't run the restaurant at 10% of capacity. So I think we're talking about three different things here.

John Cochrane:

But the demand doesn't come from lack of money it comes from US buyers.

Simon Johnson:

I understand. I think we're talking about three different things. One is the regular Keynesian stimulus, which is your point, John, about giving people more money to spend. And right now that shouldn't be the focus. There are two other things. One is making people more confident to go out, which is dealing with the medical issues that would be helpful for demand. And that would require more spending on medical assets and so on testing, et cetera, et cetera. And the other that Simon has been talking about is two forms of relief. One is for poor people, the unemployed is to help them consume, which is a good thing. It's not about demand, it's just to keep them alive that's important. And the second is to keep firms alive. That's about the supply side, making sure that the economies body in some sense, doesn't atrophy, why the virus is on. And that is really not Keynesian spending, but it's just making sure that these entities survive. And there we should probably pick and choose which ones really need help and are worth the dollars that we're putting in.

John Cochrane:

But their creditors should take care cuts, where at all feasible. And actually, let me say a word in favor of spending. The CDC decided in its infinite wisdom that no one had to pay their rent for another six months. That's ridiculous for a health agency to pass. And that's a transfer from renters to landlords. If we want nobody to pay for rent for every six months, that should be on budget paid for by the US Treasury, not a small landlord. So there's a good case for spending as opposed to what our government often does, which is mandate that a transfer is to be.

Allison Schrager:

Just I said, keep things going because we could probably ... It's pricky when you have both the supply and the demand shock. I think that's one thing we can take away. Oh, also I forgot to mention, I encourage even the audience to put in questions as we go. So feel free to join in. But you all said something which I've always believed to this become actually quite controversial on economics Twitter now. Which means you said we have to pay this debt back someday. And I think I was there when Olivier Blanchard made that address to the American Economic Association where he said, "Maybe we shouldn't worry about debt because as long as we're growing faster than our interest rate payments are growing, then we can just run debt forever."

Allison Schrager:

I do recall in his seat, there was like a very brief aside that if growth lowers or interest rates increase, that maybe this won't work and that would be really bad. It could get really bad, really fast. So let's unpack that a bit if we do continue to spend, not only in the short-term, but if we have a president Biden he's planning on spending $11 trillion over the next 10 years, what would make that happen? First of all, why have interest rates being so low despite the fact we've had so much debt?

John Cochrane:

Can I take that one on.

Allison Schrager:

Yeah.

John Cochrane:

Because everybody I've been thinking about this lately. And I've had a wonderful correspondence with Olivier and Larry Summers on this issue. As usual the quest, we're thinking about the wrong question here. So whether the interest rate is higher or lower than the growth rate of the economy their question is about, can you take a steady debt to GDP ratio, like 100 to 200%, and do you have to run very small perpetual primary surpluses or very small primary deficits and keep that debt to GDP ratio stationary. That's not the issue at hand. The issue at hand is what if we're running trillion dollar deficits during good times and $5 trillion deficits during bad times. And the debt to GDP ratio is exploding. And Blanchard, if you read his paper, he's very clear about it. There's an upper limit on the debt to GDP ratio, somewhere out there. Nobody knows quite where it is.

John Cochrane:

There's a moment when bond markets say, "You guys are never going to pay with this pay back we're done." And that's the danger. It's not really so much as slow, our children and grandchildren have to pay stuff back because that's hard to get people excited about. And it's also not really the issue. The issue is if you're doubling the debt to GDP ratio every 10 years, sooner or later, you come to the point of a debt crisis and that's kind of where you were heading. And that's really the problem, that has nothing to do with our greater than G or less than G or all these things we like to talk about. And now, why bond markets don't see that interest rates are low. And the reason is because that kind of a crisis is like a run.

John Cochrane:

Debt crises are like the Spanish Inquisition, no one expects them to come. If you knew they were coming, they would have already happened. Interest rates in fact have never forecast. They didn't forecast inflation in the 1970s and they didn't forecast the disinflation in the 1980s. So interest rates didn't forecast the Greek debts crisis. Interest rates didn't forecast the Lehman was going to go under. These things have a run like mechanics. The danger is we're in this loop where we're having big deficits in good times and huge deficits in bad times. Washington is spending as if no one ever has to pay it back. We are now bailing out more and more private debts adding to this debt. A moment will come when the combination of very large debt and the markets lose their faith, that we'll be able to pay it off in the future. Perhaps they'll see some sort of haircut coming. And then there's a debt market. And we can go into what that looks like, it's just an utter bloody disaster. [crosstalk 00:26:17] the danger.

Raghuram Rajan:

We know what that looks like, John. Just look at some of the emerging markets. Brazil has just spent close to 15% of GDP on the crisis. I think that was good spending. But Brazil is a country which has far less room to spend than industrial countries. And now the big concern in Brazil is what do the politics look like going forward? Are they going to be able to cap the deficits going forward so that the debt has some chance of being sustainable.

Raghuram Rajan:

This is John's point that in industrial countries, the markets are willing to give you more room because they think the politics are much better that eventually you'll get the deficits down. There will be some agreement on cutting spending or raising taxes. And this is the way industrial countries have behaved. They've got credibility for this. The problem of course, is the politics in industrial countries they're also changing. Just look at the previous presidential debate. And given that the belief that in fact we will get sensible fiscal policy going forward is perhaps a little more uncertain or likely to change than it was in the past. And I keep saying the difference between an emerging market and an industrial country is simply the quality of the politics. And the politics in the industrial countries deteriorate, your debt sustainability becomes a lot more like emerging markets.

Allison Schrager:

So following up on your expertise in emerging markets, I mean, how much of the reason why we've had such low interest rate has been emerging markets buying our debt, and do you think that's going to keep happening?

Raghuram Rajan:

Well, I think emerging markets have been buying debt over time of the industrial countries. But there's been also reverse flow. And the question is which causes which? Is it capital flows into the emerging markets, which is causing their central banks to send it out again by increasing their reserves or is it the emerging markets increasing their reserves and thereby pushing capital into industrial countries. And that causes a reverse capital to flow. It's hard to say which causes which. The point however, is if you have a lot of capital inflows as an emerging market, you're very worried because you don't pick the timing of when it comes in and when it goes out, it usually comes in when everybody's pouring in. And it goes out when the Fed tightens interest rates and the Fed tightens interest rates when the US economy is hurting up, not when you have surplus capital and are willing to see the money go out.

Raghuram Rajan:

So as an emerging market, you really have no control over the flows. And you saw that in March this year, before the Fed came out with this blanket set of policies, which has [inaudible 00:29:12] markets, you saw money going out of emerging markets in a big way. Now, when that happens well, the emerging market central banks have in some sense to buffer that shock otherwise they'll have a lot of bankruptcies just like we're worried here. And so what they do is they tend to support the currency at that point. And that's why they build up reserves. That's one reason why they build up reserves. And so we're stuck in unfortunate set of events, capital flows, reserve buildup, push me, pull you of capital. Nobody wants this excess capital. And that's a strange phenomenon in a world where we're building up huge debts, et cetera. But it is capital flowing around the world, which you don't control.

Simon Johnson:

Allison, can I go back to what John said a few moments ago and link that to also to Raghu's point. And think about when did our politics go off the rails with regard to think about fiscal policy, surely the problem has become primarily that in the booms, in the good times, we're no longer as careful as we used to be. Look at 200 years of American fiscal history, we ran up debts, we had run deficits and increased our debt in times of crisis that we may agree or disagree about whether that was an appropriate thing for that period of crisis, but that's what we did. And then in the good times, subsequently we grew and interest rates were lower. Perhaps they were held down on artificial, ends up some episodes.

Simon Johnson:

And we certainly were more careful on the fiscal side. I think what's characterized the latest cycle, and what's really worrying is a number of people who say that deficits and debt don't matter in the good times. And therefore when the bad times happen when a meteor strikes or whatever the next shock is, you're not ready for that. And I think that Raghu is right as always, the quality of the politics is the key thing. And that's very much about, are you careful when you can be careful in order to create space when you need it. And we are very lucky in this country, remarkably lucky that people still regard the US dollar as an attractive asset and US government debt as a relative safe haven. And if the world is very uncertain and dangerous, you want to have more of the safe assets frequently. But I agree with John, this will not necessarily carry us forever. So in the good times, you have to be more careful.

Allison Schrager:

Well, we have a question from the audience of when do you think that breaking point is?

John Cochrane:

I've been trying to make people pay attention. I've been trying to do my fiction writing talents, and let's try and put together the scenario. When does the US have a debt crisis? Imagine we have several years of very bad productivity growth. We have another severe recession. We have maybe another pandemic, maybe a war, bad things can happen all over. The US has been running more deficits. So we're at 200% of GDP. All of a sudden the US wants to bail everybody out again. So we need another five, $10 trillion. The US has chosen to borrow very short-term. So at the same time, we need to roll over our money. This is a key part of the crisis dynamics. If we would only borrow our money very long-term. Like a household that takes the 30 year mortgage rather than the industriable rate, then we're much more insulated against problems. But no, so let's add to our trillions, we need to roll over 10 or $20 trillion worth of debt.

John Cochrane:

And let's add political chaos, which I think Raghu exactly, rather than a sober country, that's saying, "Here's our long run problem." Let's suppose we're having an impeachment, an investigation, we're in the middle of another election where lawyers are fanning around the country, there's riots in the streets if you will. Then this is the kind of moment at which our bond investors say, "I'd just rather have those Swiss francs right now. I'm not going to roll over the US debt." Then interest rates spike. And then what had previously been affordable becomes not affordable. And it's not just like an emerging markets crisis because the US is the world's firehouse. It's not like your house burned down. It's the firehouse burned down. We count in the US, on our government, flooding everything with money every time things go wrong, bailing out of the financial instruments, bailing out all the companies that have taken on too much debt, supporting everything.

John Cochrane:

Imagine the calamity, when the US government is in trouble and imagine [inaudible 00:33:41] we talk about, we can always inflate rather than default. That's not obvious. Let's put it this way. In a time of fiscal real urgency, will our legislators say, "The most important thing is to bail out the Wall Street fat cats and the foreigners who own our debt rather than poor Americans." The chance of us saying, "There's a hair cut on debt." Is not insubstantial. And that leads to the crisis even more, that leads to financial calamity. The whole financial system is based on the idea of the US dollar will never default. These are unlikely events but a financial crisis in 2008 was an unlikely event. A pandemic that got out of control was an unlikely event. Unless you think about the unlikely events, you'll find one happening.

Allison Schrager:

So we have a bunch of really good questions coming in. And one is sort of on that what you were talking about is US use a lot of space to run up debts because it's seen as the reserve currency. Are we in danger of losing that, and if so, I mean, where are people going to go?

Raghuram Rajan:

Well, in the short run I don't think there's a huge concern, partly because what are the alternatives the euro, which unfortunately euro area policy is not cohesive, to recently they didn't have a fiscal policy across the euro area. Now they've started doing it. The euro may look a little more attractive. And the renminbi, and of course there are large concerns about your ability to get in and out of the Chinese market. So the US still stands out as a place where you're willing to let your money ride, and the market's accessible, it's liquid. And it's still modular what John said, fiscally very sound from the perception of the rest of the world. But we are changing the facts on the ground. For example, if you start limiting access to the payment system, if you start living sanctions here, there, and everywhere, people start worrying about using the dollar, "Maybe I get sanctioned, maybe they prevent me from taking out my dollar assets." And the more the financial system is used as a weapon, the less the US becomes attractive as a place to store your money in.

Raghuram Rajan:

And so this is a concern that already Russia is wary about using, you may say, "We can do without Russia." But what if China starts saying, "We don't really want to use the US systems of payment, we don't want to use Swift. We don't want to park our assets in the United States because there's always a risk that they might be expropriated." A lot of people are relying on the rule of law in the US and that it will not be used for political purposes. If that changes, I think there is a lot more chance that the US may be less attractive as a reserve currency.

John Cochrane:

Okay, go ahead, Simon. Then I'll jump in.

Simon Johnson:

I thank you very much, John. And so I would say Allison, that we should prepare for the day when the international flow, financial flows and portfolio shift away from the US dollar, just as Raghu was saying. It has gone on for a remarkably long period of time, it will not go on forever and I think that's entirely reasonable. But back to what point John made about the financial risks and what could bring the House of Cards down. By the way, John, I think you described Russia in 1998, really vividly in your historical example. So great empire becomes Russian precarious finance and the crisis in 1998. So they'd happen somewhere. But the really scary thing, I always say, Allison, is the politicians, including leading senators who not so many years ago, advocated that the US should default on its debt.

Simon Johnson:

That was an extraordinary moment to me that was of different political moment, sure, it was different fiscal dynamics, but that was a scary thing. If you have people who get elected, who are in charge, who think you'll be okay to reduce the value of US government debt for whatever reason, or to stop making payments for whatever reason, that is what we're going to be supporting the Cochrane scenario.

John Cochrane:

Let me add on both of these in cheering both, especially, Raghu's worry about our overuse of sanctions, which I think that just leads people. Look, we can sanction, but then they're going to find something else other than the dollar. There's a big puzzle right now. Why do people want to hold so many dollars? The need to hold a lot of the reserve currency is vanishing technologically. You can hold your money in German stocks if you will. And if you're a large institution even if you need to make payments in dollars, you can change those stocks into dollars in about 20 milliseconds and your recipient can change the dollars back into stocks in about 20 milliseconds. So the need to hold a large quantity of supposedly risk-free assets, that doesn't exist anymore technologically. Now, people still have it, but that desire for risk-free assets can go to a lot of places.

John Cochrane:

As in the 1970s, when people started to doubt sovereign debt, they went to real estate, stocks, bonds, commodities, there's lots of other places to put your money that is insulated. It may not be nominally risk-free at a short horizon, but it's insulated from your worries of a world that's falling apart politically and may inflate or default. And just as a last, I liked Simon's illusion to hundreds of years of history. We have to remember it for I'll put it at 800 years I think since Edward III defaulted on the Peruzzi Bank, our sovereign debt has not been by and large the risk-free asset. Sovereign debt is one of the riskiest assets around because there's no collateral and they can always default. We've lived in this very strange time when unbacked money and sovereign debt has been seen as the completely riskless asset, and a strange time that people wanted to hold a lot of that, even though technologically they didn't have to, those things can change. And like all tipping points they change all of a sudden when you least expect them.

Allison Schrager:

But that's a great point, because I never really thought about it. Because it's only been in my lifetime that if your currency could be the risk-free asset, but I guess that was pretty wild to people years ago. So why not German stocks? So we had a great question from Mickey Levy, in 2020, the federal budget deficit was estimated to be $3 trillion. The Fed is poised to absorb 60 to 70% of the CBO estimates of new debt in ... Sorry, 2021 to 2023. Please discuss the dynamics to these flows and what are the political implications?

John Cochrane:

Well, I'll jump in because the other two didn't do it quickly enough. So the Fed reserves our interest paying government debt, the overnight interest paying government debt. So there's really the idea that we're printing up money which will hyperinflate is wrong, as long as reserves continue to pay interest. There is some difference, the Fed jumped in and started buying up treasuries because the treasury markets weren't absorbing new debt. They saw problems and I think we're starting to see the first hiccups of resistance. And there's two other differences between the Fed's issuance of overnight government debt is held by banks in terms of reserves and therefore indirectly by you and me in terms of deposits. And bank deposits have gone up like crazy. Now apparently, investors aren't that interesting holding actual treasury bonds and bills, which is why we've gone to this direction.

John Cochrane:

How long are they going to want to hold trillions of extra dollars of bank reserves that are funneled into overnight debt, problem one. And problem two, that action shortens the maturity structure of government debt outstanding. So it means we've gone in the opposite direction, if interest rates go up, the interest rates on overnight debt go up overnight. So right away we're faced with higher interest costs. Whereas if we had funded this thing by very, very long-term debt, if interest rates went up, the US government really doesn't care fiscally until it has to for 30 years.

Raghuram Rajan:

Yeah, just on this. I think John makes a very good point when he says, "Don't think of the financing of the central bank by its issuing reserves." Which people colloquially called money printing as different from the government financing itself. And there's the whole of this modern monetary theory is based on these being very different. In fact, what we should be looking at is the combined balance sheet of the government and the central bank. That's all that matters because money is a government obligation, much as government debt is.

Raghuram Rajan:

And if you think about it that way, the point that John made, I want to emphasize it, which is what is the worst way to finance low-income spending today? It is to issue money to finance it. Because what you're doing is issuing very short-term debt to finance debt if you could, you should issue long-term government debt, because then you lock in the low interest rate to finance your government spending at this point, rather than making yourself susceptible to any spike in interest rates as you go further. So don't finance through money, finance through bonds if you can. The only reason to finance via the central bank is if the market's quite difficult to absorb in the very short run because of liquidity pressures, et cetera. But it does mean that as soon as the central bank gets the chance, it should unwind that by pushing off those bonds into the market.

John Cochrane:

Central banks could also, our Fed could do term financing. They can do fixed rate long-term stuff as well as short-term risk stuff if they wanted to. Our treasury every two bit bank in the country knows how to do swaps. So our treasury could issue fixed-for-floating swap and stop the interest rate problem. So I agree entirely. I want to invoke the spirit of your frequent co-author Doug Diamond, who says that, "Our financial crisis are always in everywhere the result of short-term debt." And that we should just put that up on the treasury building as a daily reminder to them.

Allison Schrager:

Do you think there's an appetite for 50 year bonds?

John Cochrane:

Yeah. But a 30 year bond it's like 1%. I want perpetual bonds, bonds that have ... Queen Victoria issued them at 1%. Bonds that pay just coupons and no principal ever. That would be a great innovation.

Allison Schrager:

Yeah. Well, I'm a pension economist, so I'm always about everyone's short duration. So I've always been about long duration bonds and think everyone's short, especially in the UK where they're required to hold long-term government bonds.

John Cochrane:

Yeah. Long-term debt makes a lot of sense. I mean, are you planning to die? Unless you're planning to die in a week, you don't want one week debt, you want long-term debt.

Allison Schrager:

Is it possible, do you think we have the ability, even if we wanted to inflate away debt, could we? It seems like the Fed doesn't have a lot of control over inflation anyhow.

John Cochrane:

The inflation will come not from actions of the Fed, but from the private sector. When people decide they don't want to hold US government bonds, what do they do? Go out and spend. That's the inflation. It's a fiscally led inflation is not one that the Fed can do much about one way or the other. As the Central Bank of Argentina with the Central Bank of Venezuela well, I guess, Brazil too, what can they do about inflation? When people say, "We don't want the government debt, we don't want a short maturity government debt, we don't want a long maturity government debt." There's just not a whole lot you can do about it.

Raghuram Rajan:

That's John talking about the-

John Cochrane:

[crosstalk 00:45:15] book.

Raghuram Rajan:

Which I think makes sense. But there are other reason. Even if you think that central bank credibility is the central thing, keeping inflation from going up, it's not about government debt. It's about central bank credibility. Even there, you have to worry a little bit because all the actions recently have been towards being more accommodative of inflation because central banks feel they're fighting the problem of disinflation. So they want to be much more accommodative as Paul Krugman, once famously said, they have to essentially commit to being irresponsible, commit to allowing higher inflation. The problem of course, is that if you are too successful there, you've got the reverse problem, very high inflation. So take, for example, recent Fed actions. We're going to worry about inflation over the cycle. That means they're going to run inflation a little hotter. But not just straight at that when they talk about what they define as maximum employment, they're also saying this means it has to be an inclusive employment.

Raghuram Rajan:

Now, when are minorities hired, typically at the fag end of the cycle, when you've run through ... Unfortunately, this is a feature of the labor market. When you've run through the normal majority hiring, you then start hiring minorities. Well, what that means is if the Fed is serious about this, it is going to wait for longer before it starts raising interest rates, even module of the averaging over the cycle. So I do believe this is in response to what you said earlier, central banks have been singularly unsuccessful since the global financial crisis in raising inflation rates. But now there's a danger with the huge amount of debt that's piling up that the problem may actually be the reversed one in a couple of years of holding inflation down. And if they actually sort of get away from their constraints they may actually be contributing to the problem two years from now.

John Cochrane:

Let me just chime in before Simon comes. Because I was a little too doctrinaire there. And I went to back off that a little bit. I think Raghu was exactly right. The danger is a little bit of the 1970s when we were late to the game. And it's like being, if you were an alcoholic, just taking one drink and that would really cheer you up at night. A little bit of inflation is hard to achieve. And really objectively guys, 1.6, instead of two inflation and unemployment that was down in the 4% before February I mean, maybe the Fed just needed a mission accomplished flag at a standard, say it's between one and two, and they would have been happy. The danger is dove lying effect. Suppose we have one of these fiscal problems, it manifests itself as sort of a run on the dollar. The dollar's plunging, the interest rates and bond markets are going up and now, what central banks have to do is defend the currency, which means sharply raise interest rates, even though that's going to cause a recession.

John Cochrane:

So is the Fed going to be willing to do what it did in 1980, 1982? That this is the conventional reading of history and inflation expectations are anchored because everybody thinks that the Fed is going to be tough. And if that event happens, they're going to really jack up rates. Let's not forget we were in the, I don't know, 15, 20% interest rates back then in order to contain inflation. Well, is the Fed really going to do that? I think Raghu was right. Well, they just took one drink.

Allison Schrager:

Well, you also wonder, I mean, someone my age or younger has no memory of inflation. I don't think they have when I talked to other, especially financial journalists, they have no concept of why inflation's even bad.

John Cochrane:

You should read a history book or travel a little bit. I mean, I have no memory of the Great Depression, but as an economist that sticks big in my mind about events that can happen.

Allison Schrager:

Yeah. But you wonder if it undermines the Fed's ability to sort of increase rates if people don't understand why they would. I mean, I'm shocked that so many people just genuinely don't see any downside to expansionary Fed policy. They think it's effectively a free lunch.

John Cochrane:

Well, to defendant the Fed, I think the way to interpret all of the smoke coming out of the Fed right now is that they were a little bit burned because they started raising rates when they saw labor markets improve. And in retrospect, they thought that was too early. So what they're going to do now is wait till they see the whites in the eyes of the inflation. They're really on now on inflation target. Now, an inflation target is a good and fine thing. And so the only question is once if inflation does get to two, two and a half percent do they start raising interest rates in response fast enough, or do they find excuses, impaired markets, it's still too slow, other reasons to as they did in the 1970s, not to start beating down the inflation.

Raghuram Rajan:

Almost surely the experience over the last few years will make central banks react a little too late the next time around to inflation. Because they've been fighting this war to push inflation up, haven't succeeded and they're going to be much slower and bring it back under control the next time around because they feel that they have the room, they want to make sure that as John said, who was it, William McChesney Martin, who said, "By the time you see inflation in the eyeballs, it's too late." He said all the good things that the Fed chairman have said. But nevertheless, it may well do that the next time around it's harder to control inflation. But many central banks today will want that. And in some sense, that's part of the problem that they feel a mild inflation will bring the debt levels in better sync with economic activity. And so I think they're going to be more open to higher inflation, which in fact will make it more likely.

Allison Schrager:

I have a question for Simon. So we've been discussing a lot how we really have to take that seriously, particularly as we come out of this recession. But let's assume that pandemic ends and we have a very slow but positive recovery, similar to what we had after the financial crisis. The Biden administration plans to do a lot of spending even beyond pandemic spending, some elements of the Green New Deal, certainly a lot of infrastructure spending. I mean, is this one, desirable, and two, do we have the ability to do that?

Simon Johnson:

Well, I think I would go back to I think it was the first remark John made when we started the session, Allison. Which is it depends on what you're spending it on. I think we need to boost growth, we need to boost productivity growth. We know that key elements of that are purely private sector action, but there's some other elements, including some parts of education, including research and development, including some infrastructure, for example, that need to be or arguably are better done through the public sector. And so I think I would ask that question always, Allison, are we boosting growth, are we increasing productivity? And I do think by the way that the question of who shares in that productivity growth, what kind of jobs are we creating? Are they spread around the country, for example?

Simon Johnson:

For various reasons, over the past 20 to 30 years, growth became extremely concentrated in on the East Coast and the West Coast and a few other places. And that's obviously generated a lot of friction and it's not clear that that's particularly good way to allocate resources or to drive growth. So I think if we're talking about, for example, investing more in research and development, pushing up science spending, and spreading it around the country, creating more scientific hubs and focusing on commercialization. So you're creating more private companies coming out of that scientific innovative commercialization, I think there's room for a lot of that.

John Cochrane:

But I would say the science budget is like 0.001% of federal spending right now. Basic science is not really the issue as far as money is concerned. Our productivity growth really has not come out of massive federal spending and things like the Green New Deal is designed to lower growth. We're going to spend money to do it in less carbon ways maybe but certainly not a growth agenda. So I think the forecast is for lots of spending on all sorts of things, most of which is about a social agenda, not really about focus and economic growth comes from deregulation, brutal competition, private sector innovation, which is what raises productivity. And the idea that you throw government money at it to raise productivity I think doesn't bear out.

John Cochrane:

But I would forecast lots of it, and for a simple reason, we have all this fancy stuff about transversality conditions and RNG and debt crises, and repayment and so forth. You're a politician, you're in Washington. The bond markets are offering you money at 1% at negative half to negative 1% real rates of interest. You're like a household in 2006, that's getting credit card companies and offers to refinance your mortgage. And there's some vague thing about my grandchildren might face some taxes someday that isn't just not salient compared to money being thrown at you. And I noticed in the rhetoric in Washington, there used to be a, "We're going to borrow money to spend it, and yes, our children have to pay it back. But this is worthwhile." Not that. That rhetoric is just entirely gone. This is free my why is it free money? Well, if you went down to the grocery store and they were giving you tomatoes for one cents, each you'd say, "Well, but I'll have to buy some tomatoes." And I think it's going to keep going until the bond markets say, no.

Simon Johnson:

Well, finally, I've found something to disagree with John on [crosstalk 00:54:57]. We've been agreeing far too much today, John, actually. So Federal Government spending on R&D is between 0.6 and 0.7% of GDP it used to be close to 2% in the 1960s. A large number of industries that were created coming out of World War II did have an important public dimension an investment dimension. Yes, there was procurement, there was Department of Defense. There was the computer industry, there was Silicon Valley, John, where you live now. This spread across pharmaceuticals, this spread across human genome project. We actually did this really well for about 40 years. And I would say by the way, it was done in a fiscally sense way. So Eisenhower was absolutely on board with this agenda. And after Sputnik was launched in 1957, the American response was to invest more in science and in education for science.

Simon Johnson:

And to make it easier for small smart people to go to school, because that's what they figured the Russians were doing. And they looked at how many engineers we were producing versus how many engineers the Russians were producing. And they said, "We have to do better." And they did. It was a remarkable success. And it wasn't about blowing massive holes in the budget, and all that. It was about being careful and it was about investing. And it was about thinking, I would say John, about the public–private partnership, which has been an enormous strength of this country. And I'm totally on board with not blowing up the budget. The problem with the budget, let's be quite honest, guys. The problem with the budget is over the past 30 years, some people who travel under the heading of, "Fiscal conservative," were not actually that fiscally conservative, they didn't really care about debt and deficits at all.

Simon Johnson:

It was Cheney, who said, "Debt doesn't matter." They went for broke, they cut taxes, they ran mass deficits in the good times. That leaves you no buffer, Allison, when they meet your heads. This is a goddamn media. We've been hit by the largest shock in the history of modern humankind. It has killed 200,000 people. And we have done too little as a nation on the health side and on the economic side. And we are struggling to come back and the consequences are going to be awful for millions of people. And I am with John and Raghu on the need for fiscal responsibility and the fact that we were lucky in this country, and we're not going to be lucky forever. But if you blow it all in the good times, guys, you're going to have really bad trouble when the meteor hits next time.

John Cochrane:

Let me agree and just make sure we're ... You can take that 2% of GDP that we spend on federal R&D and triple it as far as I'm concerned. Because it's still a tiny fraction of the federal budget. That's not the spending, the spending problem in our federal budget is that our government basically deserves to write checks to people. And so the problem is healthcare. The problem is pensions. I'm completely with you on R&D. Now, there is problems on how the NSF, you look at studies at how the NSF now awards contracts, and it's not as efficient as it was back.

John Cochrane:

Having to fight a Cold War and really needing results out of it was pretty handy for the federal science. So how we spend on science needs reform and you guys, we all work in academic institutions. There's politics going on that are not just about the highest quality and the best result in academic institutions. So throwing money at us, I don't want us to be on tape saying, "Throw money at us, dear our Federal Government." We also need reform at how we spend federal money for R&D, for basic science and in the universities.

Raghuram Rajan:

Just to make sure we're not leaving the emerging markets out to Simon's point, what happens when you can't spend? You get the situation in many emerging markets today. They simply do not have the money to spend on relief, they do not have the money to spend on repairing the firms. And as a result, what you're going to see is many lost years of growth. We're talking about do we get back to the pre pandemic level by the end of 2021 or the middle of 2022, there are a number of emerging markets, Mexico, Peru, India, which are talking about whether we get back in the next five years. Because the damage that's done to the economy, without the ability to spend in terms of relief, it can be really quite significant.

John Cochrane:

Can I also, and I think Simon was a little too extreme on this was the media and 200,000 people died. In World War II, 80 million people died. In the flu pandemic of 1918, far more died. This pandemic actually, I view as our fire drill. It was just enough to get our attention. But if you compare it to the bubonic plague, typhus, cholera, the influenza of 1918, there is a much worse one out there. We were caught completely flat-footed, our public health response was completely incoherent. Unfortunately, the move to reform that I don't hear anybody saying rather just defend whatever we did. But we just got the wake-up call as far as what pandemics can do, and as far as human misery can do. I'm sorry for the 200,000 who died, but I'm also sorry for the 80 million who died in World War II. I mean, horrible, horrible things can happen out there.

Raghuram Rajan:

John, give it time. Sorry, Simon. Just one second. Give it time, I think there will be a response across the globe when we get past this, how do we prevent a recurrence? How do we deal with such issues once again? And to your point, I mean, the extent of global cooperation on this issue was abysmal. And we will recognize that, and I think we will have to go back to the drawing board. What kinds of global institutions do we need to monitor the presence of such viruses, and then to bring together a global effort where do we keep medical equipment reserves? Should every country have the same, or should we have some way of sharing the reserves so that the countries that are first hit get the reserves. And in meantime, everybody starts manufacturing like mad. I mean, those are all issues we should debate now that this has become a serious problem.

John Cochrane:

Global national state, local, I mean, the failure was absolutely everywhere. And as after 9/11, there was a sort of a, "Hey, these cops need to be able to talk to the firefighters." Kind of reform. We need not only to have ... There were about 12 pandemic plans, nobody even bothered to look at any of them, because they didn't know they were there. Nobody practiced them. So yes, you need a bureaucratic reform so that ... Of course the next one won't be just like the last one. But we need to have a public health response to the next pandemic. And I think this pandemic was actually quite fortunate because it's just enough to wake us up before the next one comes, which could kill ... I mean, imagine one like this, but kills 10% or 20% of the people. That's in the biology or it's in the bio-terrorism.

John Cochrane:

That's the number one thing that needs to be done. And I hope you are right about the will to reform our international institutions and then keep it going. California put together mobile hospitals and spent a lot of money on them after H1N1 and then Jerry Brown decided to not spend the $5 million to keep them going because he wanted to spend it on the high-speed train. And then we didn't have them when we needed them. You need the 10 years of quiet that you keep these things going and don't let them develop other agendas, which is what all of our institutions did and get politicized, which is what all of our institutions did. You need regular fire drills and I hope we are capable of that institutional reform. So Simon-

Simon Johnson:

Just quickly, because John, I think the audience has to go at 5:00, even though you and I can stay on for three more hours. But just very quickly, John look, you're totally, you're both obviously right. That we need a better pandemic preparedness. I spend most of my time working with private sector, people who are trying to stand up a response to this pandemic and build something that's going to be lasting. And we are dragging behind us, kicking and screaming, the local state and federal public health officials. Okay. That is a remarkable, but I have to say to you that ultimately we will need some public investments of some kind. Because there are some things the private sector will do a lot, and I think that's appropriate. I'm all in favor of that. And we'll do some of that for pay and we'll do a lot of it for free, but then we're going to need the government.

Simon Johnson:

And just finally, it's remarkable, Allison, really, really interesting that maybe speaks to the time that we have not mentioned the number one driver of fiscal deficits and projected debt in the United States over the next 40 years. Which of course is healthcare spending. And I hope we can get back together and have another discussion because this is such a productive group. But I do think that the fact we spend 18 or going on 19% of GDP in the old days before the pandemic on healthcare in United States, we don't get much better outcomes than countries that spend eight or nine or 10% of GDP. And to John's point, we definitely didn't prepare for the pandemic and when the pandemic hit it all went pear shaped.

Simon Johnson:

Those are really important points and let's get back together and think about fiscally responsible ways to bring healthcare costs under control, to bring better healthcare to everyone. I'm sure we'll be in supporting that and to build the resilience into the system, both early warning, rapid response, and then, "Oh my goodness, it's upon us. How do we adapt to that?" I don't think we should spend more, John to be clear. I and Raghu, I think we should spend less. Maybe even dramatically less over the next 40 years. But we've got to spend it differently. And that goes back to John's original point. What do you spend it on and how you spend it is always going to be the key question.

John Cochrane:

But the pandemic response and here, I want to disagree. We can spend a lot more on pandemic response, a hundred billion dollars on pandemic response is nothing in the $5 trillion.

Simon Johnson:

We already agreed on that one, John. That I [inaudible 01:04:19].

John Cochrane:

Didn't watch it. A short change pandemic response.

Simon Johnson:

[crosstalk 01:04:23], testing, right? Can we have a final shout out for testing and spending more on testing because that's what was going to get people's lives back [crosstalk 01:04:31] back.

John Cochrane:

Just allow it, I've got the money, let me go down to CVS and take the five minute $5 test. FDA won't allow me.

Simon Johnson:

We need to talk about that test John, by the way, afterwards, about specificity and sensitivity. I have some better tests for you to consider. [crosstalk 01:04:43] do only costs $5. So that's the private sector innovation that we need. That's the competition that's now coming through, right? And the FDA has without question not been super helpful.

John Cochrane:

And that has been remarkable that we have tests, six months into a pandemic. We're talking about a vaccine eight months into a pandemic is just unbelievable. I mean, that's just a miracle, thanks to science, both federally supported and private. That's the one piece of good news here.

Allison Schrager:

Yeah. And the therapeutics too.

John Cochrane:

Somehow we stand on debt and we wind up on pandemic. But I think everything winds up on pandemic these-

Simon Johnson:

Everything comes back to healthcare, John. Everything comes back to healthcare ultimately it sounds like.

John Cochrane:

I'll show you the free market answer to healthcare where we get better stuff, much cheaper some day, but that's not for today.

Allison Schrager:

What I did is I've said I would love to reconvene this so we could delve into more of how we should be spending money. But unfortunately we only have an hour today, but hopefully we can all come back and do this again soon. Because we are up, but before we close, first of all, I want to thank our panelists who said, who are all very busy and I've learned so much. So I'm so grateful that you all joined us. And I said, I hope we can do this again. And also I invite everyone to browse the Manhattan Institute's research and subscribe to our newsletters, if you're able, please also consider supporting the institute at the link you see below. MI is a nonprofit organization and our work depends on support from people like you.

Allison Schrager:

So thank you for joining us and thank you again to our panelists.

Allison Schrager:

(Silence)

 

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