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Economic Recovery Progressing in Line With IMF Forecasts, But Downside Risks Remain

The State of the World Economy

Speaker: Olivier Blanchard, Economic Counsellor and Director of Research, International Monetary Fund
Presider: Abby Joseph Cohen, Senior Investment Strategist, The Goldman Sachs Group, Inc.
January 23, 2014
Council on Foreign Relations



COHEN: Good morning, everyone. For those of you who can't see me, my name is Abby Joseph Cohen. I'm the senior investment strategist at Goldman Sachs, and a very proud member of the Council on Foreign Relations.

I have the honor today of introducing Dr. Olivier Blanchard, who is the chief economist of the International Monetary Fund. This is such an important time for the global economy as it has been for the last several years. And Mr. Blanchard has been at the IMF in very important responsibilities during this period.

He has a very distinguished academic career. I know you all have a copy of his biography. But he has spent much of his academic career at MIT, where he has headed the economics department. He's also taught at Harvard. And he has written a textbook with the incoming vice chair of the Federal Reserve, Stanley Fischer.

So without further ado, I would like to invite Mr. Blanchard, one of my favorite macroeconomists, up to the podium so that we can begin our discussion.

BLANCHARD: Thank you for inviting me. What I thought I would do is to give you a 10-minute summary of the update that I gave two days ago. Four times a year, the fund is supposed to indicate how it sees the world. And I had to do this in snowy Washington two days ago.

I emphasized three themes. The first one is the recovery's strengthening. I was hoping this would make headlines. And the two numbers—I'm not going to inundate you with numbers—but the two numbers there that world growth 2013 was 3 percent.

And we predict—we forecast it to be about 3.7 percent in 2014. That's a non-negligible improvement, although it's still far below the more than 4 percent that we used to have.

The second is that actually we—this is largely—this is a recovery which was largely forecasted in the sense that our forecast revisions are very, very small. We just revised our number for 2014 by 0.1 percent. Therefore, what happened is very much what we expected to happen. Doesn't always happen that way, but it did.

And then the third one is heterogeneity, which is that it is not the case that all countries are recovering at the same pace. There are fairly major differences across the world. And it's not only important to know, but they interact with each other so that we're not out of the woods, and that there are some downside risks which strike us as rather serious.

So these are the headlines. And the question is, well, why is the world economy recovering? I found it useful for the past few years to think of forces pulling the economy forward, and then forces pushing it back, keeping it in place.

So you can think of—I've used this analogy of accelerator on one hand, and brakes on the other. I think it's a useful way of thinking about it.

So on the accelerator side, I mean, it's clear that there has been an incredibly strong accelerator now for many years, which is accommodative monetary policy, just getting interest rates to zero, or very close to, was a fairly strong monetary expansion.

I think we can discuss how much the unconventional monetary policy, which was pursued thereafter, how big the effect was. I think it was not very large. It was probably worth doing.

But the point is that this has been an incredibly accommodative monetary policy, which is continuing. And if you put yourself in, say, 2006, and I tell you the major central banks are going to keep interest rates at zero for the next three or four years, you would have said, "Well, it is going to lead to overheating on a scale we've never seen that's going to lead to inflation or more."

But that's not what we have seen. So the accelerator is there. But clearly, it hasn't worked, because—because of the brakes. So it's important to identify the brakes, and what we argue is that the brakes are slowly loosening in various parts of the world, so that the accelerator is getting force.

My list of brakes, would have three main ones. The first one is fiscal consolidation. As you well know, the crisis itself, the decrease in output led to a very large increase in public debt. And something had to be done about it. So fiscal consolidation was needed.

There was the hope by some—and this was very much major controversy in, say, 2011, 2012—that this fiscal consolidation would not affect demand too much, would actually boost morale, and not stand in the way of a recovery. There was this notion that if you had really strong fiscal consolidation, then you would instill confidence in people, and therefore, they would spend more, so that the second effect would dominate the first.

I think this has been thoroughly debunked. The effect of fiscal consolidation is to decrease demand, and to decrease growth in the short run. So here, I'm not saying that should not have been done. It had to be done. But it clearly slowed down the recovery by quite a bit.

There's no question, for example, for the U.S., that last year, fiscal consolidation played a really important role in leading to a relatively small growth—growth number. So that's the first.

The second is the health of the financial system, as translated in the credit conditions that you and I, you know, households and firms, can get when they borrow. And that in turn depends on the health of the banks, and depends on the health of the borrowers themselves.

And if there's a large spread between the policy rate, the rate that monetary policy sets, and the rates at which we can borrow, then again, that's a fairly major brake on demand on the recovery.

And then the third is fuzzier, but I think very relevant. And in technical terms, we call it "Knightian uncertainty" for Frank Knight. And this is this notion that there's uncertainty, but not of the usual kind; not the uncertainty where you say there's probably 0.3 that this will happen, and probably 0.7 that this will happen, but more the world in which we say, "I don't understand," which is a different world from the first one.

"I think this has been thoroughly debunked. The effect of fiscal consolidation is to decrease demand, and to decrease growth in the short run."

And it's clear that this played a very major role early in the crisis, where what was happening had never happened, and we couldn't just think about what was—I think that, again, that has played a major role.

What has happened to each of these brakes, I think, looking into the recent past, and looking to the future, is they're loosening. Fiscal consolidation has been not completely done, but the worst of it has been done in most countries.

Banks are getting back to health at various rates. I think the risks for banks are more in, what I call, the "second moments," the risk. But they are still lending at relatively low rates in many countries.

And I think that type of Knightian uncertainty is also disappearing. We're dealing with problems which are more of a type that we have seen in the past.

So that's the general frame. And then let me use this to go very quickly around the world, and tell you where I think the various countries are.

So for the U.S., my sense is the accelerator is most definitely still there. And the brakes are nearly entirely gone; which is fiscal consolidation, which was strong last year, is going to still be here this year, but much less.

I think we've been lucky this time. Banks—you know, no bank is in perfect shape. But banks are lending at low rates so that people want to get a mortgage or a business loan, can get it.

So my sense is that the recovery is very strong, is based on the very wide set of factors. Private demand is strong. It was strong last year.

I mean, last year, private demand was 4 percent. Now, growth was only 2, because of the fiscal consolidation. But it was already strong. I think it's going to get stronger.

So I think the U.S. is really in a solid recovery. And I don't have much worry about it. I think that we now can start talking about an upside risk, which is that—you know, think again of the accelerator being on its own, and the brakes being gone.

It could be that demand is actually stronger than we currently expect. This would—this would be handled—this would be handled by the Fed, which would have to increase interest rates faster than currently intends to. But that would create a lot of disruptions in financial markets. It's not priced in and would complicate it.

Next, I'm trying to order things. So the next group of countries where things are clearly better—that maybe is going to sound paradoxical—I would put the U.K. and the Euro Core, both Germany and France.

I think if you look at those countries, again, the accelerator is there, both from the Bank of England and the ECB. Fiscal consolidation, which was very strong in the U.K., has been turned down quite a bit.

Fiscal consolidation in Germany is non-existent. They didn't need to consolidate, so they're not doing it. And France, which had a lot of fiscal consolidation, is doing much better this year.

Banks—again, banks are not in perfect shape. But in all these countries, they are lending at low rates. Their spreads are small. And so my sense is that although the numbers are not incredibly exciting yet—they're not in the U.S. range—there is no reason to think that the recovery will not continue in those countries.

Continuing, this is the tour. This is if it's Tuesday, it's Belgium. The usual, very quick tour of the world.

Japan. So Japan, the growth numbers are better than I think anything we had expected two years ago. We have about—about 1.7 percent I think for 2013, 1.7 percent for 2014. These are good numbers.

Is the recovery on solid ground? I think there's still question mark in the sense that if you look at where the growth is coming from, it's coming largely from the fiscal stimulus last year, and largely from exports; some of it, itself, due to the depreciation of the yen.

For this to continue, then, you know, it has to move to consumption, which it has to a very limited extent. It has to move to investment, which it has not.

So there, it could happen. When you have growth, then consumers eventually spend more, firms spend more. But we haven't seen the next step. And that's a bit worrisome.

Two more remarks on Japan. You know, whether they reach for 2 percent inflation that they have committed to is, from an economic point of view, more or less irrelevant. Japan will not be different, whether it's 1.5 or whether it's 2. Symbolically, it is important.

They have put this as a goal, but it's not going to make a whole lot of difference. What counts is output growth, and that comes from many other things, not just having 2 percent inflation.

And then the point for Japan is really not growth now. It's this incredibly difficult balancing act of the speed of fiscal consolidation. And as you all know, they have extremely high public debt, in net terms, around 160 percent of GDP.

So they have to do something about it. But if they do it—if they don't do it, then credibility is in play, then, you know, the rate on Japanese sovereign bonds will go up. And when you have 160 percent, and you have to pay, say, 300 basis points more on each, it becomes rather expensive and difficult. So they have to avoid that.

At the same time, if they do too much, then they kill growth in the short run, and then things are not better. So they have this really delicate balance, which is, I think, going to be the issue for Japan for—for many years to come.

My text has appeared under me, so I have to go back to it.

Three more. I suspect I've exhausted my time probably. Southern Europe. And to me, this is still the place where there is good reasons to worry.

The picture is mixed. On the one hand, they are doing better on the external side. They have—as you know, many of these countries started with large current account deficits, so they had to do something to with competitiveness.

And exports are going faster than the markets are in. So the market share is increasing. That's good news.

The bad news is internal demand, which is weak in some cases, actually going down. And that's the result of a number of years now of very weak activity, which has led to weak firms, which has led to weak banks, which forces more fiscal consolidation.

And there, we—another analogy away from accelerator and brakes, but adverse loops are very powerful; which is if you have a weak economy, then firms are weaker, banks are weaker, they lend less, and so on, and so on.

And I think there are still reasons to worry there. They haven't turned the corner. I think this is going to be an issue for some time.

Last, emerging markets. So I think in general, we're fairly optimistic. We have emerging markets growing at—as a whole, at 6 percent.

It seems to me that it's largely business as usual. And there are some countries which are overheating, some countries which have shortfalls in demand, some countries which have structural problems, some not.

Brazil doesn't have enough investment. India has administrative problems, which stand in the way.

I think the big question probably from an internal point of view is China, and whether they're able to control the credit growth at the rate at which they want; neither too fast, nor too slow. And this is not a trivial task for them.

In terms of the external environment that they face, they're clearly going to face two forces going in opposite direction. The first one is to the extent that the U.S. and other advanced economies are strengthening. This will increase their exports to various degrees, depending on how open they are, and what they sell.

But it's clear that interest rates, financial conditions, are going to become tighter. And they are going to be facing capital outflows for some time.

And there was a fairly large amount of a capital inflows we saw over the last—over the last few years, which went there, because it was unattractive in the U.S. When it becomes more attractive in the U.S., it will go back.

I think we can expect this to happen. The evidence is that it's going to happen mostly from countries which are not in great shape from a macro point of view. So if your house is not in order, not only do you have to repair it, but you have to be ready for capital outflows, and that's a challenge that some countries are going to face.

In general, what the work we have done at the Fund suggests that on net, the fact that stronger growth in the U.S. is going to come with high interest rates, is on net going to be a good thing for emerging markets, that they'll get more from the increase in exports, than they'll be affected adversely by the increasing interest rates.

On net tapering rate happens—and it will happen in response to the U.S. economy doing better—is probably a good thing. But there's going to be a lot of controversies about this for some time to come.

Just wondering about two more points, two risks we should be worried about. So let me indicate one risk I'm not terribly worried about is tapering. It seems to me that the exit from unconventional monetary policy is conceptually not terribly difficult to achieve; technically, not extremely difficult to achieve.

But it has never been done. We don't know exactly what the effect of measures on rates are. And so communication issues are going to be very substantial, so that I expect—episodes maybe not of the magnitude we saw last May, but something like this to happen again and again.

I think—I tend to think of this as bumps in the road. I don't see this as a systemic crisis coming back. But I suspect it's going to be a bumpy path, but not more than that.

The other is euro deflation. So again, in our baseline, we don't have deflation. I think that's the only place in the world in this stage where I worry about deflation.

We do not predict deflation, but we see this as a risk. And our models give us about a 10 percent probability of deflation in the Eurozone this year. The swap, inflation swaps, euro inflation swaps, give roughly the same number.

Why does it matter? W Well, deflation is never very good, but there is a particular aspect, which is important for Europe, which is that countries in the south have to become more competitive relative to countries in the north. And in a fixed exchange rate, the only way you can do this is by having less inflation than the average. That's the only way you can actually become more competitive.

Now, if the Eurozone has—just take a number—2 percent inflation, then you can have zero inflation, and you'll improve your competitiveness by 2 percent a year. If the Eurozone has zero percent inflation, then you have to have deflation yourself.

"It seems to me that the exit from unconventional monetary policy is conceptually not terribly difficult to achieve; technically, not extremely difficult to achieve. But, it has never been done."

And deflation is a very costly thing. It makes the real interest rates adjusted for inflation higher, decreases real value of the debt. It probably has adverse income distribution effects, so that the—if there is deflation on average in the Eurozone, then the adjustment process, which I talked about for Southern Europe, may be derailed. And I think that's a very serious issue. So that's a risk I worry about.

Let me stop here and take questions. Good.

COHEN: (OFF-MIKE) force around the world, giving us a sense of the likely outcomes, but also very importantly, the potential risks. And I'd like to address one of the risks that you touched on very briefly.

And that is in the world's second-largest economy, China, there are signs perhaps of a deceleration. We see that in manufacturing. You mentioned concerns about this liquidity adjustment there as well.

But if you could spend just a moment giving us your thoughts in terms of the bigger changes in China, that for the last two decades, the Chinese government has pursued economic policies focused on liquidity, heavy spending on infrastructure, and of course, exports, benefiting from low labor costs.

What is clear I think to many is that the new leadership in China is looking in terms of the new economic model; one in which they need to rein in the liquidity, and also one in which they build up domestic demand, rather than just export demand, recognizing, for example, that labor costs in China are perhaps no longer the lowest in the region.

If you can give us some sense of what the path might be. You know, obviously, China, and other emerging markets, bounced back pretty quickly from the so-called taper tantrum last spring. But there are nevertheless these longer-term concerns about the adjustment in the Chinese economic model.

BLANCHARD: Good. Yes, I do not consider myself a specialist of China. But I try to follow what's going on there. I would make four remarks.

The first one is in the short run, I think the issue is how do they handle the growth in shadow banking, and in social financing? And the question is how much control do they have on it, and what tools do they want to use?

For example, do they let some local authorities go bankrupt, taking the risk that this might create contagion and have other effects. How much control do they have on local governments in telling them not to invest in this or that? I think that's what they're confronted with. And the sense is that they're making some progress, but they don't have complete control of the issue. So it could go one way or the other.

They could be unable to control it, and then, you know, we have more of a credit boom, and then we know how this ends. Are they controlling too well, and they get recession by Chinese standards, which is probably still fairly large positive growth rate, but less than what we have.

Again, our forecast for China is 7.5 percent, which is optimistic, but I think has a fairly large distribution around it.

The second is on how serious the reformers are. And I think there, there's no question that they are serious. I think that everything we hear is that they really think the current model based on very high investment rates is coming to an end, that they cannot continue. They have to move away from it.

So I think that they are convinced that they need to do something. I think they have a sense of what they want to do. And again, this is completely outside of my sphere of knowledge. But people who look at the policy aspects, seeing that they have the power to do it, or at least more power to do it than any of their predecessors for a long time.

The last point I would make is, it's clear what has to happen. Initially, we said they have to decrease the current account surplus, move from external demand to internal demand, and also move from investment to consumption. The current account surplus has decreased quite a bit, I think—we think largely for structural reasons.

But the shift from investment to consumption hasn't taken place yet. It has to take place, I think, for social unrest, social considerations, political considerations. And if you look at the reforms that the third plan had suggested of the earlier five-year plan—had suggested it looks as if it should help go in that direction. That's the assessment I have.

COHEN: OK. Let's turn our attention to Europe. Clearly, you expressed your concern that one of the potential risks would be deflation in Europe.

So let's drill down a little bit more in terms of the actual growth and inflation expectations. You indicated that core Europe is starting to do better. But even there, there's a very wide range, the U.K. growing perhaps 2.4 percent, but France, still under 1 percent.

What are the potential ways in which France and some of the other nations can bolster their domestic demand? How do they address their labor problems in terms of persistent high unemployment rates, and so on?

BLANCHARD: So I think it's a case-by-case thing. For the U.K, one has a sense that the momentum is there, so it's not obvious that they need to do much more. They still have an output gap. They still have high unemployment.

But unemployment, as you know, is decreasing very fast, and because productivity growth is so dismal, so that any increase in output leads to a large decrease in unemployment. So I think for the U.K., the question is why is productivity growth so low?

We've done some work on it. Much of it comes from low productivity growth in services, and not, terribly surprisingly, from productivity growth or productivity negative growth in the financial sector.

So, you know, I think this is part of reorganization of the financial sector. What exactly needs to be done there I think is for people like you to say, rather than for people like me.

But I think that in terms of demand, should they do much more? They have been very reluctant. And that's true of many countries. They have been very reluctant to do public investment. And it strikes us as—not only in the U.K., but elsewhere—as a good time to do public investment.

Governments, states, can borrow at very, very low rates. And this is an environment in which a private firm would think it's a good time to actually bring forward some of the projects, and start them now, rather than later.

COHEN: Isn't that also true in the United States right now?

BLANCHARD: This is very much true of the United States right now. This is true of many, many countries. Fiscal consolidation has partly taken the form of a decrease in public investment.

We know it's unwise, but we know it's unavoidable, because of the politics of it. That's the easiest thing to cut. And in many countries, we think public investment is too low.

Turning to Germany, things are going reasonably well. But again, what is striking is how—and the current account surplus of Germany comes largely from more or less a normal level of saving, but very low investment, both private, but even more so, public.

And there, I think that's another place where there must be some highways which are not in perfect shape, and they could do more on the public-investment side. This would be good for the short run, be good for the long run.

For France, I think the issue is a bit different. I think there has been—if you look at France, objectively, you look at the state of banks, you look at the degree of competitiveness. It's not perfect, but the current account deficit is relatively small. We should worry about it. It's not a very big issue.

What's very striking about France is low level of confidence of both households, which affects consumption, and firms, which affects investment.

"And it strikes us as a good time to do public investment. Governments, states, can borrow at very, very low rates."

Where does this come from? People say that there's a French dummy (ph). A French fixed effect that the French are always worried about the future—I don't know if it's true—but basically, something having to do with a lack of clarity of the policy, which has been in place now for a year.

There one can hope that—you know, there was a speech by the prime minister last week, indicating a change of direction, and an attempt to limit or decrease the level of spending, public spending. This strikes us as something very important.

I think France is one of these countries where the level of spending relative to GDP is clearly too high. And it has effects on the degree of taxation, which is needed, and people are reacting worse and worse to these very high taxes.

So I think for France, it's clear that the issue number one is to limit the size of the state, and eventually decrease it. So it's really a case-by-case answer.

COHEN: What about the longer-term consequences of this protracted period of high unemployment?

BLANCHARD: So—Larry Sum (ph)—you know, high unemployment was the major issue in Europe in the 1980s. And so Larry Summers and I worked on that issue at length at the time. And we introduced in economics, existed in physics, the word "hysteresis," which is the notion that if you have a very long period of unemployment, then some people are going to lose it, are going to lose the skills, are going to lose the morale, are going to lose what they need to do to become productive.

And so long period of high unemployment leads to a higher equilibrium level of unemployment after that, because some people just are not employable. I worked on this for 10 years, and concluded that the effect was there, but maybe was not dramatic.

I concluded that what had happened in Europe was institutional hysteresis, which is that in response to high unemployment, Europe had introduced a number of labor market institutions, such as employment protection, which themselves led to a higher level of unemployment; that that was really the channel, it had introduced labor market institutions, which were bad.

I have not seen this happen in this crisis. So I suspect that, for example, if you look at long-term unemployment in the U.S., you see that they can't get jobs. And so you have to say, "Why?"

But one hypothesis is they are unemployable. It's a bit unlikely that somebody who's been out of work for nine months is unemployable. What happens—and that's something on which I worked with Peter Diamond at MIT—is the notion that when an employer receives 50 applications, he has to rank them in some way.

And he basically—one of the criteria he's going to use is how long have you been unemployed? So that in a market which is very depressed, the long-term unemployed don't have a shot, at the back of the line. When the market becomes better, then, you know, you have to choose between people, who have been long-term unemployed, you don't have a choice – there is nobody above them. The evidence is that they get the jobs.

Now, one very important thing. There is one reform which will not lead necessarily to more growth, but would be highly desirable in Europe which has to do with employment protection.

And let me take two minutes, because I think it's an interesting story. So when the '70s, the oil shocks came, and unemployment increased, most governments in Europe tried to limit the amount of layoffs. They put employment protection, high severance pay, complex, traditional processes for which you'd have to go.

And if any of you has, you know, worked in Europe, has had a firm in Europe, you know how hard it is to get rid of people. It became clear in the '80s and the '90s, that this was excessive, that it was just standing in the way of what's needed for an economy to reallocate itself all the time.

So we had employment protection reforms, that they took a very strange form. They took the form of creating two types of contracts. So one was permanent contracts with extremely high employment protection, and temporary contracts with little or no employment protection.

So from the point of view of the firms, it solved the problem. You basically keep a core group of workers, and then you adjust with the others. From the point of view of the union people, who tend to be the ones with the permanent contracts, it protects them, because they have this set of people that are fired before they are, or laid off before they are.

But it's a catastrophe. It's a catastrophe, because the people who are—who have the temporary contracts are the young. And so the lifecycle of the young at this stage in Europe—and this was already partly true before the crisis, but worse now—is you start with a temporary contract if you're lucky. Then you get unemployment for a while, then you get another temporary contract, another one, so on and so on.

The firms which hire you do not feel any strong incentive to train you, because they don't have the right to keep you for more than 12 or 18 months, unless they transform your contract into a permanent one, which they don't want to do.

And so you have this dual labor market in Europe, and this leads to unemployment rates in Spain, as you know, for the younger, 50 percent. Number's very similar in Italy. That's a reform which has to happen, but you can see how much resistance there is to it from the point—from the point of view of the people with the permanent contracts.

So there's still progress being made, but it is slow. I don't think it's going to lead to a burst in growth, but it's going to lead to much fairer distribution of the burden.

COHEN: One final question from me before we turn it to our other attendees, and it has to do with the engagement of central banks around the world, and how they view their roles.

Clearly, the Federal Reserve was a standout early in the global financial crisis, moving forward with monetary policy of a very accommodative sort, but also in terms of its supervisory and regulatory functions, imposing tough love on the U.S. financial system in the form of very significant meaningful stress tests, and so on. And one of the concerns has been that other central banks are lagging in this regard.

If you can give us an update, if you will, in terms of the European Central Bank, the way they view their role now, and also, touching upon the change in structure there, where, unlike early in the financial crisis and the severe recession, the ECB now does have some regulatory authority on individual financial institutions.

BLANCHARD: So I think you're raising maybe the number one issue in terms of the big issues, big policy issues we have to think about for the next 10 years or more, which is one of the conclusions of the crisis is that you cannot just control the economy with one rate, the policy rate.

There had been a convergence in academia, and to some extent, in central banks, that the right monetary policy was you have a policy rate, you have a target, which is inflation, you have a policy rate, and you move the policy rates by 25 basis points, this way and that way. And if you're good enough, everything is fine.

And we learned that you can do this, and everything looks fine at some margin, and it's going very wrong at another other margin, then you get the financial crisis we got. The conclusion is that we have to use macroprudential tools, which is tools which are much more specific.

If you're using it as a housing boom, you don't use the policy rate, which affects the whole economy, but you use the loan-to-value ratio, a vice (ph)—constraints on the capital ratio associated with mortgages, for example.

That's very nice. It's right. It makes for an incredibly complex set of arrangements, because basically the question is where do you put these—these new tools?

Conceptually, if you put them outside the central bank, then you need coordination between the two. It's very complex. So most countries have concluded that has to be within the central bank in some form.

So, for example, in England, as you know, there are two committees within the central bank; one monetary, and one financial. And they interact with each other within the bank.

The issue is that the central banks—is now taking decisions which affect one group or the other with very clear political implications. Also, it is not entirely clear that the central bank, which is independent, should be the place which decides how much capital goes to this, how much capital goes to that.

So both I think for conceptual and political reasons, it's incredibly difficult to articulate exactly what the powers of the central bank should be, what limitations. How do you basically put some democratic ownership, while not eliminating the independence of the central bank, and the central banks around the world are struggling with this. You said the U.S. had done great. It did great earlier. But If I look now at the system of financial regulation, the macroprudential tools, it's a mess. But, other countries are exploring their ways. You took the example of the ECB, which has been tasked with finding what the health of banks is, and then forcing these banks to take measures.

This is an incredibly political job. They are going to be under enormous pressure here and there to do things. And it's going to make for I think a very complicated task.

I think we haven't solved that issue. That issue is there. It's going to be there for a while.

COHEN: Thank you very much. And now we'd like to open the floor. Yes, sir?

QUESTION: Paul (ph) (inaudible) chief economist at Standard & Poor's. Thank you very much for a very illuminating talk and discussion.

I'd like to focus back on Europe. I found it interesting that when you looked at the Eurozone, you separated out the core Europe, dealt with that, with the U.K., and then came onto the periphery later. But of course, the 17, now 18 countries in the Eurozone are all in a single monetary union.

And you touched on the issue of deflation in the periphery. But I wanted to sort of question you or get your ideas about the architecture issue in the Eurozone, and how you see that both as an economist, a macroeconomist, and as a policymaker.

Big development in 2012. Was the recognition at the highest level of policymaking thinking in the—being the Eurozone—that the Eurozone architecture was fundamentally flawed, and it needed to be fixed. And plans were set out to move, in their words, towards a genuine economic and monetary union involving banking union, moves towards fiscal union—genuine economic integration, and political union.

So seems to me that's one of the great sort of issues of the day, which is going to really be important as it unfolds over the next few years. I'd love to get your thoughts on—as an economist and policymaker, what you think they should be doing in terms of the architecture, and actually what Europe will look like, or the Eurozone in particular, will actually look like. So perhaps the normative and a positive perspective? Thank you very much.

BLANCHARD: I think from normative point of view, we all understand what's needed. So the banking union is clearly essential, and there there is progress. I think it will happen.

I think at least the initial exercise, which is the so-called AQR, the stress test, will take place. There'll be recapitalization. But as you know, we're not clear about the—how the—where the money will come from, if needed. But I think that's a process which—which will take place eventually.

On the fiscal union, I think—I expect—again, from a normative point of view, it is quite—it would be quite useful. Let me, however, take a point here, that that's not a panacea. Some people say that the reason why the U.S. works as a common currency area is because of the fiscal structure, and the transfer to the states. That's playing some role.

But for the U.S., what makes the U.S. function as a currency area is mobility, which is that when a state is doing poorly, people leave the state. When a state is doing well, people go to that state.

I did some work with Larry Katz many years ago on that topic. And to me, it's the dominant factor. And that will never be the case in Europe. So we'll never get to that point.

Even if you have these two, I suspect that these may not be enough to control, say, a housing boom in a country, or another, and you may have to use macroprudential tools as well. And that's some of the issues I discussed coming back in.

So from a normative point of view, all these things are needed. Even at the end, I'm not sure it would work as well as the U.S., precisely for the reason I have given, which is the lack of labor mobility.

It's—even within countries, labor mobility's much smaller than in the U.S., and across borders, it is very limited. From a descriptive point of view, I suspect that there'll be slow progress on the banking union, and very little else for the time being.

QUESTION: Dick McCormick, CSIS. A couple of years ago, you were reported in the media as favoring central banks, some central banks moving from a 2 percent inflation target to a 4 percent inflation target. Are you still of this view, and if so, would you give us the pluses and minuses of doing this?

BLANCHARD: Obviously, no minuses. No. I made—so I think there are two arguments here. I made the first one. The question is how do I feel about the second one.

The argument I made is that when there's an adverse shock hitting the economy, you want to have the ability to decrease the interest rate a lot, conceptually. How much you can do it depends on where you are relative to zero.

So I argued that if you want an economy at 2 percent inflation, and the real rate on average is 2 percent, then you're going to typically start from 4 percent, 2 and 2, and you have a 4 percent margin. Once you decrease your rate to zero, that's what you can do. Then you have to go to unconventional monetary policy and so on. It doesn't work as well.

I argued that it might make sense to an economy at 4 percent inflation, which will lead to an interest rate of 6 percent. And then you'd have 6 percent room to adjust in case of an adverse shock.

I continue to think that if we'd had, say, 2 percent more to adjust the interest rate in 2009—end of 2008, early 2009—it would have helped. So it's kind of an insurance policy.

There are going to be bad shocks once in a while. And you have a bit more margin if you operate with, on average, a high interest rate. You're able to decrease the real rate.

So that argument strikes me as right. The question is, well, what—you know, it's like you pay your insurance—your life insurance policy. You pay it every month for some event which you hope will not happen for a long time. Is it worth paying, right? Is it worth having 4 percent rather than 2 percent?

And I argued that there's no solid evidence anywhere in the world which shows that 4 percent is substantially more costly than 2 percent. The distortion's from inflation exist, but they exist at higher rates of inflation. So seemed to me that it was a useful insurance policy to buy, and that when we get back to some normal, I'd be happier to have it.

There's a separate argument which has been made recently, which is not with respect to macro, but with respect to fiscal, which is we have a—high debt levels. And either it's going to be repaid by taxpayers, or maybe it can be decreased in value for inflation.

So some people argue that one way of doing it is basically to have an inflation rate which is higher, keep the nominal rate—policy rate low, so that in effect, the real rate is negative. And this allows you to decrease the debt level more slowly. But it allows you to decrease with that level over time.

So this is using inflation to decrease the debt level. It seems to me that's a very dangerous route. That's a very dangerous argument. I can see it in situations in which things are so desperate that it's either this or default, in which case, you may want to have a smooth default, relatively smooth default for inflation, rather than an explicit default. But I don't think that any country's anywhere close to that.

QUESTION: Byron William Blackstone (ph). You said that you expect China to grow at about 7.5 percent. But at the same time, they're trying to rebalance the economy away from infrastructure and state-owned enterprise investment spending toward the consumer.

Now, my calculations show that there is no way that they can accomplish that goal and grow at 7.5 percent. The growth has to slow. So how are your calculations different from mine?

BLANCHARD: I would never question your calculations. I think that's a difference of horizons, which is that this reallocation towards consumption is going to be very slow.

So a 7.5 percent is for this year and next year, in which this reallocation doesn't play an essential role. If we look forward to the type of distribution of production, which we think they are aiming at, which is higher consumption and higher consumption of services, then you're completely right in the sense that productivity growth, at least measured productivity growth in services, is lower than it is in manufacturing, so that looking forward, say, five to 10 years, the range is much closer to 6 percent than to 7.5 percent.

QUESTION: Thank you. Nise Sagwa of Pace University. My question relates to the reactions to the tapering, and it has two parts. The first is, do the markets, the financial markets, react to flows or to stocks? And it seems to me that even the Fed is not very clear on that.

And the second is, is the effects of tapering turn out to be very negative, will the Fed try to increase the money supply by encouraging banks to lend out their reserves, either by having very low or negative interest rates on reserve balances, or by some other measures? Thanks.

BLANCHARD: So on the first, what do financial markets react to, I think that's more a question that you should be answering rather than I.

But I have a view, which is, you know, if you look at what happened in May, I think the reaction was not to a change in the flow. It was in a change in the perceived path of first, less buying, and then selling of assets. And that was a reaction to, what I could call, the "present value" of the whole path.

Basically, the markets decided that the Fed was going to eventually slow down the rate of purchase, and then turn around and sell it. So my sense is that the markets don't react to flows – or to stocks. They react to what they perceive as the whole strategy of the Fed.

Now, clearly, when you decrease the flow, you're giving an indication as to what you're going to do later. And that affects the behavior of people. – In other words, it's not a mechanical relation between putting $10 billion in the market and getting 10 basis points.

That's just—you put 10, this is a signal of a path, and this leads to markets to adjust the rate by 10 basis points. It's a way to think about it. I don't think it's an essential distinction.

On what would happen if the tapering was negative, well, they would slow it. And they really have no particular reason to want to reduce their balance sheet extremely quickly. There's no obligation to reduce the balance sheet quickly.

So I think in this case, they would basically keep the balance sheet. Now, the issue which would arise is if they have to increase the interest rate at the time they still have a very large balance sheet, then they would have to pay interest rate on the reserves in order to get people, to get the banks to be willing to keep the excess reserves.

And that would—would present a cost, from an accounting point of view, for the Fed, by paying interest. It would have, I think, from an economic point of view, it's totally irrelevant. It's basically a check to treasury. We don't think that makes any difference.

But from a political point of view, that would look bad. If the Fed starts sending checks to banks, I think that in the current political environment, Congress, some people in Congress, would react.

So I think the issue is political, but I don't see this as a major one.


BLANCHARD: That would have to pay positive in order to keep the banks willing to keep the reserves.

QUESTION: Thank you. Carol Brookins (ph), former USCD, the World Bank. I'd like to ask you about energy and this drag on Europe's economies.

Energy costs in Europe are double, that of the United States. Do you have any calculations on this impact in terms of the drag on growth, particularly in France, Germany, other countries?

BLANCHARD: I will admit utter ignorance of the issue. I do not know.

COHEN: Yes, in the back, please?

QUESTION: (Inaudible), U.S. companies have posted a mixed picture in first quarter earnings so far. The earnings looks well, but the revenues, not so good. So what's its implication for the economy? Thank you.

BLANCHARD: Again, to me, maybe incorrectly, these are—these are bumps. These are not—I mean, I think that U.S. firms are doing well. Profits are large.

One issue is why they are not investing more, and I do not have a good explanation for that. But the kind of numbers you gave doesn't worry me.

COHEN: If I may interject, because these are the sort of data that I do look at regularly. I think it's much too early in this reporting period to reach those sorts of conclusions. We still have many companies in the S&P 500 left to report, point one.

Point two, it would appear that Mr. Blanchard has really touched on very important long-term issue, and that is U.S. companies have very strong balance sheets; that is, the companies in the S&P 500. And the question is, how are they using their cash?

And over the last few years, we've seen that more than usual, about 10 percentage points more than usual, have gone for things like dividend increases and share purchases, and that 10 percent has come out of things like long-term investment and investment in research.

And that really is, I think, the long-term question. By the way, there is—there are comparable data points for the federal government. The federal government is also investing much less than it usually has invested in terms of infrastructure, but also in terms of basic research.

Just by way of example, the U.S. government used to invest 4.5 percent of GDP in things like basic research and R&D. We're now down to 2.5 percent. That is not what it needs to be, in my view.

BLANCHARD: But the reasons for public and private investment being low has been different. What is your main guess as to why firms are reluctant to do long-term investment? Is it—is it uncertainty of some sort, about how the world looks like in five years? Or is it something else?

COHEN: There are many theories out there, some people talking about uncertainty. I think the number one reason is the output gap with capacity utilization rates in the United States finally—finally moving up to the point where new investment would be encouraged.

The other thing that we are watching very carefully, and the data look better over the last few months, is the creation of new jobs in the private sector. We always look at that headline number in terms of jobs created.

Let's keep in mind the public sector has cut back 600,000 or 700,000 jobs. But there is now much better job creation taking place in the private sector in the United States.

I think we have time for one more quick question. I think we're good. I would like to thank Monsieur Blanchard for being here on behalf of all of us, and for a wonderful discussion this morning.

BLANCHARD: Thank you very much.



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