DANIEL TARULLO: Good morning everyone. Welcome to the fall edition of the World Economic Update. We have with us this morning three returning panelists, Steve, Mickey and Peter, respectively, all of whom you've heard from before.
This morning, I thought we would resort to our normal form and begin with a look at the U.S. economy and the world economy through the lens of U.S. imbalances, then talk a bit about energy and inflation and then finally move across the Pacific to take a look at both China and Japan.
But — so first, we've been doing these things for six years now, and I would say for a good part — six, seven maybe — I would say a good part of the last four or five years, imbalances, the current accounts, trade imbalances and the budget deficit has been a constant focus of our attention. And yet despite the fact that we've been looking at historically very high current account deficits, historically quite high budget deficits, the economy continues to roll along and not only has it rolled along, it has rolled along with 16 straight quarters of growth, topped off by a 3.8 percent above-trend figure reported in the third quarter, the same time as we were experiencing one of the worst natural disasters in the history of the country.
So something here is not happening that people have expected to happen. There's a shoe that some people thought was going to drop, which is still sitting on top of the bed.
So, Mickey, what is going on here? Why is it that every three months we come here and talk about big imbalances and then we come back three months later and talk about the big imbalances again?
Okay, let, let me put it as a question.
If you have such large differentials in economic growth across nations, with the U.S. growing significantly faster than Europe or Japan, and that's been the case nearly every year since 1990, and if you have such large differences across nations in rates of savings, in rates of investment, and if you believe in international trade and international capital flows, why would you ever expect current accounts or trade accounts to be imbalanced — that is, the strength of the U.S., the persistent out performance, the low rates of saving, do not just for the low rate of personal savings, (but also to ?) the budget deficit, which is sort of dissaving, the excess saving in Japan, China and other Asian nations.
I would argue that a large portion of the trade deficit and current account deficits are a direct reflection of the large differences in economic growth, saving and investment across nations.
But so I guess though the question is whatever the cause is and whatever direction those causes go in, what about the concerns of unsustainability of these historically high levels. And, Mike, what are your expectations about when, if and how things will begin to go in reverse and a reaction against the large deficits will produce bad effects on the growth side?
MICKEY LEVY: Okay, one point I would make is global portfolio managers and, in particular, read into this, Asian Central Bank that has so many reserves to invest, I think they're investing in an economically rational fashion, that is, put yourself in the shoes of a, say a, fixed-income portfolio manager in Asia that has, you know, half a trillion dollars to invest and ask yourself about how you would allocate assets.
So you might start by looking at growth differentials — avantage U.S.; look at nominally real interest rates — advantage U.S.; look at issues like rule of law, predictability and transparency of policy makers. And I think you would also come to the same conclusion; you would want to grossly overweight your portfolio — advantage U.S.
And so I think, having talked to all the major portfolio managers over there in the central banks, I think they're being very rational in overrating the U.S.
And unless there's a jarring change in global economies, and we need to talk about Japan a little bit, I see — I don't see any dramatic change in portfolios that is going to lead to a collapse in the dollar, a sharp rise in interest rates.
TARULLO: Steve, from time to time, you've paid a little bit of attention to the imbalances —
STEVEN ROACH: A little.
TARULLO: Most —
ROACH: I'm still here Dan.
TARULLO: (Laughter.) Most recently, your concern has been that a renewal of growth in other parts of the world — Japan, Germany and elsewhere — and thus a step up in domestic demand may begin to reduce the pool of savings that is being used to fund the U.S. deficits and that that may be the catalyst for moving things into reverse.
If, that does happen, do you expect it to be fairly dramatic or fairly gradual, and if the latter, might that not be the best way out of this imbalanced situation?
ROACH: Well, Dan, we never know when imbalances build whether they're domestic or international. The longer that they are not attended to, the greater the risk of an abrupt adjustment. I think Paul Volcker stated that very eloquently in a piece he wrote earlier this year in the Washington Post. And if there's anybody who knows about dealing with crises and imbalances, he's right near the top of my list.
But you know, I — with all due respect to Mickey, he sounds like a clone of Ben Bernanke. This idea that we've got this savings glut out there in the world — and you know it's not our fault. You know, we're just Americans doing our job to keep the world going because these poor suckers overseas can't grow. I mean, let's just look at this carefully.
The U.S. accounts for 70 percent of all the deficits in the — current account deficits — in the global economy today. And it's a direct outgrowth of our, at least in my opinion, of our unprecedented shortfall of national savings. You add up the savings of individuals, businesses and the government sector, adjusted for depreciation, the net national savings rate's been one and a half percent of GDP since early '02.
And if, you know, is — whose fault is it if consumers have a negative savings rate in America? Is that, you know, Japan or Germany or China's fault? Whose fault is it that the government runs budget deficits year in and year out? I mean, we can't blame that on overseas. I mean, this is our stuff that we have to take a hard look at in the mirror. And, you know, sustainability is a tough issue, and Peter and his colleagues have written eloquently on that. I know you'll turn to them — to Peter next.
But the idea that, you know, the Japanese portfolio manager is looking at growth and interest differential and doing the right thing, you know, with all due respect to the Japanese portfolio manager, who I spend a lot of time with too, they, don't have discretion. These decisions are politbureau decisions decided at the senior government level. These are conscious efforts made to keep the Chinese renminbi from appreciating and impairing their export-led growth dynamic.
So you know, we're in a pretty tricky place here, and the problem with these imbalances, Dan, from the start has not been that they're moving to a new level and they're going to stay there. They're getting bigger, bigger and bigger, and the big story I think in '06 is that the U.S. savings shortfall gets worse, our current account deficit gets larger at just the time when the surplus countries start to stimulate internal demand, absorb their surplus savings, and that makes this financing tension even greater.
TARULLO: But Steve, the — most people agree that there's going to be some rebalancing. The debate has been is that rebalancing likely to be — or how likely is it to be dramatic and disruptive, as opposed to somewhat gradual?
Greenspan has clearly been in the latter camp. You have been not saying it will be dramatic, but you have been in the camp that says there's a greater chance of it being dramatic.
My question about the real growth in other countries was whether that phenomenon doesn't make the gradual adjustment from a more likely scenario than it may otherwise have been? That is, we're not looking at a circumstance in which all of the sudden portfolio — some portfolio people in other parts of the world say, good heavens, we don't think the dollar can stay here, let's start selling off Treasury securities, and then other people in other parts of the world do the same thing, and before you know it you've got a major sell off. Here we're talking potentially about a gradual uptick in demand, meaning a gradual absorption of savings, meaning a gradual increasing the cost of capital in the U.S. and a gradual adjustment by U.S. consumers.
ROACH: In a perfectly controlled laboratory experiment, if that's all that was going on, the gradual case would be ideal, it's one that everybody wants. But you know, as I tell my kids, what you want is not always what you get. (Laughter.)
And there are other things that are going to come into play that always jar a system out of equilibrium. And more out of equilibrium you are, the greater the likelihood of an abrupt adjustment.
I'll just tick off four of them that are on my mind, all of which are quite conceivable as event risks in early '06 that could jar the system.
One, the energy shock that could hit on U.S. consumption challenges foreign perceptions of U.S. growth. Personal consumption, by the way, is probably going to slow the growth rate to less than a half a percent this quarter, so it's not idle conjecture.
Secondly, the housing bubble would burst. I know that would be upsetting to all of you homeowners in this room, but it could happen. And then that would certainly jar U.S. consumption.
Thirdly, U.S.-China trade tensions could build, get out of control, we could slap Chuck Schumer's 27-and-a-half percent tariffs on Chinese products — they wouldn't buy at the next Treasury auction.
And fourthly, the Fed transition issue. These things don't go well. Historically, the last three transitions have always been accompanied very quickly by a decline in a major asset class. The confidence of international investors today is much more important in supporting dollars that it was during earlier Fed chairman transition points.
So those are things to think about. No guarantees, but you've got a system out of equilibrium, and it's more vulnerable to a shock as a result.
TARULLO: Peter, where — how do you look at the sustainability, gradualism versus fanatic reaction issue, and obviously anything else you want to add to what the two other guys have said?
PETER HOOPER: Well, I guess I'm a gradualist at heart. But if you look at the period over which this U.S. external deficit, which I think is the bigger problem over the longer term right now, has widened, it's taken about 14 years, from zero in the early '90s to six-and-a-half percent of GDP currently, about a half-percent per year. This happened fairly gradually; this has not been a sudden — and I might note that during this period, the budget deficit went substantially into surplus for a while and then, while this external deficit was trimming down — these are not twin deficits. They're not joined at the hip. Maybe they hold hands occasionally, but they march to their own drummers for the most part. And I — my sense is that you're going to see a gradual adjustment the other way.
The dollar peaked about three-and-a-half years ago. It's been coming down roughly at five percent per year in fits and starts, and we're in the middle of another one of these bear market rallies right now. It's probably going to go on for a while if the Fed continues on this tightening course. But growth abroad is picking up. And if you look at the world's total, growth abroad has exceeded the U.S. by a comfortable margin I think over the past few years. This will continue and I think that's part of the answer, but growth is not going to be what gets the external deficit down. I mean, we're not going to grow our way out of this. The U.S. economy is very close to full employment right now. We're likely to be there, if the Fed does its job, five, 10 years down the road, so you're not going to see a big shift in growth —
TARULLO: To the contrary, won't we have to ungrow our way out of the deficit?
HOOPER: I think what's going to get us out of this deficit is a continued decline, roughly at 5 percent per year, in the dollar, with the Fed gradually raising rates, with interest rates gradually moving higher, bringing down U.S. consumption and investment, raising saving rates domestically.
Output growth, GDP, probably doesn't need to shift a whole lot. It's domestic demand growth that's going to shift as interest rates move higher, but that's not going to happen until the Fed sees the dollar moving lower and giving us some increase in net exports, simulating GDP. The risk of the economy overheating as the dollar moves lower gives you extra GDP growth, which then means you need to raise interest rates. That's the gradual process.
And I agree with Steve that there's certainly a risk out there of something abrupt happening. It's just if the dollar continues to strengthen, if it stabilizes for a few years and we get down to 9, 10 percent of GDP on our external deficit, which some of these models you've tried out can easily get you to in three or four years, then you're facing the possibility of a pretty abrupt shift once the appetite for investment in the U.S. on a the part of global investors, including official investors in Asia, begins to wane. And to get the deficit down at all in a short period of time, you're talking about a huge shift in interest rates potentially, as well as the dollar.
We talked about the —
TARULLO: Just to — just to specify what you mean —
TARULLO: — if things were to happen dramatically, the reaction of the Fed would be substantially to raise interest rates, which would be the equivalent of slamming the brakes on the economy, which would likely produce a significant recession.
HOOPER: Well the reaction of the Fed would be what's happening to U.S. GDP, employment prospects and inflation. And if you're looking at a mass exodus of investors from the U.S., that's going to raise interest rates, and the Fed may have to go the other direction to try to stabilize the economy in the face of what would be a very recessionary type of shock.
We talked about this in the Fed in the mid '80s, if you read the transcripts. And Paul Volcker was very much internally in the Fed concerned about hard-lining. Steve Harris I think made a good name for himself at the time.
And lo and behold, we went through this pretty gradually. Yes, the dollar fell very sharply over two or three year period. The current account went from three-and-a-half percent GDP deficit, which was huge at the time, to zero, but it took four or five years. And I think you'll see the same sort of — I think the most likely outcome you'll see that gradual path again this time around.
But there is — I think as you start to look at 6, 7 percent GDP on the external deficit, you do raise the risk of something more dramatic happening here.
TARULLO: And Mickey, you wouldn't discount entirely the possibility of a, as we used to say in a euphemistic fashion, a discontinuous adjustment?
LEVY: No, I mean, certainly that could happen. But what's interesting here is if you look through history globally and you look at nations that have had such high current accounts as a percent of GDP, they have all had different maladies that we don't have. I mean, we've never seen a situation where you have such a strong economy that's outperforming at such a high current account.
But let me add a few points to what's made. I think we all agree that the budget deficit is a major source of dissavings; it's a way we misallocate national resources. But I would like to point out, when we look at why the U.S. is importing so much, it's not just the profligate consumer. In fact, if you look at a composition of imports, 40 percent of all imported goods to the U.S. are industrial supplies and capital goods, even excluding automobiles and petroleum. That is, 40 percent of our imports are for business production and expansion. Is that bad? What's the rate of return on the capital we import for that?
I think Steve brings out a great point that, yes, it looks like Japan's strengthening now, and that not only should reduce its rate of saving, but increase its demand for U.S. goods. And I would note here that that's good; what we want is pro-growth solutions to the world. And I would note that the trade deficit in the U.S. has actually come down the last two quarters, and my forecast is, as a consequence of higher interest rates, the slowing down in housing and the higher energy prices, you do see next year consumption — you know, the growth will bounce back, but not to where it was, and exports should remain strong.
So I think part of the adjustment is in place on the trade side, but then you have the current account. And one thing none of us have talked about is a major supplier of capital to the U.S. is the OPEC nations. And here you have this ridiculous irony that just based on the price increase in oil in the last year on an annualized basis, it's involved an outflow — you know, U.S. consumers have continued to smooth their spending, so its revenues — increased revenue flow to OPEC members by about 250 billion additional dollars. And it's all denominated dollars, and a lot of it flows back into the U.S in the form of — you know, in their purchases of fixed income.
And so the result is U.S. consumers smooth out their consumer spending patterns, it suppresses the rate of personal savings, but a lot of the capital flows back in. And this is — this, I would say, is also a major source of imbalance.
Now one final point. And Peter made this; I think it needs to be emphasized. Part of the widening of the current account deficit in recent years is as a result of the Fed having kept rates so low for so long to try to stimulate demand. And as the Fed hikes rates here — and monetary policy works with the lag. As our nominal spending gross slows, then that should slow demand for imports and it'll contribute to somewhat narrowing balances.
TARULLO: I think Mickey has led us into the energy issue. I know that the concept of a core inflation rate is one of your favorite little devices. (Laughter.) The recent core inflation rate numbers have suggested that there is dramatic energy price increases in the last year and a half haven't really found their way into goods and services more generally, and of course now we've had some retreat of oil prices over the last month or so. Do you expect that we're just seeing kind of a lagged effect, and that the doubling of petroleum prices will eventually work its way into the broader economy, giving another push to inflation?
LEVY: I don't, Dan. I think that inflation risk is being exaggerated right now in the markets. There've already been some pass throughs on energy surcharges and transportation services in particular. But you know, there have been offsets on the other side of the equation. And you know, as appalling the concept as the core inflation rate is, it does serve a useful purpose of being able to assess spillovers from the shock piece of the price basket to those other areas. And thus far there haven't been any.
And I think that just underscores how different this energy shock is from the first two of the '70s, when we had these shocks hitting what was largely a closed U.S. economy, and the cost markup models of inflation were very, well, painfully accurate in describing this interplay between labor costs, inflation feeding more inflationary expectations, and then getting built in through cost of living indexation into wage agreements and so forth. We don't have that now.
And what is so important — and I think Chairman Greenspan eluded to this last week — are the very powerful forces of globalization that have largely severed the link between domestic labor cost pressures and underlying pricing in the U.S. He did make the point that you know, one of these centuries, globalization will run its course and we can expect that factor to subside. But you know, that — you know, that's sort of making a call on sort of the terminal end point of globalization, and I think we're just beginning in that long march.
So I'm pretty — I mean, I — look, globalization doesn't rule out inflation. But right now, globalization is largely about a huge increase in the volume of global production, but still very limited a dynamism on the demand side of the equation driven by the American — in large part by the American consumer. So given that supply/demand balance, I think you could stay in a low inflationary environment for quite some time.
TARULLO: Peter, notwithstanding the points that Steve makes, it seems as though most of the world's major central banks, with maybe the exception of the Bank of England, are more on an inflation alert now than they have been in a while. Don Kohn, a member of the Federal Reserve Board, gave a speech a few weeks ago in which he gave a very sort of balanced and thoughtful presentation on the economy, but then ended by saying he was biased a bit in the direction of learning about inflation.
Where do you come out on this, the long-term quiescence of inflation versus what a lot of the central banks seems to perceive as short- to medium-term inflationary factors coming back again?
HOOPER: Well, Steve used the word largely severed, I guess, with respect to how the global labor supply shock here has affected the Phillips Curve's relationship. I think it's weakened it; I don't think it's severed it. My sense is that you do still see the effects of tightening slack in the U.S. economy beginning to show through a bit. Core inflation has moved up over the last year and a half gradually, as the economy's near full employment. You have widely differing views about what's happening to labor costs in the U.S., but I think that's the area that we really have to be concerned about. Yes, we're facing a near term energy shock. Yes, headline inflation's running 4 percent. And yes, there's risk that that's getting passed over a bit in the longer-term inflation expectations. And against the background of an economy that's very close to full employment, the Fed I think is rightly concerned that there is a growing risk here at least a modest inflation problem.
Our own view is you're going to see core inflation, which has been running around 2 percent in the core PCE, right at the upper end of the unofficial comfort zone the Fed works with, soon to become the official one I'm sure. (Laughter.) But that, I think you could easily get into those two-and-a-half percent range and then the Fed needs to do — get into a little bit of a tightening sequence here.
DCB is — you know, if there's anywhere the tail rule whatever tells you don't do anything, or maybe in cut rates, it's been Europe. But they're looking at rapid growth in credit and money, and maybe even a high headline inflation beginning to slop over a little bit.
But I think that the key for inflation here is what happens to the labor market. We're at very close to full employment. I think you've seen a significant shift over the last year from unit labor cost inflation running around zero to now somewhere in the 2 (percent) to 3 percent range, probably around two-and-a-half (percent), on its way toward 3 (percent). That's not consistent with 2 percent core inflation. And I think you will see the Fed have —
TARULLO: Can I just ask Peter a question? Peter, you know, I was struck in going through the recent annual report of the BIF, and they reported a statistical investigation on the correlation between labor costs and core inflation. They run these correlation exercises over, you know, about a 40-year time frame. And in the case of the U.S., they found a very high correlation statistic for the early part of that period. And then it got cut by more than 50 percent in the last 15 years, as globalization has picked up. And then they found this result in literally every major developed country in the world, which suggests maybe "severed" was too strong, but that this linkage here between labor costs and underlying inflation has really changed a lot over the last 15 years. I'm just wondering what you think about that.
HOOPER: I agree with you; the Phillips Curve is weakened, but I don't think its dead yet. But after the globalization, I mean, U.S. import prices, excluding the effects of oil, have been rising faster than core inflation for the last couple years. So, I mean, there's —
TARULLO: The dollar depreciates.
HOOPER: Well, as the dollar's depreciating, that's — I mean, that's something's happening there globally that's coming through in the form of higher import price inflation that's eventually going to find its way through.
The other fact I point to is in the face of what's has been a substantial pickup in unit labor cost inflation, which admittedly is more because of a drop in productivity than a pick up in compensation — although the evidence on compensation's mixed; maybe we're starting to see a little bit of an uptrend there, too — but in the face of this, you've had phenomenal profit growth. Something's — maybe there's a lot of global competitive pressures out there, but they're not keeping profit margins down. I think there's something going on there suggesting there is still pricing power, and there is a risk that you're going to see this substantial creation of liquidity growth globally. As Japan picks up more and Europe eventually joins the party, you're going to see some inflation risks down there, despite what's going on in Asia.
TARULLO: Mickey, another central bank which is thinking about raising interest rates is the Bank of Japan, and this is truly news because for years now the Bank of Japan has had a zero interest rate policy in its efforts to confront the deflationary forces that took hold following the bursting of their own asset bubbles a decade or so ago, more than a decade ago.
The assumption obviously is that growth has now entrenched itself enough in the Japanese economy that it would be safe for the BOJ to come off of the zero-interest-rate policy, but it seems to me at least that they are talking about this sufficiently far in advance of the hint of when they're going to do it so as to allow themselves a bit of a trial balloon effect. Do you think that's what's going on?
LEVY: Unfortunately, yes. It's scary when BOJ officials call me and want to meet with me, and they say they want to talk about transparency and how to learn from the Fed about being transparent. (Laughter.)
Basically, what's going on in Japan is, after more than a dozen years — it's been very slow in coming — the Japanese banking system has been restructured and recapitalized. And for the first time in many, many years based on current statistics, year-over-year bank loan demand is increasing there, which is great.
Also you've seen a lot of restructuring in the corporate sector in Japan, and productivity's rising and profits are rising. And the missing link in Japan — and I think it's going to unfold here — is the consumer. And there's still lack of confidence, and the rate of personal savings, seven-and-a-half percent, because Japanese consumers are so cautious. That's one of the reasons why we have such a low rate of personal savings; maybe people are overconfident here.
But what's unfolding is wages in Japan are starting to rise, and their quarterly bonus schedule has just started back in. And as that unfolds and Japanese citizens gain confidence, you'll see an increase in consumption.
And so I'd say the consensus forecast is like one-and-a-half percent growth in Japan. I'd be surprised if it's under two-and-a-half (percent) over the next couple years. I've asked BOJ and MOF officials, gee, after growing at 1 percent, which is way below your potential, for a dozen years, why can't you grow faster than potential for a couple years and catch up? And the answer is either, gee, we haven't thought of it in those terms, or maybe we will, but we've made so many bad forecasts lately, you know, we'll just wait, and we'll believe it when we see it.
Now having said that, I still think it's premature for the BOJ to be raising rates. The very soon here, year-over-year core inflation and then their core inflation numbers, they do not include energy, or they include energy in it. That's going to turn from negative to slightly positive.
But nominal — I think the BOJ needs to wait until nominal spendings are — nominal GDP is persistently above 2 percent before they even consider raising rates. And I think it would be very, very foolish on their part to consider hiking rates up too early. It's just not consistent with their long objective.
TARULLO: Do you agree with that?
MR. : I totally agree. I mean, you know, in the Fed we had this blinder-led mantra of opportunistic disinflation. They have to have opportunistic inflation. They have to err on the side of being late, not early. And it's entirely premature to think about this.
MR. : I think they have a full year of just removing this excess liquidity before they begin to think about raising rates. And I think they are students of the Fed going back even further in history, going back to '36, '37, and when the U.S. faced a very similar type of situation and began to remove liquidity at a faster pace than the economy was ready for it, and we went back into another recession.
I think they're very cognizant of that. I think they've gone a long way, they've worked off the bad debt, the financial sector is looking much better, but it's still highly dependant on very low rates, and I think you're going to see the move cautiously as a result, and that's wholly appropriate. We don't expect to see an increase in Japan's rates until they're really settled.
MR. : And Dan — can I just add one thing?
TARULLO: Yeah, and as you add whatever you wanted to add, would you also answer the — or speculate as to why the BOJ is sending these signals?
MR. : Well, that's impossible. But I — (laughter). You talk about transparency.
But the point is — you know, that Mickey made, they have a very fragile private internal consumption recovery. And you know, we're optimistic on Japan but we don't see Japanese consumption growth getting much above, you know, one-and-three-quarters to 2 percent over the next couple of years. They still have a big piece of their recovery, you know, in their export business, and their biggest export market is China. And should there be any type of hiccup in China, you know, I think you'll see questions raised anew once again about the sustainability of the Japanese recovery. It's just all the more reason to be cautious here and to err on the side of being late.
You know, I think in terms of your second question, why they're talking, I do think that they take to heart the credit that has gone the Fed's way over the last five years in leading the charge on the transparency game. And I do think they're trying to be more transparent in telegraphing their intent ahead of time. But you know, transparency for the sake of transparency is not necessarily the right way to go, especially if you're about to move in what could be a premature way.
TARULLO: Well, and if they don't do it, right — if they come — if they have this series of hints over some period of time —
MR. : Well, then they lose credibility.
TARULLO: That's right. Then that's worse than doing nothing at all, right?
MR. : They have a lot they have to do along the way before they begin to raise rates.
MR. : There's a huge shift in monetary policy that's got to take place. It's going to take at least a year to get — there's going to be plenty of signals, but you're looking at an economy that's now turned around. Export are still an engine of growth, but net exports are actually declining, with imports growing even faster. And the domestic demand is really what's carrying this 2 percent plus growth now, which is a big plus.
They're looking down the road at a time when inflation's going to be moving up, and I think they want to prepare people — we got things under control, we're not going to let inflation get out of control at the other end. But at the same time, I think they're preparing us for the fact that they're going to be moving deliberately.
MR. : But you know, talking about the BOJ is just a very specific topic. I think the broader, intriguing issue here is, well, China has been growing over 9 percent a year annualized and has become a major global economic power. Japan's been asleep. And now you have the second- biggest economy in the world coming back to life, and it's going to grow, I believe, stronger than expectations while China is still strong. That's going to affect their rates of investment, rates of saving, and will affect global balances in ways that are fun to try to predict.
TARULLO: Speaking of China, during his recent trip to China, Secretary Snow again asked for changes in China's foreign exchange policy. After last summer's 2 percent shift, the Treasury was happy for a while, and now they are not so happy again. It is possible that — more than possible — that the Chinese have figured out that pressure from the U.S. government tends to be a bit — on this issue, tends to be a bit more a function of domestic politics that it is of a sustained international economic policy. But even if China were to revalue upwards some more now, or allow trading within a much broader band than they currently permit, would it make very much difference, Steve, from a U.S. perspective, as opposed to a Chinese perspective —
ROACH: No, you know —
TARULLO: — affecting our current account?
ROACH: Well, again, I mean, our trade and bilateral trade imbalance in China, in my view, is an outgrowth of our shortfall of national savings and the fact that we need to import surplus savings from abroad to keep growing and run these massive current account and trade deficits to attract the capital.
If you were to close down trade with China today, we would just run a big deficit with somebody else. And so the idea that, you know, that we need to put pressure on the Chinese to fix America's trade problem I think is, you know, just typical Washington finger-pointing.
TARULLO: Would it nonetheless nonetheless be a good thing for the world economy if China revalued or allowed trading with a broader — genuinely allowed trading within a broader band?
ROACH: It would be a good thing for the world economy if the Chinese currency were truly more flexible with exchange rates driven by market forces provided — and this is key — that the Chinese economic growth model and its financial market infrastructure is stable enough to cope with that type of currency volatility. And quite frankly, I think that the Beijing's resistance on the currency front is more an outgrowth of their concerns over their own economy than it is in dealing with some of these political pressures that are coming from Washington.
TARULLO: Elaborate that a bit. What is it that the Chinese officials are worried about happening if they get more market-driven effects on their currency?
ROACH: You know, they're just beginning. You know, all these talks of reform; decades later, they're just beginning to develop capital markets. They just listed their first major bank in international capital markets, that Mickey's a partner with —
LEVY: And they made a lot of money off that transaction.
ROACH: Thank you, Mickey. (Laugher.)
And that — but that's bank number one. And then they — you know, and they have this growth dynamic, again, that is dominated by exports and by fixed asset investment, and they have the lowest internal consumption share of any major economy in the world.
TARULLO: So what they're worried about is if they revalue upwards and there is a non-trivial hit to exports, that they have no other strong sources of growth to fill in behind.
ROACH: Right. They could have a growth accident, they can have a financial system accident, and China is about avoiding accidents. China — when you get lost in China — and I always do from time to time — think of stability. They want that more than anything. So they don't want to take risks that would damage growth or the financial sector.
TARULLO: Peter, are there — is there any reasonable prospect of a greater component of domestic demand-led growth in China?
HOOPER: Well let me say first that — (inaudible) — came out with a financial stability report for the first time yesterday and it basically said what Steve's saying, that they're not going to do anything soon because of the risk of the financial sector, to domestic output growth. But you look at the hints of what's going to be in their five-year — their 11th five-year plan that was talked about at the — (inaudible) — last month, they recognize they can't remain as dependant on growth of exports to the U.S. to keep this engine going; that the trade tensions will rise, and that becomes a less secure source of this expansion.
They're going to have to become increasingly independent. And the message that Snow I gave them I think is getting through on domestic consumption growth. And I think you will see a shift in policies oriented at stimulating more consumption growth, greater quality of income distribution, taxes, tax adjustments, et cetera, subsidies. And I think you will see a shift in investment away from low-value-added export industry toward more high-valuated, toward service-sector, toward the areas where you're going to see consumer growth ahead.
So I think this feeds into the gradualist view if you're going to get incomes up, you're going to have to allow (the terms of trade ?) to rise, you're going to have to allow the currency to appreciate over time, and that's going to be part of the process. I think this will feed into the view that over the next seven, eight, nine years you're going to see a pretty dramatic shift in the U.S. deficit toward zero, and certainly China's toward deficit.
TARULLO: Now, Peter, there's a school of thought that — holding that China's potential for increased domestic consumption is quite limited because of the absence of safety nets that we associate with more developed economies and the aging of China's population, which provides further incentive for people to hold — to save rather than to spend. What do you see that is an additional factor to those forces that might actually produce some increased domestic consumption?
HOOPER: Well, I go again to what you got out of this five-year plan or the proposals that they're talking about and some of the discussions around that. I think there is recognition that you need to begin to shift public finances a little bit more in the direction providing some of this security. You need to find ways to distribute income more to some of the poorer areas in the country, where saving rates are actually lower, and maybe that helps as well. It's not going to happen overnight, but over the next five years, I think you can make a lot of progress.
ROACH: Dan, there's one piece, though, that's really key. The safety net is important because it puts a floor under the income and security belt by the millions of workers that are laid off every year through state and enterprise reform. But the key thing — and I talk to the Chinese officials about this every time I go there — is, you know, what's the next new wave of job creation? They need — they are really focused on that, and they're stymied.
The answer I always give them is, you know, it has to be in the services sector. Their services piece of their GDP is 32 percent, which is the lowest of any major economy in the world. And under the terms agreed upon under WTO accession several years ago, there's going to be a lot of foreign competition coming into their service businesses, not just in financial, but in distribution as well.
And this is an opportunity for the Chinese, but this is a long-tailed event. They're not going to be able to push the button and just go from investment to consumption-led recovery. You know, Peter said you know, it would take, you know, somewhere between five to nine years. I think that's a realistic time frame to think of this transmission, especially if it involves coming up with new sources of job creation.
HOOPER: It's an interesting to look at the the composition of growth and consumption right now. Growth of consumption of autos —
TARULLO: In China?
HOOPER: — in China — 10 percent per year. Pretty high number. Growth of consumption of PC's, 10 times that; 100 percent per year.
You go down the list of typical services — the insurance, health care, financials accounts — they're all in the high teens to 20 (percent) annual growth rates. I mean, this is — it's starting, and over a long period of time you're going to get it.
LEVY: Dan, I disagree with your notion that it's just a lack of a safety net that is leading such high rates of savings. We hear about a 40 percent rate of saving in China. The vast majority of that is business-retained earnings. The rate of personal saving is nowhere near that high. And you can just imagine a country whose annual average growth has been over 9 percent; they're gaining confidence.
As Steve points out, consumption in China's about 42 percent of GDP; very, very low. But it happens to be now the Third World's largest consumer of luxury goods. And along the east coast of China, as you know, they're very — the consumers are very conscious of Western styles and the like. And so my strong expectation is consumption does accelerate here in China, and as people — as economic growth continues — and keep in mind, wealth grows much faster than GDP.
TARULLO: But why — Mickey, is there an expectation of consumptional increase? Because if personal savings is actually somewhat lower, than the concerns about the absence of a safety net and aging population is all the more acute.
LEVY: Just simply because even though wages — and we can't look at things parochially from the U.S. perspective. You know, it's just a trade deficit. I mean, China runs a trade surplus with the U.S., but China runs a massive trade deficit with most Asian nations.
But the point is wages are very, very low in China; but on a year over year basis, they're growing very rapidly. So you're seeing this mass migration —
TARULLO: Do we have numbers on — do we have numbers on what increment of the rise in wages tends to get spent and what tends to get saved?
LEVY: Hard to say. But the wages and wealth are rising rapidly in China, and this is going to lead to increased consumption. But once again, look at the composition of saving, and a lot of it is retained earnings by businesses, which brings up some interesting dynamics.
ROACH: If you want a good to Asian consumption story, Dan —
TARULLO: Yeah, that's what I want.
ROACH: Go to India. Go to India. I was just there 10 days ago and, you know, they don't have the investment —
TARULLO: They're more like us.
ROACH: — the export story. But they have a very interesting and increasingly broad-based internal consumption story building in India.
TARULLO: Say a bit about it.
TARULLO: Go ahead, say a bit more about India and why it's different.
ROACH: Well, you know, it's a totally different growth model. It's one that lacks the infrastructure; there's still not, I'm still looking for my first good road in India. (Laughter.) They have half the savings rate nationally that China has. And their FDI, foreign direct investment, you know, runs about a tenth the pace of China. So they're not a saving and investment story; they're much more of an internal demand story.
And you know, their consumption share of GDP last year was 64 percent versus China's 42 (percent). And the new government, you know, is being run by India's original reformers, but in a different context. They're now running a coalition that has a lot of left-leaning members, which makes it much more difficult for them to be as aggressive on reform as they were 15 years ago. But they're focused on this, and they're pushing to really add an important new element to the Indian consumption dynamic. It's more of a rural consumption dynamic.
And we tend to overlook that. Whenever, you know, investors hear the word "rural," you know, they want to move on to the next country. But this is a big deal in India, and a lot of the infrastructure that's going on — telecom, roads — is connecting rural Indian consumers to major metropolitan hubs. And the consumption dynamic is growing.
And the thing — you know, what's fascinating to me about the India-China comparison, I'm a super bull on China, but for all that we learn about China, 27 years into reforms, I mean, who's got the world-class companies? Who's got the banks? Who's got the capital markets? It's India. It's not China. China's done an extraordinary job in mobilizing its resources for infrastructure, to build this powerful export-led manufacturing platform. India's done other things. And you know, the next phase, if you look at these two countries sort of slugging it out if you want to call it that, could be very different.
ROACH: Can I tie in?
TARULLO: Yeah. Go ahead.
ROACH: Well, just to support — well, it's not a zero-sum world, but I'm going to support you on India here. And when we look we compare India and China, it's very interesting.
China's investments is 45 percent of GDP. And people say, oh, that's unsustainable, it's way, way too high. Well, if you look at the composition of that investment, over half of it is government investment; that is, taking taxpayers' dollars. And Chinese are much better than the Indian government at assessing and collecting taxes. So the command and control economy, command and control policymakers out of Beijing, collect the taxes and invest in infrastructure to facilitate the massive demographic shifts.
India, which is a democracy, is poor at collecting taxes. Their tax receipts as a percent of GDP is much lower. They don't have the infrastructure. But if you subtract from China's rate of economic growth the contribution by government investment, you get India's rate of economic growth, which is healthy and diverse and desperately in need of infrastructure building.
TARULLO: Now we'll turn to you for questions. I want to remind you first that this is an on-the-record meeting. Second, when I recognize you, please state your name and wait — we have microphones on the side? Yeah — and wait for a microphone, please. Okay.
So, questions? Yes, right in the middle there. Sir?
QUESTIONER: My name is Steven Makamel (ph). I'm from Barsten Makamel (ph).
And I want to ask you or any of you whether you can tell me what the effect on China that is of their one-child policy will have 15 years from now in relationship to what you've been saying for the past half hour?
LEVY: In the long run, it has a huge impact. But you also have to consider a nation that has, you know, 1.2 two billion people, it takes a long time for the demographics to move through the pipeline to effect economic performance.
TARULLO: I think there's actually some effort to reverse that policy, though —
MR. : Well, it's slipping — it's slipping a little bit right now. Look, this is — China embraced this policy because, given the scale of the population, they were not able to feed their people. And now that the economy's on much more solid footing, you know, there's a chance at some point that they will begin to relax this policy. If they don't do it, then their dependency ratios, the old portion of the economy relevant to the working age, will get into trouble as it is in the developed world. But that will take, as Mickey said, a lot of time for that to happen.
Right now, China and India are the two youngest economies, major economies, in the world. India is younger than China. But you know, they'll — certainly China will go through that sort of vulnerable demographic period if nothing else changes.
TARULLO: Okay. Yes, way in the back.
QUESTIONER: Thank you very much. I look forward to these sessions to plug me into the institutional groupthink of Wall Street. I've spent much of the last 30 years in Washington; I'm a retired politician.
In 1979 to '82, I was the personal liaison between Ronald Reagan and Paul Volcker. So I had an up-front view of what we were trying to do then, and it's remarkable to hear it expressed by a younger generation who have only read about it. One of the things we were deeply concerned about was the impact on the consumer. Because the consumer was so much of our economy and we had gone through this hyperinflation, we were going to have to slam the brakes on, and Paul did. And you will recall we had a V-shaped recession that drove up unemployment to 10 percent, but it didn't last very long and nobody remembers it.
What about the consumer in the United States, whose income has basically been stagnant since the dreadful events of 2000? What about the over-savings, over-profiteering of our corporate sector versus the consumption sector? What are we doing to get the consumer ready to adjust to next winter's savings impact as they try to pay the fuel bills and the mortgage?
MR. : Wow, and you worked for Ronald Reagan? (Laughter.) Where were you when we needed you? (Laughter.)
The real or inflation-adjusted disposable income is not flat. It has been increasing in the last three years. In the last year, with the higher oil prices that pushes up headline inflation, that does suppress real purchasing power, but real disposable incomes are still rising.
It does — it is a fact that over the last 15 years, while labor productivity has increased rapidly, real wages have also increased but not kept pace with that. So that gap is widening some, which suggests a higher return to capital and return to labor. That's just the fact.
I mean, the best solution is continued healthy productivity gains, and wages will catch up. But when you ask the question or imply the question, how should the government prepare the consumers to this upcoming home heating season? My response is that's not the role of the government.
LEVY: There are many parts of this question. I'll just comment briefly on the saving rate.
Personal saving rate has trended down over the last decade, helped along by a downward trend in interest rates and booming asset markets versus the stock market, more recently the housing market. As rates reverse course, as interest rates begin to move higher, I would expect to see personal saving rate begin to move back up. Certainly the saving that the household has gotten from the after markets is going to be coming to an end. We expect a pretty sharp slowdown in home prices going forward, home-price inflation.
MR. : I would just one — there is just one — this is a really important issue in the U.S. macro debate.
The personal savings rate is a negative territory right now basically for the first time since 1933, which was not one of our better years. (Laughter.) And we're getting hit with an energy shock now. And yet, if you look back at the three prior energy shocks — '73, '79, and a brief one before the first Gulf War in late '90, 1990 — that same savings rate averaged 8 percent. So consumers had a cushion then. And there is no cushion today, as you are implying.
I agree with Mickey; you know, this is — the government's job is not to target the personal savings rate, but it does underscore the vulnerability of this asset-based American consumer to get hit with a shock on income when they don't have any money in the bank. And I guess you could conceive of a scenario where consumers figure out how to extract more equity from their homes and deposit it directly in their home heating oil vendor accounts. That — barring that, this could be an unusually tough energy shock.
MR. : Yeah. By the way, hats off to Paul Volcker because it has been the Fed and other central banks pursuing stable low inflation and telling the public and the market that it's not going to allow higher energy prices to get into core inflation is what — that is what has kept bond yields low. And in sharp contrast to the 1970s, where we had an energy price shock which the Fed didn't know what it was doing, people didn't understand the inflation process, inflationary expectations rose, which drove up interest rates, which drove up core inflation. We didn't have any of that this time, so what the government can do is through the Fed follow a stable low inflation monetary policy and, again —
MR. : There goes Ben Bernanke again, yeah.
MR. : And once again, I think it was Paul Volcker in the late '70s who really turned the tide not just in the U.S., but set the stage for every major central bank in the world pursuing the right policy.
TARULLO: Yeah, sometime we're going to have to talk about how inflation acquiesce and the wringing out of inflationary expectations has changed things across the board.
MR. : Have we not maybe gone a little too far, and is our risk premiums perhaps —
MR. : — a little too compressed to the point?
MR. : And — (inaudible).
TARULLO: May as well be.
Yes. Right here, sir. Yeah.
QUESTIONER: Hi. Andre Postonick (ph) with the Financial Times.
Just wanted to get you to talk a little bit about Europe because France seems to be having what might be called a deficit of "egalite"— (laughter) — and a lot of people seem to attribute the recent rise in the dollar in front of bad employment news and so on to the fact that the euro is looking worse than usual. Do you think that there's a real risk of contagion? Or how do you account for a risk of contagion from France in terms of the social problems to the rest of Europe? And how do you appraise the risk for sort of economic policy and the reforms that are needed in the face of these social problems? And what do you see — you know, do you see these risks reflected in asset prices in Europe? And how do you — you know, where does Europe in all this?
TARULLO: Well, I guess the couple — there's obviously the possibility of social and political contagion, which at least the German government is deeply worried about, but — which we're probably not as well equipped to answer. But how about the economics of this?
HOOPER: Well, I think that there are — I mean, Europe has been an amazingly good news for the dollar all year long. I mean, starting with the constitutional crisis, the German election, which was certainly a disappointment for those who are hoping for something — a stronger endorsement of reform there, and now riots in France and questions about will this indeed affect confidence enough to have a significant negative impact?
We're still holding to the view that we'll make it through this and we'll begin to see some moderate pickup in growth somewhere in the neighborhood of trend, which is well below trend in the U.S.; one-and-three-quarter to 2 percent is a good year in Europe and half of what we expect in the U.S. But there's certainly some risks.
LEVY: I think yours is a great question because it gets to the issue of the resolve of the policymakers. And I think this is crucial for Europe because core European nations desperately need pro-growth reforms and adherence to the Lisbon agenda of reform from the tax and regulatory areas.
And will the current problems in France sidetrack that agenda? Nobody knows. I hope not. You know, I hope — I hope the policymakers show resolve.
TARULLO: Do you have anything on Europe.
ROACH: Well, on France.
I would just — you know, I think that Europe is being pushed to the point of really the deepest reconsideration of its social model that it has been through post-World War II. There is risk associated with it, but I think ultimately — and don't get me wrong, I don't think riots and social unrest is a good thing — but I think Europe needs to go through this if they're going to get to the other side.
The structural story in Europe from a pure economic point of view is now in the process of changing. And it's improving, especially in Germany, where the world's most rigid labor market is less rigid today than it was three years ago. Thirty-nine percent of the German workforce today are part-time and contract temps, giving corporate Germany much more of a flexible labor cost structure than they ever had. Shortened work weeks are being dismantled in Germany and in France, and the power of labor unions in both Germany and France is not nearly as dominant as was the case historically. Meanwhile, corporate Europe, both Germany and France, are investing heavily in IT, and there's a very powerful micro restructuring story going on in corporate Germany, and to a lesser extent but also a very important one in France.
So there is for the first time in probably 15 years some hope on the productivity front in Europe. These political issues that Peter alluded to certainly detract our attention from that. As hopefully they subside, then this structural story in Europe will become more evident.
I'm a congenital Euro-skeptic. This is the first good thing I've said about Europe in 15 years. (Laughter.)
TARULLO: Steve, it's fair to say that this good news, what's going on here, is driven, importantly, by the global competitive pressures — the Asians and labor —
ROACH: Absolutely. I couldn't agree more.
TARULLO: You know, there's an article of faith in most administration and most countries that every crisis is an opportunity to push forward whatever agenda you wanted to push forward because if you're adroit enough, you can describe how that agenda will address the crisis and the problem that's seen. I don't seen any hints yet that the French administration is going to do that — (laughter) — and it would be a remarkable break with their recent experiences. But at least it is a possibility.
Let's see. I think, if we have a very quick question. Yes, right there, sir, but please make it quick.
QUESTIONER: (Off mike) — a series of concerns about sub-Saharan Africa and its development, the Islamic jihad, the rising cost of defense to keep order and bring the rule of law around the world. Do you guys ever talk to the people in those seminars? At what point does the overhang of the long term begin to bleed into these medium- and shorter-term economic projections?
TARULLO: Sometimes those people are sitting in this very room. (Laughter.) Go ahead, Mickey.
LEVY: Of course you have to take those factors into consideration. But when you think of potential global output, potential U.S. GDP, it's driven by demographics and labor productivity and total factor productivity, which should embody the factors you're bringing up.
Now, next world economic update's going to be a special topic. We're going to hold it on January 31st, which is the day of Alan Greenspan's last Open Market Committee meeting, and we will exclusively address the world after Greenspan. Presumably by that point we're going to be addressing specifically the world that Ben Bernanke is going to make, so I look forward to seeing all of you then.
I want to thank the panelists, and have a good holiday season. (Applause.)
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