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World Economic Update [Rush Transcript; Federal News Service]

Speakers: Richard Berner, Managing Director, Morgan Stanley, Mickey Levy, Chief Economist, Bank of America, and Laurence Meyer, Vice Chairman, Macroeconomic Advisers, Llc; Distinguished Scholar, Center For Strategic and International Studies; Former Member, Board of Governors of the Federal Reserve System
Presider: Daniel K. Tarullo, Professor of Law, Georgetown University Law Center
January 24, 2008
Council on Foreign Relations

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LAURENCE H. MEYER: (In progress) -- trigger that, and that it revealed that not just risk was re-priced, but that the leveraging up of many financial institutions, both on the balance sheet and off the balance sheet, I think has led to a much more abrupt re-pricing and a more severe re-pricing of risk than we might have imagined.

One particular example of that, I think, is found in activities of banks who created so-called special investment vehicles and conduits that were funded short in the asset-backed commercial paper market, and which had longer-term assets. And the assets were complicated because they were, in many cases, structured securities. And whether they had sub-prime mortgages as their underlying collateral or not, they were complex assets.

But the key thing here is that they were funded in short-term markets. And when the concerns arose about the value of the underlying assets off the balance sheet and, to some extent, on the balance sheets of financial institutions, the funding dried up. So we developed a liquidity problem in markets, and that liquidity problem now, with aggressive action by the Fed and other central banks, I think has largely been addressed.

But what we haven't addressed is the broader concerns about credit quality, and I think now it's fair to say we're in the midst of a credit cycle in which credit quality is deteriorating. And the consequences of this re-pricing of risk have shown up both in a higher price for credit -- increased costs for credit -- as well as lenders being much less willing to make credit available. So the availability has dried up. Both, to me, will have consequences, both for markets and for the economy.

DANIEL K. TARULLO: And Dick, can you just say a few more words on why the credit has dried up to such a degree? Because there are several potential causes. One, of course, is that the potential lenders look out there and say, gee, somebody wants to borrow money. But if the economy swoons, they're not going to be a particularly good risk to pay it back.

Another reason may be that the bankers are looking at their own balance sheets, which are already encumbered by some distressed assets, and worried that even a reasonably good risk means that they have a further capital charge, and their capital ratios are a little shaky right now. There are obviously other reasons, too.

What -- roughly speaking, what do you think the mix of disincentives to do the lending right now is?

RICHARD BERNER: Well, Dan, I think both are important, because with the funding drying up for these off-the-balance-sheet entities, banks have had to put the assets back on their balance sheet in what I call the re-intermediation of the banking system. And that has in effect been a call on bank capital, so banks have less capital available with which to expand their balance sheets. So that is one factor that has made credit less available by the banking system.

Second, I think that the uncertainty surrounding the valuation of some of these assets, and the uncertainty about the overall outlook and the state of credit quality, has made lenders much more risk-averse, as it typically does in this kind of a cycle. Though both factors, I think, are important.

TARULLO: Mickey, when -- we talk about the credit markets or the credit system, but obviously there are different elements in that system. For a while, the interbank lending market was not functioning very well at all, with London Interbank offering rates much higher than people would have expected under the circumstances. Those seem to be back to normal now.

But can you disaggregate the credit markets a little bit more and say where things are seemingly operating reasonably well and where things are not?

MICKEY LEVY: Sure. Well, what -- let me just start by saying what's so unique about this is credit quality tends to deteriorate after the cycle, after a recession. And this time, in 2007, we had this huge deterioration and tens of billions of dollars of losses while the economy was still healthy. Okay? Which is scary, because now we're entering a new stage.

So we had short-term funding markets totally seize up, and they were absolutely dysfunctional. Aggressive Fed action helped the healing process, but along with that we've had -- the healing process has also included large banks and investment banks bringing back onto balance sheet their SIVs, acknowledging publicly the problem, taking write-offs, raising capital. And Dan, as you mentioned, a lot of European banks in the next month are going to acknowledge large write-offs.

Okay, so I think if you look, as you mentioned, LIBOR spreads have come down. The initial crisis in the short-term funding markets have dissipated. But now we enter a new stage, and the new stage is, well, are we entering a new -- the type of traditional credit cycle where the economy deteriorates and then we have a deterioration in credit quality?

But before we get there, I think it's very important to, as you say, disaggregate what's going on. All of the focus I've seen in the press and in financial markets is with the 10 largest banks. So if you take the 10 largest banks, once again, they've brought on balance sheet assets they didn't want to. They have taken large write-offs, which impairs their capital, their tier-one capital, and their balance sheets have been impaired.

How have they responded? Those largest banks have responded by, as you know, raising capital, but in addition they've responded by adjusting their portfolios. But in most cases, they have not radically altered the provision of liquidity to basic non-financial businesses. Now, they have tightened credit standards, but what that means is if you're a loan officer and you come into a loan committee, you'd better have good documentation now. Six months ago, you didn't need it.

Now, what about the other 8,000 banks? They're saying, boy, this is a grand opportunity to increase market share, because our balance sheets are not impaired. So, in fact, what's ironic here is if you look at commercial and industrial loans by the largest banks, it's still rising. By all banks combined, commercial and industrial loans are rising even faster.

And so to date, credit standards have tightened, but I don't see this to date as a full-blown credit crunch where liquidity is actually drying up.

TARULLO: So, Mickey, these -- a lot of people out here probably read the stories in the Wall Street Journal over the last week or so -- which were obviously anecdotal, but anecdotes are often powerful -- talking about businesses having difficulty getting lines of credit or the like. And your instinct, then, is that those are just what I said, which is to say anecdotes, rather than --

LEVY: No, I think there has been tightening of credit standards, but I would flip the argument on its head. The process, the credit process, when sub-primes were growing dramatically and banks were buying it in their off-balance sheets and the like, that's when the credit process was broken. Now when you have tightening credit standards and you re-price risk, although it's radically, it's back to the right process.

Now, we're in a transition here. The biggest -- so I would say we have had a tightening of credit standards, but if you ask the -- and, of course, high-grade bond markets, high-yield bond markets, the real cost of capital hasn't gone up that much.

So if you array the list of worries out there for most non-financial businesses, obtaining credit is not a very large worry for most of them. It certainly is in the leverage community, the hedge funds and the venture capital funds. Those -- the leverage there has been pared back. It's also obviously been pared back for all the housing sector. But outside of that, there's still a flow of credit, so I don't see it as a full-blown credit crunch.

Let me identify the crucial concern I have now: unemployment rate's starting to go up. All of this turmoil on Wall Street is clearly affecting the psychology of business executives. How is this going to affect their decisions on hiring and on capital spending, and then the flow back through.

If the unemployment rate starts to jump up, economists would say, well, that's going to affect real disposable income and purchasing power. But even before that happens, when the unemployment rate starts jumping up, that's when bank credit officers say, uh oh, our credit quality's going to deteriorate in the consumer space, and we have to rein in credit. We're not there yet, but wait and see.

TARULLO: Okay.

So now I want to turn to Larry who, as you know, spent four -- four years?

MEYER: Five-and-a-half.

TARULLO: Five-and-a-half. That time flew.

MEYER: (Chuckles.)

TARULLO: Five and a half years as a governor on the Fed and thus was confronted with obviously not this precise situation, but these sorts of questions. And Larry, let me ask, in light of what the Fed did with this highly unusual move between meetings, of a 75 basis point drop in the federal funds rate the other day, the degree to which that kind of action or, indeed, monetary policy generally is going to affect the overall circumstances that Dick and Mickey have just described.

And let me ask a bit more specifically the degree to which that depends on my initial question, which is how many bodies there are still buried there in the balance sheets -- my premise being that if there are more bad assets, that just lowering interest rates is not going to have as much of an effect on banks' increasing lending than it will if they're just worried about the relative viability of the proposed projects for which people want to borrow.

MEYER: Right. Well, cleaning up the problems is a -- it doesn't happen overnight. Banks have to raise capital; they have to clean up the problems. That is a sort of a slow process. But you're dealing with collateral damage in the economy from the weakness in housing and from the spillover of tighter lending standards -- you know, increasing credit spreads. And so monetary policy has to work very hard just to offset the wider credit spreads that were taking place.

You could argue that a percentage point, the initial percentage point of decline in the federal funds rate was just about keeping pace with how much risk spreads had opened up. And if it wants to move to outright stimulus, it needed to move sort of more aggressively.

So I think that there's still the corporate bond market. Issuance is open. Less -- you know, it's harder for the highly leveraged loans. But for most corporations, they can access the corporate bond markets. And as Mickey said, the credit availability has not dried up in banks. There's a threat to credit availability, but it hasn't materialized in a dramatic way.

So I think lower rates have a -- are a critical component of keeping the economy on a course, trying to avoid the economy slipping into recession. And I think we need to see a somewhat more aggressive action to move to outright stimulus. And one of the things that's very different about this, it's not sort of a normal sort of aggregate demand shocks. There are these sort of tail risks out there. These very dark clouds of potential problems at major financial institutions that are usually very low probability events.

And in situations like this, the Fed likes to follow what we call a risk management approach and sort of overshoot -- you know, lower rates to sort of minimize the risk of some of these really bad events occurring. And in that situation, they have to be prepared to take it back more quickly if the tail risks don't materialize, or if the economy doesn't slip into recession. And I think that's the mode the Fed is in now.

TARULLO: So Larry, with the 75 basis point move the other day seemed to come in response to the big plunge in equity markets around the world. But some of what you just said suggests that the Fed was playing catch-up, here.

MEYER: Well, I think you saw the rhetoric of the Fed change and, you know, going back to the August meeting, inflation was still the predominant concern. Until very recently, they haven't said that growth was the major concern and that further easing was likely. So the Fed rhetoric was sort of lagging behind their actions.

And, indeed, given what's happened in the financial markets, one could have argued that the Fed had to begin -- and they sort of indicated they would become more aggressive and decisive and timely, et cetera. So they have sort of indicated that something more aggressive was on the horizon, and given the sort of potential meltdown that seemed to be possible if they didn't act quickly, they decided to do that.

TARULLO: Dick, do you think -- was the Fed badly behind the curve here, or just modestly behind the curve?

BERNER: You know, I do think that their rhetoric, as Larry indicated, was somewhat behind the curve. And it's pretty clear that the markets and the Fed were out of step with one another, starting back in October.

And the risks to the Fed -- I think Larry implied some of the risks -- the risks to the Fed were that being behind the curve, the market was going to dictate the pace of monetary policy. And, as you indicated, I think their action this week instilled these people with the lingering suspicion that that is what's calling the tune for monetary policy.

So the Fed still has some work to do in terms of its communications, and to specify more clearly where they think the outlook is, where they think the risks are, and what steps they're going to take going forward to address those.

They've put a lot of that --

TARULLO: Have they boxed themselves in a bit now? I mean, if they don't give us another federal funds rate decrease in the next week, in their meeting, is there going to be a negative reaction in the markets?

BERNER: If the Fed were to do nothing at the next meeting, I think there would be a negative reaction in the markets. And so having eased 75 basis points this week and having stated very clearly -- now they're starting to state things much more clearly, as Larry indicated -- the expectation and the reality of lower rates is really out there. So they will ease again at their meeting next week.

TARULLO: One of the favorite things for macroeconomists is commenting on Fed policy. So if you have a panel of three macroeconomists, you've got to let everybody talk about the Fed.

So Mickey, what do you want to say about the Fed? (Laughter.)

BERNER: Great set-up.

LEVY: This is not a traditional monetary cycle where the Fed hiked rates too much and aggregate demand slumped and now you've got to ease a lot. What it is is a negative real shock to the economy generated by the slump in housing, the decline in residential construction decline in housing. That began in mid-2000.

We've gone for six quarters without it spreading out to the regular -- to the rest of the economy. In fact, through November, the economic data were much stronger than I had expected. All of a sudden, the data collapsed. So through November, the Fed wasn't behind the curve in economic terms.

But as has been mentioned before, in addition to the Fed's long-run objective of keeping inflation low as the best foundation for economic expansion, with the emergence of the sub-prime problem and the freezing up of short-term markets, the Fed really was faced with another short-term objective -- how to restore order to the short-term funding markets.

So all of the financial markets are focused on the short-term funding markets, and the Fed, if you call it, was behind the curve relative to the key concerns facing the markets. Then the economy started to lapse. Stock markets globally caught up with bond markets, and then they eased.

I think the Fed's in a very tough situation, because once again, it's not a typical cycle, and of course they're going to ease more. The issue is now -- okay, so you had this negative shock to the real economy through housing. It really didn't impact the rest of the economy until just recently. But now you have this total financial crisis and it creates, maybe a not negative psychology, but it starts to spill over into the regular economy, and it looks like it is.

So with this negative real shock, how much does the Fed need to lower real interest rates to prop up demand? So they've got a very unique issue. They're going to definitely ease more.

And I do worry that easing so aggressively a week before a scheduled meeting, that's the wrong precedent for what the market's going to expect and push, going forward. Not just the market; Congress.

BERNER: Just following up on what Mickey said, if you asked me a word that described the economy over all of 2007, it was incredible resilience. Housing is 5 percent of the economy, declining at a 20 percent-plus rate, subtracting a percentage point from growth. The rest of the economy was growing at a 3-and-a-half percent rate, well above trend.

And even if you look at our tracking of numbers in the fourth quarter, you look at consumer spending, 2-and-a-half (percent); business fixed investment, around 7-and-a-half (percent); government spending, around 6 percent. I mean, even there, where growth is closer to 1 percent, it's again the maximum negative contribution from housing, subtracting 1-and-a-quarter percentage points, declining auto production.

So we really -- the mood of the economy has changed dramatically, particularly with one month's number, a bad employment report, an increase in the unemployment rate where the unemployment rate has been sort of lagging and everybody was expecting it to rise more gently. It didn't, and then it jumped in one month.

So I think we can get carried away. This is a very resilient economy. It's in a period of slow growth. We've had now a considerable amount of easing. We probably have fiscal stimulus on the horizon. So I would expect that the combination of fiscal and monetary policy now is going to produce a surprisingly solid economy in the second half of the year.

TARULLO: And so, Larry, with that in mind, how quickly do you think that the Open Market Committee is going to turn back to the concerns about inflation that they were articulating quite strongly up until quite recently?

MEYER: So, I think what the risk management approach tells you is to put in place a path of policy that's uncomfortable in terms of what it would imply about inflation risks, if we don't fall into recession or if these tail risks don't occur. And that means that you have to be very timely. The Fed has to be willing to take it back.

If I look back on my experience at the Board, with the Fed easing in the fall of 1998 -- at a time when I otherwise would have expected the Fed might have been on the course of tightening -- instead of tightening, easing and then not taking it back for a while. That, in my view, led to the blowout in the equity markets -- just an enormous rise in equities at the end of '98 and through '99.

So I think that's one of the things that the Fed thinks about; also keeping rates so low for so long and being very gradual in returning them after the last recession. So these are two experiences that I think weigh on monetary policy. So I think as policymakers become more aggressive, they're also talking about, you know, "We've got to be willing. If we're going to be that aggressive up front, we have to be disciplined and we have to be very willing to take it back."

Now, how do you do it? How do you -- you know, what happens is the data plays a big role. As data surprises turn from negative to sort of more positive, then expectations of monetary policy change very, very quickly. And so it's not just Fed communications that plays a role, but policy expectations themselves change very decisively as the data begins to -- (inaudible).

MR. BERMER: I agree with a lot of what Larry's saying, and I think that that's a really important point, that policymakers have to be willing to take back the aggressive ease that they're now putting in place.

There's another factor, however, that's unique about this.

TARULLO: Can I stop you right there, though, because one criticism of the Fed that's been voiced by a minority of observers, but a non-trivial minority of observers, is precisely that, that after coming into the markets when the telecommunications bubble burst and aggressively lowering rates, the Fed didn't take it back quickly enough.

MR. BERMER: So that's the lesson that they've learned from the past, as Larry, I think, was indicating. In fact, there were two episodes that he cited, I think, that were very compelling reasons for the Fed to have learned that lesson from the past. If you're going to be aggressive in offsetting these head winds to the economy, then you have to be equally aggressive in taking back the stimulus that you've put in place once those head winds have -- (inaudible).

TARULLO: But can I ask, do we have an historical example where the Fed was suitably aggressive in taking back the stimulus? Because presumably, I mean, these guys are not immune to the political environment more generally.

MR. BERMER: Well, you know, I think it's possible that you could cite both 1984 and '94 as examples when the Fed moved pretty aggressively when there wasn't a clear and present threat from inflation, but there were future threats from inflation, given the circumstances unfolding.

TARULLO: I didn't want to interrupt, but I just want to get that through. Go ahead.

MR. BERMER: But I think there are a couple of other aspects to this that are important, in line with, you know, the repricing of risk and leveraging up. While I'm not a believer that, you know, this is an economy that's completely dependent on what happens to asset prices and leverage, those factors, I think, are still important and will take, as Larry indicated, some time to play themselves out.

We are starting to see a deterioration in credit quality for consumers. And if there's a deterioration in credit quality for consumers, then lenders to the consumer are starting to pull back and to be more circumspect. And that is going to have an impact on economic activity.

Calibrating that from the standpoint of either us sitting up here on this podium or from Fed officials in Washington or around the country is hard, because there's an enormous amount of uncertainty about the degree to which that's going to affect economic activity.

The second thing that makes it unique, that Mickey alluded to, I think, is the nature of this housing decline. There still are very large imbalances in housing markets that have to be addressed. And, you know, whatever the Fed does won't really address those in the short run. We have to see a realignment of demand and supply in housing. There still is an excess of supply.

Unfortunately, what that means is that we're starting to see in a lot of markets around the country that home prices, which have risen dramatically in the past five years, are starting to retrace those increases and to decline.

And two things happen when you start to see declining home prices. People feel less wealthy and they're less able to sell their homes, and buyers are not willing to step up in a market where pricing are falling and bid for those homes until they see some sign of stability. So with that collateral impaired, that adds to the financial and economic restraint working its way through the economy.

TARULLO: Okay, so --

LEVY: Can I add a very important point?

TARULLO: Yeah.

LEVY: And it gets to the point -- the Fed is really limited, because this is a very unique problem. I want to build on something Dick said. If you look at the Case-Shiller series on home prices -- and they provide them for 20 regions around the country -- in eight of those 20 -- eight of the top 10 where prices zoomed up the most and are now declining the most are in California, Florida and Nevada.

Okay, if you look at --

TARULLO: All of which are holding primaries in the next --

LEVY: If you look at delinquencies and foreclosures, those are three of the highest states. Now, I'm going to add something. I've recently looked at unemployment. And more importantly, I've looked at changes in the unemployment rate. And in those three states, while the U.S. unemployment rate over the last 12 month has increased from four and a half percent to 5 percent, in those three states it's increased nearly three times as much.

Okay, so the California unemployment rate is now 6.1 and it's heading up. So it's not just -- I totally agree with Dick, but it's not just a housing price problem, because people who see their house prices coming down, they'll still try to stretch and make their debt payment until they lose their jobs. So you have in these three particular states -- and if you look at the data, take national data and you take the total increase in unemployment over the last 12 months, 80 percent of it or so is in these three states.

So you have a real specific problem, a structural problem. And if you look through history, the Fed has gotten in trouble when it tries to do more than it's capable of doing.

TARULLO: Well, that's a very good point to use as a transition to discussion of the real economy question; the recession problem, as it were. Even before the subprime mess erupted last summer, we already had a softening of the housing market. We had oil prices heading upward, an increase which accelerated, although it's since pulled back some. You had a sense that, just in normal business cycle terms, things were starting to come to an end, if they hadn't already.

Then the subprime crisis hits. Now, more recently, as Dick was mentioning, and Mickey just was elaborating on, you have the almighty consumer slowing; not pulling out entirely, but certainly slowing. Unemployment, as Mickey said, has jumped quite a bit in just the last half-year. I think now even capital spending, which was holding up for a while, has started to slow.

This doesn't sound good. This doesn't sound like a good prescription for the economy as a whole. But if I'm not mistaken, all three of you and your organizations have fairly restrained expectations for what will happen. Dick, you made a recession call in mid-December, but it's for a relatively short recession and not particularly deep. Larry already alluded to his expectations that growth will be above what people think. And Mickey -- I don't want to put words in your mouth, but I think Mickey is not too far from those expectations.

So given all those factors that not only I but all of you, in different ways, were mentioning in our first segment, how come you all, if I can put it this way, are relatively non-pessimistic about the prospects for the real economy?

Dick?

MR. BERMER: Well, one of the key factors that is out there is the strength of the global economy. And there's no mistaking the fact that, in many parts of the world, global growth still is fairly strong. And that has given rise to this idea that the rest of the world can decouple from the U.S., even if there's a downturn in the United States.

I disagree with that, but I do agree that the differential between growth in some parts of the world and the U.S. will still be positive and that that will still be a cushion for U.S. economic growth.

TARULLO: Because of exports?

MR. BERMER: Because of net exports. In the past year and a half, we've seen that playing out. So that has been a source of support.

It's also been a source of support for U.S. earnings. Twenty years ago, the last time that we had the global economy be a source of support for the U.S. economy, earnings in the S&P 500, or however we measured them, from overseas affiliates amounted to about 15 percent of the total. Now they're more than twice that.

So strong growth in those economies produces relatively strong results for the affiliates of U.S. companies, contributing to corporate profits. And I think you see that writ large in the reports that we've gotten from many of our multinational companies. That, in turn, has supported their stock prices until very recently.

The concern now, I think, in markets and my concern is that we're going to see spillovers from what happens in the U.S. and from global financial conditions -- a tightening in financial conditions in many markets overseas to economic activity around the world, and while that differential will still be positive, that it will not be as positive as before.

And you mentioned capital spending being at risk. You know, the data that we've seen, looking in the rear-view mirror, had been okay. The problem is that the deceleration of the economy, tighter financial conditions, profit expectations that are now starting to sink, all those are not good news for capital --

TARULLO: It doesn't matter how low interest rates are if you don't think there's a market to sell to.

MR. BERMER: Well, you know, I think that if there's a lot of uncertainty, then people tend to disengage and pull back. And I'm not thinking that we're going to see a lot of weakness in capital spending, but it's likely that the risks are pointed to the down side in that area as well.

TARULLO: Larry.

MEYER: I think there are sort of three things. As Dick pointed out, the global economy is providing support. You know, for a decade, through 2005, net exports were subtracting half a percentage point from growth year after year after year. In 2006 and 2007, it added half a percentage point to growth. And that's where we think we are through the first part of this year. So the long decline in the dollar, the fact the rest of the world is growing faster than the U.S., that's providing support.

No doubt, given the importance of the U.S., as the U.S. slows further, certainly if it slips into recession, there, of course, could be spillovers -- spillovers through trade, spillovers through some financial markets, spillovers in Europe because they face some of the common problems in terms of subprime and banking and credit availability.

And the second issue is the fundamental resilience of the U.S. economy. Since the early 1980s, we tend to have extremely long expansions and extremely short recessions. You blink, you could miss them. And we take incredible hits and just keep going.

And one of the reasons for that is, as monetary policymakers would note, that inflation expectations have been very well-anchored and it gives the Fed much more freedom to be very aggressive and ease in circumstances like this without unnerving the markets about inflation.

And then the third, and tied to that, is timely, sufficiently aggressive action from monetary policy, potential fiscal policy, that we think will be enough to avoid the economy slipping into recession and support growth as the year goes on.

TARULLO: Mickey.

LEVY: I agree with what, you know, both Dick and Larry say, but I would add something else. If, in fact, we're entering recession, the current situation is very different than every other expansion peak. If you look at prior expansion peaks going all the way back, you tend to have a very large undesired inventory overhang, excess capital stock relative to output, and excess employees relative to output.

And that happens because, as an expansion matures, the Fed hikes rates too much in response to higher inflation, and you have a slump in demand and businesses don't read the tea leaves right and they keep on producing and hiring and spending on capital.

So if you look at all recent recessions and add them up and measure the decline in GDP from peak to trough, 80 percent of the decline is inventory liquidation and decline in capital spending. And so now you had a little inventory buildup in the third quarter, largely in autos, but business inventories are very lean.

If you look at the capital stock, net of appreciation, net capital stock relative to output, it's very low. It's been coming down all decade. Also businesses have been very judicious with their hiring. And so you don't have the typical imbalances that businesses are forced to eliminate during recessions by cutting employment and production and capital spending.

So I would say -- and then you have the Fed easing and you have the net export sector. And so the biggest concern I have right now is the psychological impact of everything that's going on. And we all feel it, and I'm sure they feel it on Main Street. And so my hunch is the average business executive right now will say, "Well, there's just so much uncertainty. I'm going to postpone some hiring and delay some capital spending plans." And that's enough to get you to a flat type growth.

I think you actually will have some inventory liquidation. In the fourth quarter, businesses weren't as successful as they wanted in trimming inventories. I think you're going to have some liquidation in the first quarter. But that's just mild.

Now, we're growing -- the difference between a half-percent GDP growth and a half-percent decline is you're so far below potential, we'll all feel it as being very, very soft. But what's happening now is, with the Fed easing and LIBOR spreads coming in, you're actually seeing a pickup in mortgage applications. Most of it's for refi's, and you have all these resets. These lower rates really helped resets and it's going to help cash flow.

The economic data for the next three months is just going to be decidedly lousy, as I think it shows up in employment and production. But I agree with Larry; in the second half -- (inaudible) -- bounce back.

TARULLO: When the guests all agree, it is the moment at which I've got to be --

MR. BERMER: Maybe we're being too polite.

TARULLO: -- the provocateur.

LEVY: It's supposed to be two economists, three opinions. (Laughter.)

TARULLO: And I'm going to get Nouriel Roubini to come to the next one of these things to make sure the sunshine doesn't prevail too much.

MR. BERMER: What I hear you saying is we should take the gloves off.

TARULLO: Well, here's one way to put it. And I can use -- George Soros sometimes sits right down there when he comes to these things. And he had an op-ed in yesterday's FT. Now, you know, George has learned over the years -- he writes very well and very effectively, and he's sort of an attention-grabber. And one of the lines, which I noted on the way up yesterday, was "Everything that could go wrong did," in talking about what happened last summer and its aftermath.

George presented what has happened as a kind of watershed moment for the global economy, not so much predicting apocalypse -- that wasn't in there at all -- but something fundamental was changing.

And one does hear people saying things like the following: "Well," they would say, "maybe these three guys are right. Maybe this will end up being just a slowdown or a mild, short, shallow recession. But we see," in Larry's terms, "a big risk at the tail," that is, that this could be something -- maybe the chances of it are only 5 percent or 10 percent or 15 percent -- but that the mix of all the problems in the financial institutions, the unmasking of a business model that seems unsustainable and was built without a proper understanding of risk, combined with all the things that were already going on in the real economy, could produce a very ugly mix.

I know none of you regards that as even a moderate probability. But are the people who are speaking in those terms just completely out to lunch?

MEYER: We've never -- I can't remember a situation when there were so many what we call tail risks, that -- (inaudible) -- could be somewhat cataclysmic and could change the whole environment and set off a whole new set of losses to major financial institutions that are still trying to deal with the current set of losses.

So I think, you know, financial regulators are, you know, definitely tuned in on these risks. But if they materialize, it, you know, will make a recession virtually unavoidable. We'll see a further gapping up in risk -- (inaudible) -- a further, you know, impact of uncertainty and caution, you know, throughout business and consumer spending. And, you know, it'll be hard to avoid a recession. So that's out there, okay, if those -- and these things are supposed to be very, very low probability. They're moderate probability and thinkable. Usually they're unthinkable.

MR. BERMER: Dan, I think the tails certainly have gotten fatter, and that's one of the reasons that, you know, I'm more pessimistic than the other two people on the podium.

But I think that there's another issue out there, and that is, we have deregulated our financial markets in some ways that are appropriate, but we are now likely to see a swing back in the regulatory pendulum. And the problem with that is finding the balance between what's appropriate regulation and having that pendulum swing back in a way that goes too far.

And I'm not speaking out of self-interest in that regard. I'm thinking about, you know, how our financial markets and our financial system, our capital markets, function not only here but around the world. So if the pendulum swings back too far, then, you know, that could actually start to impair the functioning of our markets in ways that are difficult to anticipate. And thinking about how we put in place appropriate regulations, I think, is an extremely important lesson or an extremely important challenge from these developments right here.

TARULLO: Well, just -- I mean, one has difficulty observing the developments of the last six months without concluding that we've got some fairly serious questions about risk management of financial institutions and regulation by the government, because one way or another, the mix there - in both locations didn't seem as good as it might have been.

Mickey, let me ask you something before we turn to the audience, it's on this point.

LEVY: Could I - can I --

TARULLO: It's going to - you're going to get to talk about anything you want but I want to talk about this too. (Laughter.)

Where, in classic terms, what do you see as the big downside risks here which would move your forecast significantly in negative - into negative territory?

LEVY: A full-blown credit crunch. That is, if all of this turmoil, capital losses, balance sheet impairment rotates into negative psychology, slump in demand, and then -- and then banks actually start really cranking up and tightening credit for all basic businesses and households.

But getting back to this other issue, even if we're all right, there is a tidal change in what's going on globally -- even if we're all right. In 2007 emerging nations generated over half of all global growth. Since mid-2006, U.S. economic growth has been below the Euro-zone's and below Japan.

In 2008, emerging nations are going to -- their share of global growth and global output is going to move further above 50 percent, even if the U.S. does everything right and Europe and Japan do everything right. And along with this, is, you know, jobs and wealth and profits -- and, of course, you read about the sovereign wealth funds, okay.

The other point I would make, on top of this tidal shift is, in the last three, four years, as far as I can tell, we've incurred the largest redistribution of globally wealth in history -- from energy consumers to oil producers. And, just on the back of an envelope, it's staggering. You know, it's well over $1 trillion -- the increase in oil and the flows of capital.

And I think these two, these two shifts in oil prices - and keep in mind, even if oil prices stay where they are or come down to $70 a barrel, the redistribution of wealth continues - and the shifts in global contributions to growth, and profits, and output continue even if we're all right. And this is the big tidal shift.

And so, as is typically the case, it's just so much fun to talk about The Fed, and all the nuances of the U.S. cycle, it's really minor compared to the long-run objectives. And I noted that Mayor Bloomberg questioned whether the fiscal stimulus package is best for long-run economic growth, and I think that's a great question.

TARULLO: Okay. There leave -- we hate to end with a question, but we're going to end with a question because we want to give you a chance to ask questions. So once again, when I recognize you please wait for the mike and then identify yourself before asking you question.

Yes, right here.

QUESTIONER: Thank you. Laurie Garrett from the Council.

The one thing none of you talked about was the falling value of the dollar. How much farther can the dollar fall before The Fed loses all wiggle room on interest rate changes, and consumer spending plummets because Americans can't afford to buy foreign manufactured goods?

TARULLO: Larry.

MEYER: Well, you know, I think the reality here is that in open economies today monetary policy works very much to exchange rates. As one country slows relative to other countries, as one central bank is easing relative to other central banks, the country that's easing faces a further depreciation of its currency. That stimulates net exports, that increases aggregate demand, and that's responsible for perhaps a third of the weight - of the strength of monetary policy. So, you know, this is not a time when you want to close that off.

Now, the question is, if they're on top of that normal relationship, there's a loss of confidence in policy in the U.S. -- a loss of confidence in the U.S., and we get a quantum, sort of, decline, that can lead to, sort of, disruption. And the impact of that is much more difficult and could be negative, sort of, throughout the world.

So I think there's more concern about that. It has -- it's not a limiting factor right now. One of the limiting factors is the decline of the dollar so far is putting upward pressure on inflation this year. And so that creates a little bit of concern about how much more aggressive The Fed -- the Fed can be.

TARULLO: Does either of you want to add anything?

BERNER: Sure. I think what Mickey said is really important because the shift in wealth, the shift in output and incomes, I think, is also a factor contributing to what we're seeing going on on the dollar. Particularly with respect to those countries whose currencies have been undervalued against the dollar, like China, for example, like the Gulf Cooperation Council currencies. Their currencies are so far undervalued that they have a way to go to move up.

And so the fact that the dollar is moving reflects that shift in the global economy, as well as undervalued currencies. And I think what Larry said is really important. If it's a gradual and orderly move, which is in line with fundamentals and doesn't reflect a loss of confidence in dollar denominated assets, then this is not a concern for policymakers. In fact, it's part and parcel of making monetary policy, just as in China it's part of the Chinese putting some restraint on their economy so that it doesn't overheat, and so that inflation does not pick up in a way that spins out of control.

TARULLO: Right here. Sir.

QUESTIONER: Farouk Kathwari, Ethan Allen.

Mickey, you mentioned the fact that how average business people would be thinking about. Well, we are an average business company. We have manufacturing, we have retailing and we are confused. (Laughter.)

We are confused because first we don't understand how all the experts - with all due respect - with all these experts in the financial markets could have created such a major problem. The second is now who to believe? So we are ending up becoming our own economists. So I'd just like to have your comments on that.

(Laughter.)

LEVY: My comment is I completely agree with what you're saying, so my question to you is --

QUESTIONER: (Laughs.)

LEVY: -- amid this uncertainty, how is it affecting your hiring decisions and your capital spending decisions?

QUESTIONER: Actually, I gave a couple of interviews for the Wall Street Journal and Reuters on the subject, which is that, as an enterprise, we have to look upon our own initiatives; because we look at the macro factors, and that's confusing. So we have to make decisions based on how we have positioned ourselves.

And you made the right comments, our businesses today are much more streamlined than they were 10 or 15 years back; our inventories are in better control; our hiring is in better control. But we are -- we have to be -- I would say, cautiously optimistic. We cannot, as business people, be cautiously pessimistic. And that's how we're making our decisions.

TARULLO: Next, skip -- there are two at the back -- the gentleman a little bit further up.

QUESTIONER: Glenn Louie (sp) from Ussen Ventures (ph).

Nobody's spoken about the fact that there seems to be extraordinarily - extraordinary equity liquidity. That is, that notwithstanding the credit crunch, every financial institution, and others that have had problems, have managed to raise all kinds of capital very, very quickly - whether through sovereign equity funds, whether through public offerings.

Is that likely to continue, or even somebody like E-Trade which got a pile of money from Citadel, is that likely to continue? And if that continues, isn't that an extraordinary cushion to the negative outlook?

BERNER: I would say the answer to that is, yes, it is an extraordinary cushion -- aided by monetary policy. After all, in solving the liquidity issues that we talked about before, central banks have added enormous amounts of liquidity to financial markets. This shift in wealth that we've talked about is a source of liquidity -- a potential source of liquidity. That is transforming ownership in the global economy.

The problem, of course, is that it's set against the backdrop of balance sheets that are impaired, otherwise they wouldn't need to raise the capital, and shareholders for those institutions who are being diluted by the raising of capital. And so, you know, that, together with the fact that we have this collateral that's on the balance sheets of uncertain value, which is still deteriorating, that's what creates the offsetting headwinds for economic activity.

MEYER: And I think there's a -- there's a whole industry that's grown that's very important. It's on the sidelines today, but it's those who focus on distressed assets. And, you know, many believe that pessimism is way overdone in the markets, and that, at some point, a lot of this liquidity is going to come in and we'll see it bounce it off the bottom.

TARULLO: Mickey?

LEVY: I think you're bringing out a great point because lack of liquidity is not one of the problems. We're going through deleveraging now, but all the deleveraging is occurring in -- related to subprimes, and you see, as banks write off their subprime-related debt, that's a reduction in leverage. And on the other side of the balance sheets you see this decline in asset-backed commercial paper.

The biggest question, I think the economy and financial markets face is, does this impairment -- despite the liquidity you feel out there, does it spill over into a major credit crunch? And I'm hoping it doesn't.

TARULLO: In back of that gentleman who asked - there was somebody else back there. Yeah.

QUESTIONER: Yeah, hi. Kathleen Hays with Bloomberg TV.

I just want to kind of ask about some of the latest numbers. Jobless claims are remaining around 300,000 in the latest week, and people saying that even if you account for distortions, the average in January is now below the average in December. Many of the surveys, like from the NFIB, suggesting that main-street, small businesses say things still look pretty good. So it's hard to -- how do you explain this difference?

Sometimes it feels like Wall Street has really panicked, and they can't sell their SIVs, but outside of that, things are still looking pretty good. So what's -- how do you explain that?

MEYER: I think it's remarkable how much a wave of pessimism has overcome the economy in a period of, sort of, six weeks, with one bad employment report, which is out of line with everything we're seeing in some other labor market indicators; some weakness in consumer spending, but we're talking about a, you know, a couple of months.

So I take the data now as very mixed, consistent with the slow-down, not at all consistent with what the precursors of recession would typically look like. And that economy is forming a base, low growth in this quarter, and ready to, sort of, strengthen unless another shoe, you know, drops and there's a --there's, you know, more developments that we don't know about now in terms of losses throughout the financial system.

TARULLO: Mickey.

LEVY: Kathleen, not only have initial unemployment claims come down, which suggests that the pace of layoffs has not increased, but I recently looked at both the average and duration of unemployment and it hasn't gone up, suggesting that people who are fired or voluntarily leave jobs, they either leave the labor force or they're not having duress in finding new jobs.

So I agree with you, but I still remain concerned. I think in the next three months you're going to see this business cautiousness lead to seasonally adjusted, perhaps some declines in employment.

BERNER: I think it's the early days, you know, in this downturn. And I still think it's going to be mild because there is resilience in parts of the economy, but there's enough weakness in other parts that is going to tip the balance towards a slight decline in growth.

TARULLO: Yes, ma'am -- right here. Right in the middle.

QUESTIONER: Karin Lissakers, Revenue Watch Institute.

Is the fiscal stimulus package that's being discussed in Washington now, irrelevant?

(Laughter.)

TARULLO: So we should -- we should -- we should start with that little tripditch that economists always save for if you're going to - for fiscal stimulus, you want it to be timely, so you get it out when it matters; you want it to be targeted so it goes to sources that will actually spend the money and stimulate; you want it to be temporary, so it doesn't build in a bunch of inflationary expectations or tell people they can delay using the money.

So, with that little background, --

BERNER: The risk is that it --

TARULLO: Part of the question?

BERNER: The risk is that it's going to be none of those three t's -- (Laughter.) You know, if you'd asked us all on this platform a month ago, what would be the size of any fiscal stimulus that Washington would likely adopt -- we were talking $70 billion, and maybe even that didn't seem likely. Now it looks like $150 could be the floor.

It is an election year, and with the administration and Congress now embracing the idea that we need some kind of fiscal stimulus -- not to mention some other policy changes, it looks like we're going to get something that -- no, it may not be timely because the first that it might affect the economy is sometime in second half of the year, reinforcing, I think, everybody's view that the second half of the year is going to look okay.

And if the risk is that it won't be temporary, or targeted, that it will be much broader based. It won't be irrelevant at all.

TARULLO: Anybody else want to --

MEYER: You know, if fiscal stimulus was needed, it was needed before, when the economy was really in the weak spot. The danger here is that fiscal stimulus, if you believe our forecast, the economy is strengthening in the second half of the year, it's, sort of, going to create more of a problem for The Fed, you know, having eased very aggressively, and then getting the fiscal stimulus, you know, on top of it.

Now fiscal stimulus of the type we're talking about -- temporary rebate kind of programs, tend to have very quick impacts and die out, okay, very much. So we're talking about something that could hit the economy with maximum effect maybe in the third quarter if it's -- if it's passed very, very quickly, with little spillover to the fourth quarter, and then be -- then be totally gone.

You know, you could call it risk management -- it's political risk management. That's what it is. (Laughter.)

TARULLO: Mickey?

LEVY: It's -- fiscal policy's not irrelevant at all. And it's going to provide, as Larry said, a modest boost. I question the composition and the timing of it, and whether it really addresses the problem. I would also say it's not irrelevant at all because we're talking about adding, you know, $150 billion or so to debt, and it gets to the issue, how's the best way to allocate national resources?

Stated differently, what public policies do we need now to make sure what's happening -- happened, doesn't occur again? And secondly, you know, the water under the dam, the damage that's already been -- occurred, what's the best public policy solution to help out -- boost things a little bit?

So I would just add, as a former policymaker, whenever you get with this fiscal stimulus issue there's a bit of a catch-22 because when -- in retrospect, when people say you would have needed a fiscal stimulus, at the actual moment most people are saying, gee, it's not clear that you need it because we don't know where the economy's going to go. And it's only in retrospect that people figure out this is when it would have been worthwhile. But by the time you get to the point where there's the political will to pass it, you get the circumstance where people are saying maybe it's -- maybe it's, sort of, too late.

And both of those thing may be correct but in the continuing mutual suspicions between Wall Street and Washington, that's one I've seen play out several times actually, that nobody is quite sure how to -- how to integrate those two sets of views.

TARULLO: But the counter cyclical monetary and fiscal policies in 2001 worked very well.

LEVY: Yeah, except that the fiscal policy that was enacted in 2001 was not offered as a counter-cyclical measure. It was only re-characterized as that in retrospect.

MEYER: Historically, our best examples of countercyclical fiscal policy are when there have been major changes in long-term fiscal policy that happened accidentally, to occur at a time when the economy was headed into a recession -- (laughter) -- and, you know, I called Reagan an -- you know, an accidental Keynesian. I mean, you know, he didn't -- he didn't mean to do it, okay. But it happened and --

(Laughter.)

TARULLO: Larry, come on. (Laughter.)

MEYER: -- and I think the same thing -- the same thing is true with the first -- (inaudible). So accidents are the best way of getting good fiscal policy.

(Laughter.)

TARULLO: On that note -- just validating every bit of learning.

So we're going to have to bring this to a close. And we're going to -- wait now, we'll do our spring edition, and if things settle down and are looking pretty good, we'll probably be back to the breakfast table sitting in here. And if things get worse, we'll do it at Carnegie Hall -- (laughter) -- okay. So we'll see you then.

(Applause.)

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