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Currency Wars

Presider: Jeffrey R. Shafer, Vice Chairman, Global Banking, Citigroup Global Markets, Inc.
Speakers: Kenneth S. Rogoff, Thomas D. Cabot Professor Of Public Policy, Harvard University, and Raghuram G. Rajan, Eric J. Gleacher Distinguished Service Professor Of Finance, University Of Chicago Booth School Of Business
February 10, 2011
Council on Foreign Relations



JEFFREY SHAFER:  I'm Jeff Shafer and it's my privilege today to welcome you to this Council on Foreign Relations session on currency wars.  This meeting is a part of the McKinsey Executive Roundtable Series in International Economics.  The next McKinsey series meeting will be on Wednesday, March 9th.  It's going to be on how should the U.S. change -- how should the U.S. address its China trade imbalance?

But today we're going to talk about currency wars.  And to do that I don't think we could have two better panelists.  They are Professor Ken Rogoff from Harvard; and Professor Raghuram Rajan from the University of Chicago.  They've both been chief economists at the IMF.  They both received their Ph.Ds from MIT --

KENNETH S. ROGOFF:  We're twin brothers.  (Laughter.)

SHAFER:  Which may suggest a bit a lack of diversity, but you're going to get, I think, an excellent perspective -- what we may miss in diversity in this session.

I'm not going to say much more about the two of them, because you have their bios.  But I did just want to note that Ken is the author of I think one of the most exciting books to come out on practical financial economics in a long time, along with his co-author Carmen Reinhart.  It's "This Time is Different".  If you haven't started to wade through all of its pages, I strongly encourage you to.

And I couldn't help but note that Raghu first really came to my attention when I realized that at Jackson Hole in 2005, he told us all what was going to happen when the world coming apart.  He is a person who I think saw more clearly the course we were on than almost anybody else.

One final note I would make is that Ken and a number of the rest of us just learned this morning that he's been awarded the Deutsche Bank Prize in Financial Economics.  You're, I think, the fourth winner of this prize.  It's given every two years and I think it is a much deserved honor.

With that, let me remind you to turn off your cell phone -- don't just put it on vibrate, because it'll interfere with the sound system.  And I want to note that this meeting will be on-the-record.  Some meetings are and some aren't.

Currency wars have been for a bit more than six months very much the topic of discussion in international economics and finance.  It emerged as we came out of the crisis and we had economies like the U.S. growing very slowly and economies like China and India and Brazil growing very rapidly; that this disparity drove a lot of money from the old slower moving economies to the fast moving ones, created pressures in exchange markets, reinforced my -- the easy monetary policy, adopted especially by the Fed to try to get a little more energy in the U.S. economy.

And these pressures that appeared in exchange markets were disturbing to policymakers on all sides.  It was Brazil's finance minister, Guido Mantega, who I think was the first to say that a currency war had broken out last September.  That was somebody who was seeing it from being one of the parties having his currency being forced up.

The issues of what to do about currencies took center stage at the November G-20 and they have since.  For some of us, these are old issues.  I tend to look back at the beginning of my career in the 1970s and say they look a lot like what was being debated then.  Others even older than me will say, well, this is the 1930s that we're seeing once again.

So we do have these historical contexts.  And I'm going to ask Ken and Raghu to each talk for five to seven minutes putting the issue in the context they think we ought to think about it.  Then I'll ask some questions for a few minutes and then give you all an opportunity to join in.

Why don't I start with you, Raghu.

RAGHURAM G. RAJAN:  Sure.  So you have this piece that I wrote for Foreign Affairs which is coming out next month, so let me just tell you broadly my perspective.

First, I think there are echoes of the 30s and the '60s and '70s here, but its not same play being repeated.  The '30s of course there was lots of concern about the beggar-thy-neighbor strategies followed by countries, countries going off the gold standard, depreciating their exchange rate, an attempt to grab whatever trade there was and in the process also erecting trade barriers so they themselves were protected.  Of course collectively this was a terrible strategy and took us down.

How much it took us down, that's a subject of debate.  Still, how much the Smoot-Hawley tariffs, for example, were responsible for the Great Depression we still debate that but nevertheless, it was something that was collectively bad.  We sort of -- with Mr. Guido Mantega talking about currency wars -- are arguing that something like that is repeating, well it's not.  First we don't have the kind of tariff protection being raised. Second, even as far currency themselves go, we didn't have a gold standard before this.

We have something different though.  And the concern about Fed policy and the concerns it prompted in the rest of the world is that in some sense, the ability of monetary policy at this point to increase activity in the United States is relatively limited and the view is that further monetary easing -- whether directly or indirectly through quantitative of easing -- are essentially a way of depreciating the currency, that is the dollar; allowing the U.S. to grab a little more of international trade therefore is tantamount to essentially directly depreciating our currency.

So this is not a traditional monetary policy which stands to have a positive effect in your own country, therefore increases demand, and has spillover effects on the rest of the world -- typically the currency is all supposed to depreciate a little -- but because your adding to demand, it's not seen as trying to rob demand from the rest of the world.  This time, because of monetary policy domestically is relatively -- you know, doesn't have much power, the view is this is the old traditional sort of currency play.  It's an attempt by the U.S. to grab whatever demand there is in an attempt to get itself back up to speed.

Now, I think if you look at what has happened since Ben Bernanke's August speech, the dollar has moved many ways: up, down, sideways and -- you know, I think on net it's about a depreciation of about 5 percent.  I would say that, you know, the attempt to talk down the dollar wasn't the primary aim of the Fed; nevertheless, it's perceived as problematic by the rest of the world.

Now, in the rest of the world there are two sets of people who are complaining.  One are the traditional exporters -- the guys who've followed export-led strategies, often by suppressing consumption in their own countries and emphasizing manufacturing.  China is Exhibit A here.  And these countries obviously want to see a recovery in their exports as part of their recovery strategy form the great recession and they see the U.S. actions as being unhelpful.  And also, by complaining about the U.S. it takes the spotlight a little bit off their own actions.  So that's one set.

But then there's another set who are not traditionally exporters, but who do pay a lot of attention to exchange rate and this is much of the rest of the world.  And they see a rapid dollar depreciation as politically problematic for their own growth.  These are countries that effectively become exchange rate targeters.  They're typically inflation targeters.  They typically become exchange-rate targets when they see rapid depreciation in the countries.  And you could argue the euro area is in this camp.

Now, what does all this mean?  This means -- I think -- the biggest problem in some sense is that the Feds monetary policy actions are essentially transmitted through the rest of the world when the rest of the world doesn't allow its exchange rate to move and protect their own monetary policy and keep that as a separate policy of its own.  So effectively everybody joins in the Fed -- in the monetary policy that the Fed is adopting.

What I mean by this is is the Fed is extremely accommodative right now and that tends to push the dollar down, other countries follow the Fed down or keep it -- their monetary policy extremely accommodative, because they don't want the exchange rates to appreciate.  That to my mind is the biggest problem that we're seeing emerging from this policy action.  And the consequences of that have, of course, we're seeing right now today across the emerging markets:  higher and higher rates of inflation -- commodity inflation, food inflation and energy inflation.  All the central banks say these -- this stuff is outside our control.  Core inflation is okay, but this is headline inflation.  But of course collectively, they're all pushing up the price of these -- these commodities and so on.  And in the longer run, this is going to feed into core inflation and be a problem.

So that said, how do we solve this inherent tension that is coming about from -- and this goes back to the real fundamental problem which is global imbalances?  We had that problem before the crisis; we are resurrecting that problem right now.  And that problem has to do with the different growth strategies that countries have adopted.  The U.S. is typically a growth strategy which is consumer focused, which implies a tremendous amount of stimulus -- we talked about that.  And that tends to, therefore, make the U.S. a large deficit country.

Other countries are producer focused.  China has aided its producers in many ways -- low input costs in terms of credit, in terms of energy, in terms of land and at the expense of its consumer.  So we have this dance between the exporters and the importer, the United States.  And the real concern there is how long can that dance go on.

The dance stopped during the Great Recession because the U.S. consumer didn't want to consume that much any more, but now every action of the government is on resuscitating that consumer and making that consumer consume once again.  And if you look at the last quarter's numbers, consumption growth in the United States was 4.4 percent.

So in a sense, we are going back to status-quo ante before the crisis and this is the real problem.  We need to move away from this global imbalance where we have one set of countries which are designated spenders and another set of countries which are designated producers.  In the long run, it's unsustainable because of the great liabilities that are built up by the spenders.

Let me stop here.

SHAFER:  Okay.


ROGOFF:  That was a terrific introduction by Raghu and covered, I think, really a lot of the main points.  So let me just emphasize a few.

Let me start by saying -- I mean, I think the genesis of this term, "currency wars", really came up when we had an overlay of the long-term global imbalances problem.  And the cyclical problem of the great recession, or Carmen and I call the great contraction, where the whole world fell and everyone wanted to export.  And so there's sort of two different elements going on.

There -- I think the global imbalance has much deeper roots than simply the exchange rate.  And Raghu has a wonderful book about this, which really takes it as a political economy problem because that's what it is.  It's not a macroeconomic problem; it's as Raghu was saying, what does China want -- trying to do, what is the United States trying to do?  And then there's the short-term cyclical problem -- so we can come back to that.

I want to make a comment about the whole idea that countries are manipulating their exchange rates.  Because let me tell you that is not that easy to do, unless you really fix your exchange rates.  It's a little bit like teaching your cat tricks.  And they may be better at it in Asia -- teaching their cat tricks -- and maybe there's a book parallel to "Tiger Mom" coming about training your cat.  I don't know, but it's very hard to control your exchange rate.  We academics who study it -- and I started working on it when Jeff, ran the exchange rate forecasting group at the Federal Reserve -- and I worked there and I was assigned to do exchange rate forecasting.  And I came to the conclusion, you know, Jeff, it's not just that you can't forecast these things.  I have no idea why it went up or down.

If I look at it systematically, it's very hard to say.  And that I think -- you know, that's surprisingly held up for 30 years -- that that's still true.  It is true.  I was very surprised in the '90s how successfully Japan controlled its exchange rate within a given band, and clearly a number of other Asian countries have done this at times.  I'm not talking about China where the cat is shackled basically and that's why it's kept in place.  But a number of emerging markets through, you know, very nontransparent, subtle, indirect methods have been able to stabilize their exchange rates more than one might imagine.  I frankly think I don't understand it completely.  Come back to that.

I think certainly to me this whole currency wars talk -- and what my coauthor, Carmen Reinhart, has called "fear of floating" -- does show something of an abandonment of this pretense of inflation targeting that a lot of central banks around the world have.  You go to the Basel meetings and -- with the other central bankers and you're from, you know, Peru or wherever.  You just have to say you're inflation targeting.  It's like, you know, you're going to get kicked out if you don't say you're inflation targeting.  But the fact is is none of them ever were or they have a thousand different interpretations and in these extreme events, that's something that becomes very, very clear.

So what are the policy implications going forward?  Well, I think most of our economics, whether it's your -- I refer to the academic literature -- you know, suggests that the first order thing is to keep your own house in order, to manage your inflation rate, to manage your output and try to stabilize the financial system and your economy.  And the exchange rate can become quite important than that, although it's really overstated by most countries.  Most financial leaders I talk to before and after floating their exchange rate before, they just think it's going to be the end of the world.  And a year later after they do it. They can't remember why they were worrying about it, because the fact is, its impact is not as great as they think.  But anyway, a lot of them do stabilize it.

And I think we've moved to a point where the merged markets are growing very fast -- (chuckles) -- and they just have to have a different monetary policy.  And at some point, if you're trying to hold your exchange rate fixed and you keep raising your interest rate, it's kind of hard.  And a lot of them are in that bind and it's -- they can whine about United States policy, but they ought to be happy that they're doing well and having trouble that they're -- they're fixing their exchange rates.

I think from the point of view of the United States, the big issue is to try to avoid getting into a trade war.  And that may sound very anodyne -- especially coming from the council here where, you know, people talk about good policy and it's preaching to the converted and of course we don't have trade wars.  Well, you know, let me tell you, if unemployment's really high in another year and a half and the economy's growing, but you know, unemployment's still high -- the jobs aren't picking up very well, which is a very plausible trajectory based on my work with Carmen Reinhart -- there are not too many political levers to pull.  And you start doing things that you wouldn't imagine that you would do.  And I think it's a greater risk than at any time in the last few decades that we actually slip into something.

I don't think any of the leaders in Washington or anywhere want it, but there are a lot of angry voters out there.  Inequality is just exploded.  It had briefly gotten less during the recession, but it's back to where it was.  It's worse.  And we're not talking about the United States; it's the whole world.  And there's tremendous political pressures, which I don't think we really understand.  And they're one of those things.  They seem under control and nobody seems to worry about it, but I suspect we will see it very much over the next five-to-10 years.  And trade wars is certainly a possible way that populous policies could express themselves.

And that's the biggest concern at the end of the day about the currency wars.  The rest of it is just skirmishes.  That's the real concern.

SHAFER:  I think that's a very good start.  And your last point Ken, I think is critically important.  I mean, we worry a little bit about a currency war, not because what would happen in currencies itself would be that damaging, but it could spread out into wider fields.  It would be much more damaging and trade is the center of that.

Both of you in your comments stressed that we're not talking about currency wars, but it's not clear that countries really can manage their currencies or do.  It's really about other policies.  It's about monetary policy; it's about fiscal policy; it's about subsidies and things like that.

And that raises the question:  It's easy and natural to see how you can go into the IMF for a G-20 meeting and talk about an international variable like a country's exchange rate.  Can we have meaningful international discussions of these problems when it's multiple policies in each country that come together?  I'd like to see what each of you think of that.

RAJAN:  Well, I'll take a first stab at that.

I think no.  I think this is the problem of international debate that they're really building up expectations time after time that they're going to bring forward a grand agreement.  And I have to confess that I worked for a few years on trying to bring about that grand agreement.  Then I realized that this was a mirage, that there was no way you could get the U.S. president to walk into a room and commit anything on fiscal policy in the U.S. for any time.  Even -- (chuckles) -- you know, for the next budget.

So given that -- and given that the Chinese president has the same sort of problem committing on policy towards their state-owned institutions -- you're not going to get the grand agreement.  It's not going to happen.  You're going to raise hopes of some grand agreement of some monitoring.  But what you're going to get is some tepid statement about the IMF being charged with pure evaluation or running the pure evaluation, which basically means, we look at what you did and say, you're making progress.  I mean, you can't say anything else.  And so that's -- I think, problematic.  I think that takes away from what these international organizations can really be doing.

And I think that -- two things:  One, of course, is working on the nitty-gritty of technical agreements on cross-border capital flows, cross-border banking resolution -- those kinds of things.  They're doing that, but I think that should get far more emphasis, because that's an important source of progress.  One of the biggest problems in these imbalances is really how do you manage the cross-border flows of capital and I think making progress there is very important.

The second thing they can do, I think, is take the country policies and find ways to enhance support for the more medium-term policies within those countries.  Not at the international fora, but within countries.  Now this is something they can't do right now.  They can't speak that loudly within countries.  This is something we can work for where international organizations can push what is the right global agenda a little more with the influential within countries.

But apart from that, I think this notion that we get a grand agreement which covers domestic policies in different countries, I don't think any big country's going to sign up to that.

ROGOFF:  Well, to first pick up on the point you said about there's so many things you can do under the table and it's so nontransparent.  It's very, very hard to strike an agreement that anyone actually keeps to.  There are just too many ways to cheat.

Look at OPEC.  That's pretty simple.  How much oil are you pumping out and they can't really keep control of that.  And then you're trying to do something at so many dimensions.  It's very, very hard.

I do think there's one other role the IMF can play and it's an important one and it's been frustrated at times, which is really to lobby for good policies everywhere.  And it's complicated, but it's not that complicated.  You can't run 10 percent budget deficits forever.  You shouldn't have one-sided exchange rate intervention forever.  And of course, it's very, very hard in dealing with the largest countries -- particularly China and the United States.  We may find that in Europe also.

But it really needs that power.  And I would have thought that after what we just went through that somehow the rest of the world would push harder to have some surveillance on the United States, because it just created this problem that spilled out over the whole world.  Although one senses very little appetite.

And I think -- and I'm curious of your view, Raghu, as a native of India -- I think the emerging markets have really, really been free riding.  That they're rising in the world economy; they're becoming much more powerful drivers of growth, but they really haven't wanted to take responsibility for the international institutions.  They wanted to complain about them, vilify them, blame them.  But I think we -- you know, reaching the point they need to lead them and need to play a role.

RAJAN:  No, I agree with you there.  I also agree with the point that the international institutions can make the case.  But I think that case has to be made to the democracies themselves.  Because I think, you know, no large country is going to accept the Fund telling them what to do.  And this notion that somehow we're going to give those guys some authority -- I mean, we've seen -- again, another example is the euro area.  As soon as the growth and stability pact had any bite on France and Germany, it was cracked.

And so in that sense, I think it's a pipe dream to imagine the international organization will have power, but they can have influence and I think they should use that.

But on these emerging markets:  I think you're absolutely right that they've been asking for influence, but they haven't been willing to put ideas, agendas on the table.  What is it that we want -- where is it that we want the world to go?  I think in part, they're scared of engaging, because that implies that they're giving legitimacy to the international organization, which they still don't feel they control.

ROGOFF:  You were there during the negotiations for China's larger share.  And my understanding is they actually resisted taking as large a share as the IMF wanted to give them.

RAJAN:  Right.  Well, I think this is precisely because they're still not confident that they can set the agenda.  I don't even think they know what agenda they want to set, which they can get people to sign onto.  And therefore, they're pretty happy with a situation where the international organizations are neuter, until such time as they realize, you know, what they want them to do.

SHAFER:  Well, that -- it comes to a question that I wanted to ask, but I wanted to make a comment and agree with what you've been saying, Raghu, about the importance of the organizations being seen more publicly.

In the 1980s I was at the OECD and we had the conviction that the U.S. had to do something to reduce its budget deficits.  And I realized it was pointless to talk to the delegations that came from the Council of Economic Advisers or the Treasury or somebody within the administration about this.  Until the American public decided this was a problem and they wanted something done about it, there was -- nothing was going to happen.

And in fact, it does seem to me that there needs to be more advocacy of good economic policy, a lot of which is found in the staffs of the IMF and other international organizations.  And that there needs to be more freedom to speak out to the public and to get the message out about what's at risk in policy.

ROGOFF:  So in addition to the gold contributions, countries should be required to provide free time on TV for the IMF.

SHAFER:  Free time on TV.  Right.  (Laughter.)  That's what it needs to be.  They're doing "Squawk Box" more often, I think.

But let me come back to another question in kind of the role of the emerging markets in the organizations is the question of how much their interests come together.  And to bring us back to the exchange rate, the exchange rate wars issue is often seen as emerging markets against the U.S. or against the old industrial markets.  But when I look at it, I see a lot of it is between the emerging markets.  And it was Mantego of Brazil who first coined it.  And it wasn't long after that that I heard from a multinational company that had plans to build a $5 billion factory in Brazil that had been scrapped because of the exchange rate.  And I said, what exchange rate?  And they gave the answer I expected:  The renminbi exchange rate.

To what extent should we see this currency war as really a tension within the emerging market world?

ROGOFF:  I want to pick up on the Brazil -- I mean, their -- Tim Geithner went there -- was it last week -- and tried to get them to help lobby China, because it's clear that big movements in the real, also in the Korean currency.  Not just against the renminbi -- against the yen.

So in Brazil, companies like Hyundai and Samsung -- Korean companies -- are just, you know, walking over the Japanese competition, because of the big -- which may be related to your case, but you don't have to say, you know, in what's going on there.  And of course, Chinese imports are exploding, but there are currencies that are resisting any movement and there are ones that are moving around.

RAJAN:  I mean on this I think there is an element of solidarity amongst the emerging markets.  They don't want to protest against each other.  But certainly, there's growing concern that the fixed renminbi is hurting each one of them.

And I think, you know, you heard the Indian governor of the central bank -- as well as the present governor a few months back -- complain about the renminbi.  Those protests will get louder if the renminbi doesn't appreciate faster.

SHAFER:  Well, let's turn to the audience now and take your questions.  Would you please raise your hand.  When I recognize you, wait for a microphone to come, speak directly into it and state your name, affiliation and then give one question -- not a speech.

Right here in the middle.  Why don't we start.

QUESTIONER:  Nisu Agwa (ph) of Pace University.

As you gentlemen know, it's the real exchange rate that matters and not the nominal one.  In that light, the Chinese currency has been appreciating in real terms.  So would you please give us an explanation on the relative merits and demerits of a fixed exchange rate adjustment mechanism via price level versus a floating exchange rate adjustment mechanism?

SHAFER:  Go ahead.

ROGOFF:  (Chuckles.)  You really want me to?  You know, clearly the imbalances are at the real exchange rate -- at the inflation-adjusted exchange rate.

The problem is is that prices don't move very fast and sometimes there are very big shocks -- particularly to financial systems.  So over long periods, small differences in inflation can make a big difference.  I mean, for example, in the case of the yen, it's actually had very low inflation for a long time.  And there's been more adjustment in the real value of the yen than meets the eye if you look at it.

But you know, if you don't have very heavy capital controls on, if you don't have a very controlled system, it's limited what you can do with doing it through appreciation.  Unless, of course, you have a very integrated policy, et cetera, in all the problems Europe is facing.

SHAFER:  Let's go over here.

QUESTIONER:  Thank you.  Barbara Samuels, Global Clearing House for Development Finance.

I wanted to push a little bit on the reference to exploding inequality worldwide and the recognition that if we don't have policy prescriptions for that, we really are threatened across the board.

Where would you go in terms of not just growth, but the quality of growth and distribution of benefits?  If you had that advocacy role and you know, in terms of IMF, World Bank -- you know, there's a relationship here -- what would you tell us and the world leaders they need to do?  Thank you.

RAJAN:  I can take a stab at that.  I mean, I think that -- as Ken said, we need to understand the political economy of why countries are adopting the roles that they're adopting.  And I think, you know, I personally believe that one of the biggest sources of the U.S. focus on consumption has partly been rising income inequality.

If you look at income, inequality exploded over the last -- exploded is a strong term -- increased over the last 20-25 years, but you see consumption inequality hasn't increased nearly as much.  And what's made the difference?  Credit.

So in some sense, the big sort of push for credit or the tolerance for credit has been it's kept sort of one kind of inequality at least contained -- consumption inequality.

And of course, the other aspect of U.S. policy which is different from the rest of the world is the tremendous propensity of the U.S. to stimulate the economy when in downturns.  I mean, this is why the U.S. -- combined with a secular push to consumption, there's also the cyclical push to consumption.  The U.S. has become the consumer of first and last resort, right?

And you have to ask why it has taken this bold position.  And I argue -- I mean, look at what's going on right now with 9.5 percent unemployment.  The kind of political tension in the United States far outweighs the tension in Spain with 20 percent unemployment.  And I suspect some of this has to do with the fact that the safety net is thin; you know, extending the safety net becomes a big political issue.  And of course, we're trying to find other ways of getting those jobs back.  And the Fed, you know, people have been telling me that the Fed wasn't so focus on its dual mandate before.  Now it keeps emphasizing the dual mandate as the reason for its policies.  If inflation -- core inflation is not picking up, we have to push on the accelerator, because the other part of our mandate is maximum employment.

So I think we -- these aspects of U.S. -- of the United States:  the fact that too many people don't have the skills for the kind of jobs that are being produced, the kind of story that's being told in "Waiting for Superman"; and also the fact that the safety net is relatively thin.  These are things that can be fixable in the longer run.  It's not something that can be -- can be done easily, but it's something that can be changed.

I think in China similar issues pop up, but in a sense, they're also -- the whole issue of getting the unskilled workers into the labor force.  But now I think it's going the right direction, because what you have in China is inequality for the coastal areas, the urban areas vis-a-vis the rural, interior areas.  And the way they have to try to bring up those interior rural areas is really to spread growth in there, which means more domestic-oriented policy rather than external policy.  That would be a force pushing in the right direction.

As with the United States, I think it would be less of consumer if it focused on changing these things.

ROGOFF:  I would just -- I agree with all that, but I would just add to that.

I mean, I worry about the tensions -- maybe excessively.  We're all shaped by our backgrounds.  I grew up in Rochester, New York.  I was a teenager in the late '60s and early '70s.  And you know, there was the Vietnam, the riots.  I went into an inner city high school that was -- we had, you know, incredibly violent riots at times.  And you say, oh, that's never going to happen again, which reminds me of my book with Carmen, "This Time is Different".

I mean, there are these undertones of social problems that you can let fester, you can try to temporize with credit or whatever.  But I don't think it's a problem that can be ignored.  And I suspect it will spill out into the political system in a big way one way or the other.

RAJAN:  Just one last note on that.  Just in a sense, this crisis I think is seen as a crisis brought about by the elite who figure out a way to make sure that at the end of it, none of the elite suffered.

So I think the political sort of views across the country -- vis-a-vis the elite -- and this is where policies like free trade will come under attack, because that's often a policy that is associated with the elite.  And that's why I think Ken's point that this could spillover into broader policymaking in the medium term into protectionism and so on shouldn't be dismissed lightly, because it all sort of adds up.

SHAFER:  We have another question.  Let's go back to the back of the center table here.

QUESTIONER:  Nick Bratt with Lazard.

Given the deep structural differences between the European countries, do you think the euro will survive?

RAJAN:  Well, I'll take a stab at that.  Ken's -- I mean, the euro I think will survive.  I think the question is whether every country that's in the euro today will be part of the euro.  That's a more difficult question.

But I think undoubtedly the sense that this is part of the larger European experiment.  And the kind of -- I think for the euro to break down, the European leaders will have to admit that the experiment is a failure.  I don't think they're ready to admit that.

So I think the euro will hold together.  Certainly the core -- France, Germany, maybe Netherlands and the north will stay together.  Maybe if at the end of this some of the periphery have to restructure, have to fall and don't see growth, some of them may be tempted to withdraw.  But I think the euro as a whole will be there.

SHAFER:  Let's -- you had your hand up, right?

QUESTIONER:  Another euro question.

SHAFER:  Oh, well.  I'll move people away from euro questions after this one.

QUESTIONER:  Okay.  Steve Tananbaum, GoldenTree Asset Management.

The stronger countries have been bailing out the weaker countries.  How long can that last?  Do you think it's a good policy and how do you think long term they're going to deal with some of the structural issues that are there?

ROGOFF:  I don't want to take that question up in detail here, but I want to hit on one point which is, at the end of the day, these are democracies.  You have to have support for what you're doing.  And I think it's fair to say the elite support the policies, but it's not at all clear that the voters support the policies.  It's not at all clear the leaders who are there now will be there in three years.  So it's hard to call the outcome of these things.

SHAFER:  Other questions?  Let's go back to this -- John Macon.

QUESTIONER:  Jeff, John Makin, Caxton and American Enterprise Institute.

Going back to the main thrust here:  currency wars.  I'm just -- and China.  I'm just struck by China seems to be acting as if there's a tremendous excess capacity in their traded goods sector.  They're so reluctant to let the currency adjust.

And if you think back to the crisis, here in the U.S. we had a crisis that destroyed wealth and collapsed demand, whereas the Chinese response was to increase productive capacity.  So is one of the underlying problems here evidence of a lot of excess capacity in the traded goods sector -- especially in Asia?

RAJAN:  I mean, a lot of what the Chinese did -- and I don't know the precise break up -- was not so much sort of private-sector led expansion of factories or states.  It was more, you know, infrastructure -- roads, railways and so on -- especially into the interior, which is relatively under -- has less infrastructure than the coastal areas.

But I think the Chinese understand that they have to move away from this investment-led, traded-goods-led growth.  And I think the problem is they have vested interests in the same way as the U.S. has vested interests.  We like things the way they are.  In fact, some of those vested interests are U.S. companies exporting back to the United States.

So I think that movement, which is enshrined in their next five-year plan, will take time, will be hard and will hit against interests.  I mean, the state-owned companies don't like higher taxes; they don't like big dividends.  All those things are necessary to move incomes.

I mean, one of the things that has to strike you when you look at Chinese data for what it's worth -- of course, there are big questions that are always raised -- is the low share of household income in GDP.  And obviously, consumption is low if that income share is low.  And they are aware of that.  They want to build up the household income share.  And that's why -- part of the reason why they also are more tolerant to these labor disputes, which are going to increase household wages and so on.

But I think the bigger picture story is they have to move, because I think they realize that the political tensions that will build up if they continue to rely on external demand -- indeed to the extent they have -- will be problematic, will make them too dependent.  And they themselves want to move away from that.

ROGOFF:  Raghu, if I could just ask:  Was that a throw away line when you said it's the U.S. companies that are the vested interests in China?

RAJAN:  No, no, no.

ROGOFF:  Or do you really think that's --

RAJAN:  No, no, no.  I don't think that's the biggest by any means.  I think that one of the reasons the -- you know, the attempts by Congress again and again to do something hasn't gone through is because there is also lobbying by U.S. companies: don't do anything dramatic.  I think in part because they see that, you know, at least for awhile the interests were aligned.

I think more recently, they've been more open to threats from the United States, partly because they see that the Chinese have been encroaching on the turf in China itself.  So the U.S.-China Chamber of Commerce is becoming more vocal about the kinds of actions by the Chinese government restricting the terrain in some sense of U.S. companies there.

But I think that, you know, U.S. companies themselves don't want a break down in relations for obvious reasons.

SHAFER:  I think it is if you look at the next five-year plan, you look at what's actually being done, it is clear that China is moving in the direction that U.S. Treasury would have them move.  The feeling is not fast enough.  And this is kind of a normal situation in an international difference in economic policy.

Do the discussions that take place -- used to take place in the G-7, are now supposed to take place in the G-20 or in the other IMF activities have an influence in getting governments to move faster rather than slower or to show more resistance to domestic constituencies that are against change?  Does it make a difference?

ROGOFF:  I think Japan stopped intervening in the foreign exchange market, you know, really after Dubai and the IMF meetings in 2003 -- very much out of the G-7 meetings.  But I mean, clearly, in normal times they do nothing, but occasionally something does happen.

SHAFER:  Let's go to the second table here.

QUESTIONER:  Sean Fieler with Equinox Partners.

There seems to be near unanimity within trade economists that free movement of goods across borders is unambiguously good, but no unanimity within the economics profession that the free movement of capital across borders is good.  And so we're giving countries that are imposing capital controls, so to speak, a free pass on that.

Should we be doing that or are there instances where we can, fortunately, say that that's -- that we shouldn't impose capital controls?

SHAFER:  Here's clearly another weapon in the currency war.

RAJAN:  Well, Ken's the expert on --

ROGOFF:  Oh, yeah?  (Chuckles.)

RAJAN:  Why don't you just go first -- I will offer you.  (Laughter.)  I'm happy to comment.

ROGOFF:  No.  I mean, it's certainly true that identifying the benefits of free trade is -- it's actually less straightforward than you think to try to get a big number.  There was a huge academic debate about that that continues to brew, believe it or not, but with the free movement of capital it's even less clear how big the benefits are.  Not saying we don't think they're big, but we can't prove they're big very easily.

So there's some more eclectic -- it's very tied in with all the other controls.  I mean, you could say China has controls on capital inflows and outflows.  There are controls on everything and it's a little bit hard to separate out one thing from the other.  There are very few countries who have this unfettered, free domestic, international financial system and just put controls on capital inflows and outflows.  It's much more about financial growth.

I must say, you know, if you look at the history of financial crises, bad financial liberalizations are a leading cause.  So it certainly makes sense to go cautiously and, you know, try to do it right as you financially liberalize.

I don't think there's so much of countries backsliding, even though there's talk about it, because frankly, as your income grows it gets harder and harder to put these things in and more and more expensive.  A lot of countries get stuck at the middle-income level.  They aren't able to grow easily beyond it.  And one of the things that they fail to conquer is trying to find a way to have a better financial system.

RAJAN:  Just two cents on that:  I think the problem also with capital is the way it comes in.  And to the extent that as a country's policies deteriorate, capital becomes shorter and shorter term.  It sort of becomes eventually the trigger point for that country's crisis.

And the issue is, you know, is that capital in a sense obtaining implicit insurance from the country itself -- from the country's taxpayer -- and not paying enough attention to the country's policies?  In other words, what you have is essential demand deposits going into the country and being able to move away.  And often, if it goes into the banking system, in order to support the banking system the country will bail out the banks and in the process, bail out the foreign creditors who are running.  And is that a good disciplinary device, because in a sense, those guys don't really care what they're financing?

Those are the kinds of questions that foreign capital raises, because if it came in without any guarantees, without any -- with a full weigh of the private sector making fair choices, you wouldn't worry that much.  If it comes in with these implicit guarantees either from the government or the IMF, et cetera, it's not making good choices and may actually have -- create some harm.

SHAFER:  Jacob Frenkel.

QUESTIONER:  Jacob Frenkel, JPMorgan.

I'd like to start with the terminology.  Once we define the problem as a war, we are in a state of mind of winners and losers, of a zero-sum game.  We are in a state of mind that a war has rules of itself.  In a war like in a world and an eye for an eye.  And you know, that's a world that produces a lot of blind people.

It's interesting that some decades earlier when I had the very same job that Raghu and Ken had at the IMF, the language was very different.  The effort was to find mechanisms for policy coordination and then people realized that that's not going to work, then policy cooperation and then policy harmonization and then information sharing -- (laughter) -- et cetera, but war was not mentioned in these contexts.

So why did we come to the situation of the war?  We came because of the fact that somehow, we have a world in which there was the great contraction.  Every country wanted to stimulate demand for its own products.  And here comes the key point:  Countries found their ammunition gone.  You cannot do monetary policy, because interest rates are already at zero; you cannot do fiscal policy, because budget and public debt is already huge.  So the only way is to rely -- to stimulate domestic demand by hoping that somebody from another country will do it for you.  But if everyone tries to do it we know it's not going to work, hence the so-called currency war.

So now looking forwards, the question is therefore not how to -- how to deal with the war, but rather how to prevent us being in a situation where you end up being with no ammunition whatsoever, with budget deficits that do not allow you flexibility, with external imbalances that do not create this extraordinary issue.  So it's coming back to the basic issues that both of you started, that the background was an extraordinary background of neglect, of external imbalances, fiscal positions and maybe too long too low interest rates that created havoc.  And against this background, of course, war was the only lingo that was there.

SHAFER:  For you, Jacob, I think I did the right thing to waive the injunction against making speeches.  It's very valuable, but I'd like to see what your comments are.

RAJAN:  I agree.  (Laughter.)

ROGOFF:  And I -- if you hadn't said, I was certainly going to recognize that Jacob was another former chief economist at the IMF and often refers to himself as my grandfather, because he had one person in between us -- although there are other reasons perhaps too.  (Laughter.)

QUESTIONER:  (Off mic.)

ROGOFF:  Intellectual.  (Laughter.)  I built on a lot of Jacob's work -- let me not get carried off in the wrong direction on that inference.  (Laughter.)

But you know, I do find -- I thoroughly agree with your point about countries need to start thinking about rebalancing their fiscal policy.  This idea that's promoted by some people that, you know, the only thing better than a big deficit is a bigger deficit.  And that is a very popular view still in the world.

There are risks, there are benefits, there are costs.  And again, speaking as an academic, you will sometimes read in the pages -- certainly of the FT and The New York Times and other places -- that we all now know Keynes was right.  Everything Keynes said was right.  Keynes, whatever.

The fact is that there's a literature -- there's a big economic literature on budget deficits.  You have a whole book on this, Jacob.  And as you know, it's incredibly unclear what the effects are.  Empirically it's very, very ambiguous.  And so it's certainly true that we're in a recession and so you don't want to tighten too fast, but it's not true that just turning on the spigot is just going magically make things fantastic and we all know that.

I think we academics don't -- we don't know one way or the other.  I want to be clear.  It's very, very ambiguous, the evidence.

SHAFER:  I think the power of the normal instruments is very important here and you said it starting out.

I'd always thought that the whole 1930s discussion about competitive devaluation was silly.  If you ran your exchange rate through monetary policy, you needed expansionary monetary policy, that was the right thing to do.  And we are finding in the U.S. that monetary policy doesn't have the domestic effects that we always assumed it would.  And I think that is an important reason why the debate is moving into the external sector.

We've got time for, I think, one more question.  And let me ask David Malpass back here.

QUESTIONER:  Hi.  David Malpass with Encima Global.

How do we deal -- how should we deal with the pro-cyclicality of exchange rates?  So we have a world where there are small countries and a huge amount of floating capital.  So can it push an exchange rate too far?  What should a country do about that -- either on the weak side or the strong side?  To some extent, the exchange rate begins to take over and dominate the economic fundamentals of the country.

RAJAN:  Well, I think the effects of capital flows changing the policies regime in a country is something we need to understand much better.  I mean, why these normal inflation targeters suddenly turn into trying to target exchange rate when the capital comes in in such a big way.  And you can understand what their concerns are.

Now, obviously, there are other tools that in normal times they have.  If the money is flowing in in a big way and there's a lot of credit expansion, they could also try and reduce government demand at that time to offset the tremendous growth in private sector demand.  And some countries have been trying to do that -- trying to reduce government deficits at some times, in a sense, to avert the pro-cyclicality of policy in general.

The other thing that they've been trying, of course, is to try and put some limits on capital flowing in.  And the problem with that, of course, is that every study that I've seen basically says you can do it for awhile, but typically money finds ways around.  And you know, people talking about the Brazilian capital controls right now basically say banks have a roaring business.  All it's done is expanded bank business in Brazil where they're trying to offer you different ways of getting around it and taking a cut in the process.

So perhaps you can lengthen maturities of that money flowing in, but you can't affect the quantity.  And this is a problem that we really don't have so many solutions to other than saying, just making sure that you -- this is a time when your macro policies is squeaky clean, so that you don't sort of add to the problems of the capital coming in and create a boom, which eventually ends in a bust.

So we don't have -- at least I don't think we have strong prescriptions other than watch where the credit is flowing like a hawk, be careful on supervision.  Reduce your fiscal deficit.  Do all things that you might want to do -- do structural reforms -- but there's no magic bullet in the face of these inflows.

ROGOFF:  I'd only add to that that this is something that over the long course of history countries convince themselves they're doing brilliantly and don't take these steps.  They just think their market's going up, because this administration is so wonderful or our business people are so wonderful.  And often that's partly the case, but it's greatly exaggerated by these flows.

And so it's very hard -- as the United States has demonstrated -- to have the self-discipline to realize that that's part of the problem and to engage in stronger regulation during these times, as opposed to do the opposite and have countercyclical -- to have pro-cyclical regulation, which we don't want.

SHAFER:  Well, thank you.

I've been asked before I close to give a plug for the next meeting here at the council, which is going to be on the anniversary of the Gulf War.  It will be an interactive conference with the CFR and Washington, D.C. as well.  That's Tuesday, February 15th from 5:30 to 7:30.  So you can make a note of that.

And with that, I hope you will join with me in thanking Raghu and Ken for I think a very lively and timely discussion.  (Applause.)

















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