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World Economic Update -- February 17, 1999

Moderator: Daniel K. Tarullo, Linda J. Wachner Senior Fellow for U.S. Foreign Economic Policy, Council on Foreign Relations
Speakers: Maureen Allyn, chief economist, Scudder Kemper, Roger M. Kubarych, chief investment officer and Managing Director, Kaufman & Kubarych, and John P. Lipsky, chief economist, Chase Manhattan
February 17, 1999
Council on Foreign Relations

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Mr. DANIEL K. TARULLO (Linda J. Wachner Senior Fellow for U.S. Foreign Economic Policy, Council on Foreign Relations): We are on the record, unlike many Council events, so anything that you say in question or answer format may well be recorded elsewhere. Secondly, we’re not going to begin with speeches but move right into a discussion format of questions and answers.

What I’m going to try to do this morning is to divide the hour into two, the first half of which will be a more general discussion of recent developments in the world economy, and we’ll try to take a few questions toward the end of that half-hour. And then in the second half-hour we’ll focus rather more specifically on European Monetary Union, the advent of the euro since the first of the year, and perhaps get into a bit more detail. And once again, we’ll leave time for some questions from all of you.

If I could ask, if you do have cell phones or pagers or something, if you could turn the pagers to buzz and have the cell phones at very low volume or off, it would facilitate the discussion and we’d all appreciate it. Thank you very much.

Now I’m joined up here today by three distinguished economists and commentators on economic situations generally. To my far right and the only other remaining member of the original panel, John Lipsky, the chief economist of Chase Manhattan. To my immediate right is Maureen Allyn, the chief economist of Scudder Kemper. And to my left, Roger Kubarych, the chief investment officer and Managing Director of Kaufman & Kubarych.

I’m going to begin with a question put to all three of the panelists, but I think that you’ll find that each of them will begin to take the discussion in a direction they think is particularly salient. The question is the following: It was not that long ago that Alan Greenspan indicated to the country and the world that the United States could not remain an oasis of prosperity in a turbulent international economic sea. But almost two years after the Thai baht crisis set this whole thing in motion, and almost six months after Russia and Brazil showed signs that the contagion had spread from Asia to other parts of the world, several years after Japan has been stuck in a no-growth and quite dangerous financial situation, the United States continues to grow at historically robust rates with no obvious—and I underscore obvious—sign of slowing down in a huge amount, much less dipping into anything resembling a recession.

So the first question I wanted to put to the panelists this morning was whether on this, as on very few matters, Alan Greenspan was wrong and whether the United States can, indeed, remain an oasis of prosperity pretty much no matter what happens in Brazil or in Japan or in other parts of the world in 1999.

John, why don’t we start with you, since you laid the groundwork for this last fall in your answer to a similar question I put.

Mr. JOHN P. LIPSKY (Chief Economist, The Chase Manhattan Bank): Well, I don’t want to say that the answer is going to depend on what the definition of “is” is, but I would say that I think you have to view the chairman’s remarks in context. Will the U.S. remain prosperous? The answer is most definitely yes. Is the U.S. economy healthy? I think the answer is most definitely yes. Is it unlikely that the U.S. can continue to exhibit vigorous growth in a world in which growth generally is performing very poorly and/or slowing? There I think the answer is no. And I think that was what the chairman was getting at, and on that score I think he was right.

Mr. TARULLO: Maureen.

Ms. MAUREEN F. ALLYN (Chief Economist and Managing Director, Scudder Kemper Investments Inc.): I actually take a little different take on this. Ironically, people said, “Well, maybe the world isn’t connected after all, and all the rest of the world is going down and we’re not.” And, actually, I think there is a cause and effect here, but it’s in the reverse direction. And I didn’t predict it, but looking back on it, we’re doing well precisely because the rest of the world is not doing so well, because it’s provided us with lower interest rates than we otherwise would have had and a lot more liquidity in the financial markets, which has turned out to be a very big boost.

I think the other factor that we’ve got that allows us to go on like this, and it’s something I underestimated, is the incredible growth thrust of the technological revolution that’s going on here, which is kind of unique to America. But I would say that, ironically, what might be a signal for trouble in the United States would be robust growth elsewhere, and that might cause a lot of flow of liquidity that has been here to go away. And it would be good for our export industries, but they might not carry us. So I think, in a way, Greenspan may have been wrong. Our prosperity may depend on borrowing the savings of strangers.

Mr. TARULLO: So, Maureen, you see as a risk the reversal of the flight to quality that we have been...

Ms. ALLYN: Yeah. I don’t think everything can be good, you know, which is the way it’s been sort of going. Yeah.

Mr. TARULLO: Roger.

Mr. ROGER M. KUBARYCH (Managing Member & Chief Investment Officer, Kaufman & Kubarych Advisors, LLC): Well, our prosperity is based on the tremendous business formation that’s going on. It’s basically small- and medium-sized companies that are hiring these hundreds of thousands of new workers every month, and that gives a burst to income, and that’s what’s keeping consumption ahead. It’s keeping consumer confidence very high. It’s an unemployment rate that is so—it’s been so long since we’ve had it before that I can barely remember myself when we did have such a fully employed labor market. Now then the question is: Can this continue? The answer is yes, if the small- and medium-sized business strength can continue. And that reflects an enormous array of economic activities in all lines of businesses. It’s not concentrated too much in any one area. It’s geographically widespread. And so the near-term signs are pretty good. Think of it this way: If you’ve got a lot of factories that have been built, what do you really need? You need customers to buy the stuff that comes out of those factories. And as long as we have the kind of excess capacity, not only in factories but in all kinds of endeavors throughout the world, we’re going to have downward pressure on a lot of prices.

And as long as inflation stays low, then the Fed will be either on hold or even more accommodated. And as long as interest rates stay low, the stock market will stay robust; maybe not every single part of it. There are some areas of bubbling, but the stock market as a whole stays robust. And as long as that continues, that is the basic energy behind small-business formation. So I see a relatively optimistic course for the U.S. economy, but not maybe at a 3.6 or 3.9 percent growth rate; maybe something more like 2 1/4 percent or 2 1/2 percent. But I don’t think a slowdown of that magnitude should alarm anybody.

Mr. TARULLO: John and Roger, would you like to comment on Maureen’s observation about the relative direction of flows of capital depending on comparative economic performance, and, whether you agree or disagree, how you see the phenomenon of money moving in and out?

Mr. LIPSKY: Right. Well, let’s start with the immediate short-term implication of the collapse of Asian growth last year, or ‘97-‘98, and the implication of slowdown generally abroad for the U.S. business cycle and what it has made—or the impact that it has had on the U.S. economy.

Typically, at a cyclical slowdown or at the late phase of a business cycle, in the U.S. you see rising inflation and rising interest rates, and those form a kind of a flashing yellow light for households that it’s time to slow down spending. Because of the slowdown abroad, the strengthening of the dollar and the fall of import prices, instead of rising inflation and rising interest rates, you saw the reverse: falling inflation and falling interest rates, a kind of green light for spending.

So the most notable factor that’s gone on here is that, even though savings rates have fallen to historic lows, and even though household debt service burdens are at historic highs, there hasn’t been any clear slowdown in consumer spending. I think, in essence, there’s been a signal that has been short-circuited and essentially because of what’s happened abroad. And I think that’s what Maureen was saying.

Now, in addition, what she was saying is the availability of foreign capital has always also helped to keep interest rates low, and I would say that’s certainly true for real interest rates. I don’t know about nominal interest rates. But in any case, the important point is the reason why we are able to obtain foreign savings on such good terms is because business is so bad abroad and growth is so slow that other countries—and not to get too technical, but other countries are running large external surpluses, which means they’re happy to ship their savings abroad simply because there aren’t good opportunities at home, and we’re putting those savings to use.

Now this isn’t like the ‘80s. In the mid-‘80s the dollar was grotesquely overvalued, and we had large domestic imbalances. So we had a very large external deficit that was associated with problems in the U.S. economy, and you could see it wasn’t sustainable. At this time the dollar’s reasonably fair valued, and you don’t find obvious imbalances in the U.S. economy other than a need to rebalance household income status—i.e., raise savings or lower spending. But what’s going to happen, I hope, rather than an unhappy outcome, is that the rest of the world will speed up. We won’t have such a need for foreign savings to keep our economy going because our export earnings are going to help close the gap on our external deficit, and there will be a kind of rebalancing.

So what Maureen’s worried about is, in fact, if the world starts going faster, that it’s going to result in either inflationary pressures or higher interest rates in the U.S. that’s going to be bad for the U.S. economy. I’m not so certain that that’s a near-term risk. I think that the more important problem in the U.S. is the need to rebalance household finances to restore better balance between income and spending.

Ms. ALLYN: Could I just talk about one thing?

Mr. TARULLO: Sure.

Ms. ALLYN: You said you thought it’s nominal rates that are low and real that are high. I think...

Mr. LIPSKY: In the U.S.

Ms. ALLYN: Yeah. I think you would reverse that. I think you said, not so sure, real rates are low, but nominal rates are low. Real rates are high.

Mr. LIPSKY: Real rates are still high in the U.S.

Ms. ALLYN: Yeah. That’s it.

Mr. TARULLO: Roger, do you think the rebalancing can occur relatively smoothly?

Mr. KUBARYCH: I don’t believe that the consumer is as strapped as the numbers suggest. I don’t know whether it’s purely statistical, maybe partly statistical, but I don’t think a lot of American households think they’re consuming when, for example, they put in a new kitchen in their house. I think that they feel that they’re making investments in their housing.

Now one thing that’s very important to bear in mind is the contours of this business expansion. It’s very old now, very long, the longest, but it really has not been a simple story. The early part of the expansion, a whole big sector was blocked. That was because of the tremendous excess building in commercial real estate. And for many years, most of the entire decade of the ’90s, there was hardly any contribution to economic growth from commercial real estate development, hardly any. That’s only just started to emerge. By the same token, if you look at a graph of housing activity in this expansion compared to any other one you want to mention, housing was rather subdued. For the most part, the household sector was being cautious because they had seen the impact of falling housing prices during the late ’80s and early ’90s.

This expansion was led by business investment, not by housing, not by commercial real estate development, and so in a certain sense we have the ability of having a third wind without putting huge strains, and I don’t think that we’re anywhere near the kind of credit unavailability that characterizes the end of virtually every business cycle. In fact, I think most financial institutions look at the American business and household and says, “That’s who I want to lend to.”

Mr. TARULLO: OK. Why don’t we turn explicitly to the rest of the world for a couple of minutes? And, Maureen, let me start with you. If you scan the world today, what parts, what areas, what issues concern you the most, both in and of themselves and in terms of their possible repercussions for the United States?

Ms. ALLYN: Well, I think Latin America is sort of on the front burner because I think people are feeling pretty good about Brazil because it didn’t cause a financial upheaval. But there’s a real market upheaval going down. Brazil is going to have a very, very serious recession, and that may take time to come through in how it matters to us. And I can’t bear to listen to any more of somebody saying, “Oh, Brazil’s only 2 percent of U.S. exports.” That is not how the transmission mechanism works. It works through corporate profits, and a great number of very large companies have big operations in Brazil where the profitability will be much less than people thought.

But I would add a second area that people really are not talking about very much—some people are—and that is China. And people say, “Oh, they’re not going to devalue.” That’s really not the point. What I’m concerned about is we’re getting indications that this is a very, very troubled economy and people are not paying enough attention to it. Whether they devalue or not is kind of a secondary thing. It’s whether they can help Asia find a bottom.

I would remind you that China issued its GDP forecast or GDP assessment of 1998 several days before the year ended. If you believe that that economy grew 7.8 percent, shame on you. They just made those numbers up. We have an economy where the rural incomes are declining, where prices are declining, where they have price controls in to keep prices up, where profits are declining, where electricity consumption is declining. This is not an economy that is growing very well. I think it has tremendous potential in 1999 to cause mischief to Asia and to lots of the rest of the world.

Mr. TARULLO: And how would that mischief be realized? Through further reduced imports, through debt moratorium?

Ms. ALLYN: I think it would be through a much-delayed—there’s a lot of sanguine feeling that Asia has reached a bottom, and then may go up, and I think it’s going to be very hard to do unless you can get internal Asian growth going, and that’s hard to do without China. And so I think that, you know, you could have another leg down in Asia; it could make it harder for Japan. You could get the evaluation and the trouble in Hong Kong through the financial markets. I think that this is one I’d watch very, very carefully, because nobody’s paying enough attention to that.

Mr. TARULLO: One of the interesting things about doing a panel like this, which is on tape and has a transcript, is that your wisdom or foolishness is actually memorialized.

Ms. ALLYN: Great.

Mr. TARULLO: I went back this past weekend and watched the C-SPAN tape of the first one of these that we did, and John should have this playing in Times Square, because he was remarkably prescient in identifying the trouble spots for the succeeding three months. We’re going to put you on the line again here, John. How do you see the dangers in particular parts of the world in the next three to six months?

Mr. LIPSKY: Well, Dan, Maureen has pointed out two of the salient ones. Let me make two bigger points, really, beyond that and cognizant that we’re going to turn explicitly to Europe later. Number one, 1999 is shaping up to be the slowest-growth year globally of the 1990s. It’s likely that global growth will be something between 1percent and 1 1/2 percent, well below what we’ve seen through most of the 1990s. So there is no indication that there has been any kind of turnaround in the global economy yet, and there are the risk factors that she’s already discussed and I would echo in broad terms.

Secondly—and one factor that we may turn to later, but I’m not sure—in the context of the Brazilian situation and elsewhere, it is clear that the G-7, G-22 authorities are (heat alarm buzzes) going to set off the fire alarm before we can get any further.

Mr. TARULLO: This must be the hot air—no, there we go. The hot air...

Mr. LIPSKY: Yeah. Is that the heat detector?

Mr. TARULLO: Yeah, rising up from the platform.

Mr. LIPSKY: OK. No comment. Back to the point. In the wake of the problems in Russia and elsewhere (alarm buzzes)... Now is a duck going to come down?

Mr. TARULLO: I think we should just try to talk through this.

Mr. LIPSKY: I trust that the Council staff will inform us if we’re about to be incinerated here. So...

Mr. KUBARYCH: You see, if you live in New York, you have these car alarms outside, so you’re used to this all the time.

Mr. LIPSKY: OK. Back to the point. In the wake of the problems, especially in Russia and elsewhere last year, the industrial country authorities are intent on obtaining what they like to call the “bailing in” of the private sector; in other words, the notion that somehow private creditors should be forced to pay some of the price of these debt restructurings. And you heard about that. In fact, President Clinton spoke in this very room on September 14 to propose some ideas about how to reform what has come to be called the international financial architecture. But those conversations are not going anywhere very fast. There’s no real clear consensus about what to do in specific terms.

But in general terms, debt-crisis countries are being encouraged to default effectively or forcibly restructure their external bonded indebtedness in the Eurobond market and elsewhere, and that, too, is going to have some effect of an unknown scale on the availability of credit to the emerging-market countries and could have a pernicious impact on economic developments elsewhere. In other words, just at a time when global growth continues to slow and a time in which it’s hard to say that we’ve reached a turning point, the effective actions of official authorities, while though certainly well-intentioned and well-meaning, may unintentionally have the effect of restricting capital flow to those countries and further dampening the growth outlook, and I would say that’s a risk.

Mr. TARULLO: The last question I want to put to the panel—and then we’ll turn to all of you for a couple of questions—tries to pull the world economic issues together. We’re coming up in just a few days on the G-7 finance ministers’ meetings. If we were collectively in the driver’s seat for Bob Rubin’s position papers at these meetings, what should be at the top of the U.S. agenda? What should we be pushing most as individual or collective actions among the G-7 to deal with near-term problems? Roger?

Mr. KUBARYCH: I think the most important thing is putting together a regulatory, supervisory umbrella that basically sets some common standards that everybody is obliged to approach. Nobody can expect every country to follow them entirely, but every one of these crises has, either at its origin or in its festering stage, a banking crisis. That’s been true whether you look at Mexico, whether you look at Thailand or Korea; certainly, even in Japan. And the problems of lack of transparency, phony data, covering up problems—all these things are only addressable, I think, in a collective way. And there’s been sort of little stabs at this, but making that the priority would be a healthy step; won’t be easy. There’s obviously more acceptance of this as a proposal today than there was 18 months ago, when it was ridiculed. Now people don’t ridicule the idea, but they say it’s overly ambitious. You have to be patient. But I think that’s the most important thing that can be done, getting the banking...

Mr. LIPSKY: Roger, are you talking about the G-7 countries for themselves or for everybody else?

Mr. KUBARYCH: G-7 countries, starting it themselves. First they’ve got to do it themselves.

Mr. LIPSKY: Yes.

Mr. KUBARYCH: They can’t really get the emerging countries into it until it’s functioning among the G-7 countries themselves, the institutional superstructure is put in place. And we have to make some choices domestically in terms of how we have this real patchwork quilt of different financial supervisory and regulatory organizations. We’re going to have to make some choices about modernizing that. And, in fact, the Congress is addressing this issue right now. So this is the right time to do this.

Mr. TARULLO: John?

Mr. LIPSKY: Well, I agree that that’s a very valuable suggestion and I think it’s very important, and I certainly go along with that. In addition, I would also say the G-7 itself needs to look to its own economic performance. By far, the most important contribution the G-7 countries could make to global well-being is to restore balanced growth, reasonable balanced growth, to their economies. And right now we find Japan still in the grips of the most severe recession since the oil shock. And the European economies, for reasons that may be understandable, but nonetheless are slowing once again to below-trend growth at a time in which their unemployment rates are really alarmingly high. It would be very, very useful to the rest of the world if all the industrial countries were performing up to snuff.

Mr. TARULLO: Maureen.

Ms. ALLYN: I agree with both of them, and I would just add, since I don’t expect ever too much out of the G-7, that they could at least make a statement, you know, reaffirming their belief in the openness of markets and how important that is. I think one of the big dangers we have going forward is that people do start to close down both capital and trade markets to protect themselves from global contagion, and I think that would be disastrous if it did happen. I don’t think it’s a huge threat, but I think keeping a commitment to that on our own side is a good thing, too.

Mr. TARULLO: It appears, in fact, as though Hans Tietmeyer, the governor of the Bundesbank, will make a proposal not unlike the one that Roger just mentioned at the G-7 this weekend. It’s important to note that Tietmeyer is not proposing substantive measures as opposed to a process for pulling together banking, securities, insurance regulators and, as appropriate, central bankers who are not otherwise involved in banking regulation.

I guess I would just add my own view that laying the groundwork for more coordinated regulation in the future is a very good idea. I would say taking steps now which have the immediate effect of constricting capital flows to the emerging-market world would not be a good idea, since right now I don’t think the problem is too much capital flowing to these countries. It’s quite the contrary.

Let’s take a few minutes. If there are questions on anything that we’ve said in this first part of the hour or, indeed, on any other topic—yes, sir.

QUESTIONER: We haven’t spoken too much about Japan. In the past year, Japanese have taken several steps. Do you think those steps will have an impact on the Japanese economy? And how will that affect the Asian situation?

Mr. TARULLO: Let’s go right down the row. John.

Mr. LIPSKY: Yes. Obviously, the Japanese situation has been one of the most difficult in the world and one of the most important. But just to cut right to the answer, it seems to me that the actions the Japanese authorities have taken will have an impact, and in general a positive impact, on the outlook for Japan and Asia. It just is not going to happen as quickly as most people would have wanted. The fiscal spending that has been ramped up in an enormous scale, as always, it turns out to be less useful as a short-term stimulant for economic performance than the proponents ever hope. It just can’t be turned on and off like a hot-water spigot.

Secondly, the restructuring of the Japanese banking system, which is now proceeding apace and appears to be very powerful, naturally is going to have, in its initial impact, a tendency to restrict credit availability. And that explains one reason why the Bank of Japan, in fact last Friday, undertook to lower interest rates once again to the rather eye-popping level of 0.25 percent. And overnight rates are actually lower than that, as we speak. Nonetheless, still to come to make that economy work better is going to be corporate restructuring as well. That seems to be under way. What appears to be going on is that Japanese firms are selling out their cross-holdings of shares that effectively block restructuring and reorganization of Japanese corporations.

In other words, you can take an optimistic view, and I think it would be justified, that real change of a profound nature is under way in the Japanese economy. At the same time, it strikes me that the results in terms of economic growth are going to be somewhat more delayed in coming than many would hope, and as a result, it’s hard to think that we’re already to a significant turnaround in the Asian outlook, especially in consideration of the substantial slowdown that’s under way in China.

Mr. TARULLO: Maureen.

Ms. ALLYN: Yeah. I agree with John. I think, frankly, I’ll confess I don’t know whether the Japanese government is doing harm or help at this point. I mean, the fiscal spending is going to help growth this year, but a lot of it’s the same old, same old directed spending. I think the bank reform will eventually help, but it’ll hurt first. But what we are excited about is some of the corporate restructuring, and we are actually finding companies that we can invest in different sectors in Japan, but they’re not the old guard. I think when Japan does come back, and I don’t think it’s going to be this year, it will look very different. And I think that we’re finding many more companies do actually not just say they care about profits, but actually do care about profits and really are trying to use capital efficiently, but they use it so inefficiently now it’s going to take a while. It took us a while to restructure. I think that’s...

Mr. KUBARYCH: Well, I think that there are sort of two tracks in Japan. Track one, the kinds of things that governments do, is moving along pretty well, and particularly vivid in this banking area, where they’re forcing mergers, they’re nationalizing some bus organizations, and they’re drawing in some new capital. I think one of the most significant developments is General Electric Capital investing in the big leasing operation from Long-Term Credit Bank. The Sumitomo Rubber deal is another sign that things are bubbling.

I think the big problem in Japan is this enormous blind spot that goes back over two generations of this anti-consumer attitude. The Japanese consumer, first of all, got basically gouged by a retailing system and basically policy stance that made it very difficult to buy goods at world prices. Prices of things in Japan were just way above world prices. That’s been fixed. A lot of the deregulation has fixed it. But they still tend to put the burden on the consumer, and this consumption tax is not a good idea at a time when consumer sentiment and consumer pocketbooks are hurting.

So I think if you want to have a real recovery in Japan, something that would look American-style, big rebound, the consumer has to be given some help. And so I see that before the end of this year or into next year there is going to be some big-time tax cutting in Japan. And get away from this nonsense of these public-works expenditures, which are essentially highly suspect in their economic viability, and get to the real problem: too much investment and not enough consumption. And help the consumer. When they do that, then the Japanese economy will start to take off, and their stock market will anticipate that and the Japanese stock market will outperform everybody’s once that’s done.

Mr. LIPSKY: If I could just interject, though, we can’t forget Japan’s demographics don’t look like any other G-7 country.

Ms. ALLYN: I was just going to say—yeah.

Mr. LIPSKY: And some wag said in 10 years, if there’s no big wave of immigration, Japanese demographics are going to look more like Florida than like a typical industrial economy, and that means that the vision of what the right balance between investment and consumption will turn out to be in a deregulated situation is not immediately clear.

Mr. KUBARYCH: All true, but if you’ve been in Florida recently, I can guarantee you that the Wal-Marts down there are doing very nice business.

Mr. LIPSKY: Absolutely.

Mr. TARULLO: One factor we should probably add here is the politics of Japan, and I think that very weak politics in Japan now are a bad-news but also a bit of good-news situation. The bad news is that, because of the weakness of the LDP and the inability of any opposition group truly to cohere and to become viable, there is going to be reactive and uncertain political response for the foreseeable future. What we saw with the Obuchi government’s indecision last fall about bank restructuring, requiring the United States government to remind Obuchi what he himself had already promised, will probably be replicated over the course of the next year or two.

On the other hand, the relative vacuum of power in Japanese politics right now has given an opening to people in the financial supervisory agency and in some of the other restructuring efforts, which are governmental efforts, to exercise some real authority and power and make a bit of a name for themselves, because no one is in a position to really challenge them if they appear to be doing something that is in Japan’s interests. So the way that that vacuum versus opportunity plays out will probably have a lot do to with the relative pace of recovery, although not, I think, the underlying fact of whether recovery proceeds.

Yes, sir.

QUESTIONER: One of the speakers, I think it was Mr. Lipsky, pointed to the perversity of world financial institution policy acting in a way that inhibits or discourages the flow of capital to distressed countries. Do you see any policy alteration that could alleviate this conundrum?

Mr. TARULLO: John.

Mr. LIPSKY: Yes. But, first of all, allow me to say I’m just back from a trip through Asia, and I was very struck, among other things, by my contacts with the authorities in the crisis countries of Asia, their sense of futility in trying to play the blame game at this point, of pointing fingers on whose fault this was. They are taking a very realistic view of the situation, suggesting that there is not going to be some external savior; that they have to rely on, at best, regional but essentially their own efforts, that they need to undertake domestic economic reform, structural reforms, especially in the financial sector if they’re going to get themselves back on track onto a high-growth path, as they were prior to the crisis.

Secondly, it strikes me that there are some things that could be done in short order, and I suspect they are actually being done, and that is the idea of the provision of some kind of contingency financing for countries that are healthy but rely on external finance for the capital that they need to invest and grow. And that is, for example, the reenactment, as used to be the case, of essentially what are called non-growing standbys within the IMF, in which countries that are not in crisis can come to the IMF, negotiate a program that has some standby financing facilities in which there is an agreement on policies to be implemented, with the recognition that if trouble comes, that there will be financing available, but with a preagreed specific program with the IMF. That doesn’t need any kind of international agreement, other than the agreement of the executive board of the IMF. And I believe that that is already under way and that that will be useful.

As for the so-called architecture discussions, I think they end up coming to a difficult juncture, and that is to define this idea of “bailing in.” How do you bail in the private sector internationally in a world in which cross-border finance is dominated by trade and marketable securities? As I like to point out, in the 1980s a financial crisis was, by definition, a banking crisis and, therefore, by definition, a slow-motion crisis. In a world dominated by capital market instruments, trade and stocks and bonds, essentially, financial crises become very high-speed crises and have to be dealt with in a different way.

The issues are very knotty. Outside of the problems on supervisory or the progress possible on supervisory and regulatory standards that Roger and others have talked about that I think are going to be useful but slow in coming, it seems to me that the other things that we’re going to have to rely on are using the IMF in a more creative way and relying on the efforts of the crisis countries themselves.

Mr. TARULLO: We want to turn now to Europe and the European Monetary Union so we have an opportunity to probe those issues a bit. On the first of the year the euro came into being. European Monetary Union, after all the preliminary hoopla, came into being with a transition that, if anything, was smoother than most people had anticipated. In the intervening six weeks or so, the euro, after first strengthening against the dollar, has weakened some. I think the quote this morning was about $1.12, a development which is probably not wholly unwelcome in parts of Europe, which we’re quite concerned that an overly strong euro would damp European export growth.

Although I think all of us would agree that a real assessment of E.M.U. is going to have to wait a while and probably to wait for a economic slowdown to see how E.M.U. prevails in a slow-growth as opposed to a medium-growth period, I wanted to ask people: After six weeks, is there anything about E.M.U. which has surprised you? Is there anything which is particularly salient for world economic developments now which we might not have anticipated even a few months ago? Maureen, why don’t we start with you?

Ms. ALLYN: Well, that’s a big question. I think what continues to surprise me is what the press and a lot of people attribute to the euro, which doesn’t really make a lot of sense. A couple of my pet peeves are that this is going to create a broad, deep bond market to compete with the U.S. Treasury market. I think it will inspire some corporate bond issuance, but when we look at the United States, I mean, what makes our bond market broad and deep is the fact that there’s a single issuer who takes great care in putting yield all along the parts of the curves to give liquidity in various branches. And where we find out that the 29-year Treasury isn’t liquid and the 30-year is, I mean, I think to try to say that, you know, a five-year Italian bond is the equivalent to a 10-year French bond is just-that is not the same thing in the bond markets. I think there’s some misunderstanding there.

But I think it’s going to take—as you say, the big thing is it’s going to take a long time. This is a monetary event. Monetary events take a long time to happen. And people say, “Well, they had the same currency rates for several years.” Yeah, they had a crisis in 1992, though, don’t forget, and they did not have the same monetary policy until January 1. Interest rates had not converged; they were converging. So you now have taken away two important price pieces of flexibility: currency and interest rates. And so you’re not going to take away volatility, which is what Europe wants to do. So the volatility will have to come out somewhere. It’ll probably be in either financial markets or economic growth, and I would bet on economic growth in the hinterlands.

It’s going to be interesting to see if they are willing to go all the way, and I think `all the way’ means political union, and then this may work and create just what they want to have, which is a great big market. But there’s a long ways to go between here and there, and if the slowdown that John’s talking about does happen, and I’m in that camp, that’s going to bring some strains to the fore fairly early.

Mr. TARULLO: Roger.

Mr. KUBARYCH: Well, I’m a little surprised how ragged this transition has been. I mean, I’ve read a lot of articles saying how smooth it is, but if you’re actually sitting in these markets and dealing in them, then it’s been ragged. If you bought euro on the first day, you’ve lost 5 percent in that six weeks. That’s not good. But not only that, their stock markets have weakened, and the ability to lose money in Europe has not gone away. I think that one...

Mr. LIPSKY: That isn’t experience talking?

Mr. KUBARYCH: Except for the clairvoyant. The positive surprise has been the narrowness of the yield differentials between the various countries. Now we have a lot of experience. We have 50 states, plus a couple of other jurisdictions like New York City—Jay Goldin’s in the audience, knows about this—that issue bonds. And we have a lot of experience in how the market evaluates the relative credit quality of those bonds by the yield spreads, between the best-rated municipal bond—probably the state of Ohio or North Carolina—and the worst. And we shall not say who the worst are. From time to time it’s different states and different communities.

The spreads in Europe are narrower than most of our experience in the municipal bond market already, and that’s really an enormous achievement, so there are positive surprises. The yield spreads are narrower, and I think that the bond market is trading better than I thought it would. The negative surprise is the currency is not holding up well; probably economic reasons. The economies are not as robust as we thought they might have been six weeks ago, certainly four or five months ago. And the German situation, in particular, seems to be sputtered, and that, of course, is going to have the overwhelming impact on the value of the euro, not what goes on in Ireland.

Mr. TARULLO: But, Roger, do you think that the depreciation of the euro is unwelcome in most European policymaking systems?

Mr. KUBARYCH: Oh, I didn’t say that. I think policymakers probably welcome it. But from the point of view of surprises—your question was about surprises—there was a party line about the euro that all kinds of central banks all over the world were going to want to have a big chunk of their reserves in euro, and that there was a big portfolio adjustment that needed to be done. They were underweight the euro and overweight the dollar, and this was going to have an impact. And, in fact, none of that has happened, none that I can see. Maybe it’s yet to happen, but it seems to me that investors the world over are looking at a whole bunch of economic, political, and financial issues in Europe and drawing a less-than-thrilling conclusion, and that’s not good because you’ve got a lot of new governments there, most particularly in Germany. And there is a sense that the markets are saying, “Maybe these new governments will not be as effective as their campaign rhetoric.”

Mr. TARULLO: And, unfortunately, in Germany, we appear to have two governments rather than just one that—John?

Mr. LIPSKY: Well, I think we should take a look at the very big picture, and the big picture, I would say—count me a euro optimist—so far the euro project has been a catalyst for structural change in Europe that has shocked most people. I don’t think in 1995, let alone in 1990, anyone would have given you a plug nickel for the possibility that Italy, Spain and Portugal could have participated easily in the first round of the euro because they met the convergence criteria, but they did.

Now I think that the euro is going to continue to be the critical spur for economic reform in Europe, principally through the creation of a real single financial market in Europe that’s going to eventually create a true equity market—in other words, an open market for corporate control in Europe—that is going to be the dynamic element changing corporate governance in Europe and, ultimately, changing things like rigidities in labor markets, etc. So I think this is going to work in the big picture, and it’s going to work to everybody’s benefit, our benefit and Europe’s benefit.

In the short run, there are some difficulties which are not terribly surprising. As Roger said, a lot of folks said to look at the euro and the dollar, and, of course, a lot of people want to create a scorecard for the euro against the dollar to see if it’s a success if it goes up or down against the dollar, which I think is not a very productive way of examining such a profound project. But, still, there are those who said that it’s the shift of central bank reserves that’s going to dominate exchange markets. I never understood. Others say, “Well, there’s going to be a greater use of the euro to denominate transactions.” It’s to use as a currency of transaction for international business that’s going to create a change in that, going to boost the euro against the dollar, which I never understood either.

Seems to me the relevant question is: Will the euro be a reliably low-inflation currency, emitted and managed by a credible central bank, operating within the context of a large, liquid, open, deregulated, liquid capital market? And if the answer to that is yes, and the answer to the same question for the U.S. is yes, then I don’t think we have any particular problem; rather, something that’s very good for everybody. But if you have questions in the short run about the answer, you’re more likely to have questions about whether the answer really is yes in Europe. And hence, it’s not a surprise to me to see that the euro is weakening modestly against the dollar.

Mr. TARULLO: John, circling back to the world economic situation, Roger and I, I think, agree that the relative depreciation of the euro has probably been pretty welcome in economic policymaking circles in Europe. I would anticipate that this weekend the Treasury Department will pound more than a bit on Europe saying, “Why are you running a fairly large current account surplus at a time when the rest of the world needs export earnings?” Do you agree with the anticipated Treasury position? And what’s the relationship between that characteristic of the European economy right now and the euro?

Mr. LIPSKY: Well, yes, I think we’d all be better off if Europe would grow faster. That wouldn’t destabilize world markets. It would be very good all around, I’m sure. So in that sense, yes. Do the Europeans have access to some magic formula that would produce that in the short run? And I think the answer is no. On the other hand, I would say the same thing policies that really made the euro possible in the coming years that, I think, in the end will rebound to the detriment of the European countries and their economies. In other words, if loose talk about a fiscal stimulus results in higher interest rates and higher financing costs for European governments, that is going to be much more negative for their economies than some potential modest change in short-term interest rates that could be carried out by the European Central Bank. In other words, I think there needs to be smoother coordination of European monetary and fiscal policy. I think they need easier monetary policy, and I think they need stronger growth.

Mr. KUBARYCH: See, the familiar textbooks that they use in Washington would say, “You got a current account surplus and you got a lot of unemployment; the world needs your demand and we don’t want you to pursue export-led growth.” So therefore, the textbook says, “Don’t ease monetary policy; that’ll only make the currency weaker and make your current account surplus bigger. Therefore, cut taxes or raise spending or do something like that.” And they come back and they say, “But we got these convergence criteria and we’ve got this stability pact. The fiscal policy is essentially off the table for us. We have no other alternative but a weaker currency or lower interest rates, and you’re just going to have to live with it.” I think this is a recipe for a bust-up.

Mr. TARULLO: Yeah, I agree with that. And, in fact, John’s comments raise the issue of the relationship between fiscal and monetary policy, not just in economic terms but in institutional terms. Europe has not done a particularly good job at moving forward its coordination of policies other than monetary, central bank policies. They’ve done that intentionally. They wanted to put it aside so that they achieved ECB integrity in the short term and they put off questions of the external representation of the euro, how the Euro-11 Committee would, in fact, function, whether the stability pact would be loosely or tightly interpreted over time. And I, like Roger, fear that the deferral of those questions, coupled with an easy response of, “Well, you know, we can’t do anything about it,” is a prescription for real short- to medium-term problems, although like John, I’m actually a euro optimist in the long term. John.

Mr. LIPSKY: Yeah. It’s my impression, and, of course, I could be wrong, but I think the majority of European citizens, not to mention European leaders, believe that they have to have a single market to compete effectively at a world level. They have come to believe that they have to have a single currency to sustain a single market. Now we could have a nice theoretical argument that says that’s not true, but I think they believe it. And if they do, then these problems that we mention are issues to be solved and not explosions heading down the road. In other words, if you really believe those first two tenets, then you will do what it takes to make it work. And that’s what I think is going to happen in Europe.

Mr. TARULLO: And John has just articulated the answer you will get from European officials.

Ms. ALLYN: Absolutely.

Mr. TARULLO: Jump into the lake first, and that will give you the invigoration to take the measures you need to in order to make things work.

Mr. LIPSKY: Yes.

Mr. TARULLO: Questions? Yes.

QUESTIONER: A question about the U.S. stock market. There is a body of opinion, for example, articulated by the Economist magazine that there’s something of an asset bubble building. So many people have been talking about this for so long they’re starting to be embarrassed. But if you look at the top 50 stocks and the price/earnings ratios there, which are stratospheric, is there a concern, if there is a slowdown kind of scenario, that at some point you’ll get a major, major correction, at least among those top 50 big-cap stocks, which might then have an additional wealth effect, which could be a serious problem for the U.S. economy?

Mr. TARULLO: Maureen, this relates to something you said earlier, so you may want to...

Ms. ALLYN: Sure. No, I think there is—I mean, everybody worries about it all the time, because we are away from the kind of traditional valuation measures that we feel comfortable with. Personally, I think, we didn’t have any problem when the measures of price to book looked ridiculous, or price to dividends. Wish we could explain that away. The price-to-earnings valuation, I think, is a little bit more problematic because, really, that is what you’re buying. I mean, you aren’t buying the assets; you’re buying a share of the future stream of earnings. And yes, interest rates are low and you can discount them at a lower level and the volatility of the market may be a little bit low, but I think it’s getting harder and harder to say these are absolutely perfect or undervalued markets, by any stretch of the imagination.

And, you know, I think that is certainly on Greenspan’s mind; it’s on the mind, I think, of most practitioners there. I think even people who believe as I do that the Internet and the complex of technologies with broad-band communications, biotechnology, all of this stuff, is really a once-in-a-generation, change-everything kind of thing. So, you know, enthusiasms do get ahead of things. And people are worried about it. And it is very integrated into the U.S. market, the whole U.S. economy, into the capital that has been raised to keep investment up and into the fact that it has inspired consumer spending. So I think Greenspan is worried about it, but less worried about it than he is about the bond market.

Mr. TARULLO: So, Maureen, on a scale of one to ten, with ten highest, how worried are you about something that’s loosely called an asset bubble in the stock market?

Ms. ALLYN: Oh, eight.

Mr. TARULLO: Eight?

Ms. ALLYN: Yeah, pretty worried. I’m pretty worried.

Mr. TARULLO: That’s pretty high. OK. Yes. Next question. Get the microphone.

QUESTIONER. I’d like to come to the world crisis for a moment in relationship to Europe. Clearly, Europe suffered from Latin American and from Asian crisis, and our flow of imports into the U.S. is one of the results. The panel did not mention Russian crisis at all, and I wonder if you would comment as to how you see that within the framework, both Europe and the other countries.

Mr. TARULLO: Roger’s been my guru on Russia, so do you want to take a stab at that?

Mr. KUBARYCH: Well, the Russian crisis was truly predictable, but for various reasons, people didn’t want to believe the facts in front of their eyes. There were all kinds of mistakes, decisions riddled with corruption; essentially, the Russian people were double-crossed by a whole gang of people, many of whom are still influential, if not actually in office. So the Russian situation is as close to hopeless, without something very major happening, as anybody.

That said, it is not going to have a major impact on European economic events as long as we still have really quite decent progress in some of the what we now call central European countries, who have made some important restructuring efforts, and they’re paying off. I mean, they’re not out of the woods completely, but as long as the Poles, the Czechs, the Hungarians, and so on keep their objectives clear and keep moving in the right direction, I think that matters a great deal more for Europe. Russia will not be a positive force for Europe or for world growth anytime soon, maybe for another decade.

Mr. TARULLO: Roger, it sounds to me as though you would agree with the proposition that, if Russia is to have a negative effect on the world economy, the source of that effect is much more likely to be political instability.

Mr. KUBARYCH: Yeah, I believe that.

Mr. TARULLO: OK. Next question. Yes.

QUESTIONER: Getting back to the question of inflation and commodities, I was wondering if you could comment. You see, commodities’ CRB is at its all-time low, and while that helps by making input costs lower, it also results in there being no pricing power in the paper industry, oil, steel, chemicals. And I’m wondering how come this doesn’t have a greater impact on the overall economy in terms of growth, in that, yes, technology in these companies are becoming a bigger part of the market; still, the basic economy is driven by steel companies, oil companies, paper companies. And I’m wondering why it hasn’t had a bigger impact, and if you see the loss of pricing power and earnings having impact in the future.

Mr. TARULLO: John, you want to take that?

Mr. LIPSKY: I would, actually. Thank you. I’m glad you brought that up. There was a point I mentioned it, too—the initial impact of the external crisis has been ironically positive in some ways for the U.S. economy. In other words, last year, you could say the dominant force and the biggest surprise in the U.S. economy was the sharp decline in inflation and the shortfall of pricing power relative to what producers had expected. As a result, you saw two things happening last year: real incomes of households accelerated at a pace much faster than they had expected. At the same time, corporate earnings actually fell, I think, we’re going to find in a useful sense by the time the year’s over, or we get all the ’98 figures.

So in other words, that sharp drop, among other things, in commodities and other manufactured prices represented an unexpected and inadvertent transfer of real income from producers to consumers. Now that, I think, is going to provide the dynamic for the slowdown in the U.S. economy that I foresee in 1999. In other words, in an environment in which there is no pricing power, in which, if anything, the pricing pressures in the manufacturing sector are becoming in general more intense, not less intense, then corporations and other producers are going to have to figure out how to restore profitability in an environment in which they cannot increase their prices.

As a result, I think that one of the—and there’s a test for this view. If that view is right; namely, that this is going to have a substantial impact on the U.S. economy, then we’re going to see some surprising developments. Namely, I suspect there will be and I expect there will be a slowdown in wage growth, despite very low unemployment rates. I suspect that we will see a slowdown in job growth, just as we have seen a sharp rise in layoff announcements that have brought layoff announcements, at any rate, back to the peaks last seen in the jobless recovery phase of ‘93, ‘94.

In other words, to think that you can have the kind of shock, an external shock, that has afflicted the U.S. economy and expect that we would escape unscathed will turn out to have been a pipe dream. And that’s why I think, at the end of the day, I would just respectfully disagree on that point with what we heard earlier, in that I think that, in the end, the collapse of economic growth outside the U.S. is, on balance, negative for this economy and not a positive.

Mr. TARULLO: Maureen, you want to—very quickly, because we have to...

Ms. ALLYN: OK, just very quickly. I don’t think we really disagree at some level, but I would caution you, while our internal view is that commodity prices are not going to go down forever, OK—but I think you could probably get a bounce here—but they do not form the basis of this economy, either in hiring or in output or even in earnings. And I think we do have to recognize they may never come back. This may be a real change. And what’s interesting about this technology, as opposed to the other life-changing technologies like automobiles or railroads, which used lots of natural resources, this technology uses almost none and, in fact, it saves on production costs. So I think, you know, you just have to, when you’re thinking about your portfolio, think about it in the fact that the day for those commodities may be over.

Mr. LIPSKY: Right. And I certainly don’t disagree with the impact of technology and productivity growth...

Ms. ALLYN: I understand.

Mr. LIPSKY: ...but I would say the drop in commodity prices won’t last, but it is a sign and a reflection of the collapse in demand growth brought.

Ms. ALLYN: Yes, absolutely.

Mr. LIPSKY: And that’s the important thing.

Ms. ALLYN: That’s absolutely true.

Mr. TARULLO: We’ve come to the end of the hour, and as always, we want to try to end promptly. I want to thank John and Maureen and Roger on behalf of the Council, and thank all of you, and we’ll do this again.

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