Mr. DANIEL K. TARULLO: Good morning, ladies and gentlemen. We’d like to get started promptly so that we can end promptly. Welcome to this morning’s session on the update of world economic conditions. This is the first in what we anticipate to be a series of updates, perhaps quarterly, sponsored by the Council on Foreign Relations, probably right here in this room, part of a continuing effort to focus on world economic conditions, both for themselves, and as they intersect with foreign policy concerns.
As those of you who are regular attendees at Council events can tell, this one is a bit different from some which you normally attend in two important respects. The first of which is that unlike many of the sessions here, this session is on the record—indeed, it’s being filmed as we speak—and thus you should assume anything you say may be broadcast any number of times on C-SPAN over the coming days and weeks.
Secondly, we are experimenting this morning with a somewhat different format. Unlike many of our presentations where we have the speakers make some initial remarks and then go to questions, we’re going to try this morning to use a bit more of a Q&A format from the outset, with the distinguished trio of panelists that I have sitting up here with me. I will moderate, both among the speakers and with you when we turn for questions and answers to the audience. You may perceive this as a bit of a curious hybrid between Oprah and an interagency meeting, but we’ll see how we do.
We have with us this morning, three of the most acute observers of the international economy from right here in New York City. To my far right, your far left, is John Lipsky from Chase Manhattan; between John and me, Bruce Steinberg from Merrill Lynch; and to my left, your right, David Jones from Aubrey Lanston & Co.
I thought I would begin with something which I hope is a consensus statement to the four of us, but we’ll see whether that is, in fact, the case, and then we’ll move right into comments from the panelists. The financial journalists of this country and many others have been itching to write the story that we’ve turned the corner on the world financial crisis. Personally, I must have had half a dozen such calls from different journalists over the course of the last month, each of whom I have attempted to discourage from writing the story that we have turned the corner on the financial crisis. But I think we can probably say with some assurance that we have at least reached a pause in the cascade of bad news which was coming down on us for several months, beginning with the Russian circumstances in August, and, thus, it is a good opportunity to step back a bit and assess how things are going, both in the economies which have heretofore been battered by the financial distress and also in the rest of the world, which is presumably still somewhat susceptible to economic or financial problems.
It’s also a good moment to take stock insofar as last Friday the International Monetary Fund finally announced the long-awaited stand-by arrangement with Brazil, a $42 billion package, which, it is hoped, will stave off contagion, not only from Brazil but from this hemisphere, generally. And even as we speak, we are about two-thirds of the way through the APEC meetings in Kuala Lumpur. Notwithstanding some of the noneconomic highlights of that meeting, there’s obviously a substantial interest there in Kuala Lumpur and at home in taking stock of how those Asian economies are doing, and what their prospects are over the coming couple of years.
Now with my premise that if we haven’t reached the beginning of the end, we at least have a pause that allows us to take policy, as well as analytic stock, I thought I would begin by posing the following question to each of my three colleagues up here. Assuming that, even if the beginning of the end is upon us, there’s still a good deal of vulnerability out there. What are the two or three countries, areas, phenomena which most concern you and that you think might most produce some renewed bout of financial distress or otherwise complicate world economic recovery? And, John, why don’t we begin with you?
Mr. JOHN P. LIPSKY (Chief Economist, The Chase Manhattan Bank; Director of Research, Chase Global Bank): OK. Will you grant me four? Four areas.
Mr. TARULLO: Sure. You can have four.
Mr. LIPSKY: First, Asia. Right now the Asian economies, as a whole, are in the grips of a severe downturn. The risk, of course, is that the Japanese efforts at stabilization fail in the midst of a slowing—accompanied by a slowing Chinese economy, and we end up with another round of currency disorder and uncertainty in Asia.
Secondly, the Brazilian package you just mentioned, hopefully is going to result in a structural improvement in the performance of the Brazilian economy, but it is going to produce a recession in Brazil in the coming year. The risk, of course, is that that downturn becomes a disorderly downturn, not an optimistic one.
Third, January 1st of next year, the euro comes into existence. We hope that that will be smooth and promote the creation of a single European financial market that will boost efficiency. The risk, of course, is that it ends up causing strains and problems in the European economy.
And finally, here in the U.S., corporate profits are down year on year. The cost of capital has gone up, as investors have become less confident about the outlook, despite the rise in the stock market. And we’re likely to see a significant slowdown in the U.S. in the coming year.
Mr. TARULLO: John, did you enumerate those in relative order of priority of concern?
Mr. LIPSKY: No, I would say that the Asian issue is the most pressing, and that is probably the riskiest situation going forward.
Mr. TARULLO: Bruce, would your list look about the same?
Mr. BRUCE STEINBERG (Chief Economist, Merrill Lynch & Co., Inc.): Well, I have exactly the same list of countries as John. I would begin with Brazil, however, because we have this momentary pause because the contagion has, for the moment, been halted with the Brazilian package. The capital flight from Brazil has slowed down for the time being. But it is all too conceivable that some time-three months or six months—down the road that this Brazilian arrangement will blow up.
As John said, if the package works, it means that Brazil has a recession in 1999, and that means that all of Latin America is really going to be growing in 1999, and that’s if it works. If it blows up, I think we’re talking about a recession that goes from Tierra del Fuego to the Rio Grande River and, obviously, with some implications north. So I would put Brazil first.
But, you know, immediately behind Brazil would certainly be Japan. Here we have the seventh stimulus package in seven years. I don’t think there is much reason to think that this latest stimulus package is going to be all that more successful than the six that preceded it. There are very deep-seated problems within the structure of the Japanese economy. We can talk about them later. But they haven’t really been addressed, as yet. And so the risk with Japan is that it may yet go into a deflationary black hole and suck the rest of us in after it.
The euro and Europe. The hope was that the euro would be born under the most favorable of circumstances. That’s what it seemed like a year or so ago. Now we see it’s not being born under those circumstances. Remarks out of European policymakers, especially the central bankers in Europe, don’t give me a lot of confidence in their economic astuteness. And I think that there is a period of risk as we go into early ‘99 with the euro. Europe itself is verging on outright deflation, and this does not seem to be to be noticed by central bankers over there.
And finally, of course, here at home, if our economy were to go into recession, then the whole world crisis would deepen terribly. It’s very critical to keep this economy out of recession to prevent much deeper problems for the rest of the world. But as John said, we have an incipient credit crunch going on in this economy, and earnings are down. And while the Dow is over 9,000, it has earnings expectations for ‘99 that are quite unreasonable. And the risk of a market correction over the next six months is pretty high, in my opinion. So there’s a lot of risk out there.
Mr. TARULLO: Bruce, on Brazil, do you think there was any room for improvement in the IMF package as it was announced last week, or in the Brazilian proposed economy policies which have been a precondition for the package, or is this about the best that could be done under the circumstances?
Mr. STEINBERG: Well, both, to answer your question. Would there be room for improvement in Brazil’s austerity program? Absolutely. The program is put together with spit. It requires a lot of what are really not very good kinds of tax increases in Brazil, things that are actually going to distort economic decision-making within Brazil. And those have to be approved by the Congress. And it doesn’t include enough spending reductions in the Brazilian budget, and some those need the cooperation of Brazilian states, which it’s yet to be seen if that’s going to be forthcoming. The point of this package is to reduce the Brazilian budget deficit from 8 percent of GDP in 1998 to roughly 6 percent of GDP in 1999. That’s huge. I mean, that’s why Brazil remains at risk here, because it’s still going to have a very huge internal imbalance. And with reference to Brazil, it’s not the global financial architecture which is the problem; it’s Brazil’s internal economic policies which are the problem.
So, you know, in terms of what the Brazilians are doing, stronger action would have been better, and this is the absolute minimum that they might be able to get away with.
Mr. TARULLO: OK.
David, Asia, Brazil, the euro and the U.S. economy—are those your list of concerns, as well?
Mr. DAVID M. JONES (Vice Chairman, Aubrey G. Lanston & Co. Inc.): Yes, but I’d like to look at it as something—I put it on the Richter scale of capital crisis, let’s call it. And obviously, we built, I think, to a crescendo, starting in Southeast Asia, maybe a 5 or 6 in the summer of last year. Japan, I would put in sequence there, a 7 or 8 on the Richter scale. And then coming earlier this year to Russia, which I would put in the 9 to 10 area.
And I think there’s an important point to make here, and that is how vulnerable our global fixed-income markets were for that psychological shock. After all, Russia is relatively small when we look at capitalization in its stock market. It used to be the same size as IBM. It may be a smaller company now we compare it to. But the psychological shock of their abrupt devaluation and particularly their debt moratorium in Russia really virtually shut down global fixed-income markets, particularly to lesser rated borrowers. I don’t think there’s a wide enough appreciation of how difficult that psychology was to deal with. Now we have a happily married Fed chairman, Alan Greenspan, who made a key decision in mid-October; he has another decision he’s going to make today to ease interest rates and to, in a sense, change global psychology at a critical moment.
But to me, the 10 on the Richter scale was the Russia situation. Now we’re on the other side, and Brazil may be 8 or 9. But one point I would make about Brazil and one of my main concerns is this package that we’ve come up with had no private participation as I can determine. It was essentially a huge government safety net thrown together in sort of a hurried way, just dumping IMF money and other government money into that situation as sort of a safety net in addition to the somewhat shaky domestic adjustments that Bruce mentioned. And so I think that we are not out of the woods yet.
And finally, I would just add maybe an 8 on the Richter scale early next year will be China’s difficulty. Everyone said the testament that global capital controls is China, because they were able to avoid the crisis. My view is that you just put off the moment of truth if you have an overvalued currency. They were given a little bit of room with the weaker U.S. currency. But I think as we go into next year, a fairly high reading on the Richter scale will be the question of whether or not China has to devalue? After all, Hong Kong is in the deepest recession in the postwar period, another example, as in the case of Brazil, of an overvalued currency that is really hurting the economy.
Mr. TARULLO: Yeah, but is it fair to put a couple of your comments together and say that, in the case of Russia, the biggest shock to the system was not the economic shock, but the shock that a country might actually default and that the semi-assurance that, one way or another, bond obligations would be met, if not in a timely, at least in an eventual basis, was shattered; and, on the other hand, that Brazil may reflect a bit of a reversion to some of the moral hazard concerns that were expressed last year. Because, contrary to earlier reports, it does not appear as though there was a substantial private sector rescheduling, much less forgiveness of Brazilian debt.
Mr. JONES: You summed it up perfectly. What was the key to every black box model run by Long-Term Capital Management and every other invincible hedge fund? It was that markets would continue to work. It was also that future bond trends would be the same as historic bond trends.
It didn’t take a Nobel Prize in economics to realize, at least with hindsight, that that was vulnerability. And what happened to all of those fancy quantitative global managers was suddenly Russia said, `I’m defaulting, and I don’t care. You thought you had a bond. You thought I would pay you back. We’re having such political problems, we’re changing the rules of the game.’ It was psychological and it was the abruptness of that move.
And the negative effect on all of the fixed-income markets, which had seen yields paid by lesser rated borrowers come in very much on top of the highest quality yields of Treasuries, suddenly the chairman came downstairs in an organization and said, `You’re trading what?’ He was getting bonuses paid on the basis of high-yield performance in these countries a couple of years before. All of a sudden, he said, `Shut it down. I don’t want to see any risk in this portfolio in this organization, whether a hedge fund, or the proprietary trading operation of a bank.’ And I think that is the moment of truth.
Now, as I say, we’ve come past that. Greenspan helped deal with that. The G-7 October 30th pronouncement helped deal with that, but in no way are we out of the woods on that issue, and that’s going to be a critical issue in Chairman Greenspan’s decision with his fellow policymakers today, as well.
Mr. TARULLO: Would either of you like to comment on that?
Mr. LIPSKY: Yes, I would, actually. First of all, the issue of Russia. Why were the markets so shocked in response to that development? I think there was an important message and that message was the recognition, or the crystallization of building realization that the international crisis management system is itself in crisis, that the methods being utilized to try to deal with these problems really hark back to the 1980s when the paradigm of cross-border private-sector capital flows was bank lending. And now we’re in a world of capital markets. And bank crisis are, by definition, slow-motion crisis. Capital market crisis are, by definition, high-speed crisis. And we’re still trying to deal with the problems of today with the methods of yesterday. We have to come to grips with an international financial crisis management system that recognizes modern capital markets. It can’t rely on this series of ex-post carrots and sticks but has to be structured in a way to make market discipline effective. And that’s something, even today, we haven’t come to grips with. And Russia showed, even with the involvement of the IMF, the World Bank, the backing of the G-7, that catastrophe in financial terms at least could still occur.
Now there’s an underlying reality that is being reflected in financial markets and that is, in addition to that perception of the crisis management system in crisis, there’s a recognition that the world is a riskier place than we had come to think in the mid-1990s in the midst of the Goldilocks economy. So markets are trying to figure out how risky. We know it’s not as pleasant as we had hoped. We’re not sure and investors aren’t sure how difficult it’s going to be.
Now in Brazil, happily if you will, or unhappily, depending on how you want to look at it, the problems of Brazil are not the problems of Russia and are not the problems of Indonesia or Thailand. The problems of Brazil are easy to understand and recognize and the cures are also understandable. And it’s simply the issues are really one, as Bruce mentioned, essentially of domestic, financial and economic balance. The Brazilian authorities recognize that. They’ve just had an election that seemed to endorse a government that has promised to take action, and we’ll see if they’re taking the actions that work. But happily, this is the kind of situation in which you can hope that international support through the IMF and the G-7 could really provide the confidence to convince Brazilian savers and investors that the situation is improving, and that’s the critical issue, not what foreigners think.
Mr. TARULLO: When John...
Mr. STEINBERG: Can I just...
Mr. TARULLO: Oh, sure.
Mr. STEINBERG: ...just building on something that John said. The issue with the global capital markets and what’s going on in them since the Russian default is that all of a sudden investors realized that they had greatly mispriced risk. As John said, they looked at the world as this benign place in the mid-1990s and it turned out to be a lot less benign. And what’s going on right now, and this is one of the channels—this is a major channel of contagion of the crisis into our own economy—what’s going on now—and although we’re hopefully over the hump, there’s still plenty of risk attached to this—is that the financial community within the United States, which is not only the hedge fund community but banks and investment banks, we all did the same kind of trades that long-term capital did, hopefully not at the same levels of leverage but the same trades that were premised on markets reverting to the means, so to speak. And when this thing blew up and risk premium exploded, all of a sudden we were holding the bag, and now within every financial institution, I would hazard to guess, there is a deleveraging process which is going on, an aversion to risk, a cutting back on commitments.
Now this has negative economic consequences because it means that less financing is available, certainly to the corporate sector, and if you’re a sub-prime borrower right now, you’re actually locked out of the capital markets. Who could think that a Russian default in August would lead to, you know, no junk bond issuance in the United States or very little in November, and yet that’s basically what has happened. And there’s a direct line of causality there and it goes to the issue of mispricing risk.
And even the mortgage market is being affected because if you look at—remember that most mortgages are securitized and sold off and the premium on mortgage-backed bonds—the spread on mortgage-backed bonds relative to Treasuries is at levels right now which exceed where they were in the last recession, even though those spreads have come in. So, as David was saying, we’re over the hump for the moment, but this could easily degenerate again, which is why I think today, although there’s a lot of mixed messages that Greenspan has to really accommodate, they really should go ahead and ease today because this one problem is the one that most threatens our own economy in terms of tilting it into an outright recession, that Russia did more damage to global capitalism when it tried to become capitalist than it ever did when it was communist. And I just—the irony of this.
Mr. TARULLO: You heard it here first.
Bruce, when John talked about the U.S. economy, he made reference to fundamentals. David made the reference to long-term capital management and you were just addressing this issue as well. Do you see any significant possibility of other financial hedge funds or other financial entities themselves encountering a crisis which was a catalyst for problems here, or do you think that this was more likely a one-off problem?
Mr. STEINBERG: We can’t be sure, but I think that long-term capital was a one-off problem, in part because since that happened, anyone that had positions at all similar to those of long-term capital has been cutting back on those positions. And even if Brazil three months down the road should blow up, by the time that happens, although it’ll create some really big problems in the world and will create contagion problems for Latin America and potentially our own economy, the kind of positions that—I don’t think it’s going to explode within our own capital markets to the extent that this last event did. I think hopefully we’ll be more insulated by that, but that’s not to say that more damage wouldn’t be inflicted.
Mr. JONES: Could I just add...
Mr. TARULLO: Sure.
Mr. JONES: ...that one of the blessings we have is that our financial sector has a lot of capital. We’ve had a lot of success. Our spectacular economic performance over the last eight years has, in fact, allowed financial institutions to build huge capital positions and they’ve acted as a cushion. So even if a company lost money, patterning its activities after a long-term capital management, their capital position is able to absorb it. So I don’t think we have severe systemic risk. That’s not to say that one or two institutions either in the banking side or the investment banking side were not extremely vulnerable in that mid-August to mid-October period. But I just don’t sense that we’ve had the systemic risks.
I think European institutions are in the same position. They’ve taken a bigger hit than appeared initially with respect to this global financial meltdown, but again, their capital positions were relatively strong and able to absorb it. We were fortunate perhaps in contrast, for example, with the Japanese banking system.
Mr. TARULLO: Go ahead.
Mr. STEINBERG: I just want to add two things. One, vis-a-vis the European banks—while they’re sitting back so complacent in Europe, we should understand that the exposure of European banks to emerging markets is triple the exposure of U.S. banks to emerging markets. So they actually have a lot more exposure than we do.
The second point comes back to this issue of the contagion and how it’s working through here. Losing the second point—when we see these forces in progress and the deleveraging which is going on, the institutions will survive it, but while hedge funds had been set up as the villains of the peace, their absence in terms of being risk takers right now is actually hurting the world economy. They were performing a necessary function in terms of being willing to be on the risky side of the trade. Now no one is willing to be on the risky side of a trade and this has completely blocked a lot of things that would be better to see happening right now. Probably we should be not villainizing hedge funds as we’ve done.
Mr. TARULLO: So it may be that we’re in an awkward, intermediate position where in the absence of the kinds of tools and prophylactic measures that John was alluding to earlier, just putting the breaks on such system as existed, even an imperfect one, may be creating a whole new set of problems.
Mr. STEINBERG: Well, it may be creating problems. I mean, let’s step back and think about what next year may actually end up looking like. At best, we’re talking about a very weak global economy in 1999 where economic activity really in every single region of the world is gonna be weaker next year than it is this year and Asia’s the only exception. There it won’t shrink as much in ‘99, hopefully, as it shrank in ‘98. But in that context, the less willingness to take risk contributes to that but also the less willingness to take risk becomes less important in a sense because we’re in a period where people are not as willing to take risk anyway. Companies are not going to be as willing to make investments; hence, therefore, the lack of investment capital, while it can make the slowdown worse, on the other hand, is in keeping with the view that companies might have about whether it’s worthwhile to be taking investments.
Mr. TARULLO: John, it is the case, though, isn’t it, that bank lending has continued fairly steadily even in a period in which junk bond and IPO and other kinds of financing has been less available?
Mr. LIPSKY: Well, that’s right—in fact, to the contrary. Not only it’s been better than steady, it’s been accelerating, but that’s not necessarily a sign of strength but a sign of distress, that companies have had a hard time accessing capital markets and have, therefore, turned to banks as a backstop for lending. As the capital markets have become more difficult, it’s natural, typical at this time, at a time of slowdown that bank lending tends to accelerate.
The broader capital markets issue, if we look at a big measure of growth of non-federal credit—in other words, use of credit by the private sector in general, although that data comes with a lag—it’s going to show a significant slow down in the increase of credit. And that’s one reason why concerns about things like the money supply is growing rapidly, etc., really misses the point and that is really what Bruce was talking about. Global growth is going to be slowing in the year ahead. The external sector is going to continue to be a drag. Inflation is going to be very low indeed. And most likely, given the perception of heightened risk, that investment spending that has been such an engine of growth here in the U.S. is already slowing substantially and is not going to return to the rapid increase that we’ve seen over the past few years.
Mr. TARULLO: If there is one point of, I think, consensus, not probably just among the four people up here but in the United States generally, it is that Japan’s recovery is a necessary, if perhaps not sufficient, condition for Asian recovery generally. And I thought we should probably spend a few minutes on Japan and the latest Japanese package, although perhaps we could also allude to the continuing banking problems. Let me just put the question and, David, maybe we can start with you. How impressed or unimpressed were you with the stimulus package which the prime minister announced on Monday and what kind of prognosis do you give in the medium term for Japan?
Mr. JONES: I think we’re starting to get to the saucer portion of the Japanese financial experience at least. I’m not sure whether we’re still in the downside of the saucer or at the low point, but the package represents a key factor and that is it acts like it’s getting a little bit ahead of the expectations curve. Now it’s taken a decade for Japanese policymakers to realize that the first thing you do as a government is you need to get ahead of what markets think you will do, whether it’s in a stimulus package. Finally, at least in terms of size, it was like shooting a moving target. I think we’re up to 24 trillion yen in terms of the stimulus package with some sensible tax rate cuts included there. I think individual income tax top rates come down from 65 percent to 50 percent; corporate rates come down from 46 percent to 40 percent. And also a gimmick—which I would be doing if I had to to get ahead of expectations which is everybody in the country gets a gift certificate. You have to spend it in six months, which given a high savings economy—now if I remember right, Jimmy Carter tried that a long time ago and it didn’t work very well, but...
Mr. TARULLO: Nothing he tried worked very well.
Mr. JONES: That’s true. But anyway, I do sense that this latest package, particularly on the stimulus side, is at least starting to get ahead of expectations. On the banking side, same thing happened. I don’t remember the numbers precisely, but I think we started with the banking package—bank bailout package of 30 trillion yen, but we all knew that non-performing loans were probably twice as large as the official estimate of whatever the number it was. So they’ve doubled the package to 60 trillion yen, roughly, the credit line for banks. So what I would say is that after a decade of—you have to call it disaster, the macroeconomic policymaker’s nightmare of the world in the second-largest economy in the world, where policymaking just didn’t seem to work and where we were sitting in essentially a liquidity trap where banks were unwilling to lend and people are afraid to borrow like we saw in the 1930s in this country, we may be starting to see just the first hints of a positive response.
Mr. TARULLO: It may be that after five and a half years in U.S. government, my skepticism about Japanese policymaking is now visceral so that I always tend to see the empty half of the glass, but my own very quick reading of just the outline of the program suggested to me that, A, the real question of how much real water there is is still an open one; B, that at least some of what is probably real spending is just the amount necessary to keep up public works spending from last year even though it looks like it’s incremental; and, C, that the problems with requiring or counting on municipalities and regional governments to spend, which has already been problematic, is gonna still be with us. So I was—notwithstanding the size of the package, I was unsure that there would be a huge net stimulus effect given the circumstances. Does either of you...
Mr. STEINBERG: Yeah, I would disagree with David in one way. It’s not that anything they tried didn’t work; it’s that policymakers kept doing the wrong thing for 10 years. I mean, these guys should all be taken out and shot. They are the worst group of economic policymakers that have existed in the world since the 1930s. I mean, they have just repeatedly done the wrong thing. As for this package, on our add-up, we come up with about—and, you know, again, we’ve only looked at it for a day now, but it looks like about $40 billion of incremental spending, not $200 billion which is the headline number in the package. And in my opinion, that’s enough to keep the Japanese economy from shrinking more than a couple of percent next year, but I don’t think it’s enough to even get them to have a stable economy with no growth. I think the economy there remains in great distress.
On the banking sector stuff, yeah, it’s good that they have $1/2 trillion program here. Of course, he bad loans according to S&P are $1 trillion, but, you know, the problem with the banking sector is this: At the end of the day, you’re never going to cure it unless you liquidate the underlying assets which are at the root of the problem. Let’s sell off the real estate, shut down lending to the deadbeat borrowers that shouldn’t be getting any. Of course, these are all LDP supporters so, you know, there’s a problem there, and hardly any of that has really happened in Japan.
And stepping back, you know, one further step from Japan’s problems, what’s happened in this decade is that Japan, Inc. went bust and Japan as an economy cannot recover until Japan, Inc. is fully unwound and Japan functions the way that a normal market economy is supposed to function and not in the way that this kind of private sector socialism that Japan has been premised on up to now where everybody helps everybody else out and the Keiretsu all have cross holdings in each other and so on. That isn’t working anymore and that process of restructuring both on the financial side but also on the industrial side has really begun. So I think that the medium term prospects for Japan remain pretty dismal.
I don’t think Japan is going to start growing for at least another year or two, and even when it does, I don’t think it’s going to be growing very rapidly. I think that a robust Japanese economy is probably at least five years out from this period in time because they still have so many things to do which they’ve hardly even scratched the surface on.
Mr. TARULLO: John?
Mr. LIPSKY: No, I just would take a somewhat more sympathetic view toward the problems that the Japanese authorities face in the Japanese economy without trying to minimize the problems. This is a topic that we could spend a long time on. It always struck me that folks are pretty cavalier about their explanations of where the Japanese bubble economy came from. I think it had some real roots in terms of gigantic changes of external terms of trade that imposed beneficial problems but turned out to be problems on the Japanese economy.
Bottom line: Japan is in the grips of a domestic crisis of confidence. In the United States, our savings rate has fallen to zero. In Japan, already a high savings economy, the household savings rate has increased by 50 percent in one year. The situation is dire enough so that at a zero rate—essentially a zero rate of interest, intended savings, is larger than intended investment, a problem that we really don’t know quite how to deal with. There are no easy formulas or magic answers for a situation like that. And politicians, in any country, not just Japan, have trouble dealing with situations in which policy choices are all bad choices. In other words, politicians are good at making choices that help somebody but don’t hurt anybody else, or at least that they recognize. Politicians everywhere, including in this country, are very bad at facing up the situations where decisions may help somebody but hurt somebody else, and that’s what it looks like to the Japanese authorities, that all their choices possess that negative aspect.
In other words, the issue is not really whether the Japanese measures make us think they’re doing good things. The issue is to cure the domestic crisis of confidence, and there aren’t any easy answers and that’s why I think the Japanese are resorting to what they’re doing which is some of everything.
Mr. JONES: But let me just come back to the loan. I mean, I feel like I’m being ganged up on by the...
Mr. LIPSKY: No. No. Not at all.
Mr. JONES: Let me just come back to pick up on the issue you just said, John. The key is confidence. Now you need it in this fast capital...
Mr. LIPSKY: Their confidence.
Mr. JONES: Well, in this fast world of moving capital that you alluded to so correctly. It’s two kinds of confidence and maybe it requires global confidence first and a Nikkei that begins to turn up, perhaps because of this expectations game I was talking about, and that’s all I’m playing right now. I’m not going to the fundamentals which are still extremely difficult. But if the Nikkei starts to improve, if it looks like the policymakers are ahead of the curve, then maybe you have at least a start on getting domestic confidence to build back. And I sense the one thing that favors Japan right now is expectations are so low that it doesn’t take a lot to start this process.
Now if it were the old banking world that you were talking about and we take 10 years to work our way out of any problem, I would agree with Bruce that it would be a long, long time before we start up. But in this fast world of capital flows from country to country, I think at least there’s a first tiny step in the right direction in terms of building global expectations which hopefully then builds domestic confidence.
Mr. STEINBERG: Well, if I could agree with John and maybe disagree with David here. Japan does not need the rest of the world to be that confident in it, because Japan does not require capital from the rest of the world. It has way too much of its own it doesn’t know what to do with it. What Japan needs is to rid its population of the deflationary psychology that they have. I mean, if you’re an average Japanese consumer, you think your government is incompetent, your wages are shrinking, the unemployment rate is going up in Japan, and if you don’t buy something today, the price of it will be lower tomorrow. So why bother to buy today? That’s a very, very difficult psychology to break through.
And as John said, there is no easy answer to it. I think one of the short-term things where a real mistake has been made in the last couple of months—of course, it wasn’t a mistake; it was a market event—which was as the yen carry trade got unwound and the yen shot up and the dollar fell down, most people seemed to think this was a good thing because it took some of the pressure off of emerging markets like Korea, China, Hong Kong and Brazil, for that matter. My opinion is the opposite, that this was a terrible thing, because here is Japan, an economy in a liquidity trap, which means that at zero interest rates, and actually negative interest rates, no one is willing to borrow, no one is willing to invest, and that’s because it’s in a deflationary crisis. The last thing an economy like that needs is to see its currency appreciate and to intensify the deflationary pressures internal in it. And if the Bank of Japan were doing what it should be doing right now, which I would define as letting the printing presses roll continuously right now, the yen would be depreciating, and a weaker yen might actually help unwind the deflationaries or limit the deflationary psychology in Japan.
Paul Krugman likes to say Japan should inflate its way out. I think that’s easier said than done. I don’t think they can do that. But you could, through currency depreciation, probably begin to stabilize the price level or at least keep it from falling so fast and maybe limit the extent of the deflationary psychology within Japan and maybe actually get Japanese consumers to save a little less, maybe. I just point that out.
Mr. TARULLO: Well, I’m going to play John McLaughin here and say the answer is that at least Japanese policymakers are out of denial, a state that they occupied for about three years. But perhaps they haven’t yet come to grips with the magnitude of the measure-the policy measures that they’re going to have to take.
Last question, and maybe we can all be brief in addressing this so we can turn to the audience, but that’s not a comment on prior questions, just that the time is beginning to run. John, you mentioned the euro and by implication the attitudes of European policymakers, Central bankers and I think finance ministers as well, who until recently were extraordinarily inwardly directed. They still are concerned with the success of European monetary union and believed, unlike Alan Greenspan, that they could be an oasis of prosperity in a turbulent world economy. Put the U.S. and the United States and Europe together for a moment and give at least a brief report card on how the G-7 minus Japan are doing in proving leadership and direction through this crisis.
Mr. LIPSKY: Mediocre grades frankly. There’s been too much denial about the seriousness of the problems, especially the structural problems that face the world financial markets and the world economy in general. It seems to me that we’re just now after a year and a—well, a year and a half since July 1997, the tied evaluation, at every step of the way, there has been an attempt by policymakers to underplay the seriousness of what was going on and to try to treat each individual event as if it was separate and unrelated, as if a devaluation of the tie bought could end up by causing a global economic downturn.
The problems are far more structural and come back, among other things, to our international crisis management system. It’s only now—in fact, it was in this room on September 14 that President Clinton finally began to talk about the need for addressing seriously the issue of world financial architecture. And as you just said, the European authorities, in a sense, understandably, and in a sense, rightfully so, have been completely focused or overwhelmingly focused on making monetary union work. As someone put it at the European central bank, if the euro repo rate is 25 bases points too high or too low, no one’s gonna notice, but if the payment system doesn’t work on January 4, 1999, then the European central bank is gonna be known as Europe’s answer to the Hong Kong airport authority. It’s gonna be a real problem.
So the important thing is they make it work. I think it is going to work and work well, but now they have got to turn to broader issues of regaining confidence that the financial system is being accommodated, not to a world of capital controls, but to a world of modern capital markets. And I would say that’s job number one and they’re just getting started.
Mr. TARULLO: But let me interject here before Bruce and David come. It seems to me that the job of restructuring the international financial system is both extraordinarily complicated and, of necessity, gonna take time and probably will be mildly credit constricting, if one anticipates that as a result there’ll be some kind of restrictions either through credit or through direct regulatory measures.
If that is the case, or given that I think that’s the case, shouldn’t the attention of the G-7 leaders in the first instance be directed toward restoring growth through such stimulus measures or assistance packages or the like as they can and have their subordinates working in the longer-term structural reforms and then turn to those perhaps later next year once things have stabilized, or do you really think that you have to address the long-term issues in order to restore shorter-term confidence?
Mr. LIPSKY: I think you have to begin to address the longer-term issues in order to begin to restore confidence in the system. Right now the IMF under its current guise has been converted by policymakers truly into the impossible mission force. They are being asked ex post to come up with almost overnight structural reform programs...
Mr. TARULLO: That’s true.
Mr. LIPSKY: ...for economies and that that’s—and with the application of huge amounts of external money that’s supposed to solve the problem. The connecting thread in all the crisis countries has been a flight of domestic capital as the triggering event. The issue is to create domestic confidence and confidence in capital markets. And to make that happen, you have to make market discipline work. And that is gonna take time, but you’ve got to start in a forthright manner. And the other thing the G-7 has to do is what you just said: ensure good economic performance by the G-7 economies. Right now, I think more than anything—well, G-6, G-7, let’s not be so pessimistic—what that requires everywhere is lower interest rates in a world of very low inflation.
Mr. TARULLO: Bruce, your plan?
Mr. STEINBERG: Yeah, I would have a slightly different take than John on this one. When the house is burning down, you’ve got the fire department, and you don’t worry about the new financial architecture because that is going to take time to create and I think that there could be, in a sense, too...
Mr. TARULLO: David, do you want to begin?
Mr. JONES: That’s a tough one. Chairman Greenspan gave the official answer...
Mr. TARULLO: That’s not what I want.
Mr. JONES: ...in congressional—too big to liquidate quickly.
Mr. TARULLO: Big deal.
Mr. JONES: They didn’t say that, too big to liquidate quickly given the royal capital markets we had. It’s a tough call. Chairman Volcker has actually been quite critical of that bailout, but, of course, as I saw in a publication recently, the current Fed officials turn back on Chairman Volcker and said, “What about the Hunt Brothers silver crisis? What about Drysdale securities? What about a series of what may be Drexel Burnham in which Chairman Volcker took a role to try to minimize the negative effect on the markets?”
Let’s put it this way. In principal, I agree with the tone of John’s question. How can we have an open capitalist system, free capital flows, the U.S. model for the world, and how can we now criticize Asia for crony capitalism, when in the cases when our model doesn’t work, we do bail them out? I guess I would say it’s a close call...
[interruption in audio recording]
Mr. STEINBERG: I think that we have to deal with the current situation ad hoc right now while we let the lower-downs, as you say, Dan, deal with the new financial architecture. If you want to have great U.S. policymakers and European policymakers in this situation, nobody gets an A, but at least we have policymakers that seem to know what they’re doing, to some extent, and that’s more than you could say about Europe, which, you know, for all the reasons that John was saying, was very inward looking here. I think it was an oasis, an island of tranquility, that Win Deusenberg referred to Europe as at one point.
I do think that it is incumbent on Western central banks to ease monetary policy aggressively because it’s critical to keep the West growing and not to have a recession right now because, you know, normally you think an economy like ours that’s been growing for eight years—this is, after all, the longest peace-time expansion in history—a recession wouldn’t be so bad. And normally you would say, “Yes, but if we have a recession now, we’re talking about a global recession, the first one since the ‘30s.” So we want to try to avoid that. And, really, the only tools available right now are interest rate reductions, and not only here where they’ve begun, but also once the European central bank gets going, in Europe as well.
As I said a little while ago, Europe is bordering on outright deflation right now. The so-called harmonized index of consumer prices in Europe—that’s the CPI for the Euro zone—is up all of 1 percent from a year ago, and it’s been decelerating.
One final point on Europe versus the U.S. We have much better ability to navigate our way through this than does Europe. We have interest rates which, right now, are well above European rates and, therefore, if we need to, we can bring them down a lot further than the Europeans can bring them down. I hope we don’t turn to, you know, massive tax cutting, but if we need to, the U.S. has a budget surplus, so we have some fiscal flexibility. In Europe, there is, you know, still deficits range 2 1/2 percent to 3 percent of GDP. And as much as the left-wing governments now in power in Europe would like to start a lot of Keynesian stimulus, in fact, they’re constrained by the fact that they’re already running big deficits.
And finally, we’re starting—even though unemployment is inevitably going to go up everywhere, we’re starting with an unemployment rate which is extremely low, 4 1/2 percent, and in the Euro zone it’s nearly 11 percent. So we have, really, much better ability to navigate through this period than, I think, they do.
Mr. Jones: Well, I just want to pick up on two points from John’s comments. First of all, the financial markets in Europe will be attractive to global investors, in part because of consolidation in the bond and equity markets, more liquidity. But I truly think they need to start working on an equity culture there, like we’ve developed. That means good corporate governments, that means transparent accounting, that means good reporting, good securities regulation. The U.S. the only market that has that right now and at this moment, I think Europe needs it.
Second point would be—and I’m very pessimistic about this—I don’t think we can have single currency work in Europe without greater labor mobility, without more wage and price flexibility in the labor and product markets. And at last count, something like 11 out of 15 governments in the European Union have moved decidedly left. And I think the ability to get these fundamental structural changes in the labor markets, whether you can fire somebody after you hire them, or how much you have to pay in terms of unemployment compensation and retirement benefits And, therefore, the issue of how high labor costs are in Europe, and how high the equilibrium unemployment rate is as a result becomes critical. So my view is that that single currency experiment is not going to work very long, and you’ve got to go beyond just the macroeconomic policy measures. You do have to start thinking about structural changes.
Mr. TARULLO: Just to close here, and to turn the audience, but give the—just as David tried to give a somewhat more optimistic view of Japan, just the somewhat more optimistic view on Europe and EMU is that it—it’s twofold. One, that the decision to go with EMU will force the kind of structural changes that you suggested necessary, and European policymakers had concluded they could never get the policymakers as a condition—the policies as a condition for moving ahead.
Secondly, that—that it will take center-left governments to make the kind of labor market reforms because they have some credibility with the unions. And so a number of European commentators say that center-right governments would be vilified if they did some of the same things the center-left governments may be proposing over the course of the next couple of years. But obviously, those are both, at best, speculative.
In the time remaining—and I apologize for not having as much time as we might, but I think this has been a particularly productive discussion—we will turn to questions. Please try to keep your question concise in the interest of time.
QUESTIONER: You all have presented a not entirely optimistic outlook for the next few years. Why is the Dow at 9,000?
Mr. TARULLO: Let begin with the investment banker. Bruce?
Mr. BRUCE STEINBERG (Chief Economist, Merrill Lynch & Co. Inc.): I would say a few things have gone on here. First of all, there is the thought, always foremost in Wall Street’s mind, “Don’t fight the Fed.” The Fed is easing monetary policy, that means life will be good. Now ultimately, “Don’t fight the Fed,” isn’t always the right advice; unfortunately it’s possible to premature with that. For example, at the end of the last expansion, starting in early ‘89, the Fed eased policy by 175 basis points, and by the winter of ‘90, six months later, we had a recession anyway. So you got to be careful with that.
Secondly, by the end of—by September, let’s say, when Armageddon was, basically, priced into, certainly into the fixed income markets, and also equities were extremely depressed, fund managers had raised large amounts of cash because they were expecting a lot of redemptions, and they were also quite scared about where the environment was going. The Fed started easing policy, Armageddon didn’t happen, they’re sitting on unusually large cash positions, and all of them are way behind their index. They—they are rewarded on, you know, outperforming their index. The average fund is something like 1,300 basis points behind its index right now this year. The market starts going up. They have to go along. And so all of this money that had been just accumulated was pushed back into the equity market, and that probably had quite a lot to do with this huge run we’ve just had over the last six weeks.
The final thing I will say is this, earnings expectations for next year are excessive. I don’t know how I feel about this, but I actually have the lowest top-down earnings forecast on Wall Street right now, because I think earnings are going to go down 5 percent next year, and the consensus is that they go up 5 percent. But on my forecast, the market is selling at 27 times ‘99 earnings, which is pretty incredible. And even on the consensus, it’s selling at 23 times ‘99 earnings, which is pretty incredible itself.
So I do think that as we move into early ‘99, and it turns out the economy is weak and profitability isn’t really there, that the likelihood of a correction is not insignificant.
Mr. TARULLO: Other questions? Yes, over here. Sorry, couldn’t see you.
QUESTIONER: I’m self-employed. I would like to ask what the learned economists think is the rationale for the saving of long-term capital in the sense of allowing the excessive speculation to be further encouraged by the institutions of America, and the world, banding together to keep these people in this business.
Mr. JONES: I’ll take it.
Mr. TARULLO: David, you want to begin?
Mr. JONES: Yeah, that’s a tough one. Chairman Greenspan gave the official answer in...
Mr. TARULLO: That’s not what he...
Mr. JONES: ...in congressional—too big to liquidate quickly. But he didn’t say that too big to liquidate quickly, given the royal capital markets we had. It’s a tough call. Chairman Volcker has actually been quite critical of that bailout. But, of course, as I saw in a publication recently, the current Fed officials turned back on Chairman Volcker and said, “What about the Hunt brothers silver crisis? What about Drysdale Securities? What about a series of what may be Drexel Burnham,” in which Chairman Volcker took a role to try to minimize the negative effect on the markets.
Let’s put it this way. In principle, I agree with the tone of your question: How can we have an open capitalist system—free capital flow as the U.S. model for the world, and—and how can we now criticize Asia for (unintelligible) capitalism when in the cases when our model doesn’t work, we do bail them out? I guess I would say it was a close call. I think the Fed was acting to minimize damage to the capital markets. I’m not sure the mechanism the Fed chose for this process was the best one, this consortium idea that may be around for awhile, but I guess I would say if I were in Greenspan’s spot, I probably would do the same thing.
Mr. STEINBERG: Yeah, can I just add two things to that? One, it was not a bailout of long-term capital. It was a controlled bankruptcy, in that most of the equity of the partners was wiped out by the bank. Why did they do it? Not to save long-term capital, but because, unfortunately, much of the financial community had positions very similar to the kinds of positions that long-term capital had, and if long-term capital went bankrupt and all of its positions were unwound at once, there are probably some investment banks and commercial banks that would have gone down, also, and we would have had systemic crisis. The Fed’s first brief, before it has to fight inflation, is to guard against systemic risk, and I think that that’s what it was doing with the long-term capital event.
Unidentified Panelist: Just one correction. Not all institutions are the same.
Mr. TARRULO: I just—if you think of it...
Mr. STEINBERG: Similar. I didn’t say the same. And I don’t think anyone was leveraged the way they were. But...
Mr. TARRULO: If you think of—if you think of it as an ad hoc quasi-Chapter 11 process, I think it looks less disturbing than if you think of it as the Fed running to the rescue of a bank. And as David said, it is a close call in any case because it’s obviously intervention. But as Bruce said, there’s—the Fed has systemic responsibilities in addition to the fact that there is no particularly good process sitting out there right now.
Mr. JONES: And—and the big message shouldn’t be lost. There has been a substantial decline in leverage in the financial system, and it’s not gonna come back or be put back in that way anytime soon.
Mr. TARRULO: And the final thing to say is to the degree that reputational effects are a cost, having a Novella in The Wall Street Journal, as was the case yesterday, probably imposed a whole set of external costs on the LTC and management. I think we probably have time for one quick final question. Yes.
QUESTIONER: Mr. Lipsky mentioned early on the point about bank crises being relatively slow and capital crises being relatively fast. I just wondered what your opinions were about the prospects for capital controls going forward, either on the part of creditors or borrowers, in particular sovereigns.
Mr. TARULLO: John.
Mr. LIPSKY: Yes, thank you. It’s a good question. And, of course, I think we can put the answer in a nutshell. The poster child, the example of successful capital controls that has held up for everyone to see is the case of Chile, a relatively small country that imposed some limitations, or, in fact a tax, on short-term capital inflows under very special circumstances. What’s most important is in the-is in the context of the current crisis. The Chilean authorities are removing those controls as fast as they can and are unilaterally cutting tariffs. I think our—that’s the real example that ought to be followed. It strikes me that there is a all too great a willingness to accept capital controls as a short-term palliative for—in lieu of taking more decisive policy actions in the short run as a means of trying to stabilize difficult circumstances.
Now we have to grant that in—and there are situations in which disorderly financial markets require some kind of limitations in the short run, but to establish a paradigm of controls over capital flows strikes me as to move in the wrong direction. In fact, in every financial crisis in the post-war era, the resolution has come by means of measures that we would call liberalization and reform. And they have produced steady rapid growth in external trade, and I think the greatest expansion in the world economy in any period we’ve ever seen.
This is the first crisis in which there is a risk that there—the resolution will involve a a global official adoption or approval of capital controls as a normal course of events. I suspect that the way forward lies in following the kind of line of approach taken by the IMF and the IMF’s interim committee, which is to extend the funds articles of agreement to a process of gradual capital market liberalization in the same way that the fund in the post-war era sponsored the opening of current account payments that has produced the growth, I think, is the primary reason for the sustained expansion in external trade. In other words, short-term capital controls may be needed, but they should only be seen in the context of a process that moves toward capital market liberalization in a way that makes market discipline effective. That’s what we don’t have right now and that’s what we need.
Mr. TARULLO: OK. We’ve come to the hour of 9:30, and in accordance with what we hope is consistent Council practice, we want to end promptly. On behalf of the Council on Foreign Relations, I want to thank John Lipsky and Bruce Steinberg and David Jones for a very productive interchange. And I hope to see you all here again probably early next year when we do something similar. Thank you all for attending. Thanks very much.