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World Economic Update - December 4, 2003

Speaker: Ian Morris, chief U.S. economist, HSBC
Moderator: Daniel K. Tarullo, professor, Georgetown University Law Center
Speakers: Stephen S. Roach, chief economist and director of global economis, Morgan Stanley, and William C. Dudley, managing director and chief U.S. economist, Goldman Sachs and Comapny
December 4, 2003
Council on Foreign Relations

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New York, New York

MR. TARULLO: Good morning, everyone. They’re going to be like my classes; they don’t settle down. Welcome to the December edition of the World Economic Update. We have back with us today Steve Roach, a perennial participant; an old friend, Bill Dudley from Goldman Sachs; and making his first appearance, Ian Morris from HSBC.

This morning—I should give you the introductory remarks—this is an on-the-record CFR event. Most, as you know, are not. When we get to the question-and-answer period, we will also be on the record. So when I recognize you, if you would please identify yourself and then be aware of the fact that you yourself could be quoted.

Okay, this morning we’re going to talk about three sets of issues. Two of them are going to be familiar to you, but we have something; that’s interesting to say each time, one short-term economic prospects—and I’m increasingly think of short term as through the first week in November of 2004.

Then we have the medium- to longer-term economic prospects for the United States. And finally today, with the upcoming visit of the Chinese premier to the United States, we thought it would be useful to talk about China, China’s economic position right now, but also its economic relationship with the United States.

So, beginning with the short-term economic prospects for the United States, the good news just keeps rolling. Every day there’s another piece about either jobless claims being down or productivity being up, manufacturing being up, durable-goods orders being up. And at this point it’s fairly hard to find any forecaster who doesn’t see at least acceptable growth over the next few quarters, which is the first, second, third quarters of 2004.

So the first question to ask is, are there any clouds out there which might stop the United States from reaching a growth rate on an annualized basis of, say, 3 percent or even substantially better in the beginning of 2004?

Or, at this point, are we basically like a snowball going down a hill, which is to say that the dye has more or less been cast and, absent some sort of substantial, unexpected and negative exogenous event, that’s the track that we’re on for the next nine months or so?

Bill, what do you think?

MR. DUDLEY: I think for the first half of 2004, I think things are reasonably secure. You have strong stimulus from monetary and fiscal policy. Financial conditions have become a lot more accommodative over the last six to nine months. That’s the big change, really, that occurred in 2003. Financial conditions between 2001 till March 2003 had not become more accommodative but (met?) a substantial easing—stocks up, dollar down, and long-term interest rates have stayed reasonably low.

The second thing that I think is healthy is obviously fiscal policy is still stimulative, and you’re going to get some fairly sizable tax refunds in the first half of the year. The fiscal impulse in the first half of 2004 isn’t going to be as big as the impulse in the second half of 2003, but it’s still going to be positive. It’s not until the second half of 2004 that we really have to worry about the fiscal impulse turning around from stimulus to restraint.

So I think there could definitely be a slowdown in the economy in the second half of 2004, but I think the first half looks pretty secure.

To me the only real big question I have about the outlook over the near term is the impact of the sharp decline in mortgage refinancing activity. We think that’s been a pretty important factor supporting consumer spending over the last couple of years.

We calculated a number called mortgage equity withdrawal, which is calculated—we look at the change in mortgage debt outstanding and then we subtract off the total amount of residential investment. So any increase in mortgage debt that cannot be explained by residential investment, we consider that equity that people are pulling out of their homes and using to support their spending or to pay down other debt.

That number has been running at a very high level. Over the last four quarters through the second quarter of 2003, that was running about $400 billion, 7 percent of disposable income.

Why is this a problem? Because it’s about to go down very, very sharply. The backup in long-term rates that we’ve seen is causing mortgage refinancing applications to plummet. They were around 10,000 at the end of May. Now they’re running about 2,000. So we’re going to see a very sharp decline in mortgage equity withdrawal. This could actually have a bigger effect on consumer spending than what maybe some people anticipated.

The reason why this is particularly interesting right now is while consumption in the third quarter was very good, you’re going to really have to struggle to get even 1 percent consumer spending growth in the fourth quarter. The September-October consumption data was quite poor. It probably will be better in November and December. But you don’t have a lot of momentum on the consumer spending side. And that (took me?) as the biggest question about the outlook.

MR. TARULLO: So, Bill, sort of the early post-Thanksgiving commentary and chatter about how the Christmas season is actually going to be quite a good one, you think, is overstated?

MR. DUDLEY: Well, there are certainly positives for the consumer spending outlook. Job growth is picking up, and so income growth, . the tax cuts, is finally starting to rise. And that’s certainly the argument for why spending is going to be good. That’s what people are focusing on. But I think they’re not focusing on this other piece, which is that we’re going to lose this ability of people to pull money out of their homes, which we think has been pretty important in supporting consumer spending up to now.

Another problem for the household sector is a very simple one. The household sector really has not made any significant adjustment post the stock-market bubble. If you look at the household savings rate today, it’s a touch over 3 percent. We view that as unsustainable over the long run.

We would argue that the household savings rate in the U.S. eventually—and I think this may be where Steve and I differ a little bit; Steve’s eventually would probably be closer than my eventually—but eventually we would say 6 to 10 percent is where the personal savings rate in the U.S. ultimately has to go.

So over the long run, consumption has to grow slower than income. And that’s also a problem for the household sector, looking forward.

MR. ROACH: Ian, say anything you want in addition to what Bill said on the more general question. But maybe you could also address in particular shorter-term prospects for employment growth, because presumably that, with the increased income, would be another boost for the economy going into next year.

MR. MORRIS: Well, obviously the job in initial jobless claims in recent weeks has had everyone quite optimistic about employment now. I just want to highlight, with employment we will get job gains. Things are going to get better. We’re not going to continue to get the losses we had of recent years.

The question is, at what pace? And right now the three-month moving average is about 100,000, which is still really not enough to generate substantial declines in the unemployment rate.

And we think that the Fed might want to wait until about two and a half million jobs are created before eventually raising interest rates, which sounds crazy, because market sentiment right now is that if we got to three months’ worth of 200,000 monthly gains in payrolls, we would start having to raise rates.

I don’t think it needs to come that early, because I think over the next year we would need something like four and a half million jobs growth to get back to full employment. And that’s just not going to happen. And if we look back at the early 1990s, the Fed actually waited until over 4 million jobs were created before they raised rates in February ’94. So I think they can be patient.

I suspect that average jobs growth per month will be about 100,000 to 150,000. But even if it’s 200,000, I think, you know, the Fed doesn’t need to raise rates next year. And the reason I think it might be a bit lower is this ongoing productivity improvement that we’re seeing, which implicitly is in the service sector. That’s the key difference between now and the early 1990s, when it was really a manufacturing phenomenon.

And if we are to persist in this productivity improvement that seems likely, and everyone seems to agree with, there are actually four interesting consequences. The first is that you get higher output and higher service output in particular, and perhaps higher service profits as well.

But the challenging side is that you could get lower service price inflation, which I think people haven’t really priced into. And if the Fed wants to keep inflation in the 1 to 2 percent range, I think it could be quite difficult. In fact, I suspect there’s a very good chance inflation drops below 1 percent.

And then, finally, if you have higher service productivity, it means that service employment is going to be relatively weak. And mixing all that into the pot, it means that the Fed can really afford to be patient for some time.

MR. TARULLO: What kind of growth in numerical terms are you expecting for the first and second quarters next year?

MR. MORRIS: We’re just over 3 percent, so we are betting that, relative to the market at 4, it might come in somewhat disappointing. And we agree with Bill that this drop in cash-outs from (moving to?) refinancing could overwhelm any stimulus from the tax cuts.

MR. TARULLO: Bill, what are your numbers for the first—

MR. DUDLEY: We’re a bit over 3. We think our numbers are probably a little too low. We might revise them up. But, you know, we agree with Ian that the Fed is going to be a lot more patient than people think. There’s probably a lot more slack in the labor market, too.

I mean, Governor Bernanke gave a speech a little while ago and he argued that if the labor force returns to its long-term participation rate of employment, you can generate three and a half million jobs. But it’ll take three and a half million jobs just to get the unemployment rate down to 5 percent.

So if you add in a year and a force of growth in the labor force, you’re talking about the four and a half million jobs that Ian was talking about before you get down to full employment. So there’s quite a bit of room to grow employment before the Fed really has to respond to tighten monetary policy.

MR. TARULLO: Steve, before we turn to the medium-term issues, which are obviously much more contentious, do you want to add anything on the short term?

MR. ROACH: Yeah, I’m a little nervous when I hear somebody who I respect as much as Bill say everything’s secure. (Laughter.)

MR. DUDLEY: I said reasonably secure. (Laughs.)

MR. ROACH: You know, never say never. And, you know, the question here is, you know, what kind of growth are we getting right now? And is this growth that is really sustainable and justified on the basis of economic fundamentals, or is it cannibalizing from gains that would otherwise have occurred in the not-so-distant future?

And I’m just struck by the point that Bill made. He didn’t push it quite far enough. Consumer durables in the second and third quarters of this year were up at an average annual rate of 25 percent. We haven’t seen two quarters in a row like that since 1972.

And, you know, these are called durables for a reason. You don’t buy them every month. I mean, even the overly indulgent American consumer does not buy a car every month. So there’s going to be a payback here, and that payback has already begun to unfold. You know, vehicle sales were 19,400 in August. They were down to 15,500 in October. They’re back up a little bit in November.

You know, what drove durables? It didn’t come from the economy’s internal income-generating capacity, because real-wage salary disbursements are basically flat. Maybe they’ll rise a little bit now as jobs pick up. It came from tax cuts, the refi, the last gasp of the refi, and aggressive price-cutting. It’s not sustainable.

MR. TARULLO: But do you think that we’re borrowing from ’04 or do you think we’re borrowing from ’05?

MR. ROACH: Look, Dan, no one knows with precision. You know—

MR. TARULLO: Karl Rove is intensely interested in your answer to this question. (Laughter.)

MR. ROACH: Look, you know, I understand what President Rove was trying to achieve. (Laughter.) But he may not get his wish. I mean, to think that the White House can exquisitely time the political cycle to coincide with the economic cycle is absolutely ludicrous. But that’s what this game is.

And I remember talking to an anonymous senior official from the Bush administration, and he said, “Look, this thing is guaranteed to be front-loaded. It’s going to work.” Bill just said it. I mean, the stimulus starts to fade in the second half of the year. That’s when they need momentum.

And the irony here is that this exquisitely-timed stimulus may have given them the juice sooner rather than later, and they could be scrambling when they really need momentum in the economy. But, you know, those are smart guys.

MR. TARULLO: Let’s move to the later, whenever it does come, because, unlike the short term, where the skies do seem pretty much sunny, in the medium term we have the cloud of the current-account deficit, which is right around that 5 percent number that the Fed study has identified as the breaking point.

We have fiscal deficits that do not seem to show any signs of going away. And in a pre-election year, if anything, they’re going to get worse. And then, of course, we have job growth being at best sluggish, with the productivity and liberalized trade together playing the ironic role of perhaps holding down job growth in the United States.

Now, Steve, I don’t usually have to work very hard to get some qualification on bright prospects from you. But how do all these clouds roll in together? And are we potentially—and I emphasize potentially—looking at an extended period of adjustment and retrenchment starting at some point over the next year or two?

MR. ROACH: Well, first of all, let me just be frank. I mean, right now the economy is making me feel like a total moron. So, I mean, you know, we have Chinese-like growth in America and the world has gone back to this sort of U.S.-centric growth model as if this is the way the world works.

My view is, you know, we had a seven-year period, Dan, where, from ’95 to ’02, the United States accounted for 96 percent of the cumulative increase in world GDP. And so, you know, that reflects the fact that the rest of the world has forgotten how to grow.

MR. TARULLO: Wasn’t that because of our strong dollar, though? (Inaudible.)

MR. ROACH: About a third of it was the dollar and two-thirds of it was America and the inability or unwillingness of the rest of the world to grow. So the outcome is not just our massive current-account deficit, which you correctly scaled, but an unprecedented gap between current-account deficits and surpluses in the broader global economy.

I don’t think for a second this is sustainable. There is a view, and Alan Greenspan attempted to articulate this recently in a speech he made in Washington, that, you know, we’re going to have a benign current-account adjustment.

I mean, look, I don’t mean to ever be critical of him, of course, but, you know, policymakers, politicians and (self-styled?) investment pundits, they want soft landings in everything, because that doesn’t hurt anyone. But the gap that we have right now for a savings-short U.S. economy, with the lowest net national savings rate in recorded history, with a runaway budget deficit, tells me that the current- account situation, 5 percent of GDP, is not stable.

The risk is it gets worse before it gets better. And so the resolution of that comes through currency markets, the real interest- rate response, and what that means for growth prospects around the world as the dollar continues to weaken. And that is—you know, you can conjure up all sorts of scenarios that would sort of make that internally consistent that they could be benign and soft or they could be hard and ugly.

And that’s very much a function of the very shocks, that none of us are particularly good at, that bombard the system. But the tensions are set for a significant external adjustment, not just in the world but in the surplus economies elsewhere in the world. That’s what macro tells us, and that’s something we have to be mindful of in thinking about the future.

MR. MORRIS: May I just add one point on that, too, is that we’ve calculated that if the consensus view is correct and you do get 4 percent growth between now and until the end of next year, the current-account deficit could widen from 5 to about 8 percent of GDP. And that’s a huge number. And the consensus isn’t particularly good at forecasting current-account deficits. It tends to assume that whatever it is today, it will be also in four quarters’ time.

But if we’re going to get 4 percent growth, we know Japan and the euro zone are not going to grow that quickly. China, of course, is, but it’s just not a big enough part of the global economy yet to really improve the U.S. trade balance.

So if we do get a current-account deficit of 8 percent of GDP, you’re in this uncharted territory. Nearly a trillion dollars is required from foreigners to fund that deficit. And so foreigners need to just keep buying more and more and more of U.S. assets. And that could potentially be very destabilizing for the U.S.—

MR. TARULLO: What are you anticipating, Ian, for the dollar itself? That is, even through this recent period of very good economic news in the United States, the dollar has been slipping certainly against the Euro, which seems to reflect the view that even if it’s a good place to invest, it may be slipping further, and so you don’t know whether your assets, your dollar-denominated assets, are going to be depreciating. If the dollar continues to slide, shouldn’t that provide some sort of equilibrium?

MR. MORRIS: Right. For a Euro-zone investor, for a Japanese investor, seeing the currency losses, this should reduce the appetite for U.S. assets, particularly given, although there’s been a recent recovery in stocks, we’re still well below the peak of 2000.

And this is a puzzle, because foreigners have continued to push a lot of money into the U.S. Of course, there has been a shift from European investors buying a lot of stocks and then corporate bonds to today Asian central banks buying a lot of U.S. treasuries. And so how long this game can continue will be interesting.

But we think the Euro can continue to rise to 1.30 sometime next year, and the risk is that it goes higher than that.

MR. TARULLO: Excuse me. You don’t see that—you don’t see these J-curve effects clicking in any time soon.

MR. MORRIS: There are some J-curve effects, and—

MR. DUDLEY: You’d better explain what—

MR. TARULLO: I’m sorry. I think most people here probably—initially when currencies change because orders are mostly in the pipeline, you don’t have big changes in the quantities that are imported or exported. And thus the change in the currency value just magnifies pre-existing trends rather than counteracting them.

But eventually—this is the J notion—eventually economic actors take into account the changing currency values, and so they adjust their orders and pricing accordingly. And at that point, for example, a decline in your currency ought to have the kind of effects you would expect on a current-account level.

MR. MORRIS: And we find that that influence is there, but it is being swamped by strong U.S. demand sucking in lots of import growth. And even if export growth is a little better, you find that the level of imports is so much higher than the level of exports that even a higher export growth rate still leads to a deterioration in the deficit. And in any respect, the more likely outcome is stronger import growth rather than stronger export growth.

MR. TARULLO: Okay. Bill, people on this panel, including some of the people who are up here today, have spent a good part of the last five years seeing potential problems off on the horizon, problems which, to some extent, were realized over the last couple of years, but in a much more moderate form than some of our analysis might have suggested.

What, if anything, should lead the audience to think that things are different now and that there could be more of a negative price to pay out there a year or two or three?

MR. DUDLEY: Well, I think there’s two things that would concern me over the longer term. And by the longer term, I mean maybe five years or even longer.

First of all, I think that while the productivity trends today are wonderful, a lot of the things that we’re doing at the margin are probably going to hurt productivity rather than help productivity. You think about the process of trade liberalization. It’s basically stalled in its tracks. And I think that’s one of the factors that was responsible for the good productivity performance that we had, starting around 1995 onward.

Second, deregulations have been mostly completed in the U.S. When people talk about restructuring economies, they never talk about restructuring the U.S. What would you do to make the U.S. economy more flexible than it is? So you’re not going to get the further benefits of deregulation.

And then, third—

MR. TARULLO: So are you going the other way?

MR. DUDLEY: You’re probably going the other way now, actually. You’re probably reregulating. And then the last thing that’s disturbing to me is the budget path has deteriorated very sharply, not just for the near term but for the longer term.

If you make all the tax cuts permanent, which is what the Bush administration has said that they want to do, you’re going to be faced with very large budget deficits for a very, very long period of time, even before the baby-boom generation starts to retire in earnest. And I think deficits do matter. If deficits don’t matter, then why do we pay taxes? You know, if you can convince me that deficits don’t matter, I don’t want to pay any taxes whatsoever.

You know, it’s very clear to me that high budget deficits lead to low national savings. Low national savings leads to less investment. Less investment leads to slower productivity growth. This doesn’t all happen in a period of a year or two. But over the long run, this will consign us to a slower growth rate in our standard of living.

And I view the path of the deficits, which, compared to where we were three years ago, when people were talking about paying off all the Treasury debt—not something that I was ever too worried about, but people were actually literally talking about paying off all the Treasury debt—that’s probably one of the most big changes that have happened in the last three years. And we will ultimately pay the piper for that.

MR. TARULLO: Eerily reminiscent of the ruminations of a former Goldman Sachs person. This is very much like the Rubin—Rubin, if you haven’t noticed, has been on the book circuit over the last—if you turn on the radio, you get Bob Rubin on the radio. And this is very much—is that essentially—are you essentially in agreement with—

MR. DUDLEY: I think more or less, yeah.

MR. TARULLO: Okay. Does any of you think that we have or are building even a moderate asset bubble right now? That is, Ian, you mentioned that short-term interest rates have been low. You want to keep them low for a while. Is sustained monetary laxness or accommodative policy creating any renewed danger that equities or real estate or any other kind of assets may be—

MR. ROACH: Tech stocks look very, very rich right now. But, Dan, I’ve got to just take issue with one thing you just said. You’re saying, “Well, you know, we’ve been up here, and some of us have been bemoaning this state, but”—

MR. TARULLO: I wasn’t necessarily referring to—(laughter)—

MR. ROACH: I know. I’m trying to depersonalize it. Let’s just remember one thing, that, you know, since the bubble popped—you remember, there was a bubble; it did pop.

MR. TARULLO: That’s right.

MR. ROACH: Up until the third quarter of this year, which is the quarter just completed, this has been the crummiest economic recovery in recorded history of the U.S. It’s been the most jobless recovery in recorded history in the U.S.

MR. DUDLEY: Despite massive fiscal and monetary policy.

MR. ROACH: Despite the massive stimulus that Bill just described. And it’s been characterized by record debt loads, record current-account deficits, and to me, and a significant reduction in private-sector savings, which erodes the cushion that this economy has to finance and withstand these fiscal deficits.

So, you know, the numbers have really surged to the up side. And as I travel around the U.S. and the world, you know, memories are sort of very, very short in this sort of Alzheimer-type world that we live in. And, you know, the view is that everything is fine and it’s been fine.

Well, it hasn’t been fine. And there are good reasons why it hasn’t been fine. And the issue here is, have we really come out of this huge period of excess that culminated in the popping of the equity bubble? Or have we just put this off?

And your point on Fed policy of easing aggressively and then allowing the equity bubble to sort of morph into a wealth effect courtesy of home-mortgage refinancing, extracting purchasing power from other assets, we’ve moved into an asset-based economy as opposed to an income-based economy. And there are consequences for that that we have to face if interest rates ever go up, given the debt burdens that we have.

The case for rising interest rates, in my view, is the current- account dynamic. There has never been a current-account adjustment that I know that did not require foreign investors to seek compensation for currency risk in the form of higher real rates. And if we get higher real rates with the debt loads we’ve got right now, that’s a big issue out there for the U.S. to face, and we don’t want to face.

MR. TARULLO: That makes that 14 percent number for consumer debt—

MR. ROACH: Yeah, it makes it live. Ammunition.

MR. DUDLEY: Where I think the bubble still is is in the expectations of future financial-asset returns. If you ask people, what do they expect to earn in the stock market over the next 10 years, you usually get numbers above 10 percent. And if you’re a nominal GDP world where nominal GDP growth is 5 to 6, 10 percent ain’t the right number.

So I think that’s where people are still hopeful that we’re going to go back to the 1982-1999 period, which was a glorious period, where if you had 60 percent in stocks, 40 percent in bonds over that period, you made 15 percent a year compounded, so every five years you double your money.

That was an aberration. That was a one-time deal, going from one of the worst economies in 1982 to one of the better economies in 1999. We’re not going to do that again. The only way we’re going to do that again is if we go back to a really lousy economy first. And I hope we never have another bull market in our lifetime, because it means things are going to get a lot worse first.

MR. TARULLO: Bill, those expectations you’re talking about, do you think those manifest themselves in current consumption behavior, or is this just something that’s going to mean that people are going to have to work later in their lives than they had anticipated?

MR. DUDLEY: I think it’s a somewhat iterative effect. You know, you hope that you’re going to make 15 percent on your equities. You don’t make 15 percent on your equities. Then you decide, “Well, I’m going to have to work to 75. I don’t want to work to 75. So maybe I better need to save a little bit more.”

So you start with an optimistic assessment of how much your wealth is going to grow because of financial asset appreciations. Financial assets don’t generate those kind of returns. You then ultimately have to raise your savings rate. But it happens gradually.

I think that probably the one area where Steve and I probably disagree a little bit is I think the adjustment in the household sector can play out over a very long period of time, a five- to 10- year period of time, where the savings rate does go up but it doesn’t go up quickly, so you have just a long period of time where consumption is growing, but it’s growing a little slower than income. Nothing really goes kaboom, but it’s a period of low real interest rates, weaker dollar. Things just aren’t so great, but nothing sort of blows up.

MR. TARULLO: Okay. Let’s turn to China. The paper—if you look on the leaders or front pages of many of our most distinguished economic and business periodicals over the past couple of weeks, you see big China stories. The Wall Street Journal had a big story about China’s impact on world energy markets. The New York Times had a big story, front-page story, on how China is becoming a regional economic leader in Asia, in part because of the abdication of the United States but in part because of its own momentum.

The Economist had a big story not long ago on the importance to Japan of China and used the little fact that Japan is now exporting twice as much to Asia, to Mainland Asia, as it is to the United States.

When one puts all of this together, one also realizes the incredible strategic importance of China to the United States right now. And this is a very different relationship, both economically and politically, from the U.S.-China economic relationship of five or six or seven years ago.

So now, questions about China’s economic growth are not just geopolitical questions. They’re rapidly becoming economic questions as well. And that’s why I’d like to concentrate on it for a few minutes. And let me ask, to begin with Ian, two kinds of questions about it.

First, obviously there’s been a lot of politically salient tension in the United States about China’s fixed exchange-rate policies in a period in which U.S. manufacturing jobs have been hemorrhaging. A lot of people—not everyone, but a lot of people have blamed China.

Those kinds of tensions may or may not be transitory. They may or may not reflect some sense that there’s a fundamental negative-sum game between Chinese employment and U.S. employment. How do you see the evolving U.S.-China economic relationship—obviously it’s nested in the global economy—but how do you see the relationship of China and the United States, the impact of Chinese economic growth on the United States?

And then the second question, which you can answer together if you like, is what kind of risks do you see in China? We’ve just gotten through rehearsing the risks in the United States. China arguably has its own asset bubble. Talk about your readily available credit over some number of years now. Obviously it has a lot of bad loans, shaky banks.

So is there a significant risk that whatever boom China is experiencing and providing to the world economy, that too may have some risks attached to it?

MR. MORRIS: Well, the first part of your question regarding the Chinese stealing American jobs—well, there is a redistribution effect going on to some degree, and we all probably have to acknowledge that. But the biggest killer of American manufacturing jobs is American productivity. And that’s clear in the data.

And, yes, the effects of international trade liberalization allows that influence to intensify over time. But it is home-grown American productivity thanks to the IT boom that is really allowing this transformation of the U.S. labor market further away from manufacturing into the service industry.

In terms of the impact that has on jobs when you’re experiencing a cyclical slowdown, like we have been, that only magnifies the political tensions, particularly with the presidential election coming up next year. And so it’s obviously quite—it’s understandable that Bush wants to do everything he possibly can to stimulate this economy. He’s already used monetary and fiscal policy. To some extent he’s already used exchange-rate policy. But he wants to go even further and get China to revalue the Renminbi.

But from China’s own perspective, it’s currently dealing with an investment bubble. The kinds of projects and construction projects that are going on right not within China are being fueled by the local government leaders, who all want to try and create their own economic booms in their own little territories. And it’s resulting in this massive loan expansion going on, which could contribute to a non- performing loan problem somewhere down the track if this investment downswing were to occur.

So at a time when China is still trying to deal with a large unemployment problem as it moves towards urbanization, it actually wants to keep its export sector humming along as it puts in tighter credit policies to try to slow this investment boom going on right now.

And just to give you an idea of how big this investment boom is, our economists in HSBC Asia calculated there’s something like 3,800 construction projects going on in terms of these territories that take up land space 62 times the size of Singapore. And so this kind of growth is probably unsustainable. It doesn’t have to collapse. It just needs to slow down. And that slowdown will begin to happen from next year.

MR. TARULLO: Steve.

MR. ROACH: Just briefly on China, Dan, you know, this is political scapegoating at its worst. That’s what this is all about. Our politicians—and it’s bipartisan, I might add, unfortunately led by our senator, Chuck Schumer—have put together a really dangerous case indicting China for America’s jobless recovery. They have concluded that we have a trade deficit and we have a job problem. Our biggest trade deficit is with China; therefore it’s China’s fault.

Why do we have a trade deficit? We have a trade deficit not because China is out there playing unfairly in the rough-and-tumble arena of global competition but because we have no national savings, and we have to import foreign savings from abroad to grow and we have to run massive current-account and trade deficits to attract debt capital.

If we didn’t have a trade deficit with China, if you closed China down today, as Schumer’s bill would, and he’s got 27 and a half percent across-the-board tariffs on all Chinese products coming into the U.S.—that would shut China down.

Would that change the problem in America? No. It would just push our trade deficit to who knows—Korea, Mexico, Canada, maybe even Germany. It’s impossible to know. But as long as we’re a savings-short nation, we have to run trade deficits and current- account deficits to attract the capital.

One more thing about China that’s worth noting. Everyone talks about the export prowess of China as being indicative of the fact that they’re grabbing market share from the rest of the world. On the surface, that number looks pretty compelling. Chinese exports were $121 billion U.S. in 1994. They tripled to $365 billion by the middle of this year. The world has never seen a surge in exports like that.

But guess what: Sixty-five percent of that tripling represents the exports of Chinese subsidiaries and multinational corporations in America, Japan, Europe, and their joint-venture partners. These are our companies. These are not Chinese companies. And so for us to go after China as being responsible for the imbalances that we have created at home, I think, is worrisome.

And what scares me the most is usually in these situations, like with the Japan-bashing of the 1980s, there is a counterweight—another party, the White House in this case. There is no counterweight right now. There are two potential counterweights.

MR. TARULLO: Now, wait a second, Steve. Let’s be fair to the administration on this point. There’s an irony here with China, which is that five to eight to 10 years ago, the geopolitical tensions were high and the economic interests were being deployed on both sides of the Pacific to try to calm some of the geopolitical conflicts.

Today the administration is as committed as it can be to trying to work with China, because they see China as so important for Korea. Whatever the administration has been saying on currency policy, they are certainly not backing it up with any kinds of threats—

MR. ROACH: Dan, they did textile quotas. They just did TVs. I mean, come on.

MR. TARULLO: Steve, Steve, wait a second. These people, they are in office. They’re trying to get re-elected. If they do nothing, they have a high political vulnerability. It seems to me the way that one judges them is whether they’re trying to take discreet steps that give some indication that they’re doing something or whether they really start to massively threaten the relationship by saying, “We are going to slap on 27.5 percent.”

MR. ROACH: But here’s the point. Given the sentiment that exists in the Congress, Republicans and Democrats, liberals and conservatives, farm states, industrial states, North, South, East, West, what you need in this climate is a strong political counterweight to stop that, not someone who just sort of is passive, as your President Rove is.

MR. TARULLO: He’s not my president. He’s not the president and he’s not mine. (Laughter.) But from your point of view, isn’t the most important thing is what actions actually get taken? If the administration is working effectively to make sure that the bill that is out there does not actually gain momentum, isn’t that in some sense the most important thing for—

MR. ROACH: Number one, it’s not clear they’re doing that. Number two, if the recovery is fine, then this issue will fade. They get into any trouble between now and November, I guarantee you the same guys that gave you steel tariffs will go right after China. That’s what you’ve got to think about.

So if we are—I don’t know (what word?) to use; reasonably secure? If we’re reasonably secure on the economic front through the election, then this issue will fade. But I guarantee you, the slightest bump in the road and they go right after China. And that would be very damaging to China, to Asia, to the U.S. and to the broader global economy.

MR. TARULLO: I’m not—here I am defending the administration. (Laughter.) I’m not at all sure that’s right, but hopefully we won’t have to test that proposition.

Bill, what about China’s fixed exchange-rate policy?

MR. DUDLEY: Well, I think that’s something that the administration really does have, I think, a legitimate interest in, because what the administration, I think, sees is that the dollar does have to weaken, despite their reiteration of the strong dollar policy.

And for the dollar to weaken, the easiest way for it to weaken is to weaken broadly against a broad array of countries rather than against a small array of countries. And for that to happen, you know, it would be helpful if China would be part of that process, because I think in Asia it’s very unlikely that the dollar is going to be allowed to depreciate against other Asian currencies if it doesn’t occur also against China.

There’s a tension here, though, because what the administration wants isn’t necessarily what the Chinese authorities want. China has been pretty comfortable with the current exchange-rate regime. It’s worked pretty well. They’ve had the best economic performance in the world over the last five years. They have an immature financial system.

It’s not at all clear that floating the Renminbi would be attractive. So there’s a tension between what the administration wants and what the Chinese want on the currency. And I think, you know, that tension is going to continue to exist until something happens that makes Chinese revaluation attractive to the Chinese.

Now, one thing that could happen that could make that more attractive is the fact that Chinese inflation is starting to pick up. If you think about the three things you can do to combat inflation, you can raise taxes, you can tighten credit, or in an occasional case, not very many cases, you can let your currency appreciate. Currency appreciation is a pretty attractive and painless way to deal with inflation.

So I think if we start to see more Chinese inflation, we might actually see China start to move on the currency. Then the administration would start to get what they want. But, you know, the reality is, just because the administration wants the Chinese to move their currency, it’s not clear that the Chinese see that in their interest yet. And obviously, they’re going to make that determination.

MR. TARULLO: How do you move a little bit on the currency?

MR. DUDLEY: Well, that’s the interesting question. You know, if you change the band by 5 percent or 10 percent, people are going to say, okay, that was nice, now we’d like you to change the band again. One thing that they might be able to do is think about—is talking about how they’re going to peg the Chinese renminbi not to the dollar but to a basket of currencies, and they might be able to do that in a way that could lead to some appreciation without setting it in train the idea that there’s going to be another and another.

MR. ROACH: Just one quick thing on this. China’s setting its currency—it’s pegged to the dollar, but it’s setting its currency with an eye toward managing its external position with the world, not with the U.S. I think it’s ludicrous for us to think that China should set its currency because we have a large bilateral trade deficit with the U.S. China’s overall trade position, $15 billion surplus year to date through September, is in rough balance with the world. That would argue that the renminbi doesn’t really have to move.

MR. TARULLO: But wait. But wait.

MR. DUDLEY: But in direct investment into China, though—

MR. TARULLO: Yes.

MR. DUDLEY:—the total amount of money that’s flowing into China is quite large.

MR. TARULLO: Up until a few years ago, I think that was a very, very plausible position to take, but the last couple of years, the accumulation of reserves has been massive.

MR. ROACH: There’s no question about it. But again, a currency is set with an eye toward achieving balance with the broader global economy in trade flows, investment flows and capital flows. From the standpoint of trade, with is the lightning rod in this political issue, I think the argument rings completely hollow.

MR. TARULLO: All right, but let’s distinguish—we should distinguish, though, between the political discourse in the United States and the economics of the situation. The fixed exchange rate may still be an economic concern even if not for the reasons that some constituent interests in the United States are making it a reason, right? That is, there can still be an imbalance even though it’s manifesting itself in a different way than in the trade deficit. That’s my—that’s just a limited point.

HSBC, I think, has had the view that it would be difficult to get just a little bit of exchange rate flexibility here.

MR. MORRIS: Right. We suspect that over the next two to three years, the exchange rate regime will remain as it is despite the pressure. And if there is to be an overall change, whether to a basket of currencies, like Bill mentioned, or just more flexible exchange rate regime, we’ve calculated that the real effective exchange rate would need to rise quite sharply. It would not just be a case of 10 or 20 or even 25 percent. The appreciation may be much larger than that.

MR. TARULLO: And that would be a bad thing for China? Would it also be a bad thing for the global economy?

MR. MORRIS: Well, there will be new developments and there will be some redistributions. It could be good for the rest of Asia as they become more competitive relative to China. And it will have short-run adjustments, but overall, if it does move to a freely floating or semi-floating regime, it should rebalance some of these issues that we’ve been talking about.

MR. ROACH: Hey, Dan, can I just ask you a question?

MR. TARULLO: Yeah. Yes, you may.

MR. ROACH: Do you know how Schumer’s people came up with this 27.5 percent number on the undervaluation of the renminbi?

MR. TARULLO: I do. You ask that question as if I’m a supporter of this bill. (Laughter.)

MR. ROACH: Well, no I—

MR. TARULLO: I don’t—no—

MR. ROACH: Okay, well let me tell you, okay? (Laughter.)

MR. TARULLO: All right. The answer is no I don’t—

MR. ROACH: It’s a rhetorical question, a rhetorical question.

MR. TARULLO: I don’t know how they came up with the 27.5.

MR. ROACH: This is a true story, because I pushed on this. You know, 27.5 percent is a pretty precise number even for us on Wall Street. (Laughter.) So, they convened a panel of experts. They brought them in to estimate the fair value of the renminbi. So, these experts came in, and the low number was 15, the high number was 40; they were clueless, and they averaged them. This is a true story.

MR. TARULLO: I did hear this. I did hear this.

(Laughter.)

MR. ROACH: This is the way—this is science in Washington. Your senator. (Laughter.) Your president.

MR. TARULLO: I live in the state of Maryland, okay? (Laughs.)

MR. ROACH: You spend a lot of time up here, Dan! (Laughter.)

MR. TARULLO: (Laughs.) And it’s all with you! (Laughter.)

All right, okay, we’re ready to take questions now. When I recognize you, please—do we have mikes?—yes. Please wait for the mikes, and then stand up and identify yourself.

Okay, so questions? Questions?

Yeah, Ricki (sp).

Q Hi, Ricki Tiger-Helfer (sp). I notice that you haven’t mentioned the war against terrorism or—and I will distinguish between them, even though the administration has tried to merge them—the war in Iraq. What do you see as the economic impact on those two efforts, if any?

MR. DUDLEY: Well, the first obvious impact is the fact that spending, both on defense and homeland security, are going to be on a much higher trajectory than they otherwise have been. I think what we don’t know yet is how long that’s going to last, especially in the case of Iraq. You know, obviously, the $87 billion appropriation bill for Iraq I think was a big surprise to a lot of people in terms of the magnitude of the commitment. I don’t think that’s a huge problem for the U.S. if it doesn’t go on for a long time, but if it’s $87 billion a year indefinitely, then that starts to have a real—you know, serious implications for the budget and the long-term economic outlook.

MR. TARULLO: Anybody else on that point?

MR. MORRIS: Just to make the point on, you know, in 2005, whether President Bush gets a second term or we have a Democrat president, and if the spending on Iraq is still quite large, we will have a huge budget deficit that may require a massive fiscal tightening in other areas, whether it’s taking away some of the tax cuts or finding spending cuts elsewhere. It’s very difficult to see right now, but when you think the new president is in, or President Bush is in, in 2005, that person has two years to really fix the problem before running into the next election cycle.

MR. TARULLO: But is there any conceivable way, if that—if those kind of budget deficits are persistent, any conceivable way and—to do anything about that without a major tackling of the entitlements issue?

MR. MORRIS: Well, they—there’s a lot of tricks, and they can postpone things indefinitely. And at some point that has got to come up. (Chuckles.)

MR. TARULLO: They’ve been doing it.

MR. MORRIS: But ultimately, a long-term solution will require—

MR. TARULLO: But Dan, look, the biggest—

MR. DUDLEY: Well, let’s call a spade a spade. I mean, this is classic guns-and-butter fiscal policy.

MR. TARULLO: Yeah, it sounds like the ’60s.

MR. DUDLEY: And you know, we did this last in the ’60s, and you know what happened in the ’70s. And we’re doing it today with a private savings rate that’s half of what it was in the ‘60s. There’s no institutional memory of the ’60s, which tells you that Timothy Leary was probably right. (Laughter.) If you remember the ’60s, you were not there. (Laughter.)

MR. TARULLO: Is the converse true on that?

MR. DUDLEY: I don’t remember. (Laughter.)

MR. TARULLO: (Laughs.)

Okay. Other questions? Other words and—yeah, Nancy?

Q Hi. Nancy Lieberman from Skadden, Arps. If we are hit with another terrorist attack, akin to what happened on 9/11, what do you think would be the impact on the economy?

MR. TARULLO: These guys usually punt on this.

MR. ROACH: I think it depends on what it is and where it is, frankly. You know, if it’s in New York or Washington, and—I would expect people in the rest of the country would say, “It’s too bad that you live in New or Washington.” But you know, if it’s in some other portion of the country, and it—and you know, it could have a pretty significant impact.

You know, another thing, in terms of shocks that you worry about, is SARS. You know, if SARS were to come back and we would have an epidemic of that nature, that would be a big shock to the economy. People wouldn’t go out. They wouldn’t go to the movies. They wouldn’t go to restaurants. You know, you really would have an Internet economy.

So yeah, you can certainly imagine shocks that could disrupt the U.S. economy in a pretty significant way. Terrorist attack is obviously something everybody worries about. It’s hard to put in your economic forecast. But you know, I think it really depends what it is and where it is, frankly.

MR. MORRIS: But what you would quite plausibly feel, like you did last time, is that the stock market comes down a long way, initially. The Fed might have to cut rates to try and produce a floor on confidence, making sure confidence doesn’t doesn’t fall too much.

There will be some positive benefits—I mean, terrorism is all negative; don’t get me wrong. But it would probably trigger a safe haven bid for Treasury bonds, so Treasury yields would come down, which—like last time, what it actually ends up doing is convincing consumers to refinance their mortgage and perhaps take the cash out. So there is almost this unintended positive side to it as well, although the negatives will probably outweigh the positives, particularly it would make the employment recovery that we’re seeing now that much more shaky. And if consumers decide to pull in and raise their saving ratio, like Bill suggests they should do over a few years, they may decide to do it immediately, and that would send the economy into a double-dip recession.

MR. TARULLO: I should say, as always, everything that all of us says, I think, about the economy is qualified by the possibility of some significant non-economic event, whether terrorism or a war breaking out somewhere or the like. SARS, I guess, would be another. And, as Bill says, I try to ask the questions this way because it’s so difficult to assess what the chances of something like this are, much less to try to project what they are. But it is a major qualifier. And in fact, Steve, on the China issue, here I think we can isolate with a big qualifier to my characterization of the situation, which is Taiwan. If the Taiwan independence/quasi-independence referendum momentum were to build, the administration is going to be stuck politically because their right wing is going to put a huge amount of pressure on them not to be too overt in tamping it down in Taiwan, and that is the sort of thing that could get out of control. But short of that, I don’t—the geopolitical cooperation is stronger.

MR. DUDLEY: But there is an election campaign going on right now in Taiwan that is upping the ante.

MR. TARULLO: That’s exactly what I was referring to. That’s exactly what I was referring to.

Yeah, right here, sir.

Q I’m Harrison Golden. There was a consensus at least on this side of the panel early on in the discussion that the Fed is likely to be quite patient about raising rates, but then later on in the discussion there was comment about pressure for a variety of reasons on long rates. I wonder if there can be some amplification on that and particularly what the consensus or the views are respecting the timing for the impact on long rates.

MR. TARULLO: Let’s start with you.

MR. ROACH: Well, the long rate issue is only indirectly under the control of the Fed. I mean, you know, the Fed operates at the shortest end of the yield curve and then sort of hopes that, you know, the message convinces investors throughout the curve to behave in accordance with what they’re trying to achieve. There are a lot of things that swing the long end. There is the budget issue, the current account issue, that hits the real interest rate component. There’s the inflation-deflation debate, which hits the inflationary premium or lack thereof. And, you know, I’ve been in the deflation camp. We had a serious deflation scare earlier this year. No one even knows how to spell the word anymore. And I don’t think we’re out of the woods on this one yet. I think Ian pointed out how low the inflation rate still is today, and, you know, if we have open-ended growth forever, then, you know, can forget about deflation. But I think the odds of that are still low.

To me, the biggest reason to be nervous about the long end of the yield curve, irrespective of what the Fed does, is the current account dynamic, and you know, if we get a growth surprise, a negative growth surprise, or a serious outbreak, a more serious outbreak, of protectionist sentiment in the US, I think the dollar gets unhinged, and as soon as the dollar gets unhinged—and we’re set up to do that with our current account deficit right now—the long end jacks up irrespective of the inflation-deflation debate. And that’s a worrisome development.

MR. TARULLO: Bill?

MR. DUDLEY: We actually are reasonably constructive on the treasury market, long end of the treasury market, because we don’t think the Fed is going to tighten and we think the yield curve today is very steep. You know, 10-year yields are about 4.4 percent. The federal funds rate is 1 percent. So there’s a lot of protection there in the steepness of the yield curve. The big risk to that view I think is what Steve highlighted, which is if you do get a dollar crisis. If you do get a dollar crisis and the dollar starts to fall uncontrollably, then the yield curve’s going to get even steeper. That would be the one caveat, I would say, to being constructive on the long end of the treasury market.

MR. TARULLO: Go ahead.

MR. MORRIS: I think ultimately growth and inflation fundamentals tend to drive where yields go, and if the dollar collapses, of course everything changes. But most of us aren’t predicting a dollar collapse. We all know there’s a small probability of it happening some time down the road, but most of our projections are just for continued dollar depreciation. And if that’s the case, then we need to be wary of the growth-in-inflation picture. And a good example is three or four years ago we were seeing budget surpluses forever, and if you had known back then how the deficits would turn on both the budget current accounts, you might have been bearish on interest rates, because that was not priced into the market, and yet what we actually was much lower interest rate levels on both short and long rates because of growth and inflation.

MR. TARULLO: Okay. Yes, sir. Right here.

Q Herbert Levin. If a Democrat is elected president in 11 months, what economic measures would you expect him to propose to a more or less cooperative Congress?

MR. DUDLEY: Whoa! You should answer that. (Laughter.)

MR. TARULLO: If we get a more or less cooperative—

MR. ROACH: But you probably won’t get a cooperative Congress.

MR. TARULLO: No, in all seriousness to sort of one part of the question, as a Democrat, I hate to concede anything, but the chances of a Democrat being elected president are probably better—whatever they are—better than getting a reasonably cooperative Congress out of this. But none—

Q More or less reasonable.

MR. TARULLO: More or less. Okay, it’ll be—

MR. ROACH: It’ll be less reasonable. (Laughter.)

MR. TARULLO: The administration currently thinks it’s less reasonable too, so—the Democrat—it depends on which Democrat, needless to say, number one. Number two, I think you will say more attention to long-term fiscal implications. It may not be a return of “Rubinomics” in its full flower because, after all, it was a different situation in 1993 than the one we face today, but the reasoning which Bill articulated earlier is a reason that is widely shared among those of us in exile right now. And thus, pleasant as it is to spend my exile up here with you every couple of—

MR. ROACH: (Laughs.)

MR. TARULLO: And thus, I think you would probably see something on taxes with substantial rollbacks in the tax reductions, certainly the ones that haven’t taken effect yet, quite possibly even the ones that—some of those which have taken effect. There would be probably less activity on cutting budget items, discretionary budget items.

The big imponderable, and I honestly—I just don’t know the answer, and I don’t know how anyone could predict it, is military, Iraq-type spending because you obviously cannot turn off the spigot if you are still present in a big way in Iraq. I mean, you might be able to say it should be $84 billion instead of $87 billion, or $90 billion instead of $87 billion, but you can’t make it become $20 billion when you have 150,000 U.S. troops there, and when you’re trying to rebuild the country, and you’re, at the same time, fighting a war in Afghanistan and you’ve got other commitments around the world as well.

MR. ROACH: What about trade policy, Dan?

MR. TARULLO: Trade policy is going to depend, as you said earlier, in significant part upon macroeconomic conditions. I mean, my own view is that to a considerable extent, the trade pressures that we’re currently experiencing now are the result of the macro policies that have not been employment generators, and that if unemployment were at 5 percent right now, the pressures would be substantially less. That has been true historically. And notwithstanding the speculation about whether we’re in a new era in which there’s structural unemployment because of jobs in Bangalore, or whatever, the numbers that I, and more importantly, my colleagues who look at the numbers more closely, have suggested to them that strong, robust growth and job growth at home, macro policies designated to create jobs, including on the fiscal side and not just with—that is job growth programs, not just fiscal stimulus, would alleviate quite a bit of that pressure, and then it becomes containable. But—

MR. DUDLEY: I just want to add; I think it’s very unlikely that a Democratic president will actually have a Democratic Congress to work with. And so I think the ability to actually repeal the Bush tax cuts is very unlikely. I think the best that the Democrats could hope for would be to allow some of the tax cuts that are scheduled to sunset to sunset, because the president could uphold that by a veto.

So I think the improvement in the fiscal outlook, even if there were a Democrat who wanted to do something about the budget deficit, I think would actually be quite slow, especially given the fact that the Democrats also have lots of ideas about how to use any fiscal savings, on health care, in particular. So I think the deficit outlook, it actually is not going to change very much over the near term, regardless of who the president is.

MR. TARULLO: The one—an important point here is that a lot of the answer to your question is going to depend on what the terms of the campaign between Labor Day and Election Day are. That is, what is the Democrat, whether it’s Governor Dean or someone else, what is the Democrat running on? And during the primary season, candidates tend to run on multiple things because they’re kind of feeling their way, what is creating resonance out there. But by the convention, any well-run campaign has a sense of this is what our positions are, this is what we’re running on, this is what we want the debate to be about.

If the debate is about the fiscal situation, which would be a little bit unusual, but if the debate is about that and if that becomes a big issue for the Democrat and the Democrat wins, then, Bill, I think, he actually gets—(inaudible). But short of that, which I think is more likely, you’re absolutely right.

MR. DUDLEY: Walter Mondale tried that. (Laughs.) How many states did he get? (Laughs.)

MR. TARULLO: Yeah, that was in a different era, though. That third rail is no longer a third rail, I don’t think.

Okay. Yes, ma’am? Right here.

Q Hi. I’m Gina Sorobin (sp) from J.P. Morgan. I’m wondering what you all think about the potential passage of the homeland investment repatriation legislation, and what sort of stimulative effect that might have on the economy.

MR. TARULLO: Steve doesn’t—

MR. ROACH: I think it’s going to have a very modest impact. There’s this idea out there that—the Homeland Reinvestment Act, that there’s a lot of money that’s been earned abroad by U.S. multinationals which, if they were bring that money back to the U.S., they would have to pay taxes on it, so of course they’re not bringing it back. And the Homeland Reinvestment Act would basically give them sort of a window where they could sort of bring it back and have to pay a much lower tax

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