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World Economic Update

Authors: Daniel K. Tarullo, Professor of Law, Georgetown University Law Center, John P. Lipsky, Stephen S. Roach, and Peter Hooper
October 19, 2004
Council on Foreign Relations

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Speaker: Peter Hooper, managing director and chief U.S. economist, Deutsche Bank Securities, Inc.
Speaker: John P. Lipsky, chief economist and managing director, JPMorgan Chase & Co.
Speaker: Stephen Roach, chief economist and director of global economics, Morgan Stanley
Presider: Daniel Tarullo, professor of law, Georgetown University Law Center

Council on Foreign Relations
New York, N.Y.
October 19, 2004


DANIEL TARULLO: Welcome to the fall edition of the World Economic Update. I'll repeat for you the familiar ground rules. First, this meeting is an on-the-record meeting, unlike many Council events. Second, if you haven't already done so, please silence your cell phones, pagers, Blackberries, and any other beeping devices you may have on your person.

This morning we are joined by three old friends, regular participants, whom you know: Steve Roach from Morgan Stanley, Peter Hooper from Deutsche Bank, and John Lipsky from JPMorgan Chase.

In his most recent congressional testimony, [Federal Reserve] Chairman [Alan] Greenspan characterized U.S. economic performance as having hit what he called a "soft patch" in the late spring, which the chairman attributed largely to rising oil prices. And he went on to say that the economy had since regained some traction. There has been much speculation, many metaphors, and too much swamp imagery since then for us to repeat it too much, but obviously the question is whether there was a soft patch and the economy is regaining its footing, or whether there's some more mushy ground that remains to be trodden. With rising oil prices that have risen substantially, even since the chairman gave his testimony, with consumers who as we may discuss in a few minutes already seem to have exhausted most sources of increased spending, with continued big twin deficits, the question arises where growth is going to come from. And thus the question arises whether the chairman was perhaps a bit too optimistic in thinking that things were going to turn up. So that's the first question we'll address, and we'll then get on a little bit thereafter to talk more specifically about China. But along the way, I think probably a good bit about energy and consumers right now.

Steve, do you want to begin?

STEPHEN ROACH: Thanks, Dan. This concept of a soft patch is sort of a tricky one, because if things get worse, does that mean we're in a hard patch? [Laughter.] I mean, or—

TARULLO: I think it means you're sinking.

ROACH: So, you know, I think the real debate here, though, is over this concept of traction. And traction is another one of these unfortunate images, but to me it conveys the characterization of the dynamic of an economy that is self-sustaining, largely driven by the internally-generated forces that drive income generation, and, in large part, consumer demand. And so, I think that's where you really have to look to answer this question.

And I think the income story is still a pretty shaky one, insofar as providing ongoing traction for the 70 percent of the U.S. economy that is now personal consumption. Job growth remains pathetic. Real wages are declining on a year-over-year basis through September, and so as a result, the internally-generated piece of personal income, which we call wage and salary disbursements— this is the biggest piece of personal income— for the 33 months of economic recovery data that we have, real wage and salary disbursements are up about 2.7 percent over the entire 33-month time period. And normally, you know, if you look back at the past six cycles, 33 months in the recovery, that increase is about 13 percent. So we're tracking 10 percentage points below the norm. We're missing about five percent of real disposable personal income over the broad course of the expansion. So, consumers don't really have the internal fuel here to lift the economy. So, the traction is being provided by these artificial sources of support, such as monetary and fiscal policies, drawing saving balances down, levering your favorite asset, your home, and going deeply into debt to do that. And so I don't think traction is provided by these temporary forces. The policy and the debt and the assets has got to come ultimately from the internal dynamic of the economy. And so that's missing. And so then, when you have a shock like higher energy, which is a tax on the consumer, the vulnerability is high, and it's pretty quick. And that gave Chairman Greenspan, I think, good reason to worry about the soft patches. You correctly pointed out, you know, we could have soft patch one and soft patch two here, because oil is a good deal higher; it looked like the economy was temporarily coming out of that first soft patch, and now could well go into a renewed period of softness as the impact of higher oil prices gets digested. So, we're pretty nervous about economic prospects now in the first quarter of 2005— not just in the United States, but globally in most major countries of the developed world, and to the extent the developing world is largely a levered play on demand in the developed world, we'd be very worried about a global economy that's in danger of stalling out in the first quarter of next year.

TARULLO: John, do you see any traction for the economy, to stay with the image for a bit, coming from consumers, or is it going to have to come from someplace else?

JOHN P. LIPSKY: Well, I think there are a number of ways of looking at this, but the simple answer with regard to the consumer is, so far, the right approach is if income grows, spending grows, and the notion that consumers have been somehow in some unfortunate overextended situation— that's been claimed now for years— and yet the consumer sector has provided steady and reliable growth in spending as long as income is growing. So the place you really have to look is on the business side to see if you're going to be generating basically the sources of new income. And that's where the characterization of the economy— I always get a little lost— first of all, the so-called soft patch was 3.3 percent real growth, with 5.5 percent unemployment. Ten years ago you would have said, well, we can't keep it up at that pace— there's something— this economy is about to start overheating. That's—

TARULLO: We wouldn't have said that.

LIPSKY: That's too fast. Well, I think a lot of people would have said that 10 years ago. So we need to keep that in some perspective.

At the same time, business profits are at record highs. Business profit margins are at record highs. Profit share of GDP [gross domestic product] is at record highs. So, if you ask, Is the raw material there for business expansion— that is, the principal driver of new income— the answer seems to be absolutely yes. And if you look at a forward-looking measure, like the Purchasing Managers Survey that has come off a bit still by recent standards, and fairly reliable, is signaling continued relatively solid expansion.

TARULLO: So, John, just to play this out a bit, are you suggesting that at this point business is on a pattern or a trajectory of investment, which will in turn lead to some stronger job creation, which will in turn support income, which will give consumers another boost?

LIPSKY: Yes, with the only detail in there that it doesn't actually require job creation alone to grow income. In fact, we've had relatively solid income growth. I mean, part of Steve's characterization is this isn't living up to previous recoveries. Well, you could say, Yeah, because the recession didn't live up to previous recessions, and therefore naturally the recovery— you're not recovering from falling into a hole. Net result is actually income seems to be doing quite well.

TARULLO: Now, maybe before we turn to Peter, just one definitional question to make sure we're all talking about the same thing. When we're referring to income, none of you is speaking about total compensation, right? Are you talking actually about wage and salary—

LIPSKY: Well, I think you want to— when you generally look at real disposable income as the measure that determines your spending.

TARULLO: Because I—

ROACH: I'm not focusing on that, because I am looking at the wage income that largely comes from the wage and salary disbursements paid to workers driven by job creation and real wage growth. The total disposable income has been, in my opinion, artificially supported by the serial tax-cutting of the Bush administration.

LIPSKY: But, of course.

ROACH: So that has been a very real source of consumer purchasing power— undeniable— but, again, you have to take that further. The byproduct of that is a record swing from surplus to deficit, huge massive current account deficits, and all the other imbalances that continue to undermine the sustainability of the expansion—

LIPSKY: But the issue is whether disposable income is going to continue to grow. And the answer is yes—

ROACH: No, no—

LIPSKY: --at a solid pace—

ROACH: The conclusion is no because— [Laughter.]

LIPSKY: There we go—

ROACH: Because if the job recovery continues and real wages remain under pressure, then the only one disposable income keeps growing is to keep expanding budget deficits. Now, I know your president wants to do that if he's re-elected in a couple of weeks. But you get to the point where it's very hard to keep driving income by open-ended tax-cutting and deficit-spending.

TARULLO: Peter, what— weigh in on this question, and then go wherever else you would like to. [Laughter.] Once we send these two guys back to their corners. [Laughter.]

HOOPER: Maybe it's appropriate I'm sitting in the middle here. Let me first proclaim my independence on the political question. But, [laughter] well, while I'm sitting on Steve's side of the stage, I tend to side with John on this one. I think that income has been growing; certainly, total real compensation per hour has been expanding a good deal faster than Steve mentioned.

Let's look at the facts. What's been happening to consumer spending? We had a big run-up in oil prices, overall energy prices the first half of the year. Third quarter, real consumer spending expanded at more than the 4 percent rate, and it looks like going into the fourth quarter it's still growing at a decent pace. But, I think that the key here is what is going to give us traction— it is business spending. Yes, capital spending still has not recovered to pre-recession levels, and by some judgments, that's a disappointing performance. But it's coming back from a very deep hole. We had a huge drop in investment spending during the past recession. It was a mild recession overall, but a very deep drop-off in business spending. And if we continue to get the 8 [percent] to 10 percent rate of growth in real capital spending over the next year that we've had over the past year and a half, the growth of the business fixed capital stock will still be well short of potential growth in output. So there's a long way to come there. There's a lot of potential. As John notes, there's a lot of funds within the business sector to keep this going.

All that said, yes, I think we have to be a little bit concerned about this run-up in energy prices, the further run-up that we've had. If it's sustained— I don't think it will be sustained— I think things will be coming back down a bit— but overall, it's a picture that says we're growing at above trend right now. The second half looks like it's going to come in above 4 percent. That seems to be a rough consensus. And decent prospects for some pretty good growth next year, although maybe not quite as good as we've had second half this year.

TARULLO: But, Peter, when you're— just again to clarify, when you're expecting continued consumer spending, you too are looking at increased income, mostly wage and salary income, as the source of that spending, which, in turn, is dependent on the increased business investment?

HOOPER: Yes. Employment has been a little disappointing lately. We'll see how much the September numbers were influenced by hurricanes, what-not. But it looks like things are beginning to come back there. I mean, our expectations will be getting up into the one, one and a half percent rate of growth in employment next year. And certainly, to continue with 2.5 percent to 3 percent on real comp[ensation] per hour— which is what we've had— if you look at broad real compensation, what we've had over the past year-plus. That supports 4 percent-plus growth in real disposable income.

TARULLO: Let me ask you about the compensation question though, because from late 1994 through late 1999, wages and salaries were rising at a faster rate than benefits, most of which, of course, is health care costs; and thus by definition, wages and salaries were rising more than total compensation. From the second half of 1999 onward though, those curves crossed, and at this point, basically, we are seeing an increase— I've got my figures in my scrawl here— benefits costs are now on the order of 7 [percent] to 7.5 percent a year increasing, whereas total compensation is—

LIPSKY: You mean wage compensation.

TARULLO: No, wage compensation is not 7.5 [percent]. Wage compensation is more like 3.5 [percent].

LIPSKY: No, but you were— I'm sorry.

TARULLO: Wage compensation [is] more like 3.5 [percent] with the total compensation in the middle. So, I'm wondering— that's why I asked about the total compensation. It seems to me right now that that is not a particularly good source of discretionary consumer spending, particularly in light of higher energy prices— the fact that consumers have basically drawn down their appreciated assets, and to some degree at least, debt servicing costs are increasing, at least for people with variable rate mortgages and those who have revolving credit agreements that rise with interest rates.

PETER HOOPER: You have a point that I might even throw into your side of the ledger: the fact that we've driven the saving rate down to 1 percent or less. But I think the tax cut benefit really came to an end early this year. That's not a factor that's been supporting consumer spending in the second half of the year that much. Yes, there's an issue of the quality— I mean, we'd like to, over time, see wages accelerate a bit, and we expect that that will, as long as the labor market continues to improve. I mean, unemployment rate 5.4 percent, full employment somewhere in the low fives— we're not looking at a huge amount of slack out there. You are— I think some sectors [are] beginning to see wage pressures, and that should build over time if we can continue with business spending supporting moderately above trend growth. I mean—

TARULLO: OK—

ROACH: Can I just ask John and Peter a question?

TARULLO: Sure.

ROACH: Because we have a difference of opinion here on this concept of traction. They're both arguing— and it's an important point— that the business sector awash in earnings and liquidity is going to step up. And this has been an argument that's been made for a while, and the business sector so far has been pretty reluctant. The last three months, private sector hiring averaged 65,000 a month, which is pathetically weak for an economic recovery. The CAPEX [capital expenditure], Peter, that you alluded to, has largely been driven by replacement spending. The net investment piece of capital spending that you can back out of the Commerce Department numbers is hugely depressed relative to the peak level in 2000. What companies are doing, is they're buying back shares and investing largely in capacity offshore. And you know the models that you look at to describe business behavior, at least the ones I'm familiar with, say the earnings drivers are usually the least important. The really important driver for business spending on capital labor has to do with business expectations of future demand prospects— how your— the existing capacity is going to be utilized a year out, two years out. And then if you have a need there, then you step up. So there's sort of a paradox in corporate behavior. They've got the money, but they're not spending it to generate the type of income and internal purchasing power that the economy really needs for traction. So how do you reconcile that?

TARULLO: John, and then Peter.

LIPSKY: Well, this was an argument that was made in 2003 that businesses were not going to step up, that they were not going to respond, and that it was going to be a long time until capital spending was going to revive, because they had wasted all this money buying useless technology in the late '90s. And, lo and behold, it turned out that was wrong, and business spending on capital equipment and software began to grow in 2003, and has grown strongly— relatively strongly— this year; that growth in manufacturing output, which was the most depressed sector of the economy, has been growing at a strong pace— nearly double-digit pace, and output of traditional capital goods has been growing at a double-digit pace in recent quarters. So the question is really not: When will they respond?--the question is: Will they keep it going? Because inevitably, if they keep that rate of spending going, which we think they will continue at that relatively rapid pace, inevitably it will turn into job growth.

But, I continue to point out [that] one of the iron laws of the U.S. labor market or the U.S. economy has been that growth and productivity always accrues to labor, and it doesn't have to happen through growth in wages— or, sorry, growth in jobs. It can accrue through growth in compensation to existing employees, and that is what has been happening, and that is why consumption has been going, because in fact— or why spending has been growing, because compensation has been growing, even though job growth has been relatively weak. Of course, we're arguing about whether businesses are going to continue to expand. But the traditional building blocks for business expansion— demand growth, profitability and liquidity— are all present in either normal or supernormal amounts. You can claim that businesses are not going to respond, but I think you need to give an argument as to why they won't, because all these arguments were made in 2002 and 2003 in exactly the same way, and they were wrong.

TARULLO: So, Peter, roughly speaking, is the difference between the view that Steve is taking and the one you and John are tracking that you and John see enough momentum in business capital spending right now that income will be put in the pockets of consumers who will then get enough traction to keep the cycle going, whereas Steve seems a little skeptical that business spending is going to continue or accelerate in light of the uncertainty about consumer demand?

HOOPER: Yes.

TARULLO: OK, I just want everybody to understand where the difference lies.

HOOPER: But let me expand just a bit. I think Steve has a good point that much of this growth in capital spending that we're seeing that John is talking about is replacement. I mean, firms reached rock bottom. They had to start investing more to maintain their existing capital stock. The growth of business fixed capital has sunk to the lowest rate you've seen in the last several decades as a result of the sharp drop-off. You get so low, and you have to begin to spend just to maintain what you have. And the point now is how much do we begin to raise that rate of growth of capital to be more in line with— I mean, right now the capital output ratio, roughly speaking, is declining at a pretty significant rate, which you don't see historically. That's going to have to begin to recover. The so-called accelerator or the change in the growth of business output, has picked up significantly over the last two years, and that should be supporting the faster growth of the capital stock going forward.

TARULLO: So is that the— I was just about to ask what the best leading indicator would be to show whose view is more likely to be right. Is that it?

HOOPER: Well, I think what's happening to net investment, how far it's picking up— and I think that is picking up.

Another factor working in our favor is that the capital stock has shifted toward higher rate of depreciation of equipment. I mean, tech equipment tends to wear out faster, and you need to invest more to replace it.

TARULLO: OK, let's now turn directly to energy prices. All three panelists have alluded to them. When we were here last June— we being John and Steve and I— Mickey Levy [chief economist, Bank of America Securities] as the third panelist then— I asked what level of oil prices were being assumed into the models that each of their firms was using to project economic growth, and all three said $35 a barrel for gasoline. Obviously today—

ROACH: What was the oil price back then? It was probably $35, right? That's what we always say. [Laughter.]

TARULLO: No, it was actually a little higher than $35, so you were assuming a little bit of a decrease. Obviously we're not there. How much difference has oil, at I guess this morning $53 a barrel as opposed to $35 a barrel, made not just the thinking about quarter-to-quarter economic growth, but may for your thinking about the economy going forward over a longer period?

ROACH: Well, we— you know, we—

TARULLO: One more introductory comment. There's been a lot of effort, including by Greenspan, to downplay how much difference the energy increase has made this time around as opposed to the last two genuine oil shocks. But I will— go ahead.

ROACH: Yes, that's sort of his modus— MO [modus operandi] right now, is always sort of play down problems. You know, we continue to be frustrated in really getting a clean read on the oil price trajectory, and— Is that something you want me to read?

TARULLO: I'm going to let you read it privately after you're done talking.

ROACH: OK. Oil is now down to—

TARULLO: It's got nothing to do— [laughter]--it's got nothing to do with the real world. Steve is making sure because he's—

LIPSKY: I think it's his Blackberry. That's where that noise—

ROACH: It says that the Yankees filed a protest over the game last night. [Laughter.] And it's currently under review. [Laughter.] What was the question? [Laughter.]

TARULLO: Oil, oil.

ROACH: Oil, OK. Let me turn this off. I think it's this way. Look, like probably all the panelists here, we think oil prices are going to fall sharply, and that's been wrong. They haven't. And you know we try to parse out whether it's supply or demand, and it's both. It's— demand has held up stronger than expected, especially because the China slowdown has not materialized yet with the force we are expecting. But there have obviously been some huge uncertainties with respect to the stability of supply that have played a role in driving futures prices as well.

A couple of weeks ago, we marked our forecast to market, assuming that Brent [crude oil price] peaks out at $50, which is where it has peaked, and then stays a good deal higher, but then drifts down into an equilibrium price level in the $30- to $40-dollar range over the next year, which is a good deal higher than we had previously thought. So on the basis of that, we lopped off about three- or four-tenths off of our global forecast for 2005, and about a percentage point off of our quarterly annualized growth forecast for the first quarter of next year.

I think if oil holds at $50 that the impact of that is likely to be a good deal more than sort of the linear rules of thumb that Chairman Greenspan alluded to. This is a psychological threshold, I think, for a pretty fragile global economy. And so the impact could be a good deal larger than that.

By way of perspective, I think there are just two final points I'd make on this, Dan. When we have oil-related disruption, I always hear two reactions: one, the real price of oil is below where it was in the late '70s, so don't worry about it; and, two, oil is not as important as it used to be because of energy conservation. That always turns out to be wrong. The real price of oil is really not relevant for macro analysis. What is most relevant, is the change in the real price of oil. Relative to the averages prevailed since early 2000, at $50 a barrel nominal, the real price of oil is about 65 percent above that four-year average. That is a serious disruption to an income-impaired consumer. And you know, while energy conservation continues to be an important factor in shaping the numerical impact of higher oil prices on the consumption technology in the United States, it's the psychological blow that is so important. In the energy-inefficient economies of China and India, this is obviously a very serious and growing problem. So, I don't dismiss this. I can't make light of it in any way whatsoever. I think that it does represent a significant threat to the global economy next year.

LIPSKY: Dan, if I could add— one other observation to add there is that one doesn't get all that reassured by the observation that things are yet as bad as they were in the 1970s, which was a pretty bad economic period. And so, if that's our point of comparison, of course things aren't that bad.

TARULLO: John, I think Steve identified actually maybe the more interesting question, which is not where oil prices have peaked and not, you know, how much they'll come down, how quickly— but whether we're now at a point where the medium-term equilibrium price of oil is going to be quite a bit higher than we might have thought a year or two ago because of China coming on-stream, because of supply disruption, and supply questions and the like.

LIPSKY: It's hard to feel confident in these kinds of forecasts. I can remember in the 1970s as an IMF [International Monetary Fund] staff member being provided with forecasts by the World Bank that had triple-digit oil prices per barrel in the 1980s. I think markets tend to work better than that.

All our discussion here today has the unsatisfactory aspect of being ex poste rather than ex ante explanation about oil. But it's worth asking, first of all, How did we get here? And you could line up the obvious culprits, but one of them is almost certainly that global demand was stronger than we understood. And if that's the case, the implication is the global economy probably was less fragile.

TARULLO: Most of that demand from developing countries?

LIPSKY: It quite— when you think about it—

TARULLO: So it was unexpected, I mean?

LIPSKY: Well, the part that was— just taking a step back, what seemed obvious from 2003 was that not only did the consensus views, but the views subscribed to by oil producers underestimated the recovery in the global economy and therefore demand in a situation in which it was evident that the margins of excess capacity in petroleum refining— crude production refining— were going to be minimal. As a result, it seemed obvious that we were going to likely be in a period of rising prices in which demand was going to put pressure on supply.

Now the question was, how high was that going to go? Where was it going to get to? And it seems to me that there's been, on the part of experts who got the story wrong, wanting to say it's speculation or it's risks— it's new risks— and that may be some of it, but I don't think that's as convincing as the likelihood that the global economy has been stronger. And the likely places are where the data is less reliable, and that you tend to look at Asia.

But the implication— there are a couple of implications here. Are we going to have this higher medium-term price for oil? And the easy answer will, of course— and you say, just look at the forwards. However, the forwards— the forward curve, forward prices for energy— always change with the spot price, so it's not— they don't actually tend to provide a good forecast of future spot prices for oil. So you can't just look at the oil price— oh, look at the futures curve and say, well, that's clearly what's going to happen.

It seems to me an odd idea that a product as important and as ubiquitous as energy, and petroleum in particular, would remain at a margin so dramatically above marginal costs of production for an extended period of time, but maybe that's going to happen. It strikes me, though, that the question here— are we going to— if we sustain these kind of high prices, it continues to make me think that the— the underlying economy must be stronger than we think, which is why our expectation is we are going to get some decline in oil prices.

And there are two aspects here if that's plausible. There are two aspects to keep in mind. One is that we're going to get this dampening effect of the unexpected run-up in price, but that means we get the unanticipated stimulative effect of the fall in price in the coming year that we hadn't anticipated previously; in other words, to us it looks more like time shifting than some big dead-weight loss on the global economy.

Secondly, there's a tendency to think back in a situation like this, which is impressive, in which the added income— unexpected, if you will— added income to oil producers this year is on the order— it's an annual rate on the order of $700 billion. It's not trivial. You tend to think back to the '70s, in which that sort of fell into this— remember the challenge was recycling the OPEC [Organization of the Oil Exporting Countries] surplus in the '70s, and we still seem to have that in mind, that this shift in real resources just gets lost somewhere in the global economy.

But my guess is the other aspect that we have to think about is that in fact oil producers tend to be high consumers now, not big surplus— external surplus countries, which is to say, this shift in real resources to the oil producer is going to come back into the global economy as demand— increased demand— in relatively short order.

And that's why I think it's plausible— obviously, there are frictions, and there are going to be problems, and net— net for this year and next year, it's probably a marginal dampener on activity. But I think it's way too easy to say, Oh, this is some really serious problem. You could get there, but I don't think what we've seen so far would justify that conclusion.

TARULLO: Peter, the last question for this segment— and I want to broaden the focus slightly, to include oil but other things as well. I had a conversation about a week and a half ago with an official sector economist— I guess that's about as specific as I should get— who began mumbling about the yield curve. So I took up just quickly on the train on the way up yesterday— just pulled out some numbers, and it is remarkable how much the yield curve has flattened, for different reasons. In the United States, it's because short-term rates have gone up. In the euro area, it's because long- term rates have gone down. Actually, we have a bit of an inverted curve in Britain right now. Australia is more or less flat. Japan hasn't changed very much.

As— putting yourself back into your Fed[eral Reserve] role of some years ago, as you look at the uncertainties around oil, to which Steve and John have both alluded, the odd behavior of the yield curve, given the underlying belief at the Fed that there's more traction to come, and all these variables about consumer and business spending that you were talking about earlier, do you think that there's a significant level of uncertainty in the Fed and other parts of the official sector about what actually is going on? And if so, what implications does that have for their policy going forward?

HOOPER: Well, on the yield curve, there's no question there's been a lot of flattening globally, and this is a key ingredient in—

TARULLO: Your mike's not on.

HOOPER: Oops. Mike's not on here? Says on—

TARULLO: Says on?

HOOPER: --for what it's worth. Coming back there? Good.

The yield curve is a key ingredient in indicators— the various indices of leading economic indicators— which have been coming down at a pretty significant rate. And actually, if you extract the yield curve, those indicators have actually been moving sideways, a much less negative picture. So this is an important issue. And the question is how good an indicator of growth is this? I might note that this reflects the bond market's expectations, or more narrowly, the U.S. Treasury market expectations.

There are a number of other factors influencing the market besides expectations about growth going forward— foreign, central bank purchases, the Treasuries have continued at a pretty good pace, and it's probably taking a little bit out of the current longer-end of the U.S. Treasury market. But there are some disconnects with other financial markets. The stock market hasn't been anywhere near as gloomy, nor have credit markets. Credit spreads have actually come in.

But more importantly, how good an indicator is the yield curve in forecasting economic activity? Some work, I recall, having been done at the Fed, a while back, and some work we've done in-house at Deutsche, suggest that, over the last decade and a half, the predictive power of the yield curve has dropped dramatically. The correlation with GDP growth used to be in the 70, 80 percent range; it's now dropped to less than 10 percent. So I think those— you can emphasize this particular indicator a bit too much, and I think it is giving us a little bit more gloomy view of prospects than is warranted.

TARULLO: OK—

LIPSKY: Can I just add— one second. I know you don't want me to. But the— I think it's useful here to— what you really want to do is contrast between what happened in '94 and what's happening now. In 1994, remember, the Federal Reserve raised the Fed funds rate a total of 275 basis points—

TARULLO: I remember that.

MR. LIPSKY: --during the calendar year, eventually 300 basis points. And long-term interest rates went up by over 150 basis points, 1.5 percent, but a time in which inflation was not going up. So real interest— long-term interest rates were going up, real interest rates were going up. And that's one reason why the economy slowed as much as it did in 1995, contrary to expectations that inflation was going to go up and the economy was still overheating. This time the Fed has been much more successful, in that obviously the market does not— is [inaudible] longer making this knee-jerk connection— stronger growth, inflation up, rates up— because the Fed has done a much better job of controlling inflation expectations. I think what's impressive in— that the rise in energy prices has neither resulted in an acceleration in core inflation or, from the evidence of the treasury curve, has dented longer-term inflation expectations. So I think that is a positive for the outlook.

TARULLO: You know, I'm tempted to ask another question here rather than move to China. I think I will.

Let's say for a moment that Steve's view turns out to be more correct. At this point, what kind of policy instruments are available to the government, either fiscal— we can continue, I guess, to increase deficits substantially more, although you got to believe at some point there will be a negative reaction in some set of markets. There's not a whole lot of room to do much in monetary policy right now. That's presumably one of the reasons why the Fed would like to get interest rates up, to give them some space to decrease them if necessary. If the soft patch turns out to be a bit more of a swamp, Peter, what policy instrument would you think might be available in the short- to medium-term to counteract it?

HOOPER: Well, I mean, we do have 175 basis points of Fed funds easing in the quiver now, if you will. I agree that there's certainly room for any number of fiscal actions one could take on the tax side near term, and I agree with you that we certainly have to be looking at the longer-term implications of any tax law changes, but on the spending side as well. So basically back to your standard monetary fiscal— I don't think the ammunition's all used up at this point. It's lower than it was a few years ago, no question, but you do have some scope there.

TARULLO: Steve, a few years ago, you and I would both in these sessions invoke— oh, we're going to shift now to China for a bit. We would both invoke that metaphor that the world economy was flying on a single engine and that there was some risk that when you're flying on a single engine, which was consumption in the United States, you weren't as stable as you'd like to be.

Today there's clearly a second, even if somewhat smaller, engine, which is to say that provided by China. And the The Economist's recent survey of the world economy, in which you were referred to, used a different and somewhat more startling image to describe the impact of Chinese growth in the coming years, and I'll read it to the audience.

"The integration of China's 1.3 billion people will be as momentous for the world economy as the Black Death was for 14th century Europe, but to the opposite effect." It is an arresting— it does get you to read the rest of the survey. [Laughter.]

"The Black Death killed one-third of Europe's population, wages rose, and the return on capital and land fell. By contrast, China's integration will bring down the wages of low-skilled workers and the prices of most consumer good, and raise the global return on capital."

Now, even providing the appropriate discount factor for journalistic efforts to suck you into reading a long survey in a magazine full of short pieces, is thinking in those rather epic structural terms a useful paradigm for considering the impact in the nearer term of the next few years of China on the world economy?

ROACH: You know, even I don't go that far. [Laughter.] And I think the China story is a critical story to understand the way the world works today.

The way I see the world is you've got the American consumer driving the demand side, the Chinese producer increasingly driving the supply side, at least at the margins, and that's an obvious and important force to [be] reckoned with. There's a lot of other factors going on outside of the world other than those two, but those are the two dominant forces. I think it oversimplifies the story to say that China is going to crush wages and employment growth around the world. This sort of presumes that China is on an open-ended expansion path. And if there's anything that emerges right now, it's that the Chinese economy is overheated and the new Chinese leadership is facing a formidable task in managing this rapidly growing economy without creating a serious problem of excess investment, accelerating inflation, and now they have rising property bubbles in coastal China, especially in Shanghai.

There are encouraging signs that the China slowdown may be now taking hold. There was a stunning deceleration of Chinese import growth just reported the other day for the month of September. Auto sales have really weakened appreciably and are now declining slightly on a year-over-year basis in China. I think that multinationals continue to expand their production bases in China. That will continue to absorb a lot of this excess cash flow that was alluded to earlier in the developed world. The wage rates of Chinese workers are still, you know, 20 percent of those of the developed world norm. There are some indications that they may be rising a little bit, but from low levels.

You know, economics has a concept where the— you know, the last worker hired, the last price set is really the most important price in shaping a much broader wage and price determination mechanism, and the Chinese certainly have an important role in guiding that process.

But you know, ultimately, China is not just about production. It's also about creating a base to provide consumption and prosperity for its own workers. And so they've got to think very seriously about how they go about the task of providing better balance to their economy, so they're not on an open-ended supply-side— by supply- side, I mean production side-driven— binge that's going to cannibalize output everywhere else around the world. They're mindful of their role in the global economy. And I think they're doing their best to try to manage their economy in a way that is sensitive; that we can debate— and it's an important debate— as to how successful they're going to be without, say, changing their interest rate policy, without changing their currency policy, and just staying fixated on managing their economy as central planners. That's an important discussion point.

But I do not think that China is going to crush the rest of the world here.

TARULLO: John, when we started this five years ago, we tried to talk about different regions in the world economy in every session. And what we quickly found, you and I and Steve and others who participated regularly, was we always ended up talking mostly about the U.S. economy, because we shared a view that ultimately it was the U.S. economic performance which was the most— far and away, the most important variable for world economic performance.

Not with— even if this is an— even if this economist's line is a substantial exaggeration, are we now at the point where, when we gather quarterly to have these discussions, it really needs basically always to be about the United States, yes, but then always something about China? Is it really now two important variables that are setting at least the terms by which growth will or will not move forward in the rest of the world?

LIPSKY: Well, let's put it in the following perspective. Back in the 1960s, growth in the— demand growth in the U.S. was about 3 to 4 percent. Today it's about 3 to 4 percent. In fact, for this— since 1960, demand growth in the U.S. economy has averaged 3 to 4 percent over that whole period. Pretty good, not fantastic, not bad.

The rest of the world, if we define the rest of the world's economy using U.S. export weightings, we'd find that in the 1960s demand growth abroad was about 6 percent per year, on average. By the 1990s, it was 3 percent per year.

So we went from the 1960s, a structural surplus— because the rest of the world, defined that way, was growing faster— to the '90s, in which the rest of the world was growing more slowly, but the U.S. has been relatively stable through that period.

Now fast forward to the last four or five years and you find that the U.S.--in fact, if we look at 2003, that growth gap actually surged, which is one reason— it's the obvious reason we have a current account deficit. Not that something's going wrong here; growth in the rest of the world has been slowing on a trend for 40 years, and it's too slow. So— and that was true even as recent as 2003.

So the question we've got to ask, is there a broad force that is going to accelerate growth in the rest of the world to eliminate that discrepancy, for which there's no good reason for it to be sustained? And the answer? We look to Asia, and the idea here, of course, is that that's where the tremendous opportunity is for good policies that produce greater efficiencies, and productivity gains can produce sustained and very substantial long-term growth in demand. And I think that that's likely to be the case. We're going to be talking about Asia for some time to come.

But happily— happily— as we look forward in the— just in the coming year, our own measures of demand and the rest of the world are now basically going to accelerate to about the U.S. pace not because the U.S. is slowing so much, but happily some of our trading partners are starting to do much better. And we have this tendency to think there's Asia, there's Europe, but it's easy to forget NAFTA [North American Free Trade Agreement]--Mexico and Canada— remain extremely important trading partners for the U.S. economy, and they are— they have accelerated, and are now likely to be growing in the coming year as fast or faster than the U.S. So what we're seeing— step back, big picture— NAFTA is producing— hopefully starting to produce— a more sustained area of stronger demand growth, especially stronger growth in Canada and Mexico.

Hopefully with FTAA [Free Trade Area of the Americas] or with better policies in South America, the whole Western Hemisphere growth prospect will remain more positive. Hopefully, as Steve points out, that China— not just China, of course— but India and the whole Asian region, which I think you can't usefully look at China in the abstract because the growing interrelation and interaction of the Asian economies is so critical to the overall strength there that if Asia can produce sustained and balanced growth, then this is a— this is a pretty positive picture.

TARULLO: Peter, how do you— as you look at— as you do your analyses of the world economy going forward, do you basically begin with the United States and then China, or is that too simplistic a way of looking at it now?

HOOPER: Well, I mean, we look at the industrial countries, and China is certainly key and should— I agree with—

TARULLO: Let me stop you. When you look at the industrial countries, what— to— how often in the last couple of years has something going on in Europe become a key factor in the analysis?

HOOPER: Well, Europe and Japan have been laggards, if you will, so that hasn't helped on this.

And I was about to add that China— I certainly agree with the Economist survey piece that made the point that China probably should be a regular member at the G-7 [Group of 7 major industrial economies] / G-8 [Group of 8 major industrial economies] discussions. I thought your quote was a good one, a nice choice there, and I certainly agree with the notion that a significant driver of growth here globally is the emergence of a substantial number of Chinese every year into the modern workforce, which is, I think, driving down— helping to drive lower low-income wages elsewhere. It is, I think, raising return to capital and should ultimately tend to raise interest rates [inaudible] bit.

That survey piece, I think, on the whole, was quite upbeat about the implications here.

TARULLO: Relentlessly.

HOOPER: This is not a cost to the U.S. It's actually more a cost to many of our trading partners in emerging markets that tended to produce the things that now China is producing, but they've moved on to produce other things. So, I mean, comparative advantage and free trade, this is net a significant plus to the global economy.

There are some other issues. I mean, there are a lot of dimensions to this piece. But China has chosen to follow a fixed exchange rate policy, in part to foster the creation of jobs in the export sector. This has helped, I think, on the margin to hold down rates— interest rates and inflation in the U.S. It has also slowed any progress toward dealing with our external imbalance. I think you'll see more— increasingly see pressure against the euro as sort of the escape valve here. But the U.S. external deficit in nominal terms is going to continue to grow, and this will become an issue down the road.

There are a lot of issues that were addressed in that article and some that I didn't agree with, if you want to go further.

TARULLO: OK. Well, actually, let's turn to questions now.

And Peter's last comment feeds into very nicely to a question that came from one of the national members, who is listening to this on the Web broadcast. It's from Joe Bower at Harvard, who asks: What are the implications of the over $500 billion in reserves held in China, Japan and Taiwan? What would be the consequences to the holders if they tried to use these dollars against the United States— I presume for policy leverage purposes?

Anybody?

ROACH: Well, first of all, they hold a lot more than $500 billion. I mean, the Chinese hold more than $500 [billion], Japan holds more than $850 billion [inaudible] about a number that's, you know, $1.5 trillion. We all know the story that, you know, it's in their best interest to keep buying treasuries to keep U.S. interest rates low, which props up American consumption enabling overly indulgent American consumers to buy DVD players made in China. So it's a great way to run the world. If China and Japan elect to dispose of their reserves and do different things, then, you know, the demand for treasuries goes down and, as Peter indicated, our interest rates would probably go up somewhat. We can debate over "somewhat."

What I found interesting was, over the weekend, the new Indian government announced that they're going to start using about 10 percent of their currency reserves to fund an infrastructure program, which, if you've ever spent any time in India, India really needs desperately. At the start of this year, the Chinese authorities took about 10 percent of their reserves and dedicated [it] toward the recapitalization of two state policy banks. So increasingly, you know, the reserve accumulation that's building in the developing world, especially in Asia— which is staggering— Asian economies are [inaudible]--Wait a second, you know, there's more to reserve accumulation than subsidizing the American economy. And that was a direct quote from a senior official in this article—

TARULLO: The Indian Finance Ministry, right.

ROACH: Well, I think it was the deputy planning commissioner, [Montek Singh Ahluwalia].

TARULLO: It was the finance minister, [Shri P. Chidambaram]

ROACH: They're tired of subsidizing the American economy. So you know, I think that there is an inclination here to think seriously about managing this massive portfolio of reserves. Whether or not that will have ominous or even meaningful consequences for the U.S. funding its massive current account deficit remains to be seen. It's not a positive, I think.

TARULLO: John?

LIPSKY: Well, there are— lot to talk about this. This is area where you find—

TARULLO: Not too much.

LIPSKY: I know–[laughter]--where you find rampant partial equilibrium analysis when general equilibrium analysis is needed. That sounds like econo-speak. It's the idea—

TARULLO: Is that why it sounds that way, John?

LIPSKY: Because it is. [Laughter.]

TARULLO: Right.

LIPSKY: The idea— if the Asian central bank stopped buying Treasury securities, then U.S. interest rates are going up. And it strikes me— wait a minute, wait a minute, let's take this, let's look at this in a more holistic way. The Asian economies, especially China and its neighbors— you can call them the East Asian dollar standard— in the wake of the '97-'98 Asian crisis, in which they were told by Western experts that the last thing they should do is re-establish their dollar pegs, and instead, should float their currencies— said, "Thank you very much, we're re-establishing our dollar pegs, and the lesson we learned from the '97-'98 crisis is we will never again be bereft of reserves so the next time our good friends in hedge funds in New York show up, we can kick them where it hurts and send them on their way."

The fastest-growing area in the world today is the East Asian dollar standard. So I would say— either we can say this has been a terrible mistake, and it's an accident waiting to happen, or maybe it works for them. And why it works for them, for now, is because these are very open economies with very rudimentary domestic financial systems; that they cannot domestically provide foreign exchange cover— in other words, exchange rate stability through markets— for their importers and exporters. But if they peg to the dollar, they bolt on the U.S. financial system, and they— this is the reason why about 95 percent of Chinese trade is invoiced in dollars, because then Chinese producers don't have to worry about exchange rate fluctuations.

Secondly, this is a region— you always have to look at this in a regional sense, because since '97, '98, with the massive depreciation of China's neighbors against China, there's been a huge shift of trade flows in which their neighbors export to China, and China exports out.

In an equivalent circumstance, the economies of Europe formed the exchange rate mechanism. But in Asia, they can't; it's no political format for that. So the dollar peg also provides a benchmark for preventing competitive depreciation in the region.

Now, eventually they're going to want to move to a more flexible regime, although it's not obvious what the intra-Asian solution is going to be. But they're not about to start dumping dollars and— because that would be tantamount to raising their exchange rates.

So when you say: If they stop buying Treasuries, won't that make U.S. interest rates go up? I say if they stop buying Treasuries, it's because they've changed their exchange rate policy, and we have a new state of the world. I think you could argue, if they did it in a brusque fashion, it would be significantly disruptive enough to the Asian economies, you could even argue that interest rates would go down.

TARULLO: Well, "kick them where it hurts and send them on their way" is not econo-speak. I just want to say that. [Laughter.]

LIPSKY: Thank you.

TARULLO: All right. We have time for a couple of questions from the audience. If I recognize you, please, A, wait for the microphone, and B, identify yourself before beginning to speak.

Yes. Right here, please. Carolyn? Thanks.

QUESTIONER: Teresa Havell. Not to belabor the topic, but just one little bit more of this idea of holding dollars as reserves. I noted that The New York Times used the expression, or used the language, that Washington has demanded that the Chinese government abandon its policy of buying dollars to keep down the value of the yuan and promote exports. If our panelists were members of the next administration, would they continue to give this type of advice to our trading partners?

TARULLO: Peter?

HOOPER: I think it would be— it's in China's best interests down the road to begin to loosen this policy, to move toward at least a basket and eventually to allow the currency to float more freely. You are seeing an increase in liquidity creation in China. You're seeing inflation pick up. And if they don't let it go in nominal terms, it'll happen in real terms eventually with inflation rising in any case. So yes, I would continue to encourage— I would not want to see an abrupt move. I think an abrupt move could cause a pretty sharp drop in the dollar, and that would, I think, eventually lead to higher inflation and interest rates in the U.S.

TARULLO: Anything—

ROACH: Let me just add one thing here. The hidden agenda here is that the politicians, I think, are increasingly sensitive to the Chinese currency as being a proxy for an undercurrent of protectionist risk in the United States. In this jobless recovery, there's— a number of bills have been introduced in the Congress that would slap huge tariffs on China. These bills are driven by the belief— I think it's mistaken— by the Congress that the remedy is 27.5 percent undervalued, to pick a number that Senator [Charles] Schumer (D-N.Y.) has articulated publicly.

So I think the [U.S. Secretary of the Treasury] John Snow statements and other statements coming from the White House attempt to deal with the politics of these huge bilateral trade imbalances. I think these politics are misplaced, but they're going to be a very real and, I think, lasting force beyond this election period, so you need to keep an eye on this.

TARULLO: OK. One last, and I hope, brief question, please. Somebody in the middle had a question. No?

But if not, then, John, you can go ahead and make the comment you were going to make on China.

LIPSKY: Oh, just that, as I think what I implied by my earlier statement, the critical issue is that China and its neighbors develop modern financial systems that are capable of sustaining a more flexible environment— a flexible economic environment. So I think what we ought to be doing as a matter of policy is trying to accelerate that process of financial liberalization, both within the Chinese economy and eventually internationally as well.

TARULLO: OK. I want to note that this is the only panel on any topic that has not talked about the election. We did manage to talk about the Red Sox and the Yankees briefly, but not about the election. Next panel will talk about the position of the administration going forward. We haven't set a date yet, but I think maybe early December.

HOOPER: But, Dan, who's going to win? You're the expert. [Laughter.]

LIPSKY: Will the election actually be decided by the time we have our December— [Laughter.] [Applause.]

TARULLO: I sincerely hope so. Thank you all. [Applause.]

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