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World Economic Update -- December 1, 1999

December 1, 1999
Council on Foreign Relations

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Professor DANIEL K. TARULLO (Georgetown University Law Center): We’d like to get started, please, so we can get you out of here promptly at 9:30. I’d like to welcome you all to the first World Economic Update of what I’m now back to thinking of as the academic year, but which is, in fact, the season for the Council. I am Dan Tarullo.

I’d like to first introduce the speakers today, and then we’ll get right into the program. Those of you who’ve been here before are familiar with at least two out of the three, and you may know all three.

To your far left, John Lipsky, who is the chief economist at Chase Manhattan Bank and a poster boy now for The New York Times. Between John and me, Gail Fosler, who is the chief economist of The Conference Board. And to your far right, Bruce Steinberg, the chief economist at Merrill Lynch. Couple of ground rules which, as you know, we enunciate at the beginning of all Council events. This one is a little bit different from some. This is an on-the-record meeting. There are members of the media invited and welcome to take and use whatever notes they would like. After we have our roundtable for about half an hour, we will then turn to questions and answers from the audience, and at that time I will ask you to identify yourself before you ask your question.

We will get done at 9:30, and I am particularly instructed to ask you that you shut off your cell phones, and I guess if you have an audible beeper that you do the same thing. This is the only thing here that’s underlined and in italics, so I thought I should say that.

The first area that I’d like to concentrate on this morning is that of central banks’ interest rates. We have had in the news over the last couple of months a good deal of speculation about all three central banks in the major parts of the G-7. The Fed, Federal Reserve Board, as all of you probably know, has now taken back two-thirds of the interest rate reduction that it gave during the height of the world economic crisis last year. There is increasing speculation as to whether that last 25 basis points may be soon to go as well. The CPI number this morning, for those of you who are waiting with bated breath, was .4 percent, right on expectations. Having someone check and see if they can get what the core...

Ms. GAIL D. FOSLER (Senior Vice President and Chief Economist, The Conference Board): Here’s the core.

Prof. TARULLO: Oh, core was .3, which is...

Ms. FOSLER: On expectations.

Unidentified Man: Expectations.

Prof. TARULLO: Yeah. On expectations.

Ms. FOSLER: On expectations.

Prof. TARULLO: Some expected higher rate than others. The question, obviously, for the Fed has been whether latent inflationary pressures are now latent enough to warrant another increase in the interest rates for the United States. Across the ocean, across the Atlantic Ocean, the European Central Bank seems to be giving every signal it possibly can that it is going to raise interest rates probably before the end of the year.

And on the other ocean, the Bank of Japan has been resisting, even in the wake of the G-7 meeting, calls from its G-7 partners and from many private economists in and out of Japan, and apparently now from the Ministry of Finance, to adopt a more creative, more expansionary monetary policy, even in the face of effective zero percent interest rates, such as through repurchasing Japanese government bonds in the open market.

The first question I’d like to put to the panel is whether one or more of these central banks ought, in your view, to take the action that many in the public and the private sectors are suggesting that the banks take: interest rate increases in the case of the U.S. and the E.C.B. and some sort of more expansionary monetary policy in the case of the Bank of Japan; whether they will and whether they ought to. And, John, why don’t you start?

Mr. JOHN P. LIPSKY (Chief Economist and Managing Director, The Chase Manhattan Corporation): All right. Thanks, Dan.

`Ought’ or `will’; that’s probably simpler than `ought to.’ It looks quite likely, almost certain, that the European Central Bank is going to raise rates. As you say, they’ve virtually promised us that they’re going to, and explained extensively why they think that’s correct; the Federal Reserve, similarly. I suspect what they’ve told us is that if the numbers don’t show a slowdown between now and the November 16th FONC meeting, that the chances are likely that they’re going to raise rates again. And the Bank of Japan is probably the most problematic. After all, they have just, as you suggested, endorsed a set of measures that they had previously asserted not only that they would not do but would not have any beneficial effect, in any case. Now they’ve said they’re going to do them, leaving a couple areas of uncertainty. Should the central banks be raising rates at this time? Certainly the most important thing these key central banks can be doing, on the part of the European Central Bank and the Fed, is making sure that inflation expectations—and I underline expectations—stay low. And in the case of the Bank of Japan, I think it is important and justified that they undertake measures that give confidence to the household sector in Japan that the Japanese economic recovery really has begun and in a sustainable way.

Prof. TARULLO: Thank you. Gail?

Ms. FOSLER: Well, I guess I would agree with John on the will. I’m not sure I agree on the ought. In particular, I think that the question is, in Japan, whether you fight a structural problem with cyclical policy. And the sources of the Japanese problem are not an inadequate amount of liquidity, but essentially an inadequate amount of productivity and a huge discrepancy between their manufacturing sector, which has become sort of tantamountly unproductive, and their service sector, which has really lagged even the rest of the economy. So I think that it would not necessarily give confidence to the household sector to throw monetary kerosene on the Japanese economy, but rather there’s a lot of hard reform work that needs to be done, and I think we ought to focus on that.

Prof. TARULLO: So, Gail, just to clarify, you do not subscribe to the view of some that, although structural reform is necessary to get Japan’s growth rate up, say, to 3 percent or above, that sound fiscal or expansionary fiscal and monetary measures are actually important to begin the process of recovery? And there is some limit on their capacity to take fiscal measures now.

Ms. FOSLER: Right. I don’t think that—they’re already well beyond where one might like to see them be on the fiscal side. I don’t see that undermining the monetary side sort of even further really addresses the fundamental issue, and it’s not just the banking sector; it’s the openness and level of competition in the entire economy. The service sector has a productivity level that is 40 percent of the U.S., as it’s almost an emerging market structure compared to its sort of First World manufacturing sector. I don’t think monetary stimulus fixes that problem, and I think that maybe a stronger currency does, and maybe they have the right medicine for that.

Prof. TARULLO: Bruce, maybe in addition to adding your comments to what John and Gail have said, you could at least briefly address the issue of how much difference for any one central bank’s decision the decisions of the other two central banks will make.

Mr. BRUCE STEINBERG (Chief Economist, Merrill Lynch & Company Inc.): I agree with both John and Gail about the will, so the Fed will be tightening unless the stock market goes down another 10 or 15 percent between now and November 16th, which I think unlikely. The E.C.B. will be tightening, and the B.O.J. is implementing not really a different monetary policy; what it’s really doing is it’s taking the zero-interest-rate policy on the overnight money rate and it’s extending it out to six months and maybe 12 months to keep interest rates out at zero, even if you go out that far in terms of borrowing.

In terms of what should be, I think the Fed really has no choice but to tighten, even though I don’t believe there’s any inflation risk in this economy. It has to maintain its credibility, and it would be at risk of losing it if it didn’t act next month.

I think in the case of the E.C.B. a tightening is actually not warranted. Europe’s growth rate is still pretty anemic. We are looking for a pickup in European growth in 2000 and a slowdown is U.S. growth in 2000, but what passes for a boom over in Europe is what we call a slowdown in the United States. And we still have in our forecasts the U.S. growing faster than Europe next year, so I think the E.C.B. is being premature to be acting right now, but it seems intent on doing so.

On Japan, I completely agree with Gail in terms of where the problems are. They’re structural. Now there is change. There is structural change going on in Japan, and we saw some of that today in the headlines about Nissan and Renault, and the restructuring that Nissan is undergoing is much deeper than people had expected. So it’s a good sign, but that’s a very slow-going process. There’s no way to jump-start the Japanese economy. I think the B.O.J. is correct in saying, `Hey, what more can we do?’ And really, the only thing they can do further at this point is if the yen were to start to strengthen some more, they could do what economists call unsterilized currency intervention, which would be a way of easing monetary policy and getting the yen to weaken some.

But, you know, both monetary and fiscal policy are reaching their limits of effectivity in Japan. And in Japan right now one problem is that half of the credit allocation is actually in the public sector right now, which is, you know, sort of a contradiction with the kind of private-sector renewal, which needs to happen and which is starting to happen there. So there are a lot of ongoing tensions in Japan.

Prof. TARULLO: How about the degree to which each central bank is concerned with what the other does?

Mr. STEINBERG: They should be concerned. I think it is really wrong for the E.C.B. to tighten ahead of the Fed, and it will be doing so if it tightens, because we think it’s going to tighten before the end of this month. And if it does do that, I think that is a serious mistake on their part. They should have really waited for the Fed to act first. And, of course, I don’t think they should act until next year in the first place.

The Fed is conscious of what the others are doing, but it has the benefit of being able to act on its own, paying less attention to what’s going on in the rest of the world, since our economy is performing so much better than anyone else’s.

And in the B.O.J.’s case, it really doesn’t matter, I mean, because everyone else is moving to a tighter policy. They’re still struggling with how to, you know, maybe ease policy further. So that’s not really an issue for them.

Prof. TARULLO: John, on Japan, do you have any further thoughts in particular?

Mr. LIPSKY: Yeah. I just wanted to comment. On Japan, I simply would say that there’s absolutely no doubt that what Gail and Bruce are saying is correct about the importance of structural issues. That doesn’t mean that growth can’t resume and hasn’t resumed. After all, very, very few people would have projected the kind of growth figures for 1999 that, in fact, Japan is going to have registered. It strikes me people have been excessively pessimistic about the outlook there, not to say that there aren’t big problems and that everything that’s been said so far isn’t correct. Happily, I think that we’re likely to see growth continue in Japan, probably a little bit faster in 2000 than this year.

And if I can just add a slightly heretical note here, although the central banks seem to be absolutely front and center in the minds of most people in terms of economic journalism and market participants, it’s not my feeling that they are really central stage at this point. After all, in none of these cases are we talking about changes in policies or anything more than relatively minor: 25 basis points, 50 basis points. In central bank language, this is just sort of communicating intentions, but not a change in policy. If you want a change in policy, you’re talking 1 percent, 2 percent, 3 percent changes in short-term rates. And we’re not talking about this. This is in the realm of central bank fine-tuning. And I think that’s a suggestion, that the central banks are doing on the whole, especially considering the challenges, a pretty good job.

Prof. TARULLO: Maybe I could just add one final point on Japan before we move on. I think it’s the case that, in fiscal terms at least, there will be a net reduction in stimulus by virtue of the smaller stimulus package that will come forth this fall. And so without continuing the levels of stimulus in the big spending plan of last year, there is some concern, I think, in some circles at least, that you may have a slightly contractionary effect, and maybe that accounts for some of the pessimism about next year in Japan. Whether monetary policy measures can work is obviously another story.

Gail, staying with sort of the macro perspective, what do you foresee for yen-dollar relationships in the near to medium term? And to what degree, if any, do you think these central bank decisions will have an impact on yen-dollar?

Ms. FOSLER: Well, the yen is actually somewhat stronger. We expected the yen to be about 110 at this point in time, and it was 105 this morning. When the yen moves, it always moves a lot faster than you think it’s going to. We have it moving to 95 by next year, and that’s really a response to the relative cyclical situations, which is recovery in Japan, the presence of a huge Japanese trade surplus and a bilateral trade surplus. And those are the compelling dimensions when we look at where the yen-dollar rate is. But I would like to make just one additional comment on the E.C.B., because I wonder if in Europe it’s not sort of the 1980s all over again, in the sense that it seems that the E.C.B. is fighting as much a fiscal battle as it is a monetary battle, so that they’ve been doing a lot of saber-rattling about the fact that the fiscal deficits aren’t where they’d like to see them; that the individual policies are somewhat more stimulative. And we remember sort of back to the ’80s they used interest rates as a bit of a hammer. So I just wonder if we’re not going to see a little tighter policy on the European side than we might otherwise expect, simply because they are trying to jawbone their unresolved fiscal problems.

Prof. TARULLO: Bruce, should the Treasury Department be concerned with the dollar’s level now? Should they want it weaker, stronger, just about the same?

Mr. STEINBERG: I think that it is good that Larry Summers is following the leadership of Rubin and sort of keeping the Treasury’s hands out of the story and just repeating the mantra that a strong dollar is in the interest of the U.S. When the Treasury in the past has attempted to do currency intervention and tried to jawbone the dollar in one direction or another, it’s usually led to bad results. And the markets will determine a dollar level that will be determined by the relative policy environment and the relative growth rates of these different parts of the world.

The dollar, in my opinion, is not at any risk of falling greatly over the next 12 months. I think all of these worries about our huge trade deficit are going to start to be resolved, actually, within the next few months because as the rest of the world finally picks up, U.S. exports are going to revive and our trade deficit is going to start to shrink. So people will be less worried about that.

Unlike Gail, I actually think the yen will weaken slightly over the next 12 months, not a lot, but maybe to the 110, 115 level on the dollar, partially because the Japanese recovery—I strongly believe in it, but it’s going to be slow. And people get less enthused about Japan as they see this, and partially because the Bank of Japan really is going to be a little more proactive in terms of what it does to manage the currency. But, no, I don’t think the Treasury should be pointing in any direction for the dollar right now. I think that would just lead to problems.

Prof. TARULLO: To what degree, if any, are the markets watching how the budget issues get resolved in the next month or so in Washington? And will that have any appreciable effect on exchange rates?

Mr. STEINBERG: Well, I think that right now and for this fiscal year the markets are really not watching what’s going on in Washington because this is the lame-duck phase of an administration. Whatever happens in the fiscal 2000 budget, we’ll probably have a budget surplus of $120 billion or so this year, even though we’re going to go through the spending caps by about $50 billion.

Those spending caps are completely unrealistic, and it’s just trying to find some political face-saving way to admit to that. But we’ll still have a very substantial surplus.

The issue for the markets in terms of where fiscal policy is going is going to emerge after the candidates are selected, you know, next March, basically, and then the markets will start to focus on the policy implications of, you know, both of the candidates.

Prof. TARULLO: John, do you want to get in on exchange rates at all before we move to Latin America?

Mr. LIPSKY: Well, just to echo a remark that Larry Summers made at a testimonial dinner for Hans Tietmeyer in Washington about a month ago, he said he thought that he would recommend a strong currency for all countries. So...

Prof. TARULLO: That’s in line with the European desire to have both a strong euro and a strong dollar at the same time.

Mr. LIPSKY: Absolutely.

Prof. TARULLO: We have tried, as those of you who’ve been coming to these know, to move around regionally a bit from session to session in addition to giving kind of overview, and today I thought it would be useful to focus for a minute on Latin America. There has been a series of seemingly unrelated, and mostly they’re not entirely negative, developments in Latin America over the past several months. We have default on Brady Bonds in Ecuador. We have Argentina mired in a fairly deep recession. You have a slippage in the real, plus that Supreme Court decision in Brazil, which called into question fiscal reform in Brazil. You have Venezuela in complete policy disarray. Mexico, somewhat brighter picture. But the other countries, each in their own individual way, seems to be at least problematic.

And, Gail, I wonder if you could start by addressing first a question of how serious the developments in Latin America are and to what degree they are related and to what degree they’re just a coincidence of some parallel bad developments.

Ms. FOSLER: Well, I’ll just sort of begin with kind of the top line. If you look at the I.M.F. projections, they’re looking for something like a 4 percent growth in Latin America. I think that’s going to turn out to be too optimistic. You’ve got a situation where Brazil is down this year maybe 1 percent. And they’re quite optimistic for next year, but the problems still persist. Argentina—we’re doing an experimental leading economic indicator for Argentina. We see nothing good from that indicator. We see the indicator continuing to point toward weakness. And I think with sort of a rebound in Asia and the commodity prices sort of stabilizing, that Chile, which has, of course, been hit very hard, has prospect of returning to growth.

But there’s a real question, setting Chile aside, as to whether Brazil and Argentina really have the policy framework right. I’ve been impressed, when you look at the foreign direct investment flows, that there is remarkable patience and confidence in terms of foreign direct investment flowing into the region. And in some ways the region is really significantly supported by the view that these represent sort of political wobbles on a path to what might be called conventional monetary and fiscal policies, to policies of genuine fiscal discipline, to policies of monetary complementarity, to policies that show a stable currency. And I think that the—and we talked before the session; I’m not a fan of the currency board. I think the currency board is deeply flawed. So we don’t really know what monetary policy is in Argentina.

But when we look at Brazil, I think that the political situation is very serious, and we keep seeing the real slip and slip and slip; nothing very serious, but I think maybe at the beginning of next year we’re going to have a rethink and possibly another real crisis as to whether this situation that has turned out to be a little bit better than people expected is really politically viable, and I think the jury is definitely out in that regard.

Prof. TARULLO: Bruce, are these seemingly unrelated but perhaps related events in some respects a lagged impact from the world financial crisis which, as Gail said, Latin America weathered in the short term rather better than many people had expected? Or is this really a next chapter in the problems of structural reform, which a lot of people identified in Latin America even before the Asian crisis?

Mr. STEINBERG: I think, first of all, getting back to something you said at the beginning, it’s South America which is a problem right now.

Prof. TARULLO: South. Right.

Mr. STEINBERG: Mexico is fine. Mexico’s destiny is linked to our destiny now, and all of the countries you named that have problems are in South America. It is a lagged response to the global crisis. It’s sort of the last chapter of that particular event. But the structural problems of these South American countries are in place.

Now Argentina’s problems are really a by-product of Brazil’s problems. Argentina wouldn’t be in a deep recession now had the real not been devalued so intensely. And the issue of Argentina maintaining its currency board or not doesn’t really seem to be coming up in the political process in Argentina, and with good reason. A country that has a history of hyperinflation really holds on to a solid anchor for its currency. That does mean that, at best, Argentine growth is going to be very weak next year after having a pretty serious recession this year.

In Brazil, the problems are really political. It is proving to be almost impossible to reform the fiscal situation in Brazil, and until that happens, you really can’t get the real stabilized and you really can’t, in fact, be confident that the Brazilian economy is going to function appropriately. So that’s an ongoing problem, and I don’t see any near-term solution. But even so, Brazil probably will grow slowly next year. But, you know, what we’re saying is of all the regions of the world, South America did the worst this year and is probably going to do the worst next year as well.

Prof. TARULLO: John, in addition to anything you’d like to say to supplement Gail and Bruce, what impact do you think these economic travails may have on the case for economic integration in South America, either political or economic?

Mr. LIPSKY: Right. Yeah, I think that’s the really important question here, frankly, beyond the near-term issues of growth and policy. It strikes me there are three long-term issues, central issues, with Latin America. One is that—well, Bruce already suggested—Mexico, reliably and indelibly, a NAFTA partner and therefore is viewed as part of NAFTA more usefully than part of South America or Latin America. And I think the answer there is yes, but we have an electoral test coming up in another year, and we’ll see if presidential politics continues to support the liberalizing, integrationist policies of the current government. My guess is the answer...

Prof. TARULLO: Are you talking Mexico, the United States or both?

Mr. LIPSKY: Well, good question. No, I’m hopeful on that regard. It seems to me that the market already tells us Mexico is part of NAFTA, end of story. And I think that will survive the electoral test.

The second question is the South American question. Is Mercosur going to happen or not? And if it does, that’s an extremely pivotal event. If Mercosur, the southern common market, actually succeeds, then that will become the pivotal organizing principle for economic and monetary events in South America. And the next step will lead, ultimately, to a NAFTA-Mercosur negotiation on trade and financial policies. The pivotal question in that pivotal issue is Brazil. If Brazil succeeds in economic reform, stabilization and growth, then by dint of it being the only continental-sized economy in South America, it will have inherited the leadership position and, parenthetically, will eventually assume a leadership position at an international level. Brazil will be the spokesman for South America.

Can that happen or not? I’m actually a little bit more optimistic about the outlook in Brazil than I think the ...(unintelligible) seem to be. The near-term issues are not so pivotally—I can’t be using that word—crucially fiscal. The 2000 budget program implied in the I.M.F. stabilization plan for Brazil is not terribly strenuous. And if the Brazilians continue to produce better-than-expected results in terms of growth and inflation—not wonderful, just better than expected—their fiscal problem starts to go away because as confidence returns, inflation stays low, interest rate drop, and the fiscal problem seems more manageable.

So let’s keep our fingers crossed. The government, despite political problems, has not backed away from reforms, although you can criticize them for a lot of things. And the political situation, although difficult, has not resulted in the opposition trying to pull the plug on Brazil. Anyway, enough said on that.

The third issue of importance is the fate of the northern tier of South America: Venezuela, Colombia and Ecuador. And Venezuela, despite all its problems, and Colombia, through most of the ’70s and ’80s, actually usually performed better than expected, especially Colombia. Those economies now are all in deep recession right now, and those are problems that are not likely to be solved quickly. All that comes around since Brazil really is the critical issue for the outlook for South America in the next few years.

Prof. TARULLO: John, I have the impression that Brazil’s devaluation earlier in the year gave pause to not just Argentines but people throughout South America, because of the impact that it had, as Bruce said, on the rest of South America and because of, as a number of South Americans have said to me, we reverted to thinking that Brazil is going to act in its own interests. And it’s a little bit like the way Canada and Mexico feel about you, meaning the United States; that you don’t really take account of your impact on us, but it’s pretty big, and it made us start thinking again about what the implications of Mercosur and true economic integration would be.

Mr. LIPSKY: It’s an excellent point, and I should have put the opposite. If Brazil fails, then their neighboring countries are going to have to look elsewhere for stability, and that is going to bring NAFTA right back to the fore. In other words, if Brazil is going to fail, Chile, etc., are going to be coming back to the U.S. and saying, `Let’s talk about NAFTA again. We have to have an anchor for stability.’

Mr. STEINBERG: And I think, actually, that’s probably the slightly more likely case, rather than Mercosur actually working out at this point.

Ms. FOSLER: I think that the thing about Mercosur that has always bothered me is that it’s sort of structurally flawed because it does focus on Brazil. And can you really focus on Brazil as the anchor of a free-trade area? It’s very different than focusing on the United States. The southern cone is still very much on the periphery, and it’s still very much subject to these, you know, huge waves of political instability. And even a country like Chile that has, you know, established what is kind of a poster child for effective economic stabilization policies, and yet it’s got a third of its exports, which it depends very much on, that’s still in copper. And so it’s got this huge sort of built-in instability. It was, of course, very hard hit by Asia.

But that is still very much the periphery in the global environment. And one of the things that concerns me, and maybe just as a general proposition with respect to all emerging markets, is that, you know, we’re feeling pretty good about the world being better than we thought it was going to be last year, and I think that, you know, that’s in some respects warranted. But just as Larry may have felt that all currency should be strong, you know, everybody’s in the mood to have all exports go up. And while there’s a certain amount of that that’s possible in a growing global economy, the domestic economies of an awful lot of these countries are simply not growing very fast, even the ones that are in recovery.

And if we look even at Mexico, Mexico is doing pretty well on the top line and they’ve had a couple years of pretty good domestic market growth, but their domestic market growth is going to be, you know, maybe 3 percent, 4 percent this year. These countries are not making deep economic progress that’s going to really instill a sense of achievement in terms of the broader political environment, and that’s true in spades in the southern cone.

So I think that the several times when I had been down in Argentina and Chile, they talk about Mercosur as if it is the end-all and be-all of, you know, kind of the quintessence of economic policy, without really focusing on the fact—and this serves me most in Argentina—that the domestic economy has to be an important engine in the overall development dynamic. And Mercosur doesn’t solve that, and the dependence on Brazil, which I think has inherent instability, going forward, is, I think, a big flaw in the logic of Mercosur being the solution for the trade and economic vitality of the region.

Mr. LIPSKY: But I think the commitment to Mercosur is quite tentative and not deeply felt, certainly in Chile, which is very reluctant to get into a customs union based on high external tariffs. But I think the point’s well taken in that I suspected you were about to say, and probably would have said, and there are electoral tests coming up...

Ms. FOSLER: Correct.

Mr. LIPSKY: ...in all these countries in which the voters are going to decide whether this is a direction that they think is justifiable or not. And I think these issues are likely to come to the fore in the new government in Argentina, which has an election later this month, and in Chile, which has elections before the end of the year, and elsewhere.

Prof. TARULLO: When the first Summit of the Americas, at least of the modern era, was held in Miami in late ’94, the much-rooted theme was the entrenchment of democratic and economic reform throughout Latin America, including South America. It would be interesting if such a summit were held at the end of this year to see what the articulated theme would be, because it seems to me that both of those observed phenomena have come under some stress in the last year and a half, and as you say, John, they’re going to come under some more in the next year.

Mr. STEINBERG: I actually think that because things are going to be bumpy over the next few years, the issues of dollarization of all of these economies, with the possible exception of Brazil, is going to come to the forefront again. And as we move on into the next decade, I think that the dollar stands a good chance of being adopted by any number of countries as their currency, actually, because the internal policy stability of each of these countries is always very tenuous and then it doesn’t really work. And I don’t really think the Mercosur project is going to end up working out for the South Americans. And, inevitably, they have to turn back toward the U.S. as the anchor that they need to guide their development policies and to guide the internal coherence of their own macropolicies.

Prof. TARULLO: There’s little doubt that some in South America see dollarization as anchoring them in a couple of ways, I think: one macroeconomically; the other, in their banking systems, interestingly enough. They seem to have a confidence that I think may be a bit misplaced that the Fed will end up being their de facto lender of last resort if they dollarize.

Gail, you have reservations on currency boards. Your reservations increased or decreased by dollarizing?

Ms. FOSLER: Well, I mean, if I don’t like currency boards, you can imagine I don’t like dollarization.

Prof. TARULLO: You don’t like dollarization. Well, there’s an argument that if it’s truly irreversible...

Ms. FOSLER: I mean, I think that dollarization really underscores the fact that we have a global trading system without a global medium of exchange, and so we always figure, `Well, how do we fix that problem?’ And, you know, maybe an easy solution is to think that we can have the dollar denominated; I mean, we do in some ways. Sixty percent of global trade is dollar-denominated, which is why the dollar is so compelling for those companies that deal in the global marketplace. But, you know, the only way you have of acquiring dollars, aside from Federal Reserve membership, is through your trade accounts, and I think it really sets up an inherent instability in terms of global trade.

And, also, getting back to this issue of sort of differential levels of development, many of these countries they have—you know, The Conference Board has, you know, associates in 62 countries around the world, and certainly there are globally competitive companies in these countries for whom, if they were to make a shift from their local currency to the dollar, it would be a non-event. But for the development prospects, you have got all of these gradations in terms of levels of productivity, and so you’re opposing the dollar on, you know, the entire—suddenly local entities that are competitive under a real of 1.90 or 1.99 are suddenly thrown into a dollar-competitive world. And I think that it creates a huge productivity hurdle, because if one looks at sort of currency convergence over time, I happen to believe that that is a product, in some sense, of productivity convergence and that that also gets very much at the root of the development issue.

So we can’t solve the currency and medium of exchange issue unless we really tackle all of these other institutional issues, which is, I think, probably more important and comes first.

Prof. TARULLO: Dollarization can and has been a topic of an entire program and might be in the future. But in order to preserve some time for you, let me turn now to you and ask if you have questions. And as I say, if you do and I recognize you, please stand and wait for the mic and then identify yourself before asking your question. Yes.

Ms. BARBARA SAMUELS: Barbara Samuels. Gail, you talked about us feeling more comfortable about the economy, but one issue that comes up a lot—and, Bruce, you referred to it—is the fate of the U.S. stock market. If each of you could tell us briefly, how vulnerable do you think we are to a large decline in the U.S. stock market to consumer spending, U.S. growth and the global outlook.

Prof. TARULLO: Go right down the line.

Ms. FOSLER: Well, I will expose myself as the unreconstructed optimist that I am and say not very. You know, we talk about events—you know, we all routinely get questions about what’s going to happen if there’s a 20 percent drop in the stock market, and the reality is that that’s just not very probable. And it isn’t sort of an independent event. When you look back in the postwar period, we’ve only had a couple 20 percent declines. They were back to back in the 1970s, where we had the impeachment of a president and oil prices tripling and a recession. I mean, we had a huge alignment of the planets of the universe that really, from an external point of view, dictated that stock prices at that particular point in time—that it was reasonable to be highly uncomfortable. And one would imagine that the discount rate at that particular point in time surged.

You know, we’re looking today—and certainly the market, as you can argue, is overvalued or undervalued. More to the point, do you want to take the risk of buying when it’s high, or do you want to wait and take what might be a lesser risk buying when it’s low? And you can expect the market to move around. But the actual risk of a significant and sustained decline in the stock market, one that would materially change consumer spending patterns, I think is highly unlikely.

And there has been a huge accumulation of wealth over this decade. Probably in the year 2000 consumer net worth will be double what it was in 1990. We really need not just an event, but a complete realignment of our expectations, in my opinion, as we experienced in the 1970s. It’s not to say it can’t happen, but we really need a realignment in some very deep structural ways before we would get the kind of stock market decline and persistent weakness and disappointment that would change consumer attitudes.

Prof. TARULLO: Gail, I’m sorry, but just to be clear on your views, you’re suggesting that you don’t think the premise of a significant decline in the stock market is likely to occur. But if it did occur, do you subscribe to the view that a significant decline might have more of an impact on consumer behavior today than it did 12 years ago today and in past significant stock market declines?

Ms. FOSLER: I’m not sure that any of us have successfully separated what the impact of the stock market is on the consumer, and the impact would probably be greater today because the proportion of consumers’ assets that are in stocks are greater today. But it would not, in my opinion, be the decline in the stock market, but it would be the conditions that would create the decline in the stock market and that configuration that would determine what ultimately happens with consumers.

Prof. TARULLO: Sorry, Bruce. Go ahead.

Mr. STEINBERG: Well, like Gail, I’m an optimist on this score. And let me try to go about this in a few different ways. First off, is the stock market terribly overvalued? Because you know that the probability of a big decline depends on whether you think it is overvalued or not. Well, on my estimate of this year’s corporate earnings, the S&P 500 are selling at 24 times operating earnings for this year, which is quite expensive. But, in fact, the valuation extremes in the market are really concentrated in only one sector of the market, which is the technology sector. And if you were to strip out the technology sector, the rest of the market is actually pretty cheap right now.

Most of the market has actually been in a bear market this year. The average stock is actually down in 1999. And the P/E for the S&P 500, excluding the tech sector, is around 19. And there’s very little downside risk in the broad market. Many sectors of the market are just outright cheap right now. The technology sector is obviously not, but it’s also a sector in which the fundamentals are pretty extraordinary. It’s going to have more than 40 percent earnings growth in 1999. And in terms of the stuff that we look at from a top-down perspective, it looks like the technology sector’s actually accelerating going into late 1999. And since it’s been in an acceleration for the last 10 years straight, that is pretty extraordinary.

What would happen if the market had a decline? Well, I think Gail’s point is important to keep in mind. It has to be persistent. Last year we had a 20 percent decline, but it was over, you know, six weeks later. So there was no impact whatever. And to get a persistent decline in the stock market, again Gail is correct, you need to have the general macro environment, the general economic environment, look a lot uglier than the one that we’re in right now. In fact, the economic performance of this country still looks really, really good.

What would happen if you did have one? You know, the people worry that we have a negative savings rate in this country, but the negative savings rate is fictional. And it’s just not the way that people, in terms of their own finances, really think that’s what is going on. And without going into all of the problems in measuring savings, if you added back not the unrealized capital gains but just the realized capital gains, the capital gains income that people earn, and add that to the savings, the savings rate is around 8 percent right now in the United States. It’s not negative. And it hasn’t declined in the 1990s; it’s actually been quite stable.

So even if you had a persistent decline in the stock market—let’s say it went down 20 percent and persisted—it would slow down the economy, it would slow down consumer spending, but it’s unlikely to lead to any huge disaster because the American consumer hasn’t actually seriously overextended themselves. In fact, consumer borrowing in the 1990s is the weakest of any cycle on record. So there are risks in the equity market, but I think that they’re fairly limited risks. And the idea that there’s some bubble waiting to burst on us, I think, is actually not right.

Prof. TARULLO: John.

Mr. LIPSKY: OK, so no `bubble-ologists’ here. But let me just point out then since the question—implicitly what you’ve all said is, number one, we don’t think that there’s a prima facie case for a sharp decline in asset prices broadly, the stock market in general or particular. And secondly, it’s not completely clear just how damaging a sharp decline would be anyway, and I think it sounds to me like we all agree on that.

Let me just go on to say it strikes me that there are going to be two very important tests in the coming year of the key surprises in the U.S. economy in the late 1990s. So it’s going to be a fascinating period. I’ll bet we’re all pretty much in agreement, and I’ll bet most folks here would agree, growth in the U.S. is slowing and is likely to continue to slow. It’s much more likely to slow than accelerate in the coming year. In other words...

Ms. FOSLER: Speak for yourself, John.

Mr. LIPSKY: Oh, OK. Hey, all right! All right. This is going to get interesting. I’ll assert then.

Ms. FOSLER: All right.

Mr. LIPSKY: Growth is likely to slow because the underpinnings of the surge or the strength of consumption spending and investment spending are both likely to weaken in the coming quarters; nothing disastrous, but it’s going to be a slowdown in top-line growth.

(Side B joined in progress) ...lead to stagnation in profits growth in ’98, despite an economy that everyone seems to ...(audio loss) ...slowdown in growth, and it’s unclear whether we’re going to get a slowdown in the momentum of cost increases, which after all, if anything, have accelerated a little bit or at least been steady. And let’s see if the productivity story is real and, therefore, profits growth can be sustained in that kind of a much more likely-to-be-more challenging environment.

And the second surprise of the economy has been the lack of inflation pressures compared to what would have been expected. I’m sure most everybody here, if having been told that the unemployment rate was going to fall to 4.2 percent and that the real growth was going to be sustained at around 4 percent for three years, would have guaranteed you a big acceleration in costs and top-line inflation. It hasn’t happened. So now we’re going to get a test of whether there really has been a durable change in inflation expectations and the economy that will help produce a sustained low inflation and reasonable profits growth in a context of a slowing economy.

Prof. TARULLO: And those two things are not unrelated, right? The productivity and inflation.

Mr. LIPSKY: Absolutely, because...

Mr. STEINBERG: Well, of course, it depends on how much John thinks the economy is actually going to be slowing down next year.

Mr. LIPSKY: This is just marginal.

Ms. FOSLER: Can I describe a contrary test that I think is...

Mr. LIPSKY: It’s their turn. It’s their turn.

Prof. TARULLO: I just want to make sure if there are other—we can go on with this, but if there are other questions on other topics, I want to make sure we get them. Why don’t we try right there?

Mr. PRANAY GUPTE (The Earth Times): Pranay Gupte. Question to any one of you or all of you. President Clinton recently, at the World Bank meeting, urged debt relief for developing countries, the implication being that not only the U.S. but other donor countries ought to be able to engage in this debt relief.

Do you see such debt relief forthcoming in any measure that would make difference to jump-starting economic growth, especially in Latin America? And how do you think the private sector is going to react to notions of firing people’s, I guess, economic inadequacies and mismanagement? Thank you.

Mr. STEINBERG: You know, especially in Latin America, there is no need for debt relief. The problems there are completely different. They have to do with internal policy coherence and things like that. My opinion is that debt relief is a very marginal issue in terms of making these economies go. The countries that are most likely to get debt relief are also ones that have had horrendous internal policy coherence. And what you need in these countries is really to try to put together a credible policy, you know, and try to make them more attractive as places to do business, both for the inhabitants of these countries and for foreign investors. And I think that, to the extent there is debt relief, it’s not going to make much of a difference unless it’s followed by very significant policy changes in these places, which I wouldn’t count on too much.

Prof. TARULLO: Anybody else? I should just say on the prospects for the U.S. actually granting debt relief through our appropriations process this year, they’re moderate but not terrific, I think. One of the reasons why the President vetoed the foreign aps bill yesterday was the absence of the debt-relief provisions. He cited that. On the other hand, the political hook on which the administration is making its public case is implementing the Wye accords, and that is considered to be the more popular, politically salient argument that the administration has.

So I think it’s still uncertain whether the U.S. does its part on debt relief, and, I believe, just as on the Comprehensive Test-Ban Treaty, if the U.S. doesn’t act, the excuses that other countries have available to them not to act increase substantially. And so at this point I still think it’s better than 50:50, but it’s far from a sure thing, given the profile which the President and the other G-7 leaders have given to the issues since the Cologne summit. Yes, ma’am.

Ms. IRENE W. MEISTER (Irene Meister & Associates): Irene Meister. We focused quite a bit on Latin America, but I wonder if you could turn for a moment to the impact of Russia and eastern European countries on European developments because, after all, they are very closely linked—just to have views as to which way it’s going to head.

Prof. TARULLO: On the economic side, John?

Mr. LIPSKY: Oh, sure. Just in very summarized form, in economic terms, Russia’s impact on the rest of the world and even on Europe is quite marginal. Its importance in external trade is always breathtakingly small. When you look at the data, it’s almost hard to believe. For a country that’s inherently a rich country to continue to perform as poorly as it does is amazing. But in the rest of eastern Europe and the formerly centrally planned economies, you can see a dramatic tiering. There are very different issues. Hungary, Czech Republic, Poland are mezzanine euro countries. They’re going to be part of euroland; it’s a matter of time. Then, increasingly, just like—I don’t want to draw too complete an analogy—it’s like NAFTA and the U.S. They’re going to be part of the European economy and they’re moving along.

For countries in—let’s call them the economic periphery in this sense, it’s a case-by-case study, and there’s a whole gradation from hopelessness to hopefulness. But most of them have a long way to go to get to that mezzanine euro situation that we find the important ex-centrally planned economy.

Prof. TARULLO: And with respect, we should probably add, to the three whom John identified and possibly a couple of others, Romano Prodi has made clear that he intends to try to jump-start the accession process in the E.U., which was at best in limbo and perhaps sinking lower than that under Jacques Santer.

Mr. LIPSKY: Right. And my little secret hope—and I don’t know if it’s realistic or not—is that the accession of those countries will be a key for liberalizing the common agricultural policy, or at least producing an unblockage of some of the most anti-competitive remnants in the European Union.

Prof. TARULLO: John, I always think that a new development is going to undo the C.A.P., but it never does.

Mr. LIPSKY: I know. Probably says more about our innate optimism than the realism for Europe.

Prof. TARULLO: We should probably draw this to a close. I wanted to say before closing, though, if any of you has an idea for a topic that you would like to see us address in one of these sessions, please let Maria Figueroa of the Council know either by e-mail or in person. And even if we can’t assimilate it as a whole topic for a half-an-hour discussion, I’ll make sure to get it in as a question in the introductory portions. I want to thank John and Gail and Bruce once again for coming. Thank all of you. And we’ll see you soon.