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World Economic Update -- January 11, 2000

Moderator: Daniel K. Tarullo, professor, Georgetown University Law Center
Speakers: Bruce Steinberg, chief economist, Merrill Lynch, John P. Lipsky, chief economist, Chase Manhattan Bank, and David R. Malpass, chief international economist, Bear Stearns
January 11, 2000
Council on Foreign Relations

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DANIEL K. TARULLO (Georgetown University Law Center): I'd like to welcome everyone to another World Economic Update here at the Council. Let me make a couple of procedural observations first and then we'll get right into the discussion.

First, as I've said in previous sessions, unlike most Council events this meeting is on the record. There are members of the media here. Thus, everything that all of us say and anything any of you say can, indeed, be reported outside of this room. Secondly, we will speak up here amongst ourselves for 20-30 minutes and at the end of that time we will turn to you for questions. Third, if you have cell phones or audible beepers, please turn them off. Not only because of the disturbance factor, but also because it turns out that if they are on they interfere with the mic system here as well. Finally, as I said, we will end promptly at 9:30 a.m. When we get to the Q&As, I will ask you to stand and identify yourself when I do call on you.

This morning we have two of our regulars back with us. On my left, your right, Bruce Steinberg, Chief Economist at Merrill Lynch. On my right, your left, John Lipsky, Chief Economist at Chase Manhattan. And then also joining us this morning, seated next to me, is David Malpass, Chief International Economist at Bear Stearns & Co.

What I thought we would do here in the first WEU of the new year is to go around the globe for the G7, taking a look at the major economies, at the situations in which they find themselves, as the year, the decade, the century and the millennium all begin at the same time and ask ourselves—with a bit more, maybe, perspective on recent developments and looking into the future—how we can expect them to perform.

I thought, perhaps, that we would begin with Japan. It is interesting to watch reporting on Japan much less Japan itself. It's almost as if there are two economies within Japan right now. There is the macro-economy. The macro numbers—industrial production, unemployment. Those kinds of bell-weather reporting numbers that you see. And then there is the less visible but much heralded restructuring of the Japanese economy at a micro level that is proceeding. I thought we'd begin by asking the panel how they perceive progress in each of those areas—that is prospects for macro growth in the coming year. But also, perhaps more interestingly, how is the restructuring of the Japanese economy proceeding. Is it something that is in fits and starts. Is it significant enough to give a big macro boost somewhere down the line or are we seeing it really confined to just a few sectors.

John, maybe you'd like to start.

JOHN LIPSKY (The Chase Manhattan Corporation): First, let me say. When we talk it's very reasonable to talk about the new and the old economy in Japan. You could do that here too and almost everywhere. But, obviously, in Japan it has a certain piquancy with the notion that there was an old hide-bound kiretsu-style Japan and they are moving towards a new open, market-oriented Japan. It seems to me that the transitions are, probably much more than here, going to be rocky and difficult.

So far we've seen two positive surprises. One the economy has performed almost better than anyone anticipated. After all, growth in Japan in 1999 will have reached about 1.5%. Which was quite a bit higher than the consensus estimates had been. And in our own estimate we think that average growth in Japan in this year is going to be about 2% or if we measure it fourth-quarter on fourth-quarter about 3%. So, again, we're more optimistic than the consensus about this output growth in Japan. Now, have to put this in perspective. This would mean it would be the end of 2000, even under an optimistic scenario, before the Japanese economy's output rate will have recovered back to the rate of 1997. So, if we're looking within that perspective, this is not great performance. This is back out of the hole they fell onto in 1998.

Mr. TARULLO: John, just let me interrupt you for a second. What do you see is the main source of the growth. Is it still export?

Mr. LIPSKY: Still export growth. But the real key to the transformation. They key to Japanese progress, extended progress at a more rapid rate, is structural reform in the corporate sector accompanied by reform in the banking sector. We could talk in more detail, if you want. And in both those sectors there have probably been better news than a lot of people thought. But it is still mostly on the come, if you will. Namely, measures have been announced that are going to be implemented over the next few years rather than some thunder stroke of reform that has occurred already. And the big block still—the faster growth in Japan is the lack of household confidence—which means that savings rates are sky high and consumption growth remains very paltry indeed. Unless there is some real transformation or restoration of household confidence that would produce faster domestic spending, then Japan is going to continue to limp along even with the reforms.

Mr. TARULLO: Bruce, when John mentioned the household spending continuing to be low. Another figure that I've noticed continues not to rise is private investment. Without increased domestic demand from consumers and without internally generated investment, how much capacity really is there for Japan to sustain it's recovery?

BRUCE STEINBERG (Merrill Lynch & Co.): There probably will be some pick-up in investment spending in Japan in 2000. In the old economy new economy dichotomy consumer demand is depressed in Japan but the demand for cell phones with Internet capability in Japan is going through the roof. So, the same kinds of tendencies we see in other parts of the world are also present in Japan. While the old kind of spending which is the bulk of the Japanese economy, on industrial equipment and so on, is probably going to remain fairly depressed. Spending on technology equipment and software and things like this has to accelerate because it hasn't been nearly as strong as it has been here. So that will give a little bit of forward momentum to the Japanese economy. And, you know, the problem with being on the same panel with John is that we agree too much of the time. But we too think that Japan will grow around 2% in 2000. The consensus for Japan this year is only six-tenths of a percent. So there is a lot of pessimism there. And, when you look at all the regions of the world in the developed world, the region that has the most uncertainly attached to it is certainly Japan. It could be a lot weaker or a lot stronger than people are currently thinking because so much ultimately depends on what the consumer does there. Now if the consumers had the resources, if they wanted to, to start spending but, as John said, they are a pretty depressed lot of people right now. So, the most likely scenario is modest growth. There is restructuring in Japan—and it's real. And eventually they will unwind the kiretsu system. But the level of M&A activity in Japan last year, which was at a record, was less than 10% of what it was in either the U.S. or in Europe. So, it's a long road to go for now.

Mr. TARULLO: David, do you find that the restructuring that is occurring is highly concentrated in certain sectors or is it beginning to diffuse throughout the economy?

DAVID MALPASS (Bear Stearns & Co.): So far I think it started with the big bang on the financial services and then in 1998 it was the picking up of the technology companies as well. Japan has a huge number of engineers. So supporting Bruce's point that there are a lot of range of outcomes for Japan, you've got a country that is perfectly positioned to be part of a global technology boom. They've got a lot of individual savings. People have cash. And they have a lot of engineers. So, depending on how the confidence goes in Japan that can set the GDP tone.

One note on that is that a lot of the GDP that they've been creating is just government spending. Remember how GDP statistics work. You just take the number of employees and the amount you pay them and you assume that that is output. Government output is the same as government cost. So it makes no difference if you are employing those people productively or not, that just adds to GDP. So if a government wants to get its GDP numbers up. All it has to do is borrow money and spend it an that automatically transfers into GDP. So a big chunk of Japan's growth through the 1998-1999 trough is purely borrowing and spending. And so that's not, by it's nature, sustainable. So the issue in my mind is:Japan is rich enough to afford doing this for a while and in the meantime let the productive side of the private sector try to overtake the government spending. That's the issue going on.

Mr. TARULLO: John,—

Mr. LIPSKY: Let me just add. Of course, David's right about that and the Japanese authorities, themselves, recognize that. No one believes that a 10 percent of GDP government deficit is good and sustainable policy. What is interesting to note is that we've all been talking here about confidence and it's easy to look—it hasn't received the kind of press in U.S. that you would have thought. There's really a war on, very publicly between the Ministry of Finance and the Bank of Japan over appropriate policy right now. That can't be very good for general confidence, at least I don't think. It's like in the U.S. the Ministry of Finance controls currency intervention. The Bank of Japan controls monetary policy. Just like the Treasury controls currency intervention in the U.S. So you've had such amazing things as the Governor of the Bank of Japan, in the last week and a half, announcing that a strong Yen was very good for Japan's neighbors and appropriate policy, the same day that his institution was intervening to weaken the Yen at the orders of the Ministry of Finance. And if this were going on in the U.S. it would be front page every day "Larry Summers and Alan Greenspan at War." But that's what's going on there. A very elemental disagreement within the government over appropriate policy over something as important to Japan as exchange rates. And yet everyone sort of sits around. But I can't believe that that's been very good news so far.

Mr. TARULLO: Last fall when they were all here for the G7 meetings, we had the spectacle of the Ministry of Finance sending people out to brief reporters on how misguided the Bank of Japan was on some policies.

Why don't we move a third of the way across the globe to Europe. It's been just about a year since the Euro became the currency for 11 of the 15 EU member states. European monetary union is certainly a reality. The Euro is valued rather lower, I think, that many Europeans and, perhaps, many in this country expected would be the case. But it has gained a significant foothold as an international currency in terms of denominated bond issuances and the like.

David, as you look at the first year of European monetary union and look forward to the kinds of decisions, particularly the European Central Bank has to face this year, how do you assess the performance of the EMU to date and what are it's implications for monetary policy?

Mr. MALPASS: I think that it's been a huge success. I would measure that not in the strength of the Euro versus the Dollar but in the success of it as a currency for building Europe's economy. Inflation is low. The Euro is actually strong relative to commodities and gold prices. It's only relative to the Dollar and Yen that you can call it a weaker currency. It's been strong enough to keep inflation low in Europe. And, of equal importance, it's helped them build out their economies. You've seen growth strengthening across Europe. You see the Euro having the effect of forcing change within the structural policies of Europe. In the past, Italy could excuse some of it's problems by saying "Oh, it's the Lira." Now, each country has to say, "well there's no choice on the currency, so we have to look at our own labor policies and things like that."

The Euro's been hugely successful in terms of creating a unified bond market and I think that's good for Europe's cost of capital going forward. So there's more and more issuance in Euro denominations and that's going to be a strong growth center for Europe over the next—forever.

As far as monetary policy, I think the European Central Bank's done a reasonably good job in that inflation has stayed low. I think that they face a big problem now in that there is this tendency to think that the strength of the Euro against the Dollar is the benchmark that they have to measure up to. And I think that that can sew problems in 2000. What's going to happen, for example, if the U.S. grows strongly with low inflation and we have somewhat higher interest rates here and we continue to have a technological innovation. So, capital wants to flow here. And Europe is trying to measure itself against the Dollar. We could see a situation where the Euro is weakening, which is what we expect, the Euro to weaken and to break par as we see the strength of the U.S. economy come through. Under that circumstance Europe may be tempted to raise interest rates, even though they won't be having inflation in that environment and that could get their policy twisted up into trying to have their currency as strong as the Dollar even as the Dollar keeps strengthening and creating very low inflation here. That's not a policy mix that will maximize Europe's growth rate.

One final point is that the success of the Euro is included in the opinions of it's neighbors, so everyone in Eastern Europe is clamoring to be in the Euro and, I think, that is a very positive side of what's going on with the Euro.

So, basically, a very good scorecard, growth is rising in Europe with this one problem of if they try to measure themselves against the U.S. Dollar that's probably not the right benchmark for them. They should probably measure themselves against their own inflation rate.

Mr. TARULLO: And, David, when you refer to their instinct to measure themselves against the Dollar are you alluding to this long standing schizophrenia in Europe where a lot of people wanted both a strong Euro and a weak Euro. A strong Euro because it looks like a reserve currency and a weak Euro because it's good for exports?

Mr. MALPASS: That's still there and unresolved. So Germany, their trade numbers came out this week—recently—and they were very proud of having a record trade surplus and they attribute it to the weakness of the Euro. So you have the industrial sector wanting the Euro to be weak and the central bank wanting it to be strong. And that's unresolved.

Mr. TARULLO: Bruce—?

Mr. STEINBERG: When you look at Europe and you look at the U.S. one of the clear things is that we've done, obviously, much better than them and there are three advantages that the U.S. has had over Europe over time. One of which is not replicable, probably, in Europe that is we have an entrepreneurial culture here which I don't think we could transfer to Europe. But the other two could be replicated. One is that we have extremely flexible capital markets and the other is that we have extremely flexible labor markets.

Now, with the Euro, what's happened in Europe is that their capital markets look increasingly like our capital markets and this is, I think as David was saying, this is the key to the success of the Euro that's why it is such an important development. Now the bond market and the equity market and the market for corporate control is like the American market. You're having more M&A activity in Europe last year than you actually had in the U.S. These are incredibly important developments. Over time this is going to increase the growth potential of the European economy.

On the other hand, they have made no progress in terms of labor market flexibility. They're still very hind-bound. While corporate Europe knows what has to happen the political process there is not permitting their labor markets to look like ours. Though that part of the equation is not going to converge with the American model, but my outlook for Europe in 2000 is an optimistic one. Growth is accelerating. We're looking at at least 3% growth in the Euro zone. And there's probably some up-side potential in that. I actually think under those circumstances, the Euro will probably strengthen on the Dollar. Not necessarily a lot but at least some as growth picks up. A wild card here is the response of the ECB. I'm not so worried that they are going to worry about the exchange rate of the Euro versus the Dollar what I'm worried about is that they are going to start to do more tightening prematurely—worried about a non-existent inflation problem in Europe. They've already tightened 50 basis points. Rates in Europe are still very low. We're looking for another 50 basis points before the middle of the year. Probably, actually in March as the next time that the ECB will tighten. If they keep going down that road they could choke off the growth rate of Europe before it needs to be. After all this is a region that has grown very slowly over the last decade and with very high unemployment. They actually could grow, let's call it, above potential for some time before they would need to worry about any kind of inflation problem. But as we sit here at the beginning of the year I think that prospects in Europe look quite good.

Mr. TARULLO: You know, as a political matter it's a lot easier for a political system to accept labor market flexibility if unemployment is already low. And Europe has got itself in a bit of a bind now where they're at double digit or near double digit unemployment meaning that any further flexibility which results in short term layoffs is politically very difficult, but without taking some of the steps that will open up a more flexible labor market it's hard to get out of their double digit unemployment.

Mr. STEINBERG: Well, one of the amazing things to me is that you have a twenty year period in which the U.S. created nearly 40 million jobs and Europe created none.

Mr. TARULLO: This would be the Clinton Administration talking point

[laughter]

Mr. STEINBERG: And the obvious lesson anyone should draw is that you're not going to create—you're not going to hire people unless you can fire people. Because if you can't fire them you have every incentive not to hire them in the first place. But instead of drawing that lesson, European politicians have done things, even lately, which are unwise—shorter work week in France, some moves in Germany, the latest one sounds encouraging, but in general that haven't increased labor market flexibility. Attempts to lower the retirement age in an economy which the problem is you have no incentive to hire people in the first place. And, unfortunately, those things don't look like they are changing very much.

Mr. TARULLO: John, you and I were on record a year ago as being "Euro-optimists" particularly on EMU. But I continue to qualify my own optimism by believing that a monetary union can't be judged a success until it has gone through a difficult period and not just a growth period. Would you agree with that qualification and how does that, if at all, affect your judgment of the next year or two's prospects?

Mr. LIPSKY: Oh yeah. I mean the easy response is the famous remark about the French Revolution "it's too soon to judge whether it's been a success" But the point you make is a very important one. Eventually, the business cycle will appear in Europe as well. And in essence the European authorities have eschewed domestic monetary—monetary and fiscal policies are severely constrained. And let's see how that feels when things aren't going well. But right now things are going well. In fact I'm a bit more optimistic than Bruce and David and for some specific points. If you'll let me just get them on the table.

For one. I think obviously the situation is complex, the history is different etc. But I would say the following. European authorities have stopped arguing that the Goldilocks phenomenon in the U.S. is an illusion. They have accepted the message. And the message is flexible markets tend to work if they are reasonably balanced, including labor markets. Now they have a reality to deal with. But I think that there're more going on than people seem to give credit for.

For example, let's take what's happened in Germany in the last several weeks. It's worth understanding because not so long ago there were big headlines about how the Schroeder government was opposing the Mannesman deal and they were supporting Holtzman this bankrupt construction company. And it sounded like "gee, when push comes to shove it's the old stuff all over again." What folks tended to forget was that that was right in front of an SPD leadership election which Schroeder, when people tended to think that the Schroeder government was really hanging by a thread, and what happened? The SPD voted. 86% supported Schroeder. He had actually initially won with 70% of the party's vote. So if anything the left wing, the Lafontaine wing is sort of disappeared without a ripple.

Secondly, the financial scandal of Helmut Kohl which has just shattered the CDU right now. Two months ago you thought the Schroeder government might not make it to May and now it's clear sailing. And all of a sudden what happens. All kinds of reform measures start bubbling up. These guys want to do this. It's not going to be a masterstroke that all of a sudden it's going to turn into the most flexible market in the world. But my guess is that you are continually going to be surprised. This argument has been won, politically, and it's just going to take some time. And that's going to be positive.

The second point is with David. Actually, I don't think the ECB has any idea that they are judging the success of the Euro with the stability of the Dollar. They have had a—not only very clear view—they statutorily have a very clear mandate to preserve price stability. Nowhere is the external value of the Euro mentioned in the statutes of the ECB. The problem is last summer when the Euro was weakening, everybody was saying "It's a crisis of confidence! It's a crisis of confidence! Do something! Do something!" So naturally they are trying to maneuver between these two realities, so what we see is— one of the benefits we get in the States is the Fed is supremely credible. The ECB is a brand new institution and has to earn its credibility and that makes it a little more difficult. And the Bank of Japan has very little credibility right now and we can see in practice how much room for maneuver that gives the Fed that the ECB doesn't have and the BOJ really doesn't have.

Mr. TARULLO: The ECB didn't start off very well on that score either last year.

Mr. LIPSKY: Well I think they are having a bit of a problem learning the vocabulary of how they express themselves. But when you go back and you say what decision did they make in terms of monetary policy, after all at the end of the day they are like the Fed. They set the short-term rates. That's what they do. Have they made any mistakes in that regard? I would say it's very hard to fault them on that—in that area.

Mr. TARULLO: David?

Mr. MALPASS: I would agree with both those lines. I'm actually optimistic about Europe. I think it's doing well. In a speech just yesterday in Dallas one of the governors of the European Central Bank board said that he expected the Euro to strengthen because their growth rate was going to be strong and that lays out that benchmark which is unnecessary for one and also, can set up a situation where we get another momentum shift. If we look back over the last two years or three years, we have huge momentum plays in equities, driving up the NASDAQ because everyone wants to jump onto the same stocks. But to an extent we've created that possibility in currencies. Where, if you measure yourself by the strength of your currency then the currency that is strengthening becomes self-fulfilling. It becomes stronger because it is strengthening. And the reverse happens. The currency that is weakening becomes weaker because it's weak. And that's an unnecessary volatility going on in the currency markets. And it's one that could bite Europe if we see that the U.S. is growing quite a bit stronger than Europe so I'll give you 3% in Europe—

We could see a situation where the U.S. is growing 3.5 percent, 3.7 percent and Europe growing 3 percent or 2.8 percent and if there's any disappointment in that, if the Euro weakens, that causes people to want to sell the Euro. And I think that that is just an issue that we have to think about in world monetary policy as we measure flows of funds and think about how central banks operate. I think it's not a purely constructive environment we have where the currency is the measure of the credibility—a currency relative to other currencies is a measure of the credibility of a central bank.

Mr. TARULLO: David, but whether or not Duisenberg and the ECB in their heart of hearts think about the strength of the Euro relative to the Dollar. John is surely right that they feel some need to address that issue. There is pressure being put upon—where are those pressures coming from in Europe? I mean in concrete terms, are they coming from people in the financial community? Are they coming from, sort of national, or quasi-national, rivalries with the United States.

Mr. MALPASS: I agree with John's point that Duisenberg has certainly—has been very good in saying that "we don't measure ourselves against the Dollar." I'm thinking more in terms of the way the financial markets are operating. If you see the Euro begin to weaken then you have an incentive to sell the Euro. So the incentives are coming mostly from the operations of financial markets. It's not so much a nationalism play. You don't hear Europeans bemoaning too much the level of their currency. In part because they see their exports are doing well enough and they are in a recovery.

Mr. STEINBERG: The reason that the Euro has been weaker than people expected this year has been that there's been a very large capital outflow from Europe as European investors and European companies have been buying U.S. and Asian assets. But if we're all right and prospects for the European economy are improving. That capital outflow is going to slow substantially and in all likelihood, you know, the Euro would probably strengthen some. I think the other thing to note is that in the last six months, really, the three major currencies haven't moved all that much against each other. They've actually been in pretty narrow ranges and unless something happens in one of these national economies to change what appears to be the picture right now, that's probably going to remain the case going forward into 2000

Mr. TARULLO: And two out of the three of us are not unhappy with the levels of our currencies.

Mr. STEINBERG: That's right. And it's not even clear that the Japanese, with all their debates are that unhappy either.

Mr. LIPSKY: Dan? Could I jump in? Pardon me for interrupting, we're running long, but I think it's worth getting out on the table here. There is a negative in Europe that has been a surprising negative. That is a year ago you would have said the Blair government is committed to get the Pound into the Euro, get into Europe as fast as politically possible. And events have really conspired not only against that, but it strikes me that public opinion in the UK is becoming increasingly anti-European and the Blair government has had to retreat a lot. We still have the very nasty issue of tax harmonization within Europe that the Blair government has voted uniquely against—it's been 14 to 1—on whether there should be uniform withholding taxes within Europe and this has led to not only is public opinion inflamed that the French won't let in British beef and all that but the financial community is saying we can't let these guys impose withholding taxes and undercut the strength of the city of London. This issue which has always been latent looks much more difficult that I would have thought a year ago. I don't know where it's going.

Mr. TARULLO: There is increasing talk that Labour is going to need another election before they can do anything to move things down the road. Before we run too much over the time I want to spend just talking amongst ourselves, Bruce, let's turn for a few minutes to the U.S. economy. We've got another interest rate decision coming up. There's wide expectation now that it's a question of how much rather than whether the Fed raises interest rates. A little over a year ago when the three of us looked forward the two of you were reasonably optimistic about the U.S. economy, your optimism has been born out. At that time I could find people who were not optimistic about U.S. economic performance in 1999. It is very hard to find someone, except those people who thought Y2K was going to be a disaster and have now backtracked very publicly—it's very hard to find anyone who sees anything but sustained robust growth this year regardless of whether the Fed raises interest rated by 25 or 50 basis points.

First off, do you agree with my positive assessment of where people are. But secondly, are there any even low probability contingencies which could knock those projections substantially off the mark as opposed to only incrementally.

Mr. STEINBERG: Well you're quite right, Dan, to worry about it at a period of time when everyone is in one direction. That's usually when we better watch out. Having said that I am actually more optimistic than most. I actually think that our economy is going to grow at around 4% this year which is what it did last year. And I think inflation is going to end up falling this year, rather than going up and the consensus is that it edges up a little bit. I won't go into why I think those things right now. I want to address some of the other things. I would point out on inflation, last year while consumer spending was growing almost 5 ½% the price of consumer goods, if you took out food energy and tobacco actually went down. We had deflation when consumer spending was through the roof and this tells us that we live in a very different type of economy than the one we used to live in. So, I am not worried about inflation taking hold in our economy. I think that is a low probability problem.

There are higher risks that could happen. On the Fed, yeah, it's a foregone conclusion that they are tightening on February 22. I think 25 basis points at that time is all they are going to do. But I also think that on March 21st, the next FOMC meeting, they're going to do another 25 basis points. My hope is that they'll stop there but the risk is that they are going to keep on going because the economy, from their point of view is growing faster than their notion of what the growth potential is. So one of the risks in the economy, and I would say the biggest risk, is really an interest rate risk.

Bond yields have risen as we've moved into the new year. They're probably going to rise at least a little bit more than what they've already risen. If the Fed goes 50 basis points and bond yields hang out around where they are a little more for a while, that's not going to make too much of a difference. The economy will moderate a little bit but it's not going to slow down all that much and the financial markets the equity market in particular, may have some corrective process to go through at some point, especially if bond yields move up but probably no cataclysmic event. The problem is if the Fed keeps going, you know it does 50 instead of 100, that would create much more of a slowdown. It would also create much more financial market turmoil.

A separate, although related issue, is whether the equity market has a meltdown. Last week, for a day or two, it looked like the NASDAQ was finally—the tech sector was finally going to correct and now this latest merger would suggest it's not going to any time in the next few weeks at least. We really have two stock markets, we have the technology stock markets which is about 30% of market cap., now. We have the rest of the stock market. Last year, if you took out tech from the S&P 500 the rest of the index went down even though earnings went up which is what you would have expected given that bond yields went up. Obviously tech which has the highest P/E didn't pay any attention to that and there is going to be some issue as we go through this year as to whether those valuations can be validated, sustained or whether there is going to be some kind of pull back. At the end of the day I think everything is going to turn out just fine. But then again when everybody thinks that, that's when you should probably be a little careful.

Mr. TARULLO: I want to take just a few minutes more, but I want each of you to be able to jump in on the U.S. economy and, David, among other things, the external deficit has also been on people's lists about low probability but high cost contingencies—should concerns about that be somewhat allayed by your consensus forecast that both Europe and Japan look to grow reasonably well this year?

Mr. MALPASS: Yes. Though I do think the U.S. current account deficit will expand further from it's current level. If we're growing faster than Japan we'll probably continue to have a widening current account deficit. I don't think that's cause for concern. People should think about a current account deficit the same way the do leverage for a corporation. There's a value judgment. If the corporation is using the borrowed money effectively then it adds on their return on investment. So the U.S. is borrowing money from abroad and, if we're investing it well that adds to our sustainable growth rate. And indications so far are that's the process that's going on.

We have an investment led expansion going on in the U.S. and as long as you think that the quality of investment is good, meaning people are investing in things that make some sense then that's a sustainable process as the current account deficit grows. So I agree with all of the aspects of Bruce's optimistic view. So, I'll just say I'm even more optimistic.

Now I want to mention one other false concern to go along with the current account deficit and then also express a concern because I think we've ended up being pretty optimistic about Japan, Europe and the U.S. there is an implication to that that we need to discuss.

But first, there is a concern that people have over the money supply growth in the fourth quarter and we ought to knock that one down pretty forcefully. The M numbers, the money supply grew fast in the fourth quarter because people wanted extra cash balances, either in paper money or in checking accounts in order to prepare for Y2K and for year end. There were uncertainties and it was cheap insurance and it's completely wrong to think that as the Fed printed money that went into the stock market and that was the cause of NASDAQ going up and therefore when the Fed takes it back here in the first quarter that will push NASDAQ down. NASDAQ was going up because people were recognizing the value of the U.S. economy and maybe speculating on the value of certain types of technology. The money supply that was created was consistent still, or we saw the Dollar being very strong during that period, there wasn't any more money created than the people wanted.

Shifting subjects here. If we play this out where the Fed can raise rates, and remember what's happening, real interest rates are going higher and higher and higher yet it doesn't slow the U.S. economy. Bruce says a 4% growth forecast with at least two Fed tightenings and I agree with both points there that the Fed will tighten and the U.S. economy will still grow strong. So where is the give in the system? Well the give is in foreign countries, particularly developing countries. Commodity prices have been falling as the Fed makes the Dollar very strong by having high real interest rates. We get commodity prices down. So you see it going on constantly we're just not very aware of it. Equador, of course, is having a collapse right now. Ivory Coast over Christmas had a coup and the reason for the coup was cocoa and coffee prices are low. It's an agricultural based economy where the falling commodity prices put pressure on them. In Argentina they've completely forgotten the Laffer curve. They're in a recession and what they're trying to do is to raise taxes to somehow make their economy grow. You can't grow an economy by raising taxes. So we have going on in many parts of the world a lot of strain as the U.S. tries to slow us down. If what we're doing is raising interest rates to slow down our technology economy it's simply not going to work that's an equity based economy not a debt based economy so you can't slow it down by raising rates. What you can do is slow farmers down in China, Argentina, Nebraska and that's what's going on. So it's this further polarization of the world economy that I think raises more national security risks or immigration risks for the U.S. more so than economic risks.

Mr. TARULLO: That's an interesting point. John do you want to take a minute?

Mr. LIPSKY: Yes, just real quick. Obviously, as you know, we could go on and on here. But a point worth making. There is the fact of the U.S. economy in 1999 that I'm sure surprised every single observer and that is who would have imagined in the 8th year, 9th year of expansion, with capacity utilization as high as it is unemployment as low as it is. It looks like non farm productivity growth is going to be about 4% after and average of 1, 1 ½% in the 1970s and 1980s. You can say that productivity figures are pretty squishy figures but the fact is that everything points to growth in productivity just outside of any experience. Which must be a challenge, among other things, to the Fed trying to figure out what is the real speed limit of growth in this economy.

With that if you ask, what besides the current account deficit, is also outside a normal experience in the U.S. and that is spending on business capital goods is absolutely off the charts historically. Spending on capital investment is about double the average rate of the 1980s and triple the rate of the 1960s. So if you want to ask yourself is there a potential vulnerability, well all the growth has been in high tech. High tech is essentially becoming the business capital goods sector and we normally think of investment spending as pro cyclical. In other words when the economy slows it slows, when the economy speeds up it speeds up. Now this strikes me if there is potentially a reason for a slow down and a disappointment in the stock market that's the most obvious one, because we've seen in 1999 very good profits growth in American corporations after a stinky year in 1998.

Now again just to keep it short. Despite the optimism the year 2000 is likely to be more difficult for profitability, for profits growth than the year 1999. And if that's the case with higher rates, then you start to wonder could the unanticipated assumption be that investment spending is going to go just off the charts for ever and ever? Could that be a potential source of disappointment? If it does, the combination of weaker profits growth, surprisingly, and slower investment growth could change our perceptions of just how fast the economy is going to keep going? Because remember, that in the high tech sector the analogy is that this is the gold rush and like in the gold rush, the miners didn't get rich, it was the guys selling the picks axes and shovels to the miners. So in the high tech sector it's the guys making the picks and axes that are selling real products to real people making real money the Cyscos the Intels etc—if those start to under-perform than this thing starts to look like, not like there's a terrible problem, but not quite so Never-never Land as it does now.

Mr. STEINBERG: Could I just integrate something that David and John said? Because David made the correct point that this is an equity driven economy and John pointed to a problem. But from my point of view the problem is this. The equity market goes down. The free capital available to high spending telecomm start-ups and Internet start-ups goes away and, after the market goes down, that's when you would get a slow down in technology spending.

Mr. TARULLO: OK. Now, for the Qs and As. When I recognize you please stand, wait for the mic, state your name and affiliation and please keep your question as short as possible. Why don't we start right here?

Mr. DONALD H. RIVKIN (Schnader, Harrison, Segal & Lewis): Mr. Malpass, will you be equally optimistic about the sustainability of our current account deficits if the Euro becomes a major reserve currency?

Mr. MALPASS: Yes. I think it's easily financeable—to finance the current account deficit the hurdle rate is the U.S. bond rate, so you have to find people somewhere in the world who are willing to pay—to lend money to the U.S. for a 6% return or 6 ½% return and that's actually a pretty low hurdle rate. So I think this issue of the unfinanceability of the U.S. current account deficit is the wrong focus.

Mr. PETER G. PLAUT (Bank of America): Clearly the financial markets have justified your optimist for global world growth over the last year. I was wondering if you could address your outlook for credit spreads. Have we gone too far too fast or do you think we have more room to grow? And I do understand, if you're looking at the emerging market index. That we're still much wider than we were before the crisis, but nevertheless, we learned a lot over the last year.

Mr. LIPSKY: Quick answer. It's a toss up. The fundamentals are mixed. Somewhat slower growth this year likely. That's not good. Low inflation. That is good. Dollar roughly stable. Neutral. Technicals seem to be very good right now. Profit fundamentals likely slower growth in profits. That's a negative. Sort of up in the air. No strong call.

Mr. TARULLO: Any divergence from either of you?

Mr. STEINBERG: No.

Mr. MALPASS: Not divergence. Oil prices are important in how we look at emerging markets debt spreads which is one big chunk of debt that is sitting out there. If oil prices fall then different countries are called into question. So, remember what we had here. We have an artificially inflated price of oil because of OPEC so at some point that breaks down oil prices falling changes the complexion of credit spreads. That's part of John's toss up.

Mr. HENRY ARNHOLD (Arnhold & S. Bleichroeder, Inc.): Mr. Malpass, I did not quite understand when you said that our current account deficit has been basically driven by higher investment here. I always had the impression that it was greatly used for higher consumption. Could you please comment?

Mr. MALPASS: Technically, the current account deficit is the flip side of the capital account so a way to think of it is we import and automobile from Japan and they take a treasury bill in return so they are sending us their capital and their product. Another way [TAPE ENDS]—capital account surplus as capital comes in—on the investment side. 14% of our GDP is investment so, it's not correct at all to characterize our current economy as current account deficit supplying a consumption binge. That was the allegation in 1987. One thing I could do is draw a distinction from '87. Remember the stock market crash in '87 occurred when the U.S. current account deficit reached its current level as a percentage of GDP. And the distinction I would draw, remember in '87 we had a Dollar that was weak and a government policy that was to get it weaker. So at that point people didn't want our government bonds. It became an unfinanceable current account deficit because if you bought a U.S. treasury and you were a German or a Japanese you lost money because the Dollar weakened. A huge difference in '87 the Presidential candidates were disputing that as a policy. Strong Dollar was not even spoken at that time. We have a completely different situation now. We have a standing policy in both parties of having the Dollar be strong as part of the United States so that makes the current account deficit easily financeable and what it's financing is a big U.S. investment expansion. The statistics, if we divide total investment in the developed countries the U.S. has gone up from 35% to 45% of that total in the last decade so we've had huge shift in the way the world is investing in favor of the United States.

Mr. STEINBERG: Just two quick thoughts on sustainability of the current account. First of all, the rest of the world is accelerating. That means that U.S. exports are going to accelerate. I actually don't think that the current account deficit is going to deteriorate that much if at all this year as a result of acceleration in exports. In fact, most of the deterioration that did take place in the last 2 ½ years is because our export growth stopped when the rest of the world was in trouble not so much because our imports are that strong. The second point when talking about sustainability—supposedly we have a net indebted position that is approaching 2 trillion Dollars and yet last year we had net investment outflow of something like 10 or 15 billion Dollars. What this tells me is that we don't have an external net indebtedness position of almost 2 trillion Dollars. There's a lot of stuff that just gets missed in a lot of these transactions and most of what gets missed is probably in the U.S. favor because our economies are the most globalized and, you know, that's where you're probably going to do most of the missing. So I don't think that our external indebtedness is nearly what it's supposedly is.

Mr. TARULLO: Eventually Maria and I are going to find a pessimist to be on this panel, but we've been looking hard and we haven't been able to do it yet. John?

Mr. LIPSKY: Well I can give you a scenario where the current account deficit turns into a problem. I call this sort of the "external apocalypse view" that foreigners are going to suddenly decide that the U.S. is a rotten place and the Dollar is going to fall and interest rates are going to go up and everything horrible is going to happen at once because foreigners decide that this is a bad place to be. That strikes me as a very unlikely paradigm. That's not how external crises happen. External crises are typically triggered by capital flight by locals, not by foreigners. The locals figure it out first. The risk here is that if inflation gets out of hand and you guys decide that you want to get your money out of here someplace non inflationary like into the Euro for example. Then you are going to find that the size of our current account deficit starts to make things look very dicey here. So that's why it's really critical for the Fed to keep inflation at bay. Because with this degree of a current deficit if you all decide that this was turning into an inflationary place with highly leveraged companies and unsound valuation in the stock market that's when it's time to watch out. But chances are you're going to be the ones that decide that not some guys in Tokyo, Frankfurt, London and so on.

Mr. TARULLO: John, what about a more moderated version. Rather than a crisis, just a shift. And if the scenario that you laid out a few minutes ago for a slowing of U.S. growth over the next couple of years were to occur the current account deficit still, even if it doesn't grow rapidly still at fairly high levels—

Mr. STEINBERG: —I've got to—you know that question is wrong you know because if we slowed our import growth would slow—but that's when the current account improves

Mr. TARULLO:—But Bruce that's what I was getting at. Conventionally that's what you would expect, but because capital flows have been such a big part of buttressing or depressing currency values over the last 5 to 10 years. I wanted to ask the question of whether counter intuitively by historic terms a modest slow of the economy and thus prospects for big jumps in the stock market and the likes slowing could lead both domestic sources of investment and some foreign sources of investment to move to areas of the world that look like more in the camp of rising rapidly and thereby, again, counter-intuitively by historic standards depressing, causing a weakening of the Dollar, rather than a strengthening of the Dollar as the current account deficit looks better. Is that totally implausible?

Mr. LIPSKY: No, I think that's probably what's going to happen.

Mr. TARULLO: Do you disagree?

Mr. STEINBERG: No, I think as I said the Dollar is going to weaken somewhat at least on the Euro over the next year.

Mr. TARULLO: OK

Mr. MALPASS: I think we have a big cushion. If our growth slows down. People are going to be less worried about inflation because the Fed set up such a high standard that growth causes inflation. If growth slows down you are going to see a lot of people buying the U.S. bond and it's going to make it really easy to finance the current account deficit. We won't see the Dollar weaken in that circumstance.

Mr. TARULLO: OK. Let's go back. Right Here.

Mr. CARLOS CERVETTI (Barclay's Capital): Mr. Malpass, you seem to imply that some countries in the developing world are actually following what might be wrong policies. Can you give us your outlook on the growth in these economies, particularly Latin America in light of your comments about developments of real rates in this country?

Mr. MALPASS: So, developing countries have a problem here. We have the Fed raising rates in order to stop the technology side of the U.S. economy, which is a tall order, at a time when commodity products are falling in price. So the challenge for developing countries is the growth challenge. We're going to go through another year when Mexico grows slower than the United States that's just not a right balance. They have NAFTA. They have a reasonably stable economy and yet their growth rate, even though people are happy with it their stock market is up, is stubbornly below U.S. growth rates. And Brazil is the same way. These are developing countries, they should be growing 7% a year so my concern is not—well, clearly developing countries and in Latin America in particular have the problem of unworkable constitutions. They don't have our short clear Constitution that forms the basis of rule of law. They have long imponderable constitutions that don't work. Labor immobility, high debt rates and other obstacles. But above all they don't have in the U.S. or the IMF a sense that they ought to be setting up policies where they grow 7% rather than 3%. We've got to somehow create an environment where the limits to growth gets thrown away for countries that have easy comparisons. You know, if you're starting at the bottom, you should be growing 7% as you begin to catch up. We have this problem where the per capita income between the U.S. and poor countries is getting worse not better. This is the best world environment that we can create for ourselves and yet it is not working very well outside the U.S.

Mr. TARULLO: And David, what are those constraints you see being imposed either directly or indirectly by the IMF or U.S. policies?

Mr. MALPASS: Well one problem is as the U.S. tries to use monetary policy to slow down a structural change in the U.S. economy and if you're Argentina, China you're linked into the U.S. Dollar and you just absorb that monetary policy. So that's an issue then a second issue is simply the extent of structural changes is not going fast enough in the developing countries in order to keep up with the technological change so you see Asia doing better than Latin America decade after decade that has to do with labor immobility, tax policy, I think exchange rate policy. Mexico's interest rates for the government are running 18% for the private sector are running 25 or 30% and yet they sit on the U.S. border, they feed products to us in a very healthy trade relationship, but the capital has not been balanced. That's because the Mexican peso and there's no sense that it is going to be equal to the Dollar over a period of time. So, I think major currency issues.

Mr. STEINBERG: David's just said something twice that I have to disagree with which is the Fed wants to slow down the pace of structural change. That is wrong, what the Fed wants to do is keep the labor market from tightening any further than it is. The labor market is the only constraint that this economy faces. Past utilization is actually quite low in the United States right now. The Fed is not interested in slowing down the pace of change or killing the tech sector. I don't think that's what it wants to do.

Mr. TARULLO: But I thought David was saying—I mean I don't want to speak for you—but I thought you were saying something different that is a potential asymmetry between optimal policies for the U.S. and keeping inflationary forces at bay on the one hand and the impact on much of the developing world on the other.

Mr. STEINBERG: Well the other point that David made was that Asia has grown faster than Latin America for decades and that will happen again this year. And one has to look at some of the internal policies of certain Latin countries to understand that and it's their imponderable constitutions and their lack of labor mobility and their low levels of internal savings that do these things. Would Mexico be better off if it Dollarized? It clearly would because interest rates are high in Mexico because inflation is high in Mexico and they don't really have control over that process adequately. So, there are problems that are more internal that have to be resolved internally in these countries rather than some IMF dictating some really wrongheaded way to go.

Mr. LIPSKY: But there is a really important point here. Remember that the 80s debt crisis, especially in Latin America but also elsewhere, if you take a step back and say big picture what happened. What happened was the Fed monstrously raised real interest rates and caused a recession that collapsed commodity prices and produced an environment that hadn't been seen before. High interest rates in a recession and a big deterioration in terms of trade for countries that were heavily indebted but interest rates didn't fall like they had previously in recessionary periods. What is happening now—so David is worried implicitly could that happen again if the Fed gets too wild. Well, yeah sure but we don't really think that the Fed's going to get too wild or is being too wild, but what is happening that is interesting to see that the back up in nominal yields in the U.S. in the past number of months has probably reflected an increase in inflation adjusted interest rates or real interest rates. In other words if you look at the return in the treasury index securities you can see that they've gone up in yield about as much as regular conventional treasury bonds. This is another way of saying that this is not an increase in inflation worries, as the press likes to talk about, it's an increase in real yields. What does that mean? Why is that happening? Well because U.S. productivity growth is off the charts and is much higher than anybody had anticipated. So the question remains is this the new reality? In a more productive world we're going to have higher real interest rates. For the developing world the real question is not is the Fed going to cause—or the Fed or the central banks—going to cause sustained higher real interest rates. Is the new economy, if you will, going to produce higher real interest rates than we're used to which raises the bar for these countries and puts more pressure on them for structural reform. Happily, I would say when you look around for example Latin America, wouldn't you Dave? It's not like the authorities of these countries haven't noticed this and aren't trying to do something about it and aren't trying to fight that reality and trying to bring structural reforms that work. That makes me a lot more optimistic than the beginning of the 80s.

Mr. TARULLO: Well this last bit of the discussion has been a good preview of the next World Economic Update which I want to devote to the developing world. We'll try to deal with it a little more thematic rather than just going sector by sector, but I think we want to address things like currency boards and Dollarization and the like and talk about some of the obstacles or facilitators to growth. I want to thank everybody very much and we'll see you the next time. Thank our panelists as well.

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