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Whither the Dollar?

Speakers: Stephen S. Roach, chief economist and director of global economics, Morgan Stanley, and Ethan Harris, managing director and chief economist, Lehman Brothers
Presider: Daniel K. Tarullo, professor of law, Georgetown University Law Center
March 11, 2005
Council on Foreign Relations


Corporate Conference
New York, N.Y.

Click here for all transcripts and audio from the 2005 Corporate Conference

DANIEL TARULLO: Good afternoon, everyone. Are we on? We're on. Steve and I bellow, so we can be heard even without the mikes. [Inaudible] On here. So I talk just at you, Richard? [Laughter]

UNKNOWN: Let me check the [inaudible].

TARULLO: All right. That's better. [Inaudible] I want to welcome everyone to this special edition of the World Economic Update, the [Council on Foreign Relations] program that we normally run in the mornings when people are on their way to work and also, on behalf of [Council board member and Chairman of American International Group, Inc.] Hank Greenberg, who at the last minute wasn't able to come, introduce you to this final session. The topic that had been given by the Council organizers is, "Whither the dollar?" although some have suggested that "the dollar withers" would be a better title for us. [Laughter] And to discuss the issues of the dollar and these implications, we have with us a trio of people, each of whom has been on past panels. To my left, Steve Roach from Morgan Stanley; Ethan Harris from Lehman Brothers; and Jim Grant from Grant's Interest Rate Observer. Jim, as you may have seen in yesterday's New York Times, had an op-ed on just this set of issues, but showing what a renaissance man he is, next week he's got a biography of John Adams coming out, so he kind of goes across the spectrum.

The— what I'd like to do in the discussion of the dollar at lunch today is to approach it from three sets of angles. First, just asking about where we think it's headed over the medium term, and why. Secondly, asking about the consequences of the likely direction and magnitude of change. And then third, towards the end of the session, to talk a bit about the relative risk of what central bankers euphemistically refer to as a disorderly adjustment, as opposed to an orderly adjustment of the dollar.

So, let's begin with the most straightforward question of where is the dollar going? And I'm going to suggest that we talks in terms of the next 12 to 18 months. Short-term shifts are notoriously difficult to predict with any accuracy. It is conventional wisdom, of course, that the dollar will continue to head downward. [Federal Reserve Board] Chairman [Alan] Greenspan's speech last night I noticed was almost assuming a continued decline of the dollar as he talked about the adjustment of the current account deficit in the United States. That is what one hears in sessions like this all the time. And yet, on the train this morning, I was just looking at interest rate futures and also at currency futures, and there's a remarkably narrow band that at least right now markets are expecting the dollar to deteriorate in the next 12 months. One-year interest rate futures against most major currencies predict very little change. A little bit, but just a couple of percent over the next year.

The interesting exception to that is not a currency future but the J.P. Morgan currency predictions, which again, by and large, predict just a little bit of depreciation of the dollar against other currencies, with the exception of the Chinese Renminbi, where J.P. Morgan predicts about a 10 percent decline over the next year, which obviously suggests that China will come off its pick. So we have conventional wisdom that the dollar must go down further, coupled with some sense in the markets that maybe it's going down but perhaps not all that much. So let me begin by asking each of the panelists where they think the dollar is likely to be headed in the next 12 to 18 months and why. Steve?

STEPHEN ROACH: Thanks, Dan. It does get tired repeating the conventional wisdom in the currency world. When, you know, the consensus leans one way and usually you can expect the markets to go the other way. I am a dollar bear. The broad dollar index is down 15 percent trade-weighted over the last three years. I think over that 12- to 18-month period, I would see another 10 percent, primarily against Asia, but also a little bit against Europe. That would include a change in the Chinese currency policy probably moving to a basket where [inaudible] float they would manage a little bit.

The one thing I want to add to the discussion, though, is that we are deluding ourselves into thinking that the dollar can fix the current account. It has limited ability to really create the type of re-balancing in the United States— excuse me— that I think we need. Today's numbers are a case in point. Second largest trade deficit on record. Imports are 58 [percent], 59 percent higher than exports. I believe we have an excess consumption domestic demand problem that definitely requires higher real interest rates, and so— excuse me. I get choked up when I talk about the dollar. [Laughter]

The Fed is the wimpiest central bank since the times of John Adams. And I think Jim might correct me on that. [Laughter] And they've done nothing in terms of monetary policy, despite what all of you heard last night from God. [Laughter] The Fed needs to take the policy rate up in real terms enough to slow down domestic consumption and demand, help rebuild national savings, which is really a critical piece of the current account adjustment.

If we focus solely on the dollar as the means to fix our imbalances, I'm afraid we'll end up not really having effectively addressed our imbalances and we'll be stuck in a pretty deep hole with our current account and saving shortfall for a long, long time. So it's time to get on with the heavy lifting of using the currency and the real interest rate together to bring our economy back to balance. And I'm— quite frankly, I am worried that our central bank is— doesn't have the guts to do it. This is— Alan Greenspan is not [former Federal Reserve Board Chairman] Paul Volcker. And we need a Paul Volcker to really do some heavy lifting with respect to monetary policy.


ETHAN HARRIS: Well, it's with some reluctance that I have to agree with my competitor here. The reason that the FX [foreign exchange] market can have this kind of two-way and doesn't seem to want to listen to the gloom of economists is we know that, in the short term, growth differentials, interest rate differentials can drive the currencies. So the dollar is in a pause right now. We've had the Fed tightening other central banks with stable interest rates. We've had very good growth data for the U.S. So, for a while, you can talk about the U.S. being the strong currency country because it's the new paradigm economy and grows better than its trading partners.

But ultimately, the current account comes back to haunt you. And as Steve said, the dollar can't do it alone. And even if we were to see a significant drop in the dollar, we think that the current account deficit has this kind of upward creep to it going forward. So, basically, the U.S. as a nation is asking the world not only to lend the equivalent of 6 percent of GDP [gross domestic product], but next year, we want 6.5 percent, and in fact maybe 7 [percent] the year after that. So it is not a sustainable situation. I would agree also on the kind of dimensions of it, kind of 10 percent kind of dollar weakness in the year ahead.

The one thing I would disagree with, I don't— I hate to dump all the blame onto the Fed here. I think that— I think the bigger story here is, as Alan Greenspan said last night, is they've got to get their act together on fiscal policy. And the Bush administration rediscovered the word deficit this year. And it needs to be a follow-through. And there— and it's going to be very difficult because Congress has been taught free-lunch fiscal policy in the last four years. You get your tax cuts, you get your spending increases, no vetoes, nothing. It's going to be very hard to turn around the fiscal balance. And I think that is the place where the main focus should be, in terms of putting some restraint on domestic demand, and we also need a little help from our trading partners— stimulate their economies as the currency moves. So there's a lot of things that need to happen, but it's hard to see that all coming together without further dollar depreciation.

TARULLO: But Ethan, let me just— before we move to Jim, let me just follow up a bit. Suppose that there are no significant moves within the Congress, within the administration, to begin to tighten. There's no sense of progress on entitlement reform. There's only things at the margin on the budget that are getting overwhelmed by Iraq spending. And there's not much movement abroad in terms of making economies more flexible or stimulating domestic demand. Will that in your view significantly affect the delta— the relative amount of depreciation of the dollar? And if so—


TARULLO:--what's the level of magnitude we're talking about?

HARRIS: Well, yeah. I mean, I would agree that there's kind of a honeymoon phase right now in fiscal policy, because the U.S. government sounds like they're going to do something that, you know, the gullible investors can say, "Well, maybe we will get some improvement in the budget balance, maybe we'll get— we will cut in half." But yeah, I mean it certainly creates bigger— if the various imbalances continue to worsen, if there really is no credible attempt to address the budget deficit, that just adds to the pressure on the dollar to do all the work in this trade adjustment.

So when I talk about this, I— my advice to investors isn't to kind of dig your foxhole and dive in. You want to dig it. You want to put the Dinty Moore beef stew in there and everything and store up. But don't go in the foxhole yet, because we need to see some things go wrong here, I think, to get the really ugly scenario. And I know that's supposed to be last, but—

TARULLO: That's [inaudible].

HARRIS: I will hold off on the good stuff.


JAMES GRANT: In the glossary of investment, diversification is probably the least controversial word. And yet, the mention of diversification in the context of national wealth has been now for the past three or four weeks to have set off momentary alarms before functionaries of those who utter that word are brought forward to say he didn't mean it. [Laughter]

TARULLO: Jim is alluding to the Korean Central Bank and [Japanese] Prime Minister [Junichiro] Koizumi's discussion of potential need for diversifying the reserve base of those two countries.

GRANT: No, I wasn't.

TARULLO: Oh, you weren't? [Laughter] Jim is alluding [Laughter] to the Bahraini instincts to begin stocking canned vegetables as [Laughter]--

GRANT: So diversification into what? The greenback is the world's reserve currency. It is backed not only by this economy and the idea of America, but also by the most formidable geopolitical force on the face of the earth. So, what is the alternative? The dollar depreciates not against itself but against something. What might that something be? Well, that something is the euro— the euro: a confection of Social Democrats in a confederation of nations. [Laughter] Very, very questionable.

In finance and investing, it seems to me, all in all, is value or price. You can't say that the dollar is intrinsically undesirable. It's undesirable at a level, at a price. And as with equities, as with bonds, as with everything, value is a proposition. So what is the value proposition presented by the presumptive successor to the dollar in the portfolios of Asian nations? Well, here is the value proposition of the euro. The central bank interest rate is 2 percent. And Greece has recently issued 30-year bonds at 4-and-a-quarter percent, single A-rated Greece, which, to get into the euro zone, prevaricated a little on its deficit. It wasn't [Laughter] 2.5 percent. It was 18 percent. [Laughter]

Germany is going to issue a 50-year bond because there aren't enough bonds. Germany is single-A. Greece is— I'm sorry— triple A, and Greece is single A. The spread between Germany and Greece is 26 basis points for a 36-year [bond]. That is, .25 percent is the market's reckoning of the marginal risk presented by a country that is only intermittently solvent. [Laughter]

Now, we are focused, all of us, on the dollar's weakness. I suggest that the big surprise ahead lies in the possible implosion of the institution of the euro. There's a rolling referendum this next 18 months about the European Constitution, a document of about a million pages, the work of the [inaudible]. They want to present a unified and coherent plan for the life of the continent in all its facets. And this document goes before the people, some of whom hate it, as they should. Isn't it possible that while we are looking at the dollar and everyone is hoping for the euro, that the euro goes, to use a technical term, kaput? The euro is a six-year-old currency, and yet people are issuing bonds of 30 and 50 years in it. Who says the euro will be around in six years, eight months? So I'm bearish on the dollar, but I am more bearish on the presumed alternative to the dollar.

TARULLO: And that— and by process of elimination, bullish on Asian currencies?

GRANT: On Asian currencies, the value of which is being suppressed through the most strenuous central bank action, and also on gold, which has a great advantage of not having a finance minister to protest against its rising value. [Laughter]

TARULLO: OK. Let's turn back now to something that Steve mentioned and Ethan also in passing, and that is, let's go down the rest of the world. I mean to a considerable extent the savings rate or lack thereof, the current account deficit and the fiscal deficit in the United States are enabled by the willingness of the rest of the world to finance those deficits. For a while, it was through foreign direct and portfolio investment. More recently, it's been as Jim was just suggesting, through central bank purchases of treasuries. But that, Steve, hasn't been done out of the goodness of their hearts or certainly not out of concern for U.S. taxpayers and consumers in the rest of the world. It's been done for self-interested reasons. As this adjustment process begins, is the process likely to be more difficult for countries where domestic demand has been suppressed than in the United States?

GRANT: Yeah. This treasury-buying of— especially the Chinese, it's sort of the— can I call it the cocaine of this— of our time? Is that a bad word to say?

TARULLO: Bad word. [Laughter]


TARULLO: Addictive substance.

GRANT: A bad [inaudible]. [Laughter] Sorry. You know, forgive them, for they don't know what they're getting into. But the Chinese are experiencing massive capital inflows into their system as— driven in part by trade flows, but also by speculators betting on currency revaluation. And given the fact they have this currency peg, they do everything they can to sterilize the buying of treasuries they need to support the peg, and yet they can't really do it. They have a relatively undeveloped debt market, and so, a lot of this liquidity then gets circulated into their system, which can cause problems with inflation or acid bubbles.

Meanwhile, you know, the Chinese today, probably they have about $610 billion in total reserves, if you believe the numbers, and I do, probably $450 [billion] of those— billion of those are dollar-denominated assets. Let's just say, hypothetically, the dollar drops by a third. That's, you know, a loss— a portfolio loss that's worth about 10 percent of Chinese GDP. And they keep building. These inflows keep going ahead. And so the risk is that they're really exposing themselves to a fairly significant portfolio loss in the event of dollar weakness. And so when you're talking about China, they're a poor country, you know. When you lose assets worth 10, 15, 20 percent of your GDP, it matters.

And then the final thing I'd say is that, also the— sort of the other— you know, on the other foot, here, is that there's growing hostility again on U.S.-China trade tensions, especially this— in light of the surge of Chinese textile imports into the U.S. in the early months of this year. There's going to be a lot of China-bashing this year. And China is still an export-driven growth model. And that raises risk to the stability of their growth dynamic.

And so, you know, the Chinese have sort of figured out that the best thing they can do right now is, you know, let Americans buy DVD players made in China and the Chinese will turn around and buy Treasuries made in Washington and we'll all be happy, but they're creating a monster here. And it's an unstable one that I think sews the seeds of its demise in what could be a surprisingly unstable outcome for China, which is the last thing they want. So I think there's a big wild card for China and it's getting riskier by the moment.

TARULLO: It is interesting that we sort of gravitate to China in talking about the— we start with the rest of the world, then we gravitate to China. Ethan, I'm— I wonder whether the gradual or halfway or incremental shift in the renminbi versus the dollar, which people are increasingly contemplating, is actually itself a stable potential policy measure. That is, can you shift by 8 [percent] or 9 percent, or is the re-pegging of the renminbi or the creating of a market basket that has the de facto effect of revaluing the renminbi against the dollar— is any of those things done in an incremental way likely to be sustainable, or instead just increase all the market pressures that are in essence speculating that there's going to be a further run-up in the valuation? And if so, what does that say about adjustment possibilities?

HARRIS: Well, I agree that as soon as they move a little bit, people are going to look for more. I don't think that China is the central issue in the near term on this, however. I don't— I think that the thing I would be concerned about is not trying to abandon the scheme, but more the periphery of the scheme eroding. Because if you think about it, if you're a small central bank out there and you take Steve's example, you think the dollar is going to drop 20 [percent] or 30 percent, why don't you quietly shift your reserves, because you're not really fundamental to the system. Your— the numbers are too small to make a big difference in holding the dollar up. And so you quietly move out. You do things like the— what the Koreans seem to be saying, which is, "We're not going to change our existing reserves balance but new reserves, the new current account deficit funding, we're going to be very quietly shifting into other assets." So I'm worried about this kind of hot potato thing. Who's going to get stuck being the last central bank holding the dollar up? They're the ones who are going to get the really nasty capital losses. So I think that's the concern. The other concern—

TARULLO: That's— just on that point even, the last guy holding the bag is China.

HARRIS: Right.

TARULLO: And to the extent that these peripheral central banks are already diversifying, that puts more and more pressure on the Chinese [inaudible].

UNKNOWN: Why China and not Japan?

HARRIS: Well, both— I think that—

TARULLO: You heard your friend Koizumi. He said, you know, "Look, we're out of this trade, too."

ROACH: But he's only the prime minister. He doesn't have much [laughter]--

HARRIS: No, I think the thing— I think the Chinese and Japanese, the guys, they understand that they can only opt out of the system slowly, or it'll just collapse right on the spot. The little guys, though, can opt out and they don't have to worry about creating that collapse.

One thing— the other thing I would add is that what makes this so intractable is you look at what would you really like to have happen here? You'd like to have Europe stimulate its economy, Japan stimulate its economy, and the U.S. pull back. You look at Japan, how do they stimulate their economy? I mean they really have a mess. Structural reform there could actually weaken their economy in the short term. And the same thing is true in Europe. Structural reform in Europe in the long run may create a dynamic economy that will buy U.S. products, in the short run could hurt the economy. It's really, as Alan Greenspan would say, it's a real conundrum.

TARULLO: But that— and Jim, we'll turn to you for your comments on this. But Ethan, your last set of comments is actually reinforcing the case for the question that I posed to you earlier, which is, suppose no one else is adjusting? Doesn't, then, more pressure then come onto the dollar as a result? And I— you just made a very plausible case for the proposition that no one will be adjusting, or the only way people may be adjusting is peripheral country diversifying out of the dollar—

HARRIS: Right.

TARULLO:--which at some point sets loose dollar issues.



HARRIS: That's my answer.

TARULLO: All right. Jim?

GRANT: Yeah. In one of the Laura Ingalls Wilder's books, the protagonist is at a country fair and her father is reaching into his pocket to come up with a quarter for some popcorn, or a cow. I guess it was earlier, the prices were lower. [Laughter] And he says to her that this is work and money is distilled work. And we, I think, are too used to thinking of money as something to trade or something to be long or short.

But in the case of the Chinese and Japanese money, this money sitting there is the residual of a lot of work, and one would expect resentment to grow at its melting away in value. So to agree with Ethan and Steve, it's in everyone's interest in Asia that the dollar not collapse, but it's in no one's individual interest that they not take action ahead of the others. In fact, it is in everyone's individual interest to act first.

So I think that the serial uttering of this heretical word diversification and the quick denial is a verbal leading indicator of a major shift in thought in Asia. And it's not such a subtle thought; it is why have every egg in this one basket? The marginal cost of production of a dollar bill is essentially nothing. That money has no cost to produce is a relatively new idea in the history of the world. Since 1971, that idea has become current and acceptable. So there.

TARULLO: All right. Now we're going to get to the big stuff, as Ethan characterized it a few minutes ago. Over the last couple of years, there's been a spate of mostly academic papers, but in many instances, papers by academics who themselves were once in the government as policy-makers, raising that—

GRANT: That's you, right?

TARULLO: I'm not an academic economist.

GRANT: Well—

TARULLO: Some would say I'm not an academic at all, but others would say that I'm not an academic economist. We have— and I didn't write such paper, OK?

GRANT: OK, all right.

TARULLO: So saying that the prospects for, as I referred to it earlier, a disorderly adjustment of the dollar, are actually quite significant, meaning something triggers the withdrawal of assets from the United States in a relatively rapid and large fashion, which creates this vicious circle of the dollar declining and people pulling out more assets and the rest. The administration and the Federal Reserve Board have been at pains to say that this is not really something that people should stay up nights worrying about. Last month, the Fed released a staff paper purporting to show that historically, rather, GDP adjustments associated with large current account deficits in industrial countries— that there's not much of an historical basis for thinking that there would be disorderly adjustment.

Yesterday, after Prime Minister Koizumi's comments and presumably before the Ministry of Finance clarified what the prime minister had meant [Laughter], four administration, well, two Fed and two administration policy-makers giving four speeches in four different parts of the world on four different topics, all spoke to the issue of orderly adjustment.

Secretary [of the Treasury [John] Snow said our markets here are the deepest, the most liquid, and the most liquid and the most efficient anywhere in the world. We produce the best risk-adjusted return, so no, I'm not. The question was, "Are you worried?" Assistant Secretary of the Treasury Randy Quarles in Tokyo said it's inevitable that from time to time various organizations holding U.S. securities will consider rebalancing their portfolios in certain circumstances. It's very unlikely that that sort of rebalancing would have significant effect either in the Treasury market itself, or certainly on the U.S. economy.

Last night right here, Chairman Greenspan indicated the likelihood of the unwinding of foreign investments in the U.S. occurring in an orderly fashion. And speaking yesterday, again on a somewhat different topic, a member of the Fed, Ben Bernanke, said it seemed unlikely— oh, I'm sorry. He was talking about the budget deficit. But then he predicted the likelihood of an orderly adjustment of the current account deficit. Although alone of the four, he then added the tag line of, but the risk of orderly— disorderly adjustment always exists.

So we wouldn't expect anyone from the Fed or the Treasury Department to say, "Yeah, I'm worried about the disorderly adjustment of the dollar," because that would be self-fulfilling. The fact that everybody spoke basically on the same page at the same time indicates either unusually good coordination within the administration, between the administration and the Central Bank, a little bit of worry, or both.

So the last question I want to put to the panel is, where does each of you stand on this issue of the relative risk of a disorderly adjustment in which things happen very rapidly, assets depreciate, the dollar declines in a very rapid fashion, and presumably there is some substantial real economic impact of all of this, and on the spectrum, if I can put it this way, between [economist] Nouriel Roubini and John Snow?

UNKNOWN: I'm with Nouriel.

TARULLO: I knew that.

ROACH: Look, we had a small hiccup in 1987 that I would call certainly at the time disorderly. It occurred against the backdrop of a U.S. current account deficit that widened all the way to 3.4 percent of GDP. Isn't that amazing? Today's problem, as you alluded to, is probably twice as bad as that. Right now, the current account deficit is 5.6 [percent], but it's headed up to 6.5 [percent] to 7 [percent] for reasons that Ethan alluded to.

Here's the trick. I mean, what all the officials do here, and you said it, you didn't quite use the word I'll use, but it's spin. I mean, you know, that's what they're going to always say. And they get paid to spin literally any issue. And when you have an unprecedented external imbalance, by definition the odds of a disruptive adjustment are high. And macro can't tell you when and it can't give you the bolt from out of the blue that can disturb it. But when you have this massive deficit, the likes of which we have, and the dependence we have on external financing, it takes less to stir up the pot than would be the case if we were closer to balance. That's the price we pay for this.

So who knows what the bolt of the blue is? You know, some dumb piece of legislation gets passed in Washington that's protectionist, or some other central banks, you know, announce they're going to bail out, or, you know, there's a, you know, an LTCM [long-term capital management]-type problem because, you know, some levered players have played the [inaudible] trade too much and they implode, or lo and behold, we wake up and find out that America's productivity miracle has been a scam and it's over. I have no idea what it would be. But the price we pay for these excessive deficits is that the risk of a disorderly adjustment by definition is higher. None other than Paul Volcker, whose name I now invoke twice, is on record, according to [Council Chairman]

Pete Peterson, who built this wonderful building for us, saying that there'll be a 75 percent chance of a dollar crisis in the next three years.

TARULLO: Where do you put that percentage?

ROACH: Seventy-four. [Laughter] No, no. I— you know, I don't know. You know—

TARULLO: You're low-balling Volcker.

HARRIS: Are you sure you're being precise enough? [Laughter]

ROACH: It's— I don't know if 75 is the right number, but his point—

TARULLO: Do you think it's more than 50 percent?

ROACH: It could be. It could be. [Laughter]

TARULLO: But it could be less than 50 percent?

ROACH: It could be. [Laughter]

TARULLO: He's an economist. [Laughter]

ROACH: It is a high— it is a much higher number than we normally like— I mean, you know, you do this for a living for Lord knows how long, and you always sort of— in the back of your mind you assign 5 to 10 percent probabilities for terrible things in the best of times.


ROACH: So, you know, my assignment of a terrible thing in these times would be sort of three times my norm. So, you know—

TARULLO: Fifteen to 30 percent?

ROACH: Something like that.


HARRIS: Well, to add to your quotes, Alan Greenspan no less— OK, after he— some of you may remember this. After he said that—

TARULLO: Is this just last night?


TARULLO: I hope a lot of them remember it. [Laughter]

HARRIS: Well, yeah. After he said that the current account deficit is sustainable because we've got this big globalization process going on so savings can flow across borders in huge amounts, he then said at the end of it, and said that a widely-held alternative view of the past decade to not readily be dismissed, meaning eventually there could be an abrupt adjustment.

And then I looked at back in the footnote, the source then said Roach, Harris, and Grant is the source of that. [Laughter] So even— no, that's not true, that part. But even Greenspan, you know, after going through the case for, you know, the benign adjustments so far and we think we're OK going forward, then you throw the caveat in: maybe things could go wrong. In our road show for our economics team in January, we asked our client base, what's the probability of a dollar crisis in the next three years, you know? Brilliant question there. And the average response was 30 to 40 percent chance among our group. And I—

TARULLO: And this is a client base that's largely financial clients?

HARRIS: This is— this would be both U.S. and European clients.

TARULLO: But financial or non—

HARRIS: Financial.

TARULLO: Financial.



HARRIS: You know, the client of Lehman Brothers; the kind of money-market types.


HARRIS: And I'd put it closer to 50 percent. The problem is, it's not that there's a high chance of crisis at any moment going forward, it's that the adjustment is going to take a long time. And so you're kind of relying on— you know, relying on the things to hold together for a long time. That creates high odds of something going wrong.


GRANT: I can't add to Steve and Ethan on all of that, but I maybe could take a crack at how you assess the odds in the— as a practitioner in the marketplace of something going wrong, and how you're being paid to do so. There's a market called the credit default swap market. It's a derivatives market, which is essentially an insurance market. You can buy insurance against credit going bad. You can buy it for corporations and for nations for sovereign credits.

To insure against a credit event for Greece, a single-A borrower, very [inaudible] costs you $14,000 a year on $10 million face; $14,000 a year is the premium against the risk of Greek public finances becoming so questionable that credit [inaudible]. And, you know, we can't know when. I certainly don't know when the world's currency markets might be in turmoil, but I think when turmoil— if or when turmoil does strike, the likelihood is that the complacency that is now reflected in uniquely type credit spreads and in remarkably low nominal interest rates, that will end.

And now you're being— you're really being— they beg now you to go in and buy— again, on the long side of a credit default swap contract. For France, it's four basis points: four one-hundredths of a percentage point buys you that insurance. You know, Germany it's five. Greece, four. These are astoundingly low spreads. So why not? You can't— we can't know when, but we do understand that the situation is inherently unstable, and they are asking you to take measures to protect yourself. Very rarely do you find a situation like this in which the risks are clear and probable and the cost of insuring against them is negligible. That is a gift from the investment god.

TARULLO: Let me— with all three of you then, let me press a little bit, because isn't there— there is something to the observation that historically industrial countries have not faced adjustments in a very disorderly fashion. Steve, in 1987, the impact of that market-driven disorderly event was in the end barely felt in the real economy.

ROACH: In the end. But believe me, at the time, you know—


ROACH:--it felt like the end.

TARULLO: Yes. Yes, but a year afterwards— a year afterwards, it had been absorbed way better than anybody in late October of 1987 would have thought.

ROACH: How about your friend, Mr. [George] Soros taking on the Bank of England?

TARULLO: Well, you mean in '92?

ROACH: Yeah.

TARULLO: Well, he's doing that around— he's doing that around efforts to peg a currency, OK. Right?

ROACH: But it was a disorderly—

TARULLO: That's always been an opportunity for—

ROACH: A disorderly adjustment for a once-great power.

TARULLO: Yeah, OK. But there is a difference between where the U.K. was in 1992 with ERM [exchange rate mechanism] and the rest, and where the U.S. is today. Now, I was about to say, the Fed study was careful to say just because it hasn't before, doesn't mean it's not going to happen now. It's a different situation. But with all of you guys way up on the probability, how do you— why and how do you characterize or conclude that the position of the United States today is sufficiently different, and the self-interest of the rest of the world sufficiently different, from the way things have been in the past to make a 50 percent possibility of a dollar crisis over the next three years?

HARRIS: Can I start on that? I mean, you know, I think it's important to look at that Fed study very closely, because the headlines around it were the probability—

TARULLO: No, they didn't oversell it.


TARULLO: The chairman may have over sold it a bit.


TARULLO: They did not over sell.

HARRIS: Yeah. If you read the paper, it says on average in these 23 current account crises, GDP growth slows by 1.5 percentage points from the period before to the period after. Yeah, that's a pretty good slow-down. Growth in the economy now— U.S. economy is now 3.5, 4 percent, slice a percent and a half off of that and you've got a pretty weak economy.

They said that the capital spending declined as a share of GDP by three percentage points. That's pretty ugly. A correction in the stock and bond market, not a nasty outcome, but you know, a one percentage point increase in real interest rates, 10 percent temporary correction in the stock market, and a modest movement in the currency. That was the average of these 23 episodes.

So I think that, you know, we do want to be a little cautious about when we talk about the crisis that the crisis may be a weak economy and some financial pain, but it's not necessarily recession of, you know, a big blowup in the global financial system. So when I— when I think about this, my first thought is weak economy with pretty significant pressure first on the bond market and then stock market, but I'm not thinking, you know, a major blowup.

ROACH: I just underscore the point here. This dollar issue is one piece in the adjustment puzzle as I see it. The U.S., in terms of order of magnitude, in terms of current account deficit, is a share of GDP. There have been other industrial countries that have had higher deficits, but never in absolute dollars. I mean, this is a world record by any stretch of the imagination.

HARRIS: But it's not just, you know, you know, a current account dollar issue. You know, it's a 1 percent savings rate. It's a zero real interest rate. It's— spread trade, as Jim said, is that— you know, that are at all-time [inaudible] in all sorts of risky assets. It's record levels of household indebtedness. You know, you could make the case that, you know, we're sitting on a powder keg here, and we've gotten away with it because we have this central bank that keeps feeding the hungry with zero real interest rate.

TARULLO: And a lot of central banks abroad.

HARRIS: And all the other central banks are playing the game as well, and so, in the context of a stretched system, it is quite conceivable to me that you could get a disruptive adjustment for a period of time.

TARULLO: OK, let's— I'm sure a lot of people have— in the audience have comments and questions as well. I just want to remind you before soliciting questions and comments that this is an on-the-record meeting. So you're liable to be quoted by somebody, and when I recognize you, if you'd please stand and identify yourself before asking your question or making your comment. Yes? [Inaudible] Oh, I'm sorry. And wait for a mike.

QUESTIONER: Nick Bratt with [inaudible]. I have a question which may sound flippant, but is intended very seriously.

TARULLO: That would be in the spirit of the panel. [Laughter]

QUESTIONER: And it may be— it's a very technical question, but we all understand the case for the central banks diversifying and take [inaudible] of the marginal central bank, but technically speaking, what actually happens to the dollar that that central bank sells?

TARULLO: OK. Or it doesn't buy, as the case may be.

UNKOWN: The private investor has to take it. Basically, if they stopped buying— you know, stopped paying for half or 60 percent of the U.S. current account deficit. Somebody else, somewhere else, will have to— a private investor will have to buy that security and probably will demand a higher interest rate on it, I think is a simple answer. I mean, and it— so that's what will happen, it will show up somewhere, somebody's portfolio, but that person given— if there's enough of that withdrawal, that the relative price, it will have to change—

TARULLO: And that's where the interest rate pressure is coming.


TARULLO: OK. Yes, sir? Right there. Oh, can you stand and identify yourself please? Thanks.

QUESTIONER: Paul Ciampa from Barclays Capital. It was alluded to earlier, I think by Ethan, that one of the problems with the economy is that Europe is not doing enough to stimulate their economies. Isn't it quite possible— and I'd be interested in your thoughts on this— that perhaps right now, the U.S. is doing way too much to stimulate, and it's basically an economy on steroids? And Europe, by basically doing nothing, is forcing companies to restructure, it's almost like creating an artificial debt that's forcing efficiencies and finally forcing Europe to restructure, and it's actually long-term bullish of Europe?

And you're seeing small signs of it, just like with France with changing the 35-hour work week. You're seeing a little bit more small-business creation, I think, in France and other places. So isn't it quite possibly that— they're doing the right thing, maybe not consciously, but by not stimulating, they're forcing companies to become much more efficient?

TARULLO: You mean—

QUESTIONER: Unlike our economy.

TARULLO: Policy paralysis forces the private sector reaction?

QUESTIONER: Yeah, not having— you know, not creating this kind of—

TARULLO: They have to go to the weight room instead of injecting the steroids.


TARULLO: Does anyone— plausible?

QUESTIONER: Well, you know, I— it's certainly not by design. I think that— I think we can be clear on that. But is it actually happening?

ROACH: Well, far be it for me to really say anything good about Europe. [Laughter] But, especially after Jim's—

TARULLO: Do you have any friends left when you come out of these? [Laughter]

ROACH: But no, I'm going to say something good about Europe.

TARULLO: Oh, OK. Right.

ROACH: I am. I think your story on corporate restructuring in Europe is right at the margin, and I think old Europe is slowly coming to grips with some of these labor market rigidity issues. The 35-hour work week is being dismantled slowly. Everything happens slowly in Europe, but it— and certainly in France, and in a number of key German companies such as Siemens, they have also torn up restricted work week labor contracts.

Germany, moreover, now has about 30 percent of its workers, sort of flexi-workers— temps, part-time workers— the power of the German labor unions has certainly been diminished dramatically and then— the other thing that's really interesting about Europe right now on the other side of the coin is— you know, America's great productivity story was, in large part, an outgrowth of just a lot of spending on IT [information technology]. And Europe didn't do it, and now they are. And when you spend aggressively on IT, you raise the capital relative to the labor input, and that sort of mathematically gives you a productivity kick.

So what Europe needs most of all to turn it— to get its act together, I think, is torture. They need to be punished [laughter], and policy paralysis is part of that torture. A strong euro, by the way, also tortures Europe. I think the strong euro is in the best interest of Europe.

And I think that one of the big surprises here is that we have all written Europe off, myself included, and especially the Europeans. I mean, they are more down on themselves right now than I've ever seen them, and yet, slowly but surely, at least the micro-pieces of a more constructive outcome in Europe are starting to fall into place. They have a long way to go, but what we care about in the realm of economic analysis is change at the margin, and there are some marginal, admittedly marginal changes, but going in the right direction in Europe.

TARULLO: Anything else on Europe? No?

HARRIS: Sounds good to me.

TARULLO: OK. Yeah, next— more questions. More questions? Yes, right in the center?

QUESTIONER: Stanley Arkin. What happens to the dollar if we have a major apocalyptic event in this country such as a terrorist attack?

TARULLO: On interest rates?

QUESTIONER: Oh, I don't know.

ROACH: I think it's— I think obviously it [laughter]--it would create a bit of volatility in financial markets. [Laughter] I guess that could be a trigger for a much weaker currency. I mean, you always have to— with these apocalyptic events, you always have to wonder about, is it a flight-to-quality effect or does it damage the fundamental attitude towards the U.S.'s economy, and therefore you've got these offsetting impacts? But—

HARRIS: You see, I would say— sorry.

ROACH: Yeah, go ahead.

HARRIS: I would say concerning apocalypse and concerning the likelihood of [inaudible], that you don't really have to have an opinion if values are aligned so that you are well paid for taking a risk. In 1981, U.S. Treasury securities yielded 15 percent non-call, 30 years equity risk of equity returns without equity risk. That was a proposition. The reason not to do it— the reasons not to do it were compelling. They were imminent hyperinflation, an inflation of social democracy, you know, and blah blah blah. Now what do you have? You have a universal hunger for long-dated assets issued by sovereign governments that for hundreds of years have been in the business of appreciating their currencies. That's before us now.

You can get short these securities. You can get short the credit spreads at exceptionally compelling values. So you don't have to have an idea or a view on what's the probability of this happening. You don't have to— you don't have— the best investments are ones without time horizons. You don't— you know, the speculators need something to happen. Investors can wait. And with a 10-year insurance policy on credit spreads uniquely [inaudible]--uniquely tight, you don't have to have a view. OK?

TARULLO: Other questions? Roger? Yeah.

QUESTIONER: Yeah. Thanks. Roger Kubarych, Council and HPB Group. Why are corporate CEOs of the largest companies so inept at getting their views across to a Republican administration about the dollar? Case in point [inaudible] just left, but she'll remember February 22nd, Financial Times, speech the day before by [Rick] Wagoner, the CEO [chief executive officer] of General Motors, blasting the administration's foreign exchange policy toward the dollar. It also is a company whose bonds, as Jim can verify, are now trading at yields that are close to junk bond yields. And as Ethan can verify, Lehman has changed the rules for the calculation of which company's bonds can go into their corporate bond index— first time I've ever seen such a move— to make it easier for companies like that, should they get downgraded, to stay in the bond index. I've— these are three dots to be connected.

TARULLO: Roger, when you talk about— you talk about dislike of administration— you said foreign exchange policy—

QUESTIONER: That's what [inaudible]--

TARULLO:--do you literally mean foreign exchange policy?

QUESTIONER: No. Wagoner's speech was all about the dollar, that the dollar was being allowed to be too strong, that the administration had not criticized the— all of this, what do you call it— manipulation through foreign exchange intervention. It was a first-class blast at the administration.

TARULLO: And was that— was the— either the text or the subtext to push China more?

QUESTIONER: And Japan. He's more worried about Japan than Korea -

TARULLO: They want them to sell their U.S. government security.

QUESTIONER: He wants to see the dollar down like [Institute for International Economics Director] Fred Bergsten wants to see the dollar down. And many other CEOs want to see the dollar down because they're not making any money. If you look at the GDP figures, the car industry in the U.S. hasn't made any operating income in five years. The reason why the companies still have net cash flow is because they run banks, finance companies, GMAC [General Motors Acceptance Corporation], Ford Motor Credit. But operating income of U.S. auto— just look at the GDP accounts: negative for five years. So that's a troubled sector, that's the casualty of the strategy of having a very high dollar relative to a situation where you wouldn't buy so many foreign cars or foreign car parts, and you'd have a smaller current account deficit.

But where we are now has a legacy. It got here and it got here through a process of essentially subsidizing the housing market with very low interest rates. Each one of your guests has said that. And we've had a housing boom which has allowed high consumption and we've had a manufacturing sector that employs a couple million people less than they used to.

UNKNOWN: Well, I guess John Snow is supposed to be here, right? [Laughter]

TARULLO: He's off pitching social security privatization. [Laughter]

QUESTIONER: I don't agree with what the administration's policy [is] on the dollar, but I'd said— I'd say two things. One, they— there— Snow's own belief as he told me personally is that at this stage it's counterproductive to push China. And it's better off to kind of go softly with them and hopefully the revaluation will occur. They don't react well to being pushed too hard. That's what he said. I'm just representing him here.

The other view that you might accept is that to come out and say we have a weak dollar policy might be disruptive financial markets, so better to stick to the old mantra we've got a strong dollar even though it drops every year, and we don't do anything to stop it, but we've got a strong dollar policy because you don't want the disruptive adjustment.

But I agree with your premise, which is that it's time to get on with the adjustment. If I was the treasury secretary, I'd in a very subtle way be changing my language around the dollar. Not come out and say we've got a disaster here, time to sell, but more kind of, let's let the markets find a sensible level for this -

UNKNOWN: But wait. I mean, Roger, I mean, it hasn't— the dollar's down [inaudible] at 15 percent, three years, the administration's let it— you know, they've played ball. I mean, every once in awhile, you know, the president says something out of the other side of his mouth, but the general philosophy of the strong dollar rhetoric that has driven at least the official statement of the U.S. currency policy has been tolerant of market-driven declines in the currency, and I think— I'm not going to sit— and I'm the last person to defend the administration, but I think if they saw another 5 percent a year for another few years they— that would be the objective or the thing they really want to forestall, because there are consequences as if the dollar's decline gets out of hand and spills over into other asset classes that— which threaten the asset-dependent U.S. economy.

But, I think that— you know, Snow is a CEO— a former CEO, and I think he understands the story and is constrained as to how far he can take the rhetoric, but I think he has certainly taken the stance that has not resisted the dollar's, what he would say, orderly decline.

TARULLO: OK. I think we have one last question. Yes, sir?

QUESTIONER: Actually, I have two questions.

TARULLO: Yeah, but from one person. [Laughter]

QUESTIONER: I'm Roger Kline. First question is, are each of you short the dollar in terms of your personal balance sheet, and if not, why not? That's one question.


QUESTIONER: I'll hold the second one.

TARULLO: You guys want to answer that first.


TARULLO: Ethan? Now if those are mostly—

HARRIS: I had it—

TARULLO:--mostly yen— mostly yen [inaudible]--

HARRIS: I was carrying a 5,000 yen note in here but it seems to have disappeared.

QUESTIONER: No, I'm curious. You just made a compelling argument. You're all more or less in agreement, I want to see if you have the strength of your ostensible convictions or whether actually—

UNKNOWN: I've been—

QUESTIONER:--there's not that much going on.

UNKNOWN: I'm involved as a general partner in a fund that invests in Japanese equities, and we hedge half of our exposure. So we have great confidence in our corporate analysis, in our security analysis, we have a little less confidence in macroeconomic stuff. So we are— we used to hedge— we used to hedge 100 percent of our exposure, we now hedge 50 percent. And personally, gold.


HARRIS: I talk the talk, but don't walk the walk. I don't have any real— I mean, in terms of— there's nothing significant in my own personal portfolio. The— I am very conservative right now in my investments, I'll say that much.

UNKNOWN: But they're dollars.

UNKNOWN: But they're in dollars.


TARULLO: I'm told by my broker that I am overweighted in foreign-denominated assets.

UNKNOWN: Yes. [Laughter]

QUESTIONER: Yes, what?

UNKNOWN: Yes, he's short the dollar.

QUESTIONER: Is he really? And that's short the dollar on your balance sheet.


QUESTIONER: OK. That's one. The second question is you— Jim, you said that the— you talked humorously earlier about the euro going away. I'd like to know did you actually halfway mean that, and what do your three colleagues think about the prospect of that happening?

GRANT: I think the prospect is very small, but you are being paid to bet it might happen because of the tiny spreads that are given to sovereign credits in Europe and the low level of nominal rates. You don't have to believe that the euro is going to— is going to be discontinued and the countries are going to revert to their legacy, sovereign currency. I think that is a nontrivial possibility given the uncertainty surrounding the approval of this constitution, given the existence of five million unemployed in Germany.

There are inherent contradictions in a confederation of any kind issuing a currency for an economic zone. The sum of those contradictions is [inaudible] presents you with a risk that is much greater than zero, yet the market is calculating the odds of anything bad happening at about zero. And it's the spread between those two calculations on my part that lead me to [be] very bullish on these insurance speculations or investments on euro-zone interest rates and euro-zone sovereign credit risk.

TARULLO: I don't think that the prospects of non-ratification of the constitution are trivial for the acceleration of integrating forces in Europe. But I also don't think that the— even the rejection of the constitution raises a large risk of unwinding of the integration that's already occurred. There's an interesting idea being generated among some people who study Europe and Europeans themselves, that right now Europe is at a kind of equilibrium point of integration, that if the constitution goes through, not much more is actually going to happen in the medium term, and if the constitution doesn't go through, there's actually not that much that's going to get unwound either. OK? Do you have anything to say about Europe?

UNKNOWN: It's a political experiment from the start, and a political commitment that binds the member countries to the currency. The economics are questionable, but I think the politics, unless there is true upheaval in the European political structure, will keep the euro intact.

TARULLO: OK, that is now the end of our panel, and now the president of the Council on Foreign Relations, Richard Haass, is going to give the answers to all of the questions that we are talking about. [Laughter]

RICHARD HAASS: Well, I'll give two quick answers and then we'll say thank you. On Europe, just remember the following: 25 countries, 15 are going to decide it in parliament. Those 15— excuse me— it sails through. Ten countries have public votes— referenda— on their relationship with the constitution. Out of those, two, three, four, most are in doubt. Even if one of those or two of those, were to go down there's then ways of recast— having a second vote in those countries and wording could be such in which the constitution is not the vote but it's whether you agree to stay in Europe and support the constitution in that context.

I would be surprised at the end of the day if one had a— any of the European countries essentially voting, not something against the constitution, but against staying in Europe. But again, we're really only talking probably, I would think, maybe two, which are clearly the British, which is the caboose of the process, possibly pulling maybe one or two others. But I wouldn't exaggerate it.

On that— on China, two things. The reason John Snow says what he says about not jawboning the Chinese too hard is twofold. One is, most of his colleagues tell him not to do it because the United States has so many other equities right now with China, including North Korea, and a few other issues. Secondly, it'd be useless. The Chinese leadership has made a political decision. But what matters more than the absolute value of their large holdings of dollars is employment, and this Chinese leadership cannot afford massive growth in unemployment. It's already high enough in China, or too high, and as a result they are willing to— at least up to now, they've been willing to trade some of their value away from the assets they're sitting on in order to avoid the political risk of larger of amounts of underemployment or unemployment. I don't know if that continues forever, but that's clearly a decision by the Chinese government.

This conversation, which has, by the way, been sensational, also whoever called economics the dismal science has not heard these gentlemen. [Laughter] Rarely has there been as much laughter on the subject, but maybe we're laughing before we cry. [Laughter] I'm not sure.

This has been a great day— day and a half. And what I want to do is just say a couple of things. One again, I want to thank David Kellogg and Jacqui Schein and others, who helped put it together. Really, this has been sensational. [Applause]

This is— it's particularly good when one remembers the fact that this is the first time we've ever done this. And when I got here, as part of my commitment to the corporate program, I— one of the first questions I asked was: "Why isn't there a corporate conference?" And there was quiet— rarely there was a silence around the table, I said, "Well, great. Let's do one." And roughly a year and a half later, this is the result. I think we're off to a really good start.

That said, I expect we can always do better. We'll be getting in touch with you, and we'll essentially give you a chance to give us feedback. And we can take the criticism, though. As I always tell my wife, I think the entire concept of constructive criticism is overrated. [Laughter] So, I point that out at advance before you all let us know what you— what you really think.

But again, let me thank you for your coming here, you've all got incredibly demanding and busy lives. We appreciate your taking the time. What I heard, it's been a— I think again, a really good series of sessions. I want to thank everyone who spoke. But again, I really want to thank you all for taking the time to listen, to ask the questions. And more broadly, again, to thank you for your interest in this institution.

This is an important time for the Council and these issues that we're working on, the issues that we talked about the last day, but the issues also of war and peace and the rest. These are not abstract issues. Foreign policy, national security matters in ways that I believe it hasn't mattered in a long time. I've been in this business for about 30 years, and I can't think of a mome

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