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| Authors: | Daniel K. Tarullo |
|---|---|
| Stephen S. Roach | |
| William C. Dudley | |
| Ethan Harris |
April 4, 2003
Council on Foreign Relations
Speakers: William C. Dudley, Stephen Roach, Ethan Harris
Presider: Dan Tarullo
April 4, 2003
New York, NY
Dan Tarullo (DT): Good morning everyone, welcome to the spring version of the World Economic Update. We have today two returning panelists, and we're pleased to welcome one new one. You all recognize Steve Roach down at the end and Bill Dudley on my right. Sitting to my immediate left is Ethen Harris, Chief US Economist for Lehman Brothers. What I thought we'd do this morning ... everybody is focused on the war, from our point of view the question is the impact of the war on the economy. But most economists are also trying to look beyond the war to ask, "What then?" Principally asking the question whether the removal of the uncertainty, which the end of the war would arguably portent, would mean renewed robust growth.
What I'm going to try to do this morning is get our panelists to separate those questions a little bit, hard as it is to separate the question of the impact of the war from what comes after the war. But talk a little bit about the direct effects of the war, or a prolonged war, or a prolonged period of doing peacekeeping on the world economy. And then we'll, I'm sure, segue quite naturally into the issue of ... so get a quick resolution, we get a relatively favorably resolution, what does that mean for the underlying strength of the economic and prospects for, as I said, renewed, fairly vigorous growth?
Okay, day by day the news shifts and the market shifts with it. And you wake up one morning and the headlines in the Times look pretty good in military terms, the markets go up. You wake up the next morning, headlines don't look so good, the markets have gone down. We're going to be probably in that mode for a little while now, so we're going to have to do some stipulating here to try to get a useful discussion going. Rather than predicting, let's stipulate that instead of things ending within ten days or two weeks from now, things drag on in Baghdad. There is street fighting; there is a lot of unpleasantness both in military terms and political terms; there is increased restiveness in other Arab countries; you know, there is some sense that it's going to be a very expensive process even after the fighting is over. How much of a negative effect does that have in and of itself on the economic going forward? Ethen, do you want to start?
Ethan Harris (EH): Well, let me first say that, you know, you look at this group, and you're not going to get any rose colored glasses.
William C. Dudley (WCD): I know, we usually get an optimist. (Laughter)
EH: I think we'll live up to the dismal Science Monitor. You know, I think that the impact of this war is, you know, fairly easy to quantify in some regards and very hard in other regards. The easy to quantify stuff is the impact on budgets. We know that we're going to get big budget deficits out of this; we know that we're going to have a big peacekeeping cost in any reasonable scenario. And we also know pretty well how oil prices will affect the economy, a $10 increase in oil prices, which is our estimate of the war shock, affects about a half a percent of growth.
But the harder stuff to measure is the psychological stuff, and that in fact is what will distinguish a good from a bad forecast in terms of the outlook. And our view is that it's a major shock to the economy. You know, we think that we'll get only one percent growth in the first half of this year. Coming from a trend growth of about 3 percent, that's not a very favorable outcome. We think you can see in the data the war impact: we hit a wall in February, and it's continued into March. And as long as the war goes on, we're going to get recession-like readings for the US economy. So it's, you know, very hard to imagine any real pickup here until the war is over. A very long war, I think we get a recession in the United States.
I also think that, you know, while we'll get some kind of recovery coming out of this war, the war is another episode where we've had these repeated false recoveries in the US economy. With each one of them you take a little of the cyclical resilience out of the economy; the economy loses some of its mojo, and here we go with another soft patch in the US economy. And with each of these soft patches, you come out of it with a more cynical corporate sector wondering when we're ever going to get through on growth.
WCD: Ethan, let me ask, if I could, if you could decompose just a little bit the factors that would induce the recession that you talked about. To what degree would that be the direct effect of continued higher oil prices? And to what degree would it be the psychological impact to which you referred in holding down investment, keeping consumer sentiment depressed, and the like?
EH: Well, I don't think you can get a recession with just the conventional oil shock impact. If you look at a big macroeconomic model, you know, if oil prices go up to $60, $70 a barrel, that may be enough to get a recession on its own. But if you look back in history, the oil shocks to the economy when you've gotten a recession, it's been when there's already a very fragile economy or there is additional psychological impact. You know, the early oil shocks in the '70s and in 1990, you had huge psychological effects that came with the oil shock, you know, people forecasting $200 oil, and this had a very devastating effect on the economy.
It really is about ... it's about psychological, I think it's mainly the corporate or the business sector in general that is the risk factor. For the consumer there's a bit of an offset. I don't want to sound flippant here, but, you know, we saw it with the 9/11 event; when people get depressed, some of them go out and shop, you know, you buy shoes, golf clubs. There's a little bit of offset to the consumer from the doom and gloom. You know, you buy in order to feel better about the world. Obviously you're also worried about your job, and so that discourages spending. On the corporate side of the economy, there's no kind of patriotic effect on spending, there's no, you know, "shop to feel better" effect; it's all negative. It's hunker down, wait, see what happens, and then we'll start spending.
DT: Okay. I suspect we don't have a whole lot of divergence on this point. But, Bill, anything you want to add to what he said?
WCD: A little bit. And I would argue that the war effect on the economy is not the fundamental reason why the economy is weak.
DT: Right.
WCD: I think the war is a factor, but we're talking now about probably three quarters in a row they're going to be below trend: the fourth quarter, the first quarter, and the second quarter. And to argue that you've gone through this very long period of below trend growth just because of a war that's being fought far away, that's going well, that's going to be over relatively shortly, I think that's over weighting the war. My view, and I think Steve shares this view too, is that what's really driving the economy is that we're in the midst of very large balance sheet adjustments caused by the bursting of the stock market bubble, which are causing corporations to be reluctant to invest, causing households to try to save a greater portion of their income because obviously their financial asset returns have been very disappointing, and causing state and local governments to have to raise taxes and cut spending. On top of that you have trade drag because the economy is actually doing better (Laughs) than Europe and Japan, and the dollar is still overvalued; so, it's very, very hard for the US economy to develop much momentum. The other thing I think driving the weakness of the economy is that the stimulus from monetary and fiscal policy in '03 is distinctly less than the stimulus that we had in '02. Now, that will change a bit once we get the tax cut package passed, but that hasn't happened yet. So I think, even after the war, the economy would be pretty weak.
DT: I told you we were going to segue seamlessly (Laughter) into the underlying economy issues. Steve, add anything you want to what Ethan and Bill have said, but also if you could look ahead a little bit to next week's meeting of the G7 Finance Ministers. Under the current circumstances, is there anything in the near term that they ought to be doing in order to offset whatever the negative effects of the war are?
Stephen Roach (SR): Well, I think your question urges us correctly, Dan, to put this in a global context. You know, I think what's going on in the United States and what's going on in the Middle East has really opened up some huge fault lines in the way the world works right now. The world is dangerously US-centric. And, you know, the one number that always bears it out most acutely is really that since 1995, the United States has accounted for 64 percent of the cumulative growth in world GDP at market exchange rates. I mean, that's just bizarre, ridiculous, and unsustainable. And it's unsustainable in the sense that, you know, late last year our current account deficit hit about $550 billion in annual rate, or 5.25 percent of GDP. And let me tell you, if these tax policies and post war rebuilding, as well as military related plans, go through in terms of the budget deficit, the budget deficit is about to blow up before our very eyes. And unless we spontaneously discover the art of savings in the private sector, we're going to have current account deficits, the likes of which we can't even contemplate right now. And that has huge consequences for the world because it brings the dollar into play big time. So, you know, I characterize the world as a very dysfunctional place right now. The US is the best of the lot, but we're going down a very reckless path in the standpoint of managing a savings short economy and being increasingly dependent on the rest of the world to fund our excess consumption.
The only other thing I'd add, Dan, is that because of the world's dependence on the US, what we're seeing in terms of the numbers that Ethan and Bill laid out, which I do agree with, it's global in scope. And in fact it looks like the way we put the numbers together, that Europe will actually have a down quarter in the current quarter, and Japan will be down this quarter. And clearly the one leg the world had to keep the global growth rate in positive territory was Asia. And Asia has just gotten a huge punch right in the midsection with this SARS related disease, which has brought service sector activity, whether it's travel, financial services, even retail, to a virtual standstill in most key ASEAN countries, and it's also having an impact on China. So, you know, I think world GDP growth will be negative in the current quarter. I'd call it a global double dip. (Laughter)
DT: Back to the G7 for a second, what, if anything, should the G7 countries be doing right now ... and maybe this is more a Central Bank issue than it is a Finance Minister issue ... to try to offset some of the near term negative forces?
EH: Don't strangle each other.
SR: Well, the G7 has been just ... has not done an outstanding job in recognizing the imbalances in the global economy. Europe continues to lag in terms of structural reform and getting out of the straightjacket that they're put in by pan-regional monetary and rules-based fiscal policy, and, you know, Japan is always "manana." And so these are two key regions of the world which have no domestic demand growth. And so in the world that I envision, the dollar is going down possibly big time, and so their days of sort of being free riders on the basis of undervalued currencies are over because their currencies are going to go up. And what are they going to do for growth in that climate? So they've got to move aggressively in on locking domestic demand by biting the bullet on structural reforms, and they're politically unwilling to do that.
DT: How about monetary policy in the European Central Bank?
WCD: Well, I think they clearly can do more. I mean, what you'd like to see in an ideal world is the dollar depreciate gradually; that improves US trade balances, and that puts pressure on Japan and Europe to stimulate economic policy, both through the structurary forms that Steve alluded to, but through also monetary and fiscal stimulus. And one of the problems in Europe is the stability pact ... you could call it the instability pact at this point ... which basically ties their hands on fiscal policy at precisely the wrong moment.
DT: Hasn't tied France's hands though.
WCD: No, that's the one country that sort of said, "Well, we're not going to really worry about it." But, generally, it is a constraint on the enthusiasm with which they embrace fiscal stimulus. Deficits can go up, but they can sort of go up passively, as opposed to actively where you actually cut taxes and try to stimulate the economy. I think that you need the US to be less the engine of growth in the world; I certainly would agree with Steve. And for that to happen, you need a weaker dollar that puts pressure on other countries to follow more stimulate economic policies. The problem though is everyone is acting in a reactive mode rather than an anticipatory mode. So by the time you get the ECB to ease monetary policy, it's sort of after you've had a bad economic out turn, and so it doesn't turn out to be very effective in that circumstance.
DT: Now, Ethan, you're going to learn ... you're already seeing what a hard time I have pinning Wall Street economists down on policy measures. But since this is your first time, maybe you will be more pinned down. (Laughter)
EH: Well, I don't think we need some kind of coordinated rate cut, and I think it would be very difficult to achieve at the moment. But that doesn't mean individually they shouldn't all be cutting rates. Normally I'm a big fan of the Fed, I worked there most of my career, but this idea that we balance risks to the outlook, or we can't understand the risks, I don't believe that. The risks are in the downside in both inflation and growth. And so I think the Fed needs to, you know, kind of get out of the foxhole it seems to have dug, and cut rates. I think the ECB finally seems to be on the track of cutting rates, and we expect further rate cuts from them. And there's at least some hope that the Bank of Japan, now that we have a new leadership there and a little more cooperation between them and the MOF, there is at least hope that they can no longer make the excuse, "Well, the other guy's not doing anything, so I'm not going to do anything." So, I think that in all these respects we need further easing.
DT: Okay. Let me ask one more question sort of from the geopolitical/military perspectives. I mentioned in my opening comments that markets seem to be tracking military developments fairly closely, and “military developments” is a surrogate for how quickly things will be over. I have had a sense, but I may be wrong, and that's why I'm asking you gentlemen, that the market is not, at least up until the last week or so, looking over the horizon to a whole other set of geopolitical problems. North Korea is lurking out there as, arguably, a much bigger immediate national security threat to the United States than Iraq has been. In Washington for some time now, and only a little bit more recently exploding into the newspapers, there's talk emanating from administration surrogates about potential action against Syria and/or Iran in the wake of a victory in Iraq. Have the markets priced in those kinds of possibilities and those kinds of risks? Or will they react very negatively with great volatility if two months from now the National Security Council is overtly talking about some other military step? Steve?
SR: No, the markets are not pricing in anything beyond what they perceive to be a relatively prompt end to the immediate hostilities in Iraq. And I think as I travel the United States and as I travel the world, I get the distinct sense that investors loaded with cash, desperate to put it to work after, you know, three terrible years in the markets, are looking for a victory-driven improvement in confidence and a release of spending by consumers and businesses alike. And, you know, there may be some of that. But the issue is, will it be short lived, will it be sort of like a post 9/11 snap back that lasts for a few months? And the operative view that Alan Greenspan has put forth is that the big driver for the coming rebound in the US will be the business sector in spending on new capacity. And in my opinion, I think that's the last thing that will happen, not the first thing that will happen.
DT: Well, we've had a little up tick in IT spending though ... right? ... already?
SR: We had a little up tick in the fourth quarter, and it's probably going down again big time in the first quarter.
WCD: That's only about a third of overall investment spending too. So, you know, it's like, okay, let's focus on the thing that's going up and say that the whole complex is going up. The reality is ... (Overlap) ... long term ...
DT: But, for a while, everything was going down.
WCD: Right.
DT: And now it's at least stabilized.
WCD: Yes, but long cycle equipment stuff, airline purchases, you know, power generation equipment, all this stuff that takes four or five years to get ordered and installed is still heading down, and structures are still heading down. I mean, how many people are going to build another office? Like Goldman Sachs is building the biggest office building in New Jersey; and I think if we had to do it over again, we probably wouldn't be building that building. We're certainly not going to build another one. (Laughter) We sold ours before we moved in. (Laughter) But again, you know, with corporations in the industrial world completely lacking in pricing leverage, with the world awash in excess capacity, I don't get it. You know, why are we going to have a capacity led resurgence of business spending activity? What am I missing, Dan?
DT: Steve, should we be distinguishing ... ? I mean, I've given the panel today ... I'm going to play the optimist ... (Laughter) an uncharacteristic role for me.
SR: I'm just trying to pin down a guy from Washington. You know, it's hard to do that. (Laughter)
DT: Those of us out of office can be pinned down. (Laughter) It's the people in office who are hard to pin down. The excess capacity, which you have, I think, insightfully ahead of the curve been writing about for some time now, is principally a manufacturing phenomenon, right?
SR: Wrong.
DT: You think it's both, it's services as well?
SR: Well, look, we all work for an industry that has more excess capacity than we ever dreamt imaginable. (Laughter)
DT: But that may be a bit of that New Yorker perspective, right?
EH: I don't agree that it's quite as dire as (Laughs) Steve argues. I mean, at the end of every recession you have tremendous excess capacity in the economy. What the economy needs now is an end to the shocks. I mean, I don't agree that there is some kind of fundamental, you know, ten year structural message in the US. I think what we've had is one shock after another, and it doesn't give businesses time to catch their breath. You know, we have the 9/11 event, the tech wreck, the stock market crash, Iraq, corporate governance scandals. Now, a lot of these come out of the same process, you know, geopolitical problems and the excesses of the '90s. But what you need is a break from the shocks, some time to heal, then you're going to get better spending. Corporate America needs to have some optimism that there's growth down the road. I mean, this is the fundamental model of investment. I mean, this is the accelerator.
WCD: But there are always shocks. Look at the late 1990s, we had the Asian crisis in 1997, we had long term capital management in 1998, and the economy went sailing along. So I don't think the shocks are the primary reason why the economy is suffering. The key issue on capital spending is can capital spending increase exogenously before demand increases elsewhere. And the question is, well, why would businesses increase their capital spending before they seek demand for those goods and services. Got me. The second is ...
DT: Wait, is the theory ... ?
EH: How do you ever recover from recession?
WCD: Well, typically demand rises quite sharply in the first year of recession, businesses see the demand, and therefore they ramp up their capital spending. But if the demand isn't there and you're at a capacity utilization level that's the lowest since 1983, what's the rush? The second issue, I think, that's inhibiting capital spending is Wall Street. Three years ago Wall Street was telling corporations, "We want you to maximize EBITDA, earnings before interest, taxes and depreciation allowance." That's very pro-investment. Now they're telling companies that they want them to maximize free cash flow. That's not good for investment at all. So, investors are demanding from corporate America that they restrain their investment, and that's going to lead to a higher share price. What do you think corporate America is going to do? They're going to restrain their investment.
DT: Okay, let me try to paint a slightly less gloomy picture and then let you guys take pot shots at it, okay? Let's now assume that, contrary to the implication of my earlier question, that the political guys in the White House say, "No more adventurism before the 2004 election because we don't want to entail risks for the economy that could endanger the election." So, geopolitics goes into a somewhat more quiescent period for a while, number one. Number two, in the wake of the victory in Iraq, oil prices come down substantially. Number three, and Steve may differ with this, but the plateaus, at least in investment spending, mean that at least that's not a negative any longer in the economy. Number four, the end of the Iraq war plus the lack of front page stories saying we're going somewhere next increases consumer confidence somewhat. Why isn't there inherent in that set of factors and others a prescription for, you know, increasing growth around the order of 2.25, 2.5 percent year on year from about now?
WCD: Very possible. That seems completely doable if you get all those things. Absolutely. (Laughter)
DT: Okay, so it is a question of the probability of those things?
WCD: Right.
DT: All right, and how improbable ... you and I probably are in a position to make an assessment on the geopolitics of it ... but other than that, how improbable are the other things that I mentioned?
WCD: They're probably not individually, any of them, improbable by themselves, but collectively that's the center of the distribution. I would say probably not.
DT: Aren't they all kind of related to each other though?
WCD: Well, we don't know, we don't know if the markets do a lot better when the war is over or a little better when the war is over. We don't know if the markets do a lot better, do consumers respond a lot or a little. So, I think the magnitude of the responses is also very important.
DT: Okay. Do you guys want to ... ?
EH: Well, I think that, unfortunately, the outlook is, you know, kind of the positive scenario, is the trend growth economy; it's not a booming economy. And all these risk factors create kind of a big distribution at the low end.
WCD: But it's a different trend than we had in the late '90s, right?
EH: Well, I think potential growth in the US is about 3.25 now.
WCD: But Dan's giving us like a ...
DT: Two and a half.
WCD: ... 2.25 percent.
EH: We can do a little better than that if everything goes right, yeah.
SR: Well, Dan, the way to sort of try to assimilate this is, you know, to put Bill and Ethan and myself together here. There is context which, I would agree with Bill completely, is that we're in this post-bubble workout period where, I think, the trend growth rate is going to be lower than you just said for a while. We can argue that, but I think that's been the case since the bubble popped and is likely to be the case for a few more years to come at least. And then on top of that trend, you do have, as Bill correctly said, you always have shocks. And, you know, that's the bad news. But the good news is they're shocks, because shocks wear off. As devastating as 9/11 was, you know, there was a response even in this city once we were able to, you know, wrap our arms around it. And, you know, the shock of this war, the shock of higher energy prices, even the shock of what's going on in Asia, they will wear off.
But I would just argue that as long as this sort of context exists where you have a slowly growing economy open to periodic shocks, you don't have the cushion that you would have in the late '90s when you could get hit with, you know, these shocks that Bill just described and barely flinch. So, in a slow growth economy, shocks matter a lot more, but shock is not the whole story. It's the context that really describes and delineates the ability of an economy to withstand shocks. And then I just come back to the point that, you know, we have less of a cushion, but the cushion around the world doesn't exist.
DT: Steve, let me ask you first, because then I want to move on to another topic. What would it take to change your fundamentally negative view on medium term prospects? Or maybe a better way of putting it is, what in your view has to happen, which may just inevitably take time to kind of accelerate it, but what has to happen before you would see us returning to a trend growth of say 3 percent?
SR: Look, you know, what would it take? Probably a labotomy. (Laughter) I mean, at this point, you know, I'm stuck on this. I just see the world as being dangerously US-centric and therefore dependent on an economy that now has a legacy of structural excesses from the bubble, namely the massive and ever widening current account deficit, record lows in our national savings rate, record highs of private sector indebtedness. The US can't carry the world the way it did. So, you know, the formula that worked post '95 doesn't work unless the US steps up to the plate and purges its excesses, unless the rest of the world decides to bite the bullet on structural form and figure out how to grow on its own. And until those two things happen, you know, what you see is what you get. I think it's going to be still pretty dicey and pretty tough in the world. You know, there will be fluctuations around the trend, and there will be quarters when it looks terrific, and there will be quarters where it looks pretty crummy.
DT: Ethan, Bill mentioned fiscal deficits. Steve has now mentioned both depressed savings and a current account deficit. How serious ... this is the twin deficit issue redux ... how seriously do you take all of that as a threat in the medium term?
EH: It certainly is a threat. But, I mean, developments aren't all negative there again ... (Laughs) ... I want to sound, too, optimistic here. (Laughter) But saving rates have picked up. I mean, effectively what we've seen with the tax cuts is that the federal government cuts taxes, creates deficits, and the private sector saves the money. So, we've seen private savings rise at least a little bit. So the imbalances are growing, but they're not quite as bad as has been portrayed. I think, you know, we're going to have a very big and persistent current account imbalance. I think it means steady downward pressure of the dollar. We survived it in the past, you know, in the '80s we had a big collapse in the dollar and the economy weathered it, although it wasn't exactly great for the global economy. You know, these are risks. The budget deficits probably, you know, $300 billion kind of deficits are here to stay. You know, we've got Reagan II going on now, you know, defense spending and tax cuts. So, you know, these are issues that are going to weigh down the economy.
But again, I don't want to overdo it, but I come back to my main point, which is that, you know, what we need in the economy now is a resting period. You know, the time for corporate America to heal its wounds, which it's gradually doing, time for the consumer to build up savings a little bit, a relief from these shocks, and give it time, and the economy will start to come back again. I think it's very similar to the early 1990s: it took a long time to kind of heal from the banking crisis and the real estate crisis. But, eventually, the healing process ends if you stop having the shocks to the system.
DT: So, with the scenario that I laid out to Bill a little earlier, premised upon relative quiescence, relative non shock.
EH: That's the good scenario. That to me eventually gets you to a healthy economy.
DT: Notwithstanding the twin deficits.
EH: Right, yes.
DT: Do you agree with that.
WCD: I think that the twin deficits are sort of unavoidable at the current time, given the growth differential between the US and Europe and Japan. What you want to see, I think, over time, is a weaker dollar, which then will curb the current account deficit over time. And I think the fiscal stimulus right now actually is completely appropriate; the fiscal stimulus basically facilitates the balance sheet adjustments of the private sector. If you didn't have that fiscal stimulus, the economy would be even weaker and you'd have big budget deficits anyway. The problem I have on the fiscal side, in terms of the policy course that we're embarked on, is not the near term fiscal stimulus, but the fact that we have lots of fiscal stimulus out there in 2012 and beyond. And that's really the problem, I think, in terms of the budget, not the problem in terms of the near term big budget deficits today.
DT: Okay. A couple of weeks ago Ben Bernanke, Governor on the Federal Resource Board, former economics professor at Princeton, gave a speech to members of the Fed Board on what to do, which was pretty academic in some sense and particularly since it picked up on a lot of what Bernanke has done in his own scholarly work, it might have particularly seemed that way. He did a speech on monetary policy targeting, basically. And much of that speech was taken up with talking about the unusual or new or innovative instruments, which are open to the Fed in the event that conventional monetary policy instruments are not adequate to fight deflation. To what degree, (A), are all of you concerned about deflation? Is it just a sort of low probability thing that people talk about because it's kind of fun to talk about? (Laughs) Or is it something that we should really be worried about? And, (B), to the degree that we ought to be concerned about it, do you agree with Ben Bernanke that, yeah, it may start coming up on us as a phenomenon, but that doesn't mean that in an era of low interest rates we are left helpless to combat it. Steve? It is ... to talk about.
SR: Yes. Look, I was the first jerk to talk about deflation, probably that was about 14 months ago. And as a former true historian ... I was a former Fed staffer myself ... I have a lot of ... well, no, now I only have a few friends left ... (Laughter) ... at the Fed, and they're in pretty senior positions because, you know, at the Fed, unlike most organizations, they promote you when you get older because of age. (Laughter) And they called me up when I started talking about deflation, and they said, "You know, you're really embarrassing the reputation of a former Fed staffer. You're becoming a crackpot, and we expect more from our illustrious alumni." (Laughter) And I'm exaggerating a little bit, but this is sort of the way (Laughter) the conversations went.
And then around the middle of last year the Fed staff, in fact 13 economists, in The Economist, on the Fed staff published a paper on deflation; the topic was "Lessons From Japan." But, you know, we all knew what the real message was here, and that is watch out, you know, it could happen here. On November 6th, the day after the election, the Fed eased by 50 basis points and admitted that 25 of them were to take out some insurance against this so-called “crackpot scenario” that, all of a sudden, they were attaching greater credibility to. A week later, Greenspan went out on the circuit and said, "Look, the chances of deflation are remote; but if it happens, here's what I would do." And then Bernenke published his paper, and he keeps talking about it.
So all of a sudden, you know, the crackpot scenario has become the operative risk factor in shaping the monetary policy debate in the US. And I think that's appropriate because, you know, we entered this recessionary period in '01 in exceedingly low inflation rates. So, cyclically, if we go into another brief recession here, it will be two recessions in three years. And that will take you a lot closer, even in the face of an energy shock, to deflation than otherwise might be the case. And in addition, there's still the legacy effect of excess supply in the US and around the world, which puts downward pressure on the global price level. And find in that just the whole concept of globalization, whether it's tradable goods or even the, quote, unquote, "non tradable services," which are now going global big time, that are also putting downward pressure on the price level.
So, I don't think you can take the risk of deflation lightly in any way whatsoever. The Fed is trying to quash any concern, whatsoever, that we could get there. I think the so-called “nontraditional tools” they have, in large part, are untested, and it's not clear at all to me that they would work. The only two things on Bernanke's list of 19 things to do to stop deflation that I am sympathetic to would be if the Fed were to monetize large budget deficits. And I totally agree with Bill that we're looking to monetize a big short term stimulus like a cut in payroll taxes, as opposed to a multi year tax reform and/or being on board with a conscious policy to take the dollar down.
DT: Okay. Ethan, you're the Fed alumnus.
EH: Yes. Well, first some facts here, which are that core consumer price inflation is now almost 2 percent, okay? So, we still have a long way to go. It took Japan ten years to get into its mess, and, you know, to get the negative one percent inflation with Japan, you know, got a long way to go. So, yeah, we're heading down that track, and it is a concern out there on the horizon. But I think to get to deflation in the US, you'd need a major recession. So, you know, it's kind of the second risk. The first thing I'm worried about is, will we have the recession. Then, I'll worry about deflation after that.
Now, why is the Fed out there talking about deflation and unconventional monetary policy and so on? Well, frankly, they're trying to counter the impacts of Japanese policy. The Japanese have convinced financial markets that quantitative easing doesn't work. And, I think, the message is really that they did such an inept job of conducting quantitative easing, that it failed. But the Fed wants to preempt that kind of sense of helplessness; they don't want to see that word "Japan" on the front page of the Wall Street Journal with the US and equal sign next to it. So, I think, the reason the Fed is talking so much about quantitative easing is an attempt to preempt a lot of the kind of negative sentiment out of Japan. And it's risk management, right? You're in the risk management business; you're supposed to get ready for worse case scenarios, and so you talk about unconventional policy.
Now, will it work? It's going to be tough. It's definitely not as effective as conventional monetary policy. I think Steve is right that, you know, push down the yield curve as much as you can, buy long dated Treasuries. The Fed can do it; they did it in World War II, you know, lower long term interest rates to, you know, one percent or something. You know, there are things they can do, but they're definitely desperate measures.
DT: In percentage terms, what's the probability of deflation some time in the next two years?
EH: A 10, 15 percent chance.
DT: Steve, you'd put it up where, 40, 45?
SR: Yes, I'd double it, 20 to 30.
WCD: I'd probably put it at about 20. I think Ethan's right, that as long as you don't have a recession, the disinflation gradient is ... you're still having disinflation, but the gradient is very gradual. Inflation is falling maybe a quarter percent, a half percent per year; so, it's going to take quite a few years to get to zero. But I agree with Steve, if you have a recession that changes things pretty dramatically, because you get a bigger output gap, the disinflation gradient gets a lot steeper. And then you have to worry about the risk of deflation in a one or two year type of time frame. What the Fed is doing, I think, is very simple: they're trying to anchor inflation expectations by saying, "Look, we have all these tools to prevent deflation, so don't worry." Because if you have inflation expectations anchored, then the markets are a lot more comfortable with people who have large debt burdens. And they're also making it very clear that if we do ease it again another 50 or 75 basis points, that's not the end; there's some other stuff in our tool kit. And they want people not to be nervous that the Fed is running out of ammunition. I do agree with Steve that it's not clear how well it would work.
The other thing, I think, is also very important is how quickly does the Fed move. You know, one of the problems in Japan is they got to zero percent interest rates and quantitative easing, but only after the economy fell into deflation. I think one of the things I get a little worried about on the Fed is they have a pretty optimistic view about the economy. And therefore they may actually get to the quantitative easing after you're in a recession, and at that point it may be too late.
DT: Steve, you've made the point on a number of occasions that our last recession was atypical, certainly for postwar dips, that it was driven more by the pulling back of investment than it was by overheating of the economy with the Fed stepping on the brakes. Can we learn anything from history on ... which I guess is prewar history ... on what happens when you have that kind of recession and what happens when price levels go down, as they did in the '30s, and what kind of risks there actually are for self fulfilling negative downward cycle?
SR: You ask me that because I'm the oldest person on the stage? (Laughter)
DT: No, that may be one of the reasons, but that's not the proximate reason. It's because you've been looking at this.
SR: That's all right. I'm giving you a hard time. I apologize, Dan. (Laughter)
DT: You aren't giving me a hard ...
SR: This recession that we went through and the period that we're in right now are post-bubble periods. So, it is unlike the typical post-World War II business cycle climate, where recessions are caused by the Fed going after inflation in goods and services. And, you know, you go back to the cycles of yesteryear when I was a pup, and, sure, they were more Austrian, you know, these huge excesses of capacity, speculative bubbles in financial markets. But, you know, Lord knows, the economy was so different, the institutional arrangements were so different; you don't want to extrapolate on the basis of the past.
But the lesson that I take is that when you do get a huge imbalance between supply and demand on the real side of the economy and the balance sheet underpinnings of the private sector get distorted in a similar fashion, you know, the conventional process of cyclical healing that we have become accustomed to doesn't work that simply. It's a different ... So, you know, this recession that we have been through in 2001 was off the charts. I mean, you know, the sectors that normally are the weakest in the recession were the strongest: cars and homes. So you ask yourself, you know, if those sectors were stronger in recession, we're going to get the pent up demand for them to drive the recovery. I mean, you know, everyone in America bought a car last year. If you didn't need one, you bought one anyway because they were giving them away. (Laughter) And now, you know, Detroit is panicking, and they're going to do it again. But when you start to look at the process of economic recovery, the period we're in right now does not resemble the climate that most of us have plied our trade in. It's a very different period. And I just stress again, Dan, it is so different, not just in the US, but even more different globally.
DT: Okay. The last question before we turn to the audience. A couple of you have already mentioned the dollar. We talked about the relative risk of deflation, what's the relative risk of a rapid correction in the dollar, as opposed to a more gradual one, which I think all of you seem to believe, that there's going to be a significant depreciation of the dollar looking forward? What's the risk that it's rather more rapid than gradual?
EH: Well, you know, our forecast ... forecasts always look very smooth when you put them down on a page. (Laughter) We have the euro at 1.12 at year end; that's a very radical kind of number. I think there's a risk of it. I mean, if you go back to the '80s, you know, what got the dollar to really collapse was when it became really kind of a big political issue around the dollar. And I think that's the mechanism. You know, it becomes politics, it becomes very in the center of discussions between ... the rest of the G7. You know, Congress starts rattling away about it. Then you can really see a sharp drop in the dollar. I think it's already vulnerable because, finally after years of ignoring the current account deficit, it's now on the radar screen. And that's the way it works. And, I mean, I think financial markets are like four year old kids; they can only focus on one thing at a time, and they get obsessed with whatever they're working on. And the current account was just not in the play box for a while there. So, now that it's there, there's a substantial risk. I don't know what kind of probability I'd put on it, but a 1980's scenario, you know.
DT: Bill?
WCD: I agree with that. But I think what has to happen first is Japan and Europe have to do something that makes them look more attractive. So, you need some sort of a trigger, I think, in the rest of the world to divert those money flows away from the US. If that happens, then the dollar could go down very, very sharply because in the short run the current account deficit is fixed, so that determines how much money has to flow back to the US. If foreign investors don't want to increase their holdings of dollar assets by that magnitude, all that can adjust in the short run is the dollar. And if that's the case, the dollar could move much lower very, very fast.
SR: Just to Bill's point, expectations right now are so low, with respect to the prospects of Japan and Europe, that all you need to trigger this dynamic is that the expectations simply get less worse, if that's a word. (Laughter) So, you don't need to have, all of a sudden, a ray of light shine on policy makers or economic performance in either region; it just has to get less dark.
DT: Steve, have you been surprised that to date we've had only about a 5 percent decline in the dollar on the trade weighted average basis?
SR: Well, you know, the dollar went down a lot; it's come back, you know, as we've moved into Iraq. It's been generally a managed landing, which in a dysfunctional world with its still US-centric, with the Chinese wild card and their…currency playing a key role in the story, you know, I think the soft landing, in retrospect, is not all that surprising. But I don't necessarily think that you can use what has happened as a good predictor of what's going to happen.
DT: Okay. We'll go to questions now. I neglected to say at the beginning that this session is on the record, so all of you are on the record as well. When I recognize you, if you would please, first, wait for the microphone to get to you, second, identify yourself, and then, third, ask the question. Have questions right here. Sir?
KT: Ko Tacha. What is your forecast for current account and the budget deficit for the end of the year and for next year?
SR: We've got a 6.25 percent current account forecasted as a sure GDP by the middle of 2004. We have a budget deficit in the current fiscal year of $350 billion and in excess of $400 billion next year.
EH: Budget deficit, $325, and probably a similar number next year. Current account, we don't have that big ... something like 5 percent GDP. It's still a pretty ugly number. The US is the only country in the world that could get away with a current account deficit like that. (Laughs)
WCD: We're more pessimistic on the budget, $425 for this year, $450 for next year. And we think the ten year is probably about $4.2 trillion, so it doesn't go away. On the current account, sort of in between Ethan and Steve, a little bit further deterioration, $550, $575. But we think that the current account is going to get worse before it gets better.
SR: Okay, $425 this year?
WCD: Yes.
SR: Based on ...
DT: How much push?
SR: What kind of tax ... ?
WCD: We're assuming that the Bush administration gets something, you know, 80 percent of what they're asking for if the dividend exclusion gets trimmed down. We think the war is going to be ... you know, the $75 billion isn't all the war cost, in our opinion. And we just think that there's going to be another big revenue shortfall this spring, the stock market down again last year, capital gains receipts, options related income receipts. So, we think there's going to be a second negative budgetary surprise in terms of the final tax settlements for 2002 taxes.
DT: Okay. Back of the room. Yes, Sir?
MZ: Hi, I'm Mort Zuckerman with US News.
DT: Oh, it's Mort.
MZ: Steve, you have been concerned about another bubble, which is the residential market bubble. Given the fact that it's produced in the last quarter of last year $320 billion in net refinancings on an annual rate, it's been a big part of the sustenance of this economy. How do you assess the residential pricing and the ability to raise money through refinancing in an environment of still fairly low interest rates going forward?
SR: Well, you know, consumers have been creative about uncovering new ways to spend. (Laughter) Sort of like scavengers, you know, they suck extra purchasing power out of one asset, throw it away, and go on to the next one. (Laughter) And, you know, we did that with Nasdaq, and now we're doing it with homes. And, you know, Greenspan laid it out pretty well, there's not a whole lot left to take out of the property asset, especially if there are signs that we're very late in the house price appreciation cycle. If house prices start to now roll over, you could say that the refinancing induced binge of consumer buying will have peaked. And that gets into the whole issue of, you know, what does it take to crack the property market. And, you know, these are long cycles, Mort, and, you know, the IMF has a piece out that deals with this in detail, it's reported in the papers today. And they just point out, as others have, that over the latter half of the 1990s into the present time, we've had about a 27 percent increase in the nationwide home price in the US, adjusted for inflation. And that's a record spurt over a protracted period of time. So where do you go from there? You know, my guess is at a minimum you peak out and on a worse case scenario, especially if you get some rising unemployment, you could go down. We all say that housing markets are local, not national, and I think that point is fair. But I think we're at the end of our rope in using that sector to support the US economy.
WCD: If I could just add one thing. Mortgage equity withdrawal is how we take a look at how much people are monetizing their homes, and in the fourth quarter of last year, 5 percent of disposable income. It's probably going to go down from there. So the thing that was providing the most support to the consumer in 2002 is going to lessen even in a best case scenario going forward.
DT: Roger.
RA: I'm Roger Altman of Evercore Partners. Does each of you forecast a rising unemployment rate in '04, and how high do you think it will get?
DT: Because we don't know how high it went up today.
EH: Does anyone have a Blackberry?
DT: The top? What did it go to?
M: 5.8 percent, the unemployment rate, and 108,000…
WCD: Our forecast was negative 100.
EH: What did he say, they were down?
WCD: Down 108?
EH: Congratulations. (Laughs)
DT: Take a bow. (Laughter)
(Overlapping Voices)
EH: I'm very incredulous about those things.
WCD: How did you do it? (Laughter)
EH: Well, I used my usual forecasting tool, a quarter. (Laughter)
DT: But not until '04.
EH: In our forecast for the unemployment rate, peaking at 6.4 percent. You know, forecasting the unemployment rate is very difficult at the moment. I know that's what economists always say about forecasting. (Laughter) But the unemployment rate just is so out of whack with everything else we know about the labor market right now. The fact that it went down today, or was flat today I guess, flat in the context of 100,000 job loss, isn't that a little ... ? I mean, it should be going up.
DT: But that guy is getting in the reserves and going to Kuwait, that's what's happening.
EH: Yes, well, that's part of it. But that's probably only worth about 40,000 in this latest number. But, you know, you have to kind of make a guess here. At some point is the unemployment rate going to start jiving with the other labor market indicators and is it going to start creeping up, consistent with the underlying growth in the economy? So we have it going to 6.4 by late in the summer.
DT: Go ahead.
WCD: We had it going to about 6.4 too, and then it sort of flattened out in a plateau, and it doesn't start to come down again until the second half of 2004. So we're sort of thinking it goes up another half a percent, and then stays there for maybe 12 months or so before it's starting to come down.
DT: Okay. Let's see, right there. Yes?
CB: Hi, Chris Burn with Fortress Investment Group. We've talked a lot about adjustment of the dollar, and since last July the dollar has adjusted a lot against the euro, but it has not against the Asian currencies, hence the trade weighted change. The Asian Central Banks are the biggest fan of the dollar, they intervene, and they're the biggest buyers of dollars out there, essentially carrying out American…policy, and delaying the adjustment in the US manufacturing. Is this a real issue in your mind? And does it have the potential of being a political issue?
SR: Yes, I think it's a big issue, Chris. And, you know, the world's a really fascinating place right now, because everyone thinks they deserve the weaker currency. (Laughter) I mean, you know, the Japanese are absolutely convinced that the yen-dollar needs to go to 1.40 or some number in excess of that. And moreover, they think that they should have the final say on the way the Chinese at the…be pegged with the dollar. And the Europeans also feel that they probably should have a weaker currency, although they're less explicit in expressing those views, as Europeans tend to be. (Laughter)
But, you know, this is a relative price, zero sum story, so all currencies can't go down. And I think at the end of the day, you know, the dollar, the currency for the world's largest current account deficit story that the world has seen, will go down.
I think economics will work. The risk is that if you get some responses that could border on competitive currency devaluation, that we then go down a pretty slippery slope that is also accompanied by heightened trade frictions. And that raises some real questions as to where we're going in this glorious experiment that we tend to call globalization. So I think, you know, you've got your finger on a hot button globally, and certainly one that we're focused on as well.
DT: Okay. Yes, Sir, right here.
MT: Maurice Tempelsman of Leon, Tempelsman & Sons. In the past Chairman Greenspan was willing to take on board the productivity/technology benefits in positioning himself in the fight against inflation. That genie is out of the bottle, the genie of increased productivity/technology. How do you see that playing out in your future forecasts? What weight do you attach to it? How does that play out in a quasi deflationary environment?
WCD: I could take that. We would not be at all as optimistic as Chairman Greenspan on productivity. First of all, if you look at how productivity has performed both through the recession and during the recovery, it's following a very normal cyclical pattern. It's high, but it's always high in the first year of an economic recovery. Number two, I'm not convinced at all that the source of this productivity is the high return projects that Chairman Greenspan alludes to. I think it's labor shedding, I think the companies are shedding workers and making the existing workers work harder. And, three, if you think about some of the long term developments that are going on, they're not really very pro productivity. Higher security costs, less of a trend towards globalization, less of a trend to trade liberalization, less of a trend to deregulation, more money going for defense spending. When I look at the factors over the medium term that affect the productivity outlook, I think they are quite a bit more negative than they were five or ten years ago. So our trend productivity number looking out in the next five years is 2 percent per year. That's not bad compared to the very poor experience we had from '73 to '95, but it's not this, you know, rosy new economy kind of story that we were talking about in the late 1990s either.
EH: I mean, I agree that some of this gain ... well, first of all, to me the productivity performance through the weak period of growth here has actually been quite remarkably good. But the other point is, I think to the extent that if we look back in history at big cycles of new technology, history says you get a big spike of innovation, and the productivity gains them come later. This is, you know, the old story about mass production and the cotton gin and all these other historical episodes. So I think there's a credible case that there are ongoing benefits from the technology investment you had in the '90s. Firms in a sense have slowed down their pace of acquisition of new technology, and that gives them a chance to actually use it correctly, and to use it for labor shedding in a sense. (Laughs) And so I think there's something a little more fundamental there. But, you know, the really rosy kind of 3 percent plus trends and stuff, I don't think even Alan Greenspan believes that. And I'd hate to let anyone read any of my papers from that period, but ... (Laughter) ... But that seems out the window. But I think a low 2 percent number makes sense.
DT: Back of the room, yes, right there, Sir.
SG: Sharif Ghalib, Energy Intelligence Group. As economists were created to make weathermen look good, I have just two questions. One is, to what extent ... I think we get nervous when economists and the IMF and the EU all become pessimistic at one time. To what extent do you think you're understating the potentially optimistic trends, lower oil price, consumer confidence that may be improved by what has happened in Iraq, business confidence coming back, the Nasdaq being stronger than most? To what extent do you feel you may be overdoing the pessimism, at least in the near term? What percentage would you attach to the pessimistic in the short term? My sense is it's being overdone.
EH: It sounds like Steve's question. (Laughter)
DT: Then if we ask Steve, he'll have the answer. (Laughter)
SR: Look, I'm tired of being pessimistic. (Laughter) I really am.
DT: For a week. (Laughter)
SR: It's depressing.
DT: You're right.
SR: And I've been a pessimist for about three years, and it hasn't been a bad place to be.
DT: No.
SR: I don't really share your depiction though of everybody is pessimistic. You know, you happen to have three people on this stage that are pretty close, but by no means is representative of what the economics profession, what the policy circles believe, and what investors are pricing securities on around the world. And, you know, I think that it's quite possible that there is this animal spirit aspect of victory and recovery just waiting in the wings, and it's intangible, and that we may be missing a part of that. We're not particularly good, at least I'm not, in being able to diagnose these rapid and dramatic swings back and forth on the expectations front. Which is why I just stay with the fundamental framework of, you know, you've got an imbalanced world that's dependent on the US, and you've got the US still facing a lot of unfinished business in purging the excesses of the '90s. And until we make more progress on either one of those fronts, the world's or our own excesses, I think it pays to stay generally cautious. And if you want to call that pessimistic, that's fine with me.
DT: Go ahead, Ethan.
EH: Well, you're asking about a short term bounce, and I think you can come up with a positive scenario. We could get Fed easing, we could get a significant tax package. The energy tax in the economy is coming down as oil prices come down. I think there is a case for some kind of cyclical bounce. I think we all agree on the stage here that we'd kind of tend to fade that move if we saw it happen in a major way. If we saw a 4 percent GDP number, we'd start to question whether that's really the new trend. But, yeah there are ... you know, the end of the war ... Let's face it, the economy didn't look all that bad in December, January. You had purchasing manager readings in the mid 50s, you had generally some sense of at least modest growth in the economy, and then we hit a wall in February. And so we can at least kind of think about moving back to the trend we were in before the war, and maybe with a little luck here these various other stimulus will give us a little pop to growth.
DT: And, Steve, a little bit unduly modest here, the consensus has moved considerably closer to Steve over the last 14 months, number one. Number two though, if you're looking for pockets of relative optimism, I was in one yesterday. One of the think tanks in Washington did something that purported to be like this, but it wasn't, it was interesting. (Laughter) With three of their senior fellows, two of whom are former, relatively senior, well in one case very senior policy makers. And they were not, there's no four percent numbers being thrown around, but there was a much more optimistic sense up on that dais, than there is up on this dais. I think it's a little bit of a Washington New York split right now, but I don't think (Inaudible)
SR: Well it depends on the think tank you went to in Washington.
DT: Yeah, well, but this was IIE. And so in that sense it was notable.
SR: I think you've got to recognize one thing: there's an automatic brake on the economy. If the economy starts to grow fast, what's going to happen to interest rates? Bond yield are going to go up. Mortgage refinancing is going to slow down. So until you get the mortgage refinancing at a level that's sort of sustainable, which is a lot lower than it is right now, you have an automatic braking mechanisms of the economy. So if you get this bounce, you're going to have a pretty big break that's going to offset that.
DT: Okay. Last question. You've been very patient, sir, but now that we're running low, if you could make it brief.
RG: Richard Gardner, Columbia University. Members of the panel have suggested that large domestic deficits may be helpful in the short run, because of the fiscal stimulus. Harmful in the longer run in the out years, because they raise long term interest rates. Should we conclude from this that we ought to consider either repealing, or modifying substantially the tax cuts that are due to kick in, say, in 2005 and beyond.
DT: Is your affiliation such that you want me to answer that question? (Laughter)
DT: Ian, I think that's for you.
DT: Okay. Yes, Dick, absolutely. (Laughter) (Applause) Okay. Thank you all very much. Thank our panelists. We'll see you next time.
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Global Economy 