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World Economic Update

Speakers: Peter R. Fisher, Senior Managing Director and Head of Fixed Income, Blackrock, Inc., Desmond Lachman, Resident Fellow, American Enterprise Institute for Public Policy Research, and Peter R. Orszag, Adjunct Senior Fellow, Council on Foreign Relations
Presiders: Sebastian Mallaby, Director, Maurice R. Greenberg Center for Economic Studies, and Paul A. Volcker, Senior Fellow for International Economic, Council on Foreign Relations
March 16, 2011, New York
Council on Foreign Relations

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SEBASTIAN MALLABY: Okay, good morning. I think we can get started. Those of you who have braved the weather obviously realize that there are a few things going on in the world economy, on which we might want to be updated. We've got a great team to do that.

I'm Sebastian Mallaby. I direct the Center for Geoeconomic Studies here at the council. Over there is Desmond Lachman, who is at the American Enterprise Institute and well-known for getting the recession right; Peter Orszag from Citigroup; and Peter Fisher from BlackRock.

So I'm sure we'll go to Japan at least -- and so forth in time, but I want to start with the U.S. outlook, maybe with Peter Fisher, and just say simply, you know, the Fed came out yesterday and said things are picking up a bit but not enough that we want to change our policy on QE2. So they feel it's just kind of in the middle. How do you feel about the short-term outlook in the U.S.?

PETER R. FISHER: Well, the Fed's finding itself in the same pickle it was in last year a few months later on, which is they sort of feel things ought to be picking up, but they can see in their forecast horizon when a massive federal fiscal stimulus starts coming out.

So they know they're going to want to shift gears and move on to normalizing rates at some point. But once that fiscal retrenchment comes into your forecast window, the question is, how much do I want to do? So you know the state governments are massively going to be retrenching. They don't have an option because way too much focus on default and not enough recognition. They're just going to cut back on spending. And it's going to be obvious and painful.

The federal government has reached its maximum political sustainable trajectory into the economy. I'm anxious to get Peter's views on that. And so those forces are waning on growth. There's not any inflation in the pipeline. World growth -- IMF said it was going to be picking up speed here. Doesn't feel like that anymore. That's what the IMF said months ago. So it looks like the risk factors in global growth are now all to slow down.

And so you've got a cyclical recovery that's pretty tepid. It's okay. You're really waiting around, looking for business fixed investment to pick up, to see if it's going to happen. And we're still waiting to see if it's going to happen.

MALLABY: Right. The January forecast the IMF put out was 4.2 percent of global growth. Do you feel that's much too high, a little too high?

FISHER: I think it's a little too high. I think everything's going to kind of lean against it. Emerging markets, when they come to that, will be tightening a little bit; not enough growth here; Europe's going to be a little too tight -- all the things we're likely to touch on, but that seems to be toppish now.

MALLABY: So, Peter Orszag, flesh out this question of the fiscal position a bit for us. I mean, is that right, to think of that as a significant drag on the outlook on, say, a six to one year -- six-month to one-year view?

PETER R. ORSZAG: Sure. Six-month to one year, you've got state and local operating deficits, which will impose, let's say, 1 percent of GDP drag on the macro outlook as state and local governments raise taxes and cut spending -- mostly the latter. And then at the federal level, the only question is how much retrenchment occurs. And you've got -- it's, I mean, a very interesting dynamic going on in Washington, with disagreement over not only the spending level, but more importantly, the policy riders that are attached to spending bills, that is causing a lot of consternation.

You saw in the newspapers yesterday and this morning that the bill that just passed the House to provide another three-week, temporary stopgap measure on spending created backlash among more than 50 Republicans, not only because there's a little bit of frustration with rolling -- you know, these rolling, temporary things, but just as importantly, they didn't like the fact that the policy riders -- that is, the restrictions on abortion and on health care funding and other things -- were not included in this temporary stopgap measure.

As you move forward to the full-year debate -- you know, roll forward three weeks -- the arguments over those riders I think are going to be more contentious than just the spending level. And it doesn't have macroeconomic consequences, except to the extent that it causes deeper cuts than would otherwise be the case in order to alleviate the concerns among House Republicans.

MALLABY: Well, let me just follow up on that, because it seems like there's a double problem here. One is that the level of stimulus coming out of public spending and tax policy is going to go down, so that's a drag. But the second, as you pointed out, is there's a huge amount of political fighting, and therefore economic uncertainty, around the numbers here, around whether you could actually get a defunding of the government if they don't agree, the next rollover in three more weeks time.

Do you think policy uncertainty -- and this is a point that Alan Greenspan made recently in a -- in an article he wrote in International Finance, a journal published by my colleague Ben Steele (sp) here. Do you -- do you think that policy uncertainty is compounding the fiscal drag?

ORSZAG: Well, I think it's worth kind of separating different components of the policy uncertainty, and sort of go back five or six months. There were two components of the policy uncertainty. One was the perception that the administration was antibusiness, and going to go do some crazy things; and the second, I think, was the medium- and long-term fiscal imbalance.

On the first one, I think the administration has done a good job in tempering that down, in sort of lowering the temperature level on the administration's outlook, both through the Daley appointment and through the tax deal, and even through things that may not ultimately bear that much fruit, like the regulatory review. But optically, they have done a very good job in kind of dialing down, again, the temperature on that component.

Now, on the fiscal front, that's still there, clearly. The administration did not really include any out-year serious proposals in the budget, in part -- you know, they will argue they have to let the congressional drama play out and then they can step in if it looks auspicious. But that's still there.

MALLABY: Desmond, do you see other headwinds? We've talked about the public sector. What about in the private sector? In real estate or somewhere else, do you see other problems that --

DESMOND LACHMAN: Yeah, absolutely. You know, the way in which I see it is that the fiscal stimulus has been supporting GDP growth. What we're going to see is we're going to see that fading as the year goes on. It turns into a drag as you go into 2012. Peter Fisher mentioned there you've got the issue of states and local governments are going to be cutting back drastically, so you've got to ask yourself what is really going to upset that.

What I'm seeing is the housing market has still not adjusted, you know, that it's very clear that a huge amount of inventories overhang this market, that what we're going to be getting is we're still going to be getting foreclosed properties coming onto a glutted market. So you're getting now estimates that you could be seeing house prices falling perhaps by another 10 (percent), 15 percent before all of this is over. And that's going to have an impact on the consumer.

I'm also concerned, you know, that since the beginning of the year, since the IMF has been making a forecast, instead of oil being at 75 (dollars), $80 a barrel, we're seeing oil at $100 a barrel. We don't really know where it's going, but presumably we're going to see a risk premium staying in. So oil is yet another drag.

And the final thing I'd say is you've got problems from a global economy, in my view, is extremely troubled, you know, particularly when you look at a place like Europe, you know, that we're just going to get a series of crises. And what that can do is that -- and, you know, we're seeing that right now with events like in Japan -- what that does is, it changes people's attitude towards risk; it changes the way in which the equity market is being priced.

And the equity market has been really what has been the way in which quantitative easing has been working fueling the recovery. So, you know, when I put it all together, to me this looks very much like 2010, where a great degree of optimism at the beginning of the year -- you know, when the economy's on steroids. And when you take it off the steroids, it's -- what you're going to see, I think, is you're going to see perhaps not moving into recession, but certainly you're going to see an abrupt slowing in U.S. growth, you know, as you go towards the end of 2011.

MALLABY: Do you want (to comment ?)?

FISHER: If I could just add one point on -- exactly on the house price point and how important that is. We know most Americans have most of their wealth in their house. And I'm not clever enough to know what house prices are going to do for the next two to three years.

But the fiscal logic of federal, state, local means property taxes are going up for the next 10 years. That's one component of how we work our way out of this. And to my simple forecast, that means house prices aren't going up for another 10 years. Whether they keep going down or not or whether they go down 5 (percent) or 10 (percent) or 15 (percent) and -- just that kind of pressure of property prices going up, you know, that means a savings rate, to my guess -- it's not a forecast; it's a guess -- stays in a 6 (percent) to 10 percent window.

And it's going to be really hard to get consumption. Consumption can chug along at 2 percent. You know, we'll get a little 2 percent growth in average hourly earnings and a 2 percent growth in consumption. But I just -- I think the rate of dissaving is just going to keep that overall savings rate up there, making it hard for consumption to be the traditional engine of growth we've had here. I don't know if either of these guys agree or disagree with that.

ORSZAG: Well, look, I think -- I think it is -- I'm not sure that I completely buy into the property tax offsetting, I mean, being the only driver of holding down housing prices as opposed to a variety of other factors, but I agree with the conclusion, both on the centrality of the housing price as a driver of household behavior and on the possibility that we are in for an extended period of time in which we don't experience significant house price increases, which, by the way, is consistent with experiences following other financial sector-driven downturns. So I would agree with that.

I also just want to point out, I mean, even if we do achieve, I am sympathetic to the perspective that we are sort of back where we were early, you know, this time last year. Prospects look rosier but we can get -- it's still the -- it's still the startup phase of the recovery, and we can get knocked off course pretty easily, whether it's from something -- you know, last year it was Greece and a few other things; this year it might turn out to be Japan and the oil price. But the broader point is, we can get knocked off course.

And what I would say is, even if we achieve 3 1/2 percent growth, don't forget that that still implies, based on historical relationships, the unemployment rate only comes down by about a half a percent, over the year, and that's if we grow at 3 1/2 (percent). And obviously, if it's lower, then unemployment rate comes down even less. So you're looking at something like 8 1/2 percent unemployment at the end of this year when we've already got 6 million people who have been unemployed for more than six months. And I think a big concern is folks losing their attachment to the workforce and just giving up and having their work skills atrophy, which we're starting to see in a variety of different metrics, including a dramatic increase in disability insurance applications.

LACHMAN: And that becomes a long-term headwind for growth.

ORSZAG: That becomes a -- look, this is what happened to continental Europe during the 1980s. You had a temporary downturn, and the -- depending on whether people actually leave the labor force or not, either the -- I guess the way to put it is, the employment-to-population ratio remains low for a significant period of time. And that is a -- that is a headwind on medium-term productivity.

LACHMAN: But I would just add that if we do have the kind of gaps in the labor and output market that Peter Orszag is suggesting and that I think that one really almost certainly has, what that means is you get downward pressure on wage growth; you know, that takes really what's been characterizing the U.S. recovery.

So it's very difficult to see, if you don't have wage growth, you don't have employment growth, how a consumer that is overleveraged is somehow going to be leading this recovery, particularly if you've got house prices falling and equity prices not doing too much. So you know, it's difficult to see how you really get growth coming out.

And I guess what frightens me most about the U.S. outlook is that if we do get a downturn, we've really run out of ammunition; you know, that we've now got concerns with, you know, the political forces that will prevent another stimulus occurring.

But I think beside that, one's really got issues of long-run fiscal sustainability that limits, you know, what you can do. What we did in March 2009; what we've done right now with, you know, another 180 billion (dollar) stimulus -- you know, you're not going to be able to do that again.

So you know, hopefully I'm wrong, that you don't have the downturn. But if you do have the downturn, I think that from a policy point of view one's going to be incredibly constrained.

MALLABY: Well, that raises a big question, because -- and we're going to go back to the Fed, where we started -- maybe ask this to Peter Fisher, since he worked there, which is to say, you know, have we really run out of ammunition? What is the limit to QE2, QE3, QE4? I mean, if you're not going to get inflation because you have excess capacity, can't you just carry on printing money and monetize your stimulus?

FISHER: Well, if you don't create inflation, if you're not worried about creating inflation for whatever set of forces, demographic, or put yourself in Japan in 2001 or whatever, you can print a lot of money. You may not get above-trend growth out of it. (Chuckles.) You may just collapse the velocity of money, and the savings rate goes up, and you are in the liquidity trap that Japan's in.

So you can print the money and you can avoid some bad outcomes. So you can help grease the skids of the -- dealing with the terrible calamity in Japan, if you have a Bank of Japan, you have that option. That doesn't mean you're going to get 4 percent growth out of it, although then maybe for a quarter of reconstruction data coming through, right, which is just going to be lumpy.

So yes, that -- I think there is a high hurdle on the Fed doing QE3. It would be a severe negative shock. We've alluded to a few we can imagine. I think it would -- it would be a 2012 event.

MALLABY: You mean the QE3 would be the shock, or --

FISHER: No, no, they would have had to be in response to some severe shock.

MALLABY: Yeah.

FISHER: So it could happen. I think it's a -- it's a high hurdle, but I don't think it's off the table that the Fed would feel okay if there's a -- if oil goes to 150 (dollars) and stays there for six or eight months, and consumption collapses to zero, yeah, I can -- I can imagine them doing QE3, a higher hurdle. But I don't think that gets us back to, you know, 4 or 5 percent growth. It's padding the runway. It's not helping with the liftoff.

ORSZAG: Right. I mean, look, if we were to experience another -- some other shock that caused -- and maybe the way to phrase it is caused the unemployment rate, instead of slowly ticking down, to actually increase back -- you know, back another direction -- the right policy would be an additional round of fiscal stimulus. That is a much more direct punch to inadequate aggregate demand than anything at this point the Fed can do. But I think it's correct to note that that probably won't happen in any -- to any significant degree. So I think at this point we should just hope that this doesn't happen, because that's a bad situation to find ourselves in.

MALLABY: But if for political reasons, you do not get that direct punch from fiscal policy, if you are running a central bank, you do nothing, or you do more -- you do more --

ORSZAG: Yeah, I think -- look, the unemployment rate goes back up to 9 1/2 percent, I think the Fed acts, just like they did with QE2. The problem is that, you know, the three channels that you get through possible measures like that, you'll have an interest rate channel, a confidence channel and an exchange rate channel -- I mean an interest rate channel, an equity channel and a -- and an exchange rate channel. They're all pretty modest in the current environment. So you know, the Fed would act in that kind of scenario, but you don't get -- I'm agreeing with Peter Fisher here -- you don't get that much kick from it, as opposed to, you know, a couple percent of GDP in direct fiscal stimulus, which if -- especially if coupled -- the right policy in that kind of setting is what the right policy was six months ago, which is more short-term fiscal stimulus coupled with significant out-year fiscal consolidation, enacted now, to take effect in two or three or four years.

LACHMAN: Well, I couldn't agree with that last point more, you know, that I think that that is vital because I think otherwise the Fed has really very difficult policy choices. The United States finances a lot of its budget deficit from abroad. Just engaging in QE3 without any notion as to what you're doing on your fiscal side runs the risk of allowing foreigners to entertain the notion that this might just be one enormous Ponzi scheme, you know, in which the United States is monetizing its debt. They look to the race on inflation. And then what happens is you get the long-term interest rates behaving in a way that is not the way in which quantitative easing is supposed to work wanting -- if you're wanting the long-term interest rates to come down. But if you spook markets that you're off to the races, you're going to be monetizing this debt, going down an inflationary path, that is no good.

So that is the reason that I think that, you know, you really want to do the ideal policy is, you know, to maintain fiscal stimulus on a short-term basis, but to make serious commitments as to what your medium-term path is to reduce the debt. We shouldn't lose sight of the fact that we're running a deficit of a mere $1.6 trillion. It only goes out for as far as the eye can see. The debt is on a very dangerous path. One's really got to be doing something that shows that you're really addressing those problems seriously.

MALLABY: I mean, maybe there's a segue to Japan, right, where, you know, in contrast to the San Francisco earthquake at the beginning of the 20th century where there was a gold standard, and therefore a limited supply of money, when there were insurance claims in San Francisco, the gold moved to San Francisco to pay those claims, to pay for reconstruction, and drain money and liquidity out of New York, and then you had the 1907 stock market meltdown. Now, the Bank of Japan is responding by saying it will print money. Now, in that circumstance, is that right?

FISHER: Yeah, the central banker's toolkit, whatever the chapter of the horrible event that happens to the economy, an adverse shock, the short-run answer is print money. As we just said, that's not the long-run answer to stimulate growth. But you are trying to avoid the spiraling contraction of business confidence and consumer confidence, and you're trying to avoid that contraction in money.

I mean all of the advanced economies are now playing a game; it's, can you reduce your debt-to-income? You've got other games you're playing, too. You're trying to keep up GDP. There are a few other things you're trying to do. And if you destroy too much money, if the velocity of money collapses and that's how you -- because you've collapsed too much debt, collapsed too much confidence, that's not a really good way to get to a better equilibrium in your debt-to-income ratio. That just gets you to a worse place.

So you don't want to collapse it too fast. You don't want to collapse it too slow. And they don't want to see another adverse shock here lead to a further decline in the velocity of money and a decline in household and business confidence. So, yes, that's the toolkit.

Now, that doesn't really rebuild your economy. Japan becomes a less wealthy society than it was because they got to use up some savings to rebuild. You get -- measured GDP goes up. But so, yes, it's the right response for the central bank, who is already worried about the economy being too fragile, but it doesn't really give you a kick. It's not -- it's not the answer to getting above trend growth.

MALLABY: Well, it seems to me as if the Japanese government can say, you know, there's no inflation in sight, we need a few hundred billion dollars to rebuild, and we will print the money to do that. And if it then creates inflation, where is the -- where is the -- where is the policy mistake or the policy risk? Or why is that a bad idea?

MR. : Go ahead.

LACHMAN: Yeah. I don't know that I disagree, you know, with the Bank of Japan pumping in a huge amount of liquidity right now to restore confidence. But I think that the Japanese really have to look at their problems from a longer-run point of view.

If the United States public finances is compromised, I'm not sure what the right adjective is for the Japanese. They're running a public debt-to-GDP ratio that is around about 180 percent, you know, something -- a multiple of what it is in the United States, running a very large budget deficit. They've been able to do that because they've been able to finance that domestically. The problem is, if you look ahead, Japan's demographics are appalling; that what's occurring is you're getting a very rapid increase in that part of the population that is aging, very few people who are young.

So what occurs is, if you look forward the next two or three years, the trend that we've seen in Japan for their savings rate to collapse is -- actually then continues. So, you know, you've really got a public finance problem that has to be addressed. And this earthquake isn't helping this, you know, by increasing the amount of money that you've got to pump in.

So, you know, I think that there are short-term responses that the Japanese can and should do, but they've really got to be mindful about the extremely dangerous path on what -- which their debt is and on which their saving rate is going forth. You know, and I'm not sure how they're going to be tackling that problem.

MALLABY: I noticed that, you know, you're extremely pessimistic about the U.S., more pessimistic about Japan. But earlier, when you mentioned foreign headwinds, you put Europe first. So let's clarify your -- (laughter) --

LACHMAN: (I'm a pessimistic guy ?). (Laughter.)

MALLABY: Can you cheer us up by talking about Europe? (Laughter.)

LACHMAN: I was trying to keep it optimistic. (Laughter.)

No, Europe is really -- once again, I'm at a loss to find the right adjective as to how bad Europe is, because basically -- you know, it's -- I mean, this is not -- it's not -- actually, a lot of this is priced into the market, you know, that if you see where interest rate spreads are on countries like Greece, Portugal, Ireland, what markets are doing is they're pricing in a very high probability that those countries are going to default, notwithstanding the $140 billion that has been thrown at Greece, or the $110 billion that has been thrown in Ireland. It's basically, you know, what -- the story in Europe is not very complicated. It's a question of countries that are in a fixed exchange rate system -- as fixed an exchange rate system can be, you know, that they don't have their own currencies. What they've managed to do is to run extremely high fiscal imbalances, as well as external imbalances.

So, you know, if you take just, for instance, a country like Greece, you know, managed to run up -- in a fixed exchange rate system, it's got a budget deficit at 15 percent of GDP in 2009, when the target is 3 (percent). The issue in a fixed exchange rate system is that there's no way that you can reduce that budget deficit the way in which the IMF and the EU are asking them to do, bring it down to 3 percent of GDP, without a currency devaluation. What that's going to do and what you're seeing is occurring is that the Greek economy is literally imploding; that the last four quarters, GDP in Greece has contracted by 6-1/2 percent, their revenue collections have collapsed. So this is something that really can't work.

You know, my view is that it's really only a matter of time. What's occurring is that Germany and France, you know, together with the ECB, are propping these countries up because they understand that it's not just a question of a crisis in the periphery, it's a crisis in the European banking system, because the European banks -- you know, if I just look at the four peripheral countries -- Spain, Portugal, Ireland and Greece -- they owe a mere $2 trillion in sovereign debts, you know, to the European financial system. So this is -- you're just trying to hold up something that is intrinsically flawed. And what you're doing is you're asking these countries to tighten their budgets and to follow policies that is really growth destroying.

So what you're going to get is you're going to get the political pressures. You know, we just saw that in Ireland. The government gets thrown out. We're going to be seeing it in Greece -- you know, that there's a whole grassroots movement not to pay taxes. You know, give this time. These countries will be forced to leave the euro; they'll be forced to default on their debt. And, you know, when that occurs, it's not going to be pretty.

I've got no doubts. You know, I don't think that this is a question of if this happens; you know, I think that what's fair to debate is when it happens. You know, you can keep this afloat, you know, through public money for a long while, but you can't fix this.

MALLABY: I was at an event yesterday with John Paulson, the hedge fund manager, who mentioned Portugal, Spain, Greece, Ireland and France. He put France on the list, too. That just really cheered me up. (Laughter.)

No, I want to go to the members in a second. Just one last question -- maybe, Peter Orszag. But it seems like, you know, if you've got unrepayable debt in Europe, you can do one of two things. You can either default and restructure the debt, or you can have a bailout. And what's happening instead in Europe is a sort of muddling through in the middle, where the Germans give you some money, but they say it's not really a bailout and they say you might have to default later.

So the market interest rates remain very elevated because of default risk not being taken off the table. And therefore, the sort of reluctant bailouts are self-canceling. I mean, they cannot work because there's no promise that they will be full-throated bailouts. Therefore, it will just raise the final cost of clearing the mess up. Is that right?

ORSZAG: I think the "muddling through" characterization is right. Look, in addition to the explicit restructuring, there is also the possibility that has been floated but not embodied in the most recent agreement to purchase debt on secondary markets at a -- basically at a discount, which you can think of as a form of restructuring. And I think you're seeing a lot of ongoing tension over that route because the people who don't want to do an official restructuring see it as a kind of third-way, softer version of what needs to happen.

But we're -- look, the general theme here is, if you look across the U.S., Japan and Europe, all three are stuck in an environment in which they have out-year fiscal problems that are extraordinarily difficult to tackle. And muddling through until they're hit with more severe consequences is the common theme across the entire developed-economy world basically.

MALLABY: Let's ask members to come and ask some questions. I should have said at the beginning, this is on the record. (Laughter.)

MR. : It's better he told us afterwards.

MALLABY: I told you, didn't I?

Who -- I can see a question there.

QUESTIONER: Thank you. I know it's a fluid situation, but with the nuclear risk in Japan, could you talk about potentially what that could mean economically? And do you have a sense of overall how much of Japan's GDP might be trimmed as a result of the impact of the earthquake?

MALLABY: (Off mic.)

FISHER: Well, I -- we know measured GDP goes up when you do reconstruction, but we know the supply-disruption effect is down. And so I'm very dubious anyone has a good point estimate right now. So I think that -- I don't really know how to even walk my way through that if there really were some profound fallout issue, radiation issue, to the world's still tied-for-second economy, what that would do to world GDP. It's got to be a big, huge hit to global consumer confidence and business confidence if you had a serious radiation problem that looked like it was enduring.

So the Tokyo stock market rebounds, you know, on day three, if you will. That wasn't a really big rebound for my taste. So I think -- I don't know how to say something more precise about Japanese GDP, and I'm skeptical that anyone can.

I would add, I'm rather anxious when I see how little the dollar has moved. So here you have North Africa -- revolutions across North Africa, the world's tied-for-second economy has taken a body blow, and the dollar kind of goes sideways.

MALLABY: Did you expect more of a --

FISHER: I would have expected a little more. So the rally we got in Treasurys looks to me to be a short-covering rally for all people who were short duration. And the dollar -- and it means to me the world capital markets are still a little bit on hold; they're still saying, gee, I don't know what this means. So it is a short covering in Treasurys, if Japanese equities (come off ?), those are all knee-jerk reactions. And I don't think we've seen the reaction yet in capital markets that's more profound.

So I'm just telling you I don't know.

ORSZAG: So, I guess, three comments. First, the direct -- I mean, I think -- I do agree with Peter Fisher that the important channel here is a confidence and secondary effect. The direct effect so far -- if we look, for example, at the prefectures where the tsunami hit -- and I don't want to discount the pain and suffering involved -- they amount to 6 (percent) to 7 percent of Japanese GDP. And you can work through then, you know, in terms of a direct effect, the mechanics of the initial disruption and then the rebuilding that Peter suggested. The experience in other kinds of natural disasters suggests roughly a wash with a different time period. In other words, an initial decline from the disruptions and then above-trend activity as the rebuilding occurs.

But that's sort of the narrow, conventional analysis. The more important thing, I think, involves confidence channels and, if there is a significant radiation effect, how that plays out, including in unexpected ways. And you know, basically, the supply chains now are so integrated that you'll see all sorts of unexpected effects coming from that.

The final -- the third category, the final category is the effect on the future of the nuclear industry. And frankly I think, you know, if you look -- there was an excellent article -- just to do a little CFR advertising, excellent article by John Deutch in, I think, the most recent issue of Foreign Affairs, on shale gas and its implications for the U.S. energy sector. This just reinforces the point that unconventional natural gas is a huge force in -- especially in the electricity sector, in the United States, and that basically without a carbon price and with that huge increase in unconventional natural gas, the future of the nuclear industry in the U.S. looks dicey, and this, I think, just kind of further reinforces that point.

MALLABY: That's also -- I mean, you know, the Germans have closed down seven reactors.

ORSZAG: Right.

MALLABY: And I think I read that something like 90 out of 400 nuclear reactors in the world are in areas with significant seismic activity. So if you had the closure of one-fifth or something in response, I mean, that's a pretty good -- that's a vector for transmitting disruption.

ORSZAG: With some upward pressure on electricity prices, but you know, you have to get more granular, depending on the area and the grid and different generation --

MALLABY: There's a question in the back, over there.

QUESTIONER: I wonder if we could talk about China for a second.

MALLABY: Could you just say -- identify --

QUESTIONER: Yeah. I'm sorry. Chris Brody, Vantage Partners. I wonder if we could talk about China for a second. There was a statement in the press, I guess a couple days ago, by the Fitch rating agency saying that China was going to have a banking crisis by 2013. I wonder if you talk in general about China and patch it into your comments about the rest of the world.

MALLABY: Do you want it, Desmond, or --

LACHMAN: Well, I think, you know, China is another reason why one would really have to downgrade one's global forecast. You know, basically what's occurring right now -- China has got problems both in terms of price inflation as well as in asset price inflation; you know, that they realize that the stimulus that they provided to the economy was perhaps excessive -- you know, was a huge fiscal stimulus, enormous easing of monetary conditions; credit just went through the roof, you know -- and that that's the probably the cause for Fitch agency's concern about a banking crisis.

So I think that what China is trying to do is, they're trying to slow the economy. Hopefully they can do it in a way that would be a soft landing, you know, so rather than growing at 9, 10 percent, they grow at 7, 8 percent; you know, that that is -- they've done that before. You know, there's reason to hope that they can do it again.

I would just say that, you know, the notion of a banking crisis in China -- you know, I'm sure that the banks have made horrendous loans and all the rest, but I would be careful not to equate a banking crisis in a country like China, where the banks are state-owned, where there's a lot more ability for the state to go in, go fix the problem up, than it is in the United States. So you know, I think that even if they do have a bank crisis, the banks need to be recapitalized, I would think that China is a lot more amenable to a smooth resolution process than the United States.

So I have noted myself for not being overly optimistic about the rest of the global economy, but China isn't a place that really worries me.

MALLABY: If I can -- sure --

FISHER: Maybe we have a little disagreement up here. I mean, I think that they've got the same dilemma that we have, even if the government has more levers or hands into the banking system. They've had massive investment growth. All those investment assets are not going to pay off at the rate they were presumed to pay off.

The high savings rate in China is not really a function of a high personal savings rate. It's still the problem of the high corporate savings rate from the state-owned sector. There's no way to recycle that money efficiently. It just goes plowed back into more and more investment, some of which may be of dubious quality. And at some point that comes home to roost, especially if the leadership has re-engineer a slowdown.

So the transition from really powerful investment-led growth and asset boom and export boom to a better balanced economy, you -- can you really calibrate that as, you know, closely as -- I mean, Chinese leadership is very wise, but having the premier stand up and say he wants to have growth slow down from 7.5 percent to 7 percent -- you know, think what would happen if President Obama tried to, you know, pretend to all of us he could calibrate growth in 50 basis point increments.

So I think that it's a bit of delicate surgery that they're going to do just at the moment they're having a leadership transition. So the next leadership of China, just as any political leadership is going to have, is going to have an incentive to get the bad news over with promptly and be able to blame it on their predecessors, and that's coming into focus in exactly this window.

Now, I actually think that it is -- I want to agree with Desmond -- to say it's the banking crisis and think that translates into our way of thinking. I don't think it'll be quite like that. They will probably engineer a soft landing to their political taste but in the capital markets and the equity market in China it'll feel like a hard landing. They think nothing of whipping around their equity market and having it go up and down, you know, on sort of bad news getting pumped out into the market and the authorities throwing the levers they have at their disposal.

So I think we've got to be very careful not to take the vocabulary we've developed for ourselves -- banking crisis, hard landing, soft landing -- and assume that translates into the Chinese equation, even though the underlying economics are really just like ours. The problems are there and they're going to be dealt with one way or another.

MALLABY: Ken Rogoff has a story about becoming chief economist at the IMF and noticing that his team has moved the (forecast ?) of China from 8.4 to 9.7. You say well, why did he do that, and the answer was because the government did. (Laughter.) And we always -- we know one thing about Chinese statistics. They come out how the government says they're going to come out.

Another question. Wait for the mic, please, then --

QUESTIONER: Arthur Rubin, ING. The Journal reported the other day an observer noting that he was somewhat more optimistic about the possibility of a grand bargain in the U.S. in which taxes would be raised a little, there will be some meaningful trimming of benefit programs, Social Security, et cetera, et cetera, but that just meant going from 0.1 percent to 10 percent that it would happen.

What do you think is the possibility of some rational restructuring of the U.S. economy to deal with the long-term fiscal problem we face?

ORSZAG: I think that commentator was Bob Reischauer, and I sent him an e-mail saying for the first time that I can remember and perhaps the first time in history, he's now more optimistic than I am.

Look, I think the difficulty is -- there's some possibility -- the difficulty is that you really need to parse what it is. There is a higher probability of something that's more process oriented where you agree on some targets and mechanisms and things like that, and then the question becomes, how is that enforced? What -- how much teeth does it really have?

So the prospect for something that is process driven or process oriented, probably decent. Directly doesn't do anything and it may not have that much teeth. The prospects for actual legislation -- so that is, actually doing the out year fiscal consolidation -- much harder, and let's break that down a little bit.

The difficulty on revenue is there just is not a lot of support for a revenue increase even though for the medium-term fiscal problem -- the 2015 to 2020 problem -- I don't see how you get around it. So it's just very awkward for policy makers to vote for a revenue increase when the 10-year bond's below 4 percent. I mean, it just is an extraordinarily awkward thing. The one thing that may have a little bit more momentum behind it is Social Security.

So I could attach some weight -- not huge probability but some weight to a Social Security deal and interestingly, in addition to the comment that you read there was also a -- an article in one of the -- I think The Hill -- in one of the D.C. newspapers suggesting that the administration's economics team, Geithner and James Sperling in particular, were pushing Social Security reform and the political advisors were suggesting that was not a wise thing to do at this point.

But the fact that there's -- if that reporting is right, that there's even a very active debate internally, suggests that that's more auspicious than the alternatives. And I could imagine a plan coming together that involves changing the way that we measure inflation in the Social Security program to a more accurate index the Bureau of Labor Statistics, say, uses.

The one revenue piece that polls very well -- it's always, like, at the top of the political viability list in terms of revenue increases -- is some modest increase in the taxable earnings base under Social Security -- that you'd raise the earnings threshold a bit. And so you can -- and then a few other components -- you can start to cobble together a Social Security reform plan which would help to boost confidence that in this polarized political environment, we can still get something done. On the other hand, it would basically do almost nothing to reduce the 2015 to 2020 deficit problem.

MALLABY: One of the frequent elements in the commentary is that people are discussing stuff in Congress but the White House and the administration are silent. I mean, is there sort of method to that apparent madness or -- I mean, it --

ORSZAG: Is that for me?

MALLABY: Yes. (Laughter.)

ORSZAG: He shifts uncomfortably.

Look, I think there are -- there are other examples in which allowing the Congress to lead a bit produced success. So I would point to the Cadillac tax -- the tax on high-cost insurance plans that was included in the health reform act that I think most people thought would never actually happen, and it's plausible to me that if the administration had gotten out there too soon on that it would not have happened. So it sort of got parallel parked into doing that.

The same thing on the fiscal commission itself, which came from a -- you know, from Conrad, Senator Conrad and Warner and others really pushing it. That led to the fiscal commission. So you could -- you could imagine this also occurring -- that the Conrad-Warner group, especially around the debt limit, demands something serious on out-year fiscal consolidation and if that's true, if that's right, it's not a crazy legislative strategy not to go out first with your own proposal but to kind of let that play out a little bit and then embrace it as it does.

I think the question becomes, the timing is now so constrained in terms of how quickly things need to happen that to have Superman jump on the stage, you know, 30 seconds before the bomb goes off might not be enough time. So I think the concern is even if that is the strategy -- and I guess there are questions about whether it is -- but if that is the strategy, you're getting to -- close to the period in which, you know, an appearance is necessary.

FISHER: Peter may not, as the former OMB director, may not like the way I'm going to say this but the biggest charade in Washington is that the executive branch is in charge of fiscal policy. Our Constitution is very clear. Congress is in charge of fiscal policy.

They set the tax rate, how much revenues get collected. They say how much gets spent and they set the debt ceiling. They've got three levers -- they only need two but they have given themselves three -- and the charade is that Congress sits around and says, what are you dong to do about it, executive? And then whenever the executive says something they say, I don't like that. And we really won't get a political fix to our fiscal follies until someone in Congress steps up and reads the U.S. Constitution and recognizes that they're in charge of this subject and it's their responsibility. The administration can help them but it -- it's up to Congress.

ORSZAG: Well -- (laughter).

FISHER: And there are constitutional provisions in states where -- constitutional and statutory provisions where the executive really has more levers -- the line-item veto, the impoundment powers that existed in the U.S. before the 70s. You can get to a structure where the executive has power but this executive branch doesn't have those powers.

LACHMAN: As people can tell from my accent, I grew up in Arkansas. I know this country very well. (Laughter.)

But it would strike me that history is not entirely on your side on this -- that --

FISHER: It's completely on my side.

LACHMAN: In the -- in the sense that the 1983 Social Security fix involved big involvement from the White House. The 1993 tax --

FISHER: You get it done -- you get it done but it's not a parliamentary system. In your country you get a government and you have a fiscal policy or you'll get a new government, and that's very tidy.

LACHMAN: OK. (Laughs.)

FISHER: In ours it doesn't work that way.

MALLABY: Over here.

QUESTIONER: Todd Johnson --

MALLABY: The mic's coming. Yeah.

QUESTIONER: Todd Johnson from Ferrari Consultancy. Wondering if you could comment a bit about the reaction or what we could expect over the next 12 months from emerging markets -- (inaudible) -- finance ministries thinking, Brazilian, South Africans, et cetera, and their concern ever increasing about hot money inflows and what that may result in terms of capital controls, et cetera, over the next 12, 18 months or so. Thank you.

MALLABY: Desmond -- (inaudible)?

LACHMAN: Yeah. I think that that question really depends very much on what is your view of the global outlook. You know, if you think that the global outlook is going to be a benign outlook -- you know, everything humming along like it has been right now -- emerging markets have got a huge problem in that what they've got is they've got high interest rates, the capital's coming in, it's pushing up their exchange rates -- they're really not quite sure what to do with it. The exchange rates have appreciated to levels where they see them as being damaging from a long-run point of view because they realize that this is likely to be -- (inaudible).

So, you know, there's the whole discussion about capital controls. If, on the other hand, you subscribe to my view -- you know, that the United States economy is going to slow, that the crisis in Europe is going to only increase, that we might have problems in the Middle East that might be another blow to the global economy -- then what you're going to have is you're going to have a return to risk aversion. And that's going to be the last thing on these countries' minds, that we go back into a world like 2008, 2009, where as risk aversion in the developed countries' capital markets increases. the money rarely gets withdrawn so that the Brazilian real, instead of being at 160, you know, goes back to 240 or whatever. You know, you really get the exact opposite side.

So the full answer is, I think, that this problem with capital controls is a real problem right now but I think that if the global outlook changes it's going to be -- you know, they're going to have a different set of problems to deal with.

MALLABY: But doesn't depressing global outlook in the rich world drive more capital into the search for better returns in the emerging world and exacerbate the --

LACHMAN: That wasn't the experience in 2008, 2009, is that -- you know, if you get my kind of scenario, that you're going to have financial firms having additional losses -- what the tendency is as you begin to repatriate the stuff from abroad, you begin to take risk off. And then what this is is, in the same way as you were in a virtuous cycle on the way up, you begin to be in a vicious cycle on the way down. You know, because basically what you're doing is you're putting money into countries in order to get -- right now what you're doing is you're getting high interest rates and the prospect that those currencies keep appreciating. As soon as those currencies begin to depreciate, you know, your calculus is different. You're not going to be wanting to hold a currency that depreciates, and as soon as everybody begins putting it out the depreciation really gains a momentum of its own.

MALLABY: And -- (name inaudible) -- in the front over here.

QUESTIONER: Charles -- (off mic) --

MR. : Upside down.

QUESTIONER: Sorry. I'd like to go back to something Peter King said earlier. In 19 --

MALLABY: Peter Fisher.

QUESTIONER: -- in 1995 or so personal consumption was about 66 percent of GDP. By '72 -- I'm sorry, by 2007 it was 72 percent of GDP. It was the -- it was the -- it was the highest of -- in the entire world in 1995. It was much, much higher and everybody said we've got to get back to the point where savings -- personal savings will be 6 to 10 percent of GDP as it always was, and that will fuel, you know, savings and investment and so forth.

But we sort of seemed to hope it would take, you know, 20 years for that to actually happen. And now it seems to me that we're just trying to get back to where we keep personal consumption at 70, 71 percent, where it is now, but rather than fund it by, you know, other countries by buying bonds the -- just the Fed buys them. Now, shouldn't we try to make -- shouldn't we try to get to a path towards something like what you said rather than constantly trying to push us -- push ourselves back to where we were in 2006 and 2007?

MALLABY: Lord, make us virtuous but not yet.

FISHER: Yeah. I guess -- I think my comment was really aimed at pointing out that I think we are on that adjustment path -- that consumption will come down as a share of GDP. I think household savings is going to stay in this neighborhood and that will be a good thing for global rebalancing.

But therefore, consumption will not be the force that gets us above trend growth. So I was doing sort of a bit of algebra on the components of GDP in saying, gee, I think we're going to get savings in 6 to 10 (percent) neighborhood for a few years here. I think that's a good thing too but I'm not making a normative comment on it. But therefore, I don't see how consumption is likely to be the driver of above-trend growth, with a world outlook not very different from Desmond's. I don't think exports are going to be the driver of above-trend growth. They may give us a little kick.

Government spending isn't going to be the driver of above-trend growth because it's hit its maximum velocity and slows down from here. Therefore, I -- (inaudible) -- the postulates, it's been the (sixth ?) investment, and maybe it will and maybe it won't. So I don't know -- I mean, so I'm agreeing with you, but therefore, where does the above-trend growth come from?

LACHMAN: But, you know, I think the question you raised is really a very important question, you know, in the sense that the world right now is characterized by a number of countries that have got themselves in deep problems in terms of deficits.

I'm not just thinking of the United States but I'm thinking of Japan. I'm thinking of Italy. I'm thinking of Spain. I'm thinking of the United Kingdom. And this poses a real problem for the global economy because if those deficit or saving-deficient economies try to increase their saving from a global point of view, what has to happen is the surplus countries -- the Germanies and the Chinas of the world -- have to reduce their savings in one way or another, you know, and I think that that is really a major challenge for the global economy is that the Germans are wont to lecture the United States in terms of United States has to be more responsible on the budget side and increase saving and all the rest, but they show no inclination to move in the other way, nor do the Chinese.

So, you know, you've really got a problem in terms of these kind of -- all I'm saying is that I don't think that the United States can solve this sort of problem by itself. What you need to do is you need to have global coordination of policies, and my observation -- but I'm looking at it from the outside -- every time I look at a G-20 meeting or the like, you know, you just find that there's no risk activity on the side of the surplus countries to really make this adjustment possible.

MALLABY: One last question, maybe over there in the back.

QUESTIONER: (Off mic) -- go back to Peter Fisher's question, which you raised rhetorically, about above-trend growth. I mean, apart from doodads, where does it come from? And some people would say clean energy spending. But without a price of carbon we don't see the investment flow. So what is the prospect for above-trend growth -- what sectors?

MALLABY: Two minutes.

FISHER: (Laughter.) I don't -- I don't know. I'm nervous that businesses with a lot of cash on their balance sheets will be happy to invest but not in the United States. So they may invest here. Median wages haven't been growing very rapidly here. That's bad news if you try to get elected to Congress. It's good news if you're trying to improve the competitiveness of the U.S. economy. So maybe there will be factories built here and investment made here but I'm nervous it'll be outside the U.S. And I don't -- I don't have a sector-by-sector forecast, I'm afraid. I'm a bond guy. (Laughter.)

ORSZAG: I guess I would just quickly say that look, there are still auspicious signs too. It is still the case that even with a slowing of world economic output that exports are growing rapidly, and even if we experience some further slowdown it will continue to grow rapidly. Investment in equipment and software, so that the shorter end of the -- the stuff that depreciates rapidly has been booming so there are trend -- (inaudible) -- but there are a variety of sectors or areas where things -- that things look good.

I agree that the core problem that we face is -- well, there's two really. There's recovering from this -- and they're related but they are distinct -- recovering from the severe shock that we lived through where private-sector borrowing imploded -- one dynamic in the U.S. And the second is, even without that, we needed to shift from consumption-led to other-component-led growth and it's very difficult to pull off both transitions simultaneously, which is kind of, sort of what we're trying to do.

MALLABY: Thank you very much, Desmond, Peter, and Peter. (Applause.)

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