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World Economic Update

Speakers: Lewis Alexander, Former Counselor to the Secretary of the Treasury and Former Chief Economist, Citigroup, Bruce C. Kasman, Chief Economist and Managing Director of Global Researchm J.P. Morgan, and Stephen S. Roach, Non-Executive Chairman, Morgan Stanley Asia and Senior Lecturer and Senior Fellow, Jackson Institue for Global Affairs, Yale School of Management
Presider: Sebastian Mallaby, Maurice R. Greenberg Center for Geoeconomic Studies, Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations
September 13, 2011, New York
Council on Foreign Relations

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SEBASTIAN MALLABY:  (In progress) -- our panelists are Lewis Alexander, first and former counselor to the secretary of the Treasury, former chief economist at Citigroup, north of us here; a future something too, although he hasn't told me yet what the future is, but there is a future, I'm sure.

Next to me, Steve Roach, who is, I think, now non-executive chairman of Morgan Stanley and also a senior fellow, senior lecturer and senior presence at the Yale School of Management; and Bruce Kasman, who is the chief economist and head of global research at J.P. Morgan.

Please remember to turn off all those cell phones, BlackBerrys and things that go beep.  Don't please just put them on vibrate, because they interfere with the sound system.  And I should remind everybody that this is on the record.

So let's start with the U.S. outlook.  And I'll go to Bruce first, perhaps.

How sharp do you think the current slowdown is in the U.S.?  And what, if any, difference do you think the president's speech last week makes on the outlook?

BRUCE KASMAN:  Well, let me just start by saying I think there are two very different forces of motion playing out in the U.S. right now.  The first is one we've seen through the first half of the year, which was a sharp slowing in growth, one which gave us growth averaging below 1 percent.  We can see that dynamic having played out very clearly in relation to some things which we would characterize as temporary shocks -- the rise in inflation, the dynamics around the Japan earthquake.

And I think as you're going into the early summer -- and it's important to recognize this -- actually, the data flow has started to improve.  If you look at the economy in June, into July, the production side, the consumer spending side, just about all of the macro data has improved.  So I think as you actually look at the current quarter, you're probably going to be a little surprised that it would more likely be an economy that's growing 2 percent or so.

That's not, though, I think, a reason to be encouraged here, as I think two things are very clear.  One is the phase of slowing we had in the first half has done some damage.  And I don't think you have to look any further than the labor-market report most recently or the manufacturing and business surveys, the ISM surveys, to see that.

And the second, and I think the bigger issue, which really comes in terms of addressing your question is we're getting hit by something else.  I think, starting at the end of July and coming all the way through now, there's been a new shock.  It's filtered through global and U.S. financial markets.  It's hit U.S. consumer confidence very hard.

I've been characterizing it as a crisis of competency, which is this idea that in the face of soft growth, disappointing growth, there's a real, I think, concern about the ability of policymakers and policy institutions, not just in the U.S. -- I'd argue U.S. and Western Europe -- to really deal with it.

And I think what we will need to understand to really have a good answer to your question is how much has that shock hurt us?  That shock is partly a sentiment shock.  It's partly about real things happening in a world in which U.S. fiscal policy may be turning tight as we move towards 2012 and an environment in which we're not dealing with our medium-term challenges, where the Fed is turning cautious.

I think the Fed has been very bold so far.  But when Bernanke is talking about an operation twist and is not thinking about moving aggressively against the backdrop of weak economic growth, that's a Fed which is clearly expressing at least some constraints in its willingness to move.

Our view overall is that this is going to be an economy which is going to neither surprise us by going into recession or is it going to surprise us by rebounding very quickly.  Unfortunately, I think malaise is the best way I would describe what we're headed into, growth that is going to be 1 to 2 percent.  So for those of us who are worried severely about recession, that might be a little bit on the upbeat side.  But I don't see the policy environment, the dynamics on sentiment here, providing enough lift, even as some of the shocks that hit us earlier in the year fade.

And I'll end by just raising what I think is to me the deeper question that I'm asking myself.  There's a question about whether the U.S. economy will grow, but there's also a question about whether the U.S. economy can grow.  And unfortunately, I don't think the answer to those two questions are separate.

It very well may be the case that the reason why we're not growing now has to do with these temporary forces that have held us down.  But the longer that lasts, and with policy that's not responding aggressively and decisively to offset that, you could find yourself very easily getting stuck into a mode where that weakness feeds on itself and starts to create structural issues that are harder to get around.

So the bottom line, I think, is we're going to have slow growth.  I don't think we're going to have a recession.  And I'll end on the note of saying I think nothing is inevitable, and policy matters an awful lot.  And right now I don't think the markets nor do I have enormous confidence in our policymakers' ability to manage --

MALLABY:  OK, you've thrown down the gauntlet slightly there.  And Lewis was, until recently, a policymaker.  And you're saying there's a crisis of competency.

Is that a bit harsh?

LEWIS ALEXANDER:  I would put it a little differently in the sense that we're facing some very fundamental choices about the direction of economic policy in the United States.  I think all you have to do is really compare the president's speech to the program that was laid out by Mitt Romney, which is the most detailed sort of economic program that's been put out on the Republican side.

They are really two very different visions for how to take things forward.  And in some respects, I think the election we're facing in a little over a year from now is going to be one of the most, you know, consequential ones we've seen, at least since 1980, and arguably since the 1930s, in terms of setting the direction for how economic policy is going to go.

Now, I think that's a good thing in the sense that I think we are actually going to have sort of an election that's really about big choices we have to make about economics. 

Now, unfortunately, from the forecasters' perspective, essentially what I'm saying is this fundamental uncertainty that Bruce has raised, I just don't see how it really gets settled before the election; that that's frankly why we have elections.

And so if anyone was kind of hoping that the political process was going to confront these very, very, very big choices and come out with a clear answer before going through this national election, I think they're going to be disappointed.  And in that sense, I kind of agree with Bruce's basic outlook that I just don't think we're going to get there.

I guess I would put it a little less in terms of competency and put it a little more in, look, there are -- these are consequential questions about what the role of government should be that are unfortunately -- you know, they're ones on which we don't really have consensus at this point, and we're going to have to sort of work through the political process.

MALLABY:  When you say consequential, you're talking about how to balance the budget in the longer term, where to cut in spending --

ALEXANDER:  That's -- obviously there's a set of questions around balancing the budget.  The good news is there's consensus around balancing the budget.  One of the things that's notable is the reason we had the mess around the debt ceiling is fiscal consolidation has become a retail political issue.

I'm quite confident that we are going to get our fiscal house in order one way or another, in part because of that basic political force behind it.  What's unclear is how much are you going to do it on the spending or the tax side.  And that comes back to these fundamental questions about what kind of government do you -- does this country really want to have.  But it also comes back to issues on regulation.

I have to admit, I watched the Republican debate last night, and the notion that people were talking about, let's just get rid of Dodd-Frank -- look, I spent two years of my life kind of working on those issues.  And there are lots of things wrong with Dodd-Frank, and I probably don't -- none of us really want to get into a debate about it.

MALLABY:  I think our friend from J.P. Morgan knows somebody who also has --

ALEXANDER:  Right.  But the notion that the right response is to just, you know, completely get rid of it, that's a kind of fairly fundamental choice about sort of how you want the economy to run.

And again, the good news is we're going to have an election about these big things.  And I think the hope we would have is that you get on the other side of the election and you'll get a much clearer sense of direction.  The problem, of course, is that election is 14 months away.  And for people who are sort of involved in the financial sector, there's a lot of uncertainty about how that's going to go.  And I just don't see that cloud of uncertainty lifting very quickly.

MALLABY:  OK.  So, Steve, so Lewis is saying we've got vibrant democracy presenting us with binary choices, but they're not going to be made soon, so there's going to be basically policy drift, policy uncertainty, coming from the fiscal authorities.  Where does that leave the monetary authority?  What do you expect out of the meeting coming up?  How much can the Fed do?  How much should it do?

STEPHEN ROACH:  Well, first of all, I'm glad that Lewis said he has great confidence that we're going to get our fiscal mess in order.  I wish I could share that optimistic assessment of our political process from either side of the aisle.

The Fed is clearly out of bullets when it looks at conventional policy but is attempting to be ever more creative in looking at unconventional policy.  QE1 worked because it was the right thing to do in a crisis.  QE2 failed because it did nothing to one of the key mandates that the Fed is required under law to focus on, which is full employment.

And the next round of creative policy, whether you want to call it operation twist or torque or some other clever word, begins when long-term interest rates are already extraordinarily low.  So you have to ask yourself, what kind of juice is the economy going to get from a Fed that is aimed at reducing longer-term interest rates further?

So I think the Fed is pretty much at the end of the rope and in a fiscal quagmire.  That leaves public policy, Sebastian, unhinged from doing its basic job, which is running the engine of what had been the greatest economy in the world.

And let me just say one other thing about the basic outlook.  I think Bruce has laid out the right framework.  But, with all due respect, I would disagree with the conclusions.  The framework is to look at the underlying growth trend in the context of potential shocks.  And whether we call the shock, you know, confidence or competence or whatever, I think it's occurring against the backdrop of a fundamentally impaired post-crisis U.S. economy.

And I think one number really says it all here.  Consumer demand in real terms in the United States, not this quarter or last quarter, but over the last 14 quarters, since the beginning of 2008, has grown at an average annual rate of 0.1 percent.  That's 71 percent of the economy.  It's the biggest consumer in the world.

Consumers are in the throes of a Japanese-style balance-sheet recession.  And they've made some progress, but partial progress, in paying down debt and rebuilding saving.  There's years to go in this process.  And that is what is constraining the underlying trend.

So when we get hit with a shock, the possibility of a weak economy getting hit with a shock, going back into recession, is a lot higher than the possibility of a strong, fundamentally sound economy getting hit with a shock.

I think the risk of a double dip -- I can't quantify it with any great precision, but it's a lot higher than is commonly appreciated.

MALLABY:  One more question on the U.S., because you mentioned this debt overhang.  And that does prompt the kind of heretical, slightly over-the-horizon question about monetary policy, which is to say, look, QE2, the idea appeared to be to ease financing conditions for businesses, pump up the equity market, make debt cheaper, and so forth.

But ultimately, if the problem is a debt overhang, maybe inflation, which erodes debt, is not such an awful thing, and that the next sort of big bazooka in the toolkit would be to shift the inflation target up to 2 percent.  You could call it nominal GDP targeting.  There's a bunch of ways you can phrase it.  But isn't that the -- if you were to see a real double dip, a slowdown from Bruce's 1 (percent) to 2 percent baseline --

ROACH:  Too circuitous, Sebastian.  I mean, look, if the problem is a debt overhang, you've got to be honest and embrace some type of programs, like we saw in the 1930s, of debt forgiveness, whether it's on the mortgage front or other forms of excess household sector indebtedness.  And, yeah, somebody's going to have to pay for that.  Right, Bruce?  (Laughter.)

KASMAN:  Could I jump in here?  And I'm going to speak as an economist here, not as a J.P. Morgan representative --

ROACH:  No, I wasn't alluding to you.

KASMAN:  I want to come back to -- I think I'll come back to you in the same way you came at me, which is to say I have a lot of agreement with the framework you're using, but I have some real differences in the way I would draw conclusions.

I come back to this point about whether the U.S. economy can and will grow.  And what Steve is saying is very much right.  We're in the midst of an overhang as we're unwinding leverage, as we're going through the aftermath of a financial crisis.  That means it's harder to grow.  That means it's more difficult to get the kinds of lift in parts of the economy that you want to provide stimulus.

But that doesn't mean we can't grow.  And I think if we stop from the assumption that a deleveraging cycle that an economy that has had a major shock on the financial side means it can't grow, then we've kind of, I think, made conclusions which will drive their own outcomes.

The U.S. consumer is not in the process of actively retrenching or deleveraging anymore.  The deleveraging has happened as savings rates have gone from one and a half to 5 percent and as housing activity, which is the most important part of the household balance sheet from debt, has moved down.

Consumers are now with stable savings.  Savings rates have been stable for two years.  What consumers are in the midst of is post-traumatic stress disorder.  They're not willing to make the leap of faith.  In a world in which their balance sheets have been damaged, credit availability has been damaged, job security has been damaged, and confidence in Washington has been severely damaged, they aren't willing to make that leap of faith in terms of moving towards more normal spending patterns.

The issue we have right now, I think, is to get that dynamic going in a world in which the U.S. corporate sector is not only in fine shape, but has shown signs over the last 12 months of actually moving in a more positive direction.  And if policymakers stop here and say, hey, there's nothing we can do -- let's just accept this as a longer-term problem -- we're going to create longer-term problems which are going to be much more severe.

On the fiscal side, I completely agree with the issue around fundamental, deep-seated disagreements on what we should do.  But we have a situation right now where current policies, if they're unaffected, are going to give us a two percentage point drag on demand as we turn into 2012.  That's unacceptable, regardless of what you think we should be doing over the next 10 or 15 years here.

To say that the Fed is out of bullets is, in some sense, right, but in some sense, I think, is actually wrong.  The Fed has plenty of things it can do to affect inflation expectations, to affect confidence in the system.  What I'm actually surprised by is a Fed that said a year ago that quantitative easing, balance-sheet expansion, is the natural extension of policy at a zero interest rate, is now in a world in which we're much weaker and, I think, much more a threat than we were a year ago at this time, is sitting around doing operation twist or torque.  And I think the Fed should be more aggressive.  I think fiscal policy needs to at least not be very tight as we go into 2012.

ROACH:  Well, why isn't the Fed -- I mean, are you implying that there's been a politicization of the central bank in America?

KASMAN:  Well, I think there's two issues here.  One is, when Bernanke laid out his incrementalist policy in July, which he did at the congressional testimony, I think he felt the economy was still in the face of temporary shocks and might need a little bit of insurance but wasn't fundamentally needing more easing.

And I think there's a process going on here where I would actually expect the Fed to surprise us with more, not less, over the next few months.

MALLABY:  OK, I want to --

KASMAN:  But I want to agree with Steve.  I want to say I think there has been political --

MALLABY:  Don't agree.  That's boring.

KASMAN:  -- political -- OK, I'll agree.  Let's go on.

MALLABY:  Let's move on.  We can come back to the U.S. in the question session.  But I want to get Europe on the table, Lewis.  So in one year's time, will Greece still be a member of the Eurozone?

ALEXANDER:  I think the most likely outcome is yes.  But I would caveat that in a couple of different ways.  First of all, I think it's important for people to remember that the connection -- the connection between the sovereign quality of the debt and whether or not they've defaulted or restructured and what not and the Euro is not one for one.

It's easy to imagine a situation where you could have a country in some sense go through a sovereign restructuring will still remain in the Eurozone.  I think people tend to equate those two things.  But to achieve that outcome, you've got to have some sort of mechanism for supporting the banks in the relevant countries.

In part I answer the question that way because I think it is in both sides' interest to try and pursue that option.  If you think about it from the Greek perspective, is it worth -- does it make sense for them to go through the disruptive process of taking themselves out?  The costs are very high.  They're, I think, going to do an awful lot to sort of stay out of that.

If you think of it from the perspective of Europe as a whole, essentially the problem they face is, once you start down that road of taking people out and doing the sovereign restructuring in a disruptive way, it's very hard to contain the contagion.  And to a certain extent, that's what we're dealing in.  And if, ultimately, what you care about is not Greece but Italy and Spain, in some ways it's easier to defend Italy and Spain if you defend Greece.

And I think that basic logic is what's playing out.  We're obviously at sort of a crucial point now with where markets are.  My baseline guess is that both sides are going to see it as in their interest to continue to go down this road.  I do believe that there are sufficient resources to get that outcome if they are marshaled in the appropriate way, but there's massive policy risk on both sides.

From the Greek -- to some extent, from Greece's perspective, it's the fundamental question of will the political process be willing to impose the obvious pain through policy choices that is necessary to stay on that path?  I think part of the reason they're going to agree to it is the politicians at least understand that it's pain either way, right?

I mean, if you look at, say, for example, what happened in Argentina, Argentina had five presidents in about a week, all around the choice of when you go into default.  Default is not something that is good from the perspective of any politician's perspective.  And so they are -- I would argue they will try and find a way to stay on that path, even though the cost of doing so is very obvious.

On the flip side of it is can Europe come together around a mechanism for essentially supporting the financial system that allows you to sort of keep this thing going for another year?  That is a political challenge for the current leaders, most notably Angela Merkel.  I think it -- again, it is in their interest to continue to go down that path.  But that is a hard thing to orchestrate.

And so there's -- while I think it is -- I think it is, in some sense, the most obvious political outcome to try and get there.  Whether or not that's feasible is an open question.

MALLABY:  OK.  So, Steve, so I'm going to ask you the kind of European version of the question I put to you with respect to the U.S., which is to say, if Greece is going to be restructured but it's probably going to stay in the Euro, the question then is how you dampen down the contagion from the Greek restructuring.  You've changed what were thought to be AAA credits in the sovereign space across Europe.  You've changed them now into risk assets.  And so you see that effect in this red zone on Italy and Spain, and some extent France now.

How do you control this contagion when the political process involves corralling 17 different governments?  Does it wind up on the central bank again?

ROACH:  Well, the recent turnover on the professional staff of the ECB suggests that that is a very contentious issue within Europe, Sebastian.

There -- I mean, look, the EMU is a flawed currency zone.  We've known that from day one.  The fiscal piece is missing in action and has been disrespected in terms of fiscal rules by everyone, starting with Germany and France.  And now Greece is sort of left holding the bag, following by example.

There's three options -- fiscal, monetary and breakup.  I'm with Lewis.  I don't think there'll be a breakup.  I think ultimately there will be a move toward more of a fiscal discipline, I would hope.  And maybe that's wishful thinking.  And there'll have to be some type of pan-regional bond associated with the backstop funding of this crisis.

And I think an interesting question is what countries are covered by the bond.  Does it -- if it's a bond that's aimed at the economically viable survivors -- and I would put, obviously, the core countries, but I also put Spain and Italy in that, but excludes some of the peripheral countries that clearly are facing solvency and not liquidity issues, then, you know, Greece stays in, but de facto has been relegated to a second-class-citizen status.

I think the ECB is really in the crossfires of a potentially dangerous political dynamic that's playing out in Europe.  I think Greece is a foil for the main event in Europe, which is Germany versus the rest of Europe.  What type of EMU is sustainable in Europe?  Is it the German Bundesbank style, or is it a style that has been perpetuated by most of the other countries in the region?

MALLABY:  We're almost at the time when we should go to questions from members in the audience, but I want to -- just one last question to Bruce, which is to say, does this trouble in Europe and the slowdown in the U.S., what kind of consequence does that have for the rest of the world economy?  I mean, we were facing overheating in large chunks of it -- very appreciated exchange rates in some places, inflationary pressures elsewhere.  Does this now take the pressure off because the cycle is slowing down?  And does that mean the end of what the Financial Times likes to call the currency wars?

KASMAN:  Well, first of all, I think it partly depends on how you see Europe playing out.  Europe is the major flashpoint I think we have to deal with.  And I'm a little bit more worried here in the near term, in part because I don't know whether Greek institutions can deliver any commitment.  And I think the European partners are beginning to see that.

And I think that, as much as everybody wants to prevent this thing from playing out in a really messy way in the next few months, it may not be easy to prevent that.  So I think there's a particularly heightened risk here that the Greek situation does unravel.

I do think the notion of ring-fencing Greece, using the ECB very aggressively, making a very strong commitment that banks will be recapitalized and that no one else will follow the Greek path, is not only the way to contain this, if it's possible.  It is the right, I think, path to take here.

So I would have to emphasize, though, that if we do have this messy, disruptive default in Greece, all bets are off on not only how does it affect the real economies, but also in terms of financial transmission, not just to the developed world but the emerging-market worlds.  And I think, you know, let me talk about the rest of the world assuming we don't have that blowup, which I do think is of heightened risk.

I think, in that scenario, there's no doubt that the global economy is integrated in the industrial sector in growth, and there's no doubt that what's happening in emerging markets is a cooling of their growth path as a result of that, also as a result of actions they've taken.  I think the Chinese economy clearly shows that, and some other EM countries are starting to show that as well.

As you note, in many respects this is welcome.  EM was, I believe, in the early stages of overheating.  And you could argue that this is the second time in three or four years where an overheating in EM has been, to some degree, limited by events outside.  (The one ?) in 2008 wasn't necessarily desired in the way it played out, though.

So we have that benefit.  I think we are seeing EM central banks stop their normalization process.  I still believe the Indians will tighten this week, but I think the Chinese are done.  The Brazilians have started to ease.  A couple of other countries have started to ease.

The question is whether this is going to turn out in a benign way for them or not.  And I think, quite frankly, if you could put in for the Chinese and the Indians and the Brazilians a 2 percent U.S. economy as far as the eye can see, they'll be very happy, and I think they'll end up with better outcomes.  They'll end up having a better opportunity to rebalance their growth path.

However, I don't think you're going to see in this environment more willingness to provide support in terms of currency flexibility.  I don't think you're going to see significant easing coming out of EM.  So I think it would be a mistake in this environment to think that there's going to be some major transition in EM policies that are either going to, you know, shift the nature of currency profile in the world or is going to provide any significant offset in terms of demand on the slowing side that's taking place in the U.S. and Western Europe.

MALLABY:  Did you want to --

ROACH:  Just one point on China, especially in the aftermath of the rumors that hit late yesterday in the trading day.  China's largest trading partner is Europe -- bigger than the U.S.  And I'm very optimistic on China, over the next three to five years, that it shifts away from the external demand, export-led growth model to one of internal private consumption.  But that's a process.  That's not the here and now.  Today China is still an export-, an investment-dependent growth machine.

One of the scariest things that China lived through was late `08 and early `09 when external demand collapsed in the depths of a crisis just after they had done a monetary tightening.  They're rerunning the move again.  They've done a monetary tightening to deal with the inflation issues that Bruce was alluding to.  And now they're worried about an unexpected shortfall in external demand made in Europe.

So they're making waves and supporting Italy or Europe in the broad sense.  But the risk here is that, you know, that China is believing, as many have, that this is a liquidity and not a solvency crisis.  And so they're going to waste some of their capital in flailing at Europe.

But make no mistake about it.  Whether this rumor is true or not, I don't know.  And I think it's premature to judge any conclusion.  It's in China's self-interest to shield itself from an external demand shock.

MALLABY:  OK.  Well, let's go to members, bring them into the conversation.

So if you have a question, please raise your hand.  I can see one right here.  The microphone is coming.  Please speak directly into it.

QUESTIONER:  Malcolm Wiener, and I have a quick question for Dr. Kasman and then one for the panel.

You mentioned that the American consumer is now saving 5 percent of income but that it was anticipated it would return to normal.  But that's the new normal.  When I was studying economics 50 years ago at Harvard, the assumption was that the American consumer always saved 7 percent and spent 93 percent.  And it seems to me that's a healthy outcome, that we should be saving more, but that, of course, government has to make up the current slack through government fiscal programs.

And then a more general point.  If one assumes that, in some form or other, Greece inevitably will default, what's the best way of containing that?

KASMAN:  OK.  On the first question, let me just say, first off, we don't really know what the saving rate is in the U.S.  The average revision of the U.S. household savings rate, looking back over 20 years, is four percentage points.  So when we say the savings rate today is 5 percent, we don't really know if it's 7 or 8 percent or is it 2 or 3 percent.  And, by the way, the bias is significantly toward savings rates being revised upward over time.

The second point is I think when we look at the household and the adjustments it's making, we should understand that almost all of the dynamics that take place on the debt side have to do not with household savings but with household investment.  It has to do with housing demand and housing finance.  That's where the leveraging took place.  That's where the deleveraging is taking place.

Today household demand for new housing, housing remodeling, is at record lows relative to GDP.  It's going to stay there for some time.  The deleveraging that's taking place is taking place very slowly as amortizations run above new mortgage originations, as the foreclosures, which are not off the household balance sheet, are actually gradually grinding down.

We're on a path now, with a stable savings rate and housing demand on a relatively stable path, of household debt to income to come down 20 to 30 percent as a share of disposable income over the next three years.  And that's going to happen pretty much regardless of whether the economy is growing at 2 or 3 percent.  If we push the economy to extremes, that will shift.

So I would argue the behavioral shift that's putting in place the deleveraging is pretty much done.  If you give the household sector some income and some wealth creation, it will basically move in a relatively stable way in relation to those things.  But that's not good, because normally early in an economic cycle, with consumer durables depressed, with households turning more pessimistic, usually you get your leverage on growth by households taking a leap of faith back to normalcy.  And the idea that they don't do that and just hold, I think, is one of the reasons why this economy can't grow in the way it has coming out of previous deep recessions.

My two cents on Europe is I think you need to ring-fence Greece.  I think you need to create a much closer commitment on the part of the partners to both recapitalize the banks in Europe, to make it very clear that funding will be available for anybody, including Italy, including Ireland, Spain, and the ECB can't get out of this, even though conceptually and, I think, philosophically it's the wrong thing for them to do.  But if you're going to hold EMU together, the ECB has got to be in there buying debt and completely funding the banking system in Europe.

Even with that, I'm not sure you're going to contain it.  But I think you need those things.  I think the reason why Greece will get the next round of funding might be because it's going to take three or six months to get that political process in place.  But that's, I think, the necessary conditions to try to limit the contagion that will be playing out.

MALLABY:  Another question.  Yeah.

QUESTIONER:  Richard Weinert -- (inaudible).

I'd like to ask about the internationalization of the Renminbi.  How quickly do you think this will occur?  And what will be the effect on the U.S. economy?

MALLABY:  Steve.

ROACH:  Well, you said the internationalization of the Renminbi has been growing in a very rapid rate over the last couple of years but still is in a relatively low level as a share of currency trading.  I think the Chinese have every intent in stepping up and accelerating the pace of currency reform, but very gradually.

And they're doing it for two reasons -- to, number one, diversify their own sense of currency risk in a world where the other major currencies are clearly in trouble for a variety of fairly well-known reasons, and secondly, to defuse some of the anti-China political pressures that arise from time to time in countries with high unemployment rates and large bilateral trade imbalances with China.

And I think the process will continue.  I'm not of the view that China will emerge as a major reserve currency in the world at any point in the immediate future.  And I think this is an important but perhaps overblown step on the road to free-floating and convertible currency, which I think is still going to take, you know, another five to 10 years.

MALLABY:  Another question.  I can see one over there in the back.  Then we'll come here.

QUESTIONER:  Does this work?  Yeah.  Andrew Gundlach, Arnhold and S. Bleichroeder.

I'd like to ask the panel why they think the Euro is so strong.  It doesn't make any sense to me.  There's a banking crisis, a sovereign crisis, a growth crisis.  They haven't raised any equity for their banks.  And the Euro, although the past few weeks it's been a little bit weaker, to me is ridiculously strong.

MALLABY:  Lewis.

ALEXANDER:  In some sense, currencies are always a question of what's the alternative.  One of the things I find striking is if the U.S. is going through its challenges by itself in a world where Europe was doing very well, that would be a very different world.  Alternatively, if Europe was going through its problems at a time when the U.S. was unequivocally doing very well, that would be a very different world.

So to a certain extent, your question is kind of the question of what's the alternative.  Obviously you start looking at other currencies that are potentially safe havens, like Switzerland.  Just given what the SMB has done recently kind of gives you the sense of sort of where that goes.

And so, to some extent, your answer is, relative to gold, it's doing pretty -- it's not doing particularly well at all.  So it's -- it really is a question about what.  In a kind of perverse sense, we are lucky in a way that Europe and the U.S. is going through sort of problems more or less together, because had you not had that happen, I think you would have seen potentially a very different outcome that would have been much more disruptive.

MALLABY:  I'm feeling a slight stretch here.  So we've got, you know, U.S. in trouble, Europe in trouble, but the good news is at least it's equilibrium.

ALEXANDER:  For my entire -- I started my career working in the division of international finance at the Federal Reserve Board in Washington.  For my entire professional career, we have been worried about the dollar crisis.  And, you know, part of the reason --

KASMAN (?):  With good reason, Lewis.  (Laughter.)

ALEXANDER:  Of course.  Of course.  I'm not saying those concerns weren't justified.  But we haven't had it.  And it's striking to me that, given what the United States economy has gone through over the last three years, that we haven't had it.  But part of the reason is the rest of the world is going through big problems as well, and it's always a question of sort of relative strength.

So, you know, it is a kind of perverse thing, in a way, but imagine what the world had -- where the dollar would be, for example, if Europe had not had these problems.  That would have -- those would have been circumstances under which the fears of a dollar crisis would have been much worse.

MALLABY:  Right.

Question over here.

QUESTIONER:  Juan Ocampo, Trajectory Asset Management.

A follow-up question on the Euro for whoever wants to field it; capital flight within the Eurozone.  The Bundesbank, I think the last time they showed numbers, owed somewhere between 300 (billion) and 400 billion Euros in terms of the unsettled clearing from the peripheral central banks.  That's a number that had grown from roughly zero not that long ago.  It's an accelerating number that's basically driven by deposits flowing out of Italy into Germany and what have you.

Is this something we should worry about?  Is there a number at which, you know, the Germans start to say, hey, enough, like a trillion?  Nobody's mentioned it.  And I just wonder if this is something that we should be aware of and what your points of view on it are.

MALLABY:  (Inaudible) -- have a crack at that?

ALEXANDER:  Yeah.  The general question of capital flows within Europe is definitely something people should be worried about.  Obviously one of the ways this whole thing could unwind is if, say, for example, Greek citizens looked up one day and decided they didn't want to hold deposits in Greek banks; they wanted to hold Euro deposits in German banks.  That would then create a set of pressures where the only way the Greek banks could fund themselves was essentially through the ECB.

The relevant thing is actually not the target system, but it's what sort of assets the ECB is willing to take on its balance sheet, because ultimately the Bundesbank's counterparty is not really -- it's vis-a-vis the ECB; it's not vis-a-vis sort of the bilateral parties.  And so what those things reflect is sort of the position that exists on the ECB balance sheet.

And say, for example, if you had that situation where you had a run like that, the ECB would -- that would be a decision that would -- a situation where the ECB would be forced to make a pretty hard choice.

The interesting thing about this is, when you look at other circumstances like this, people don't run as much as you might think.  Argentina in 2001, for example, had this hard peg to the dollar.  There was -- up until the default at the end of the year, it was pretty much freely available that anybody who held a deposit in the Argentine banking system could convert it into dollars and take it offshore.  There was literally no limitation on it.

There was not a run in the way that you would recognize Northern Rock.  There was a slow bleed.  That is what you've seen in Europe up until now.  But I think one of the ways contagion would work is through that channel.  So, say, for example, imagine you had sort of a disruptive scenario that involved a Greek default sometime in the near term.  You could imagine dealing with the Greek situation by sort of essentially putting on a set of controls.

The natural next question is, what do people in Portugal do?  What do people in Ireland do?  And that's why, in some sense, supporting the banks and having a mechanism for making sure that you don't see those things is a crucial thing.  So there's dealing with the sovereigns, but there's also dealing with support of the banks.

MALLABY:  But how much of a shift is that, actually?  Because my understanding is the banks are already funding themselves through the ECB, so we have the mechanism in place.  I mean, they just do more of it.  Isn't that right?

ALEXANDER:  Yeah, but there's a fundamental question of how much, over what maturity and what not.  For example, there are sort of immediate liquidity issues which central banks are typically designed to deal with, but there are sort of longer-term issues about sort of near-term funding.

Say, for example, if you use the analogy of what the United States did in 2008, a very important part of the crisis response was the guaranteeing of bank debt that was provided by the FDIC.  So essentially one of the ways of dealing with the funding problems with the U.S. banks in extremis was to have the FDIC essentially provide guarantees to bank borrowing that was more than just short term.

In some sense, that's really the crisis the European banks face at this point.  The ECB could provide it.  The question is, are they going to be willing to?  Obviously Stark's resignation last week is sort of an indication that there are real pressures on this.

You know, in some sense, the ECB is being asked to be the fiscal sharing mechanism for the union at this point.  It is essentially doing what a European-wide mechanism that does not currently exist would be asked to do.  And there's sort of a fundamental question of whether or not you really want the central bank to be doing that.

ROACH:  That's precisely the point, Lewis.  Paul Volcker, when he made a very public critique of the Federal Reserve in 2008, raised a very important question as to the legal authority of America's central bank to take increasingly toxic assets onto its balance sheet.  And the resignation of Axel Weber and Jurgen Stark, I think, is right out of a page of that same script.

The hardline Bundesbank type, German central bankers, are raising strong objections to the politicization and fiscal intrusion of the European central bank in managing this crisis.  And so I go back to the point I made earlier.  I think that Greece is a warmup for the main event, which is Germany versus the rest of Europe.

And I think the idea that we can solve this crisis by ring-fencing Greece ducks the big issue.  This issue is about the future of the EMU or maybe EU and the role that Germany plays both politically and economically in guiding what is turning out to be a failed experiment.

KASMAN:  Just a couple of observations very briefly.  I think that when we look at these flows, there are two things we should recognize.  And I completely agree with the way Lew described the situation.

First is that it is reflecting an ECB which is sitting with fairly significant credit risk if there would be a Greek default.  And we shouldn't lose sight of that.  And it's increasing as they continue to intervene in markets.

And the second point is that the contagion and the risks of, you know, people moving assets out of Greece is quite significant here, because you can't simply contain it with an FDIC insurance process.  This is a story about if Greece goes down, the risk is going to be that there not only will be capital controls in Greece, but that there will also be a conversion of Greek assets that are now in Euros into whatever you want to call it; the new drachma or whatever.

So the risk that this starts to accelerate in a significant way is such that I think the fact that Greece is in EMU, the fact that it doesn't have the currency flexibility, the fact that there's free mobility of capital and labor within the region, combined with the fact that Greece is running a very large deficit right now, means that if Greece goes down, it goes down a lot harder than Argentina, goes down a lot harder than Iceland.

Both of those countries went down about 15 percent in GDP terms, peak to trough.  I think you could be easily talking about a Greek default, if it came to it, without support from its neighbors, where it went down 20, 30 percent, and Greek institutions fall apart and we're left with something like a military that has to take over.

I think the consequences of this in this environment are, you know, quite more dire, given the free movement of capital and what the arrangements that exist in the region are right now.

ALEXANDER:  Just a very quick -- I just want to -- (inaudible) -- a little bit to what Steve said.  There is this crucial question of where is the line between fiscal and monetary policy.  I think the way to think about the cycle the U.S. went through in 2008 is when the Lehman default happened, that was the point where essentially the Fed said we have reached our limit of what we can do with our legal authority.  And essentially the ball was put back to saying that's the point where you have to go and ask for explicit fiscal authority.  And that's why -- that's when the TARP debate happened.

In some sense, the debate in Europe has all been about that border where, in some sense, the convenient thing to do is to just let the ECB do it because it's a structure that's in place.  And in some sense, the ECB has done it reluctantly, but it's done it with the presumption that the assets they have taken on their balance sheets, they'll be made whole for.  That's, in some sense, the implicit promise that's there.

But it is this question about how far are they prepared to go in an environment where the political decision-making process in Europe needs to come together around some common mechanism that can provide support for the system.  If they can't get to that, they've got a real problem.

ROACH:  But Lewis, again, if there's no breakup option and they're reluctant politically to move to a more coherent fiscal policy, then, you know, it just falls to the ECB to save the EMU, right?

ALEXANDER:  You've described a situation to which there is no good outcome if you rule out a fiscal sharing mechanism.

ROACH:  Yeah.  No, I'm just saying, if that happened --

ALEXANDER:  Right.  If you rule that out, then you're sort of forced into other scenarios that are more difficult.

MALLABY:  Over there.

QUESTIONER:  Blake Haider, Citi.

Can you give us some perspective and outlook on the IMF meetings in two weeks and whether you see any sort of new EM-led policy consensus coming out of it, particularly in light of the Chinese-Italy rumors last night?

ALEXANDER:  IMF?  I'm not sure I have any, you know, good insights or anything else to offer.  I mean, if you look at -- I would start with, in some sense, the G-7.   You've got the G-7 first and then you've got sort of the IMF meetings.  In some sense, it seems to me that the G-7 has kind of agreed to -- you know, agreed that we've all got to do what's right for us, which is sort of a typical thing.

I would like to hope that you would get something out of the IMF, but I have -- I'm not sure I'm terribly hopeful (when ?) I see any sort of obvious solution.  The notion that, say, for example, the Chinese would come to sort of provide some solution, I don't know.  I will leave that to Steve to --

ROACH:  Well, I think it'd be interesting.  I think there'll be a lot of attention on Madam Managing Director to elaborate on her suggestions that she made at Jackson Hole on the recapitalization of European banks.

MALLABY:  She's backpedaling already, I think.

ALEXANDER:  As a U.S. official who was partially responsible for dealing with the IMF staff when talking about estimates, I have some perspective on what she's dealing with.

I would make the following observations.  I think the general notion -- and you've heard it here -- that the European banks would be better off if they had more capital is not a particularly hard argument to make.  I would point out that that is a hard debate to have in public, right?  Regardless of what you think about the substance of the issue, the notion that policymakers should debate that publicly is kind of a different question.

The numbers that sort of were floated of $200 billion capital hole seemed roughly plausible to me.  I will say, having, again, dealt with it from the U.S. side, the IMF -- I mean, I spent some time trying to convince the IMF that their numbers were too high in 2009, which turned out to be right at that particular point in time.  But the IMF has a lot of expertise on this, and I would point out that the new IMF managing director was actually responsible for managing French banks when she was in the ministry, so she sort of knows something.  But the notion --

MALLABY:  She didn't know anything then, but now she seems to --

ALEXANDER:  Well, but partly it's this notion of is that a debate you really want to be having in public?

MALLABY:  Right.

ALEXANDER:  I mean --

MALLABY:  Byron Wien has a question.

QUESTIONER:  Byron Wien, Blackstone.

There's been a preoccupation on this panel with the discussion of Europe and the United States, which is two thirds of world GDP but a very small part of world growth.  World growth is coming from India, China and Brazil and other emerging-market countries.  But China has certain risks as a result of a possible housing bubble and a banking crisis.  India has inflation problems that are quite severe.  And Brazil's growth is slowing down.

I wonder if you could comment on the emerging markets and what the implications of a U.S. and European troubled economic period are going to have on them.  Are they going to be undisturbed by this?  Are they going to continue to be the engine of world growth?

ROACH:  Just briefly, Byron.  I was getting worried that this is like the first meeting I've been at when I look out at both Byron Wien and Jacob Frankel and neither one of them had asked a question.  (Laughter.)  Thank you.

Jacob, I'll talk to you later.

Look, I think the lessons of late `08 and `09 showed the flaw in the so-called decoupling model.  While there's a lot of very compelling growth momentum in the emerging markets, these rapidly growing economies are not oases of prosperity when the developed world is in trouble.

China in particular wants to become a more balanced economy, but today is unbalanced and unstable and is heavily dependent on exports and external demand.  India is very dependent on external capital to deal with its current-account deficit.  Brazil is heavily dependent on global demand in the developed world to support the resource piece of its export business.

So a shock in the developed world is a big deal for the emerging markets.  And I think there are some vulnerabilities there that are not appreciated by those, including the IMF, who put out their world economic outlook.  I believe the title last spring was "Two-Speed World," as if, you know, you've got one set of economies that are just insulated from the rest of the world.

This is a globalized world where the trade flows, capital flows and, to some extent, labor flows, information flows, are in this together.  And I think these shocks in the developed world are big risk factors.  And again, I go back to the -- if there's a logic to what China purportedly was leaking out last night, it's that connection that is very important to them.

MALLABY:  We're coming up on 9:00, but if Bruce or Lewis has a last thing they --

KASMAN:  Well, let me just sort of go on top of this question with the idea that I think I would look at the experience of the last 10 years as showing you that there is a decoupling taking place but that that decoupling can't withstand shifts in financial markets globally that are extreme.  2008 and 2009 was the interruption of what had been and what continued to be, after the recession, of a two-speed global economy, with the EM much stronger and becoming increasingly driven by their own domestic dynamics.

So I would think if you can hold growth in the U.S. and Western Europe positive and modestly, you can have growth continue at a solid pace in the EM.  A caveat on that is I think the Chinese economy is downshifting for domestic reasons, and I think it's unlikely that you're going to get any meaningful offset coming from the Chinese authorities to what's been happening in terms of slowing growth elsewhere in the world.

So I would look at a pattern which we haven't seen in the last 10 years whereby the global economy slows, the Chinese economy downshifts to a 7, 8 percent growth rate, but we don't get a policy response out of China, out of India, which, again, I think India's going to keep tightening monetary policy.  And therefore, you're not going to get that impulse in the other direction that we had in 2009, we had in 2002-2003, to provide a lift.

If I'd just make one other little point is I don't think we want to ignore Japan.  Japan has been a very important part of global growth dynamics this year and is going to continue to be.  So -- and it's going to be, I think, one of the reasons why Asia as a unit can outperform the rest of the world in a significant way if there isn't a much more disruptive financial-market event playing out, likely coming from the European stuff we've been talking about.

QUESTIONER:  So you see a rebound in Japan right now.

KASMAN:  I think third quarter in Japan is tracking 7 percent, and Japan's average growth for the next three or four quarters is going to be 2 to 3 percent, which is -- you know, it's a temporary phenomenon.  It's a rebuilding rebound off the earthquake.  But in terms of this crucial time where we're watching the global economy, its impulse is an important positive.

MALLABY:  Yes.  Well, thank you very much, everyone, for coming.  (Applause.)

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