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World Economic Update

Speakers: Stephen S. Roach, chief economist and managing director, Morgan Stanley, John P. Lipsky, chief economist and vice chairman of the investment bank, JPMorgan Chase & Co., and William C. Dudley, partner and chief U.S. economist, Goldman Sachs & Co.
Presider: Daniel K. Tarullo, professor of law, Georgetown University Law Center
June 30, 2005
Council on Foreign Relations

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Council on Foreign Relations
New York, N.Y.


DANIEL TARULLO: Good morning, everyone. Welcome to the last world economic update of the academic year and the fiscal year. I want to remind you please to shut off or at least mute all BlackBerries, cell phones, and any other beeping electronic devices. I'd also like to remind you that, as is our custom with this program, it's on the record and not, as is often the case with Council programs, off the record. Also, we will follow our normal procedure, which is to say we'll have a discussion up here for a while, then we'll turn to you for questions. When I recognize you for a question, please stand and identify yourself, and do wait for the microphone.

As all of you who have been coming to these programs know, we normally start off -- or at least for the last several years, we have normally started off by talking about the U.S. economy, in substantial part because talking about the U.S. economy has been tantamount to talking about the world economy. This morning we thought we would invert things a bit and begin with Europe. Beginning with Europe in substantial part, of course, because of the votes on the [European Union (EU)] constitution in the Netherlands and France a few weeks ago and the subsequent happy gathering of the EU leaders, where they failed to conclude a budget agreement and where it appeared as though the only statesmen left in Europe were from the former communist bloc. Then we will turn to the world economy more generally and talk about the issue of a savings glut or lack of investment opportunities, which has been raised by, among other people, [former member of the Federal Reserve Board of Governors] Ben Bernanke.

But first with Europe, and I want to talk about three different implications of European economic -- the economic situation right now. First, the short-term question as to whether, in addition to some downward pressure on the euro in the aftermath of the Dutch and French vote and the budget debacle, we are seeing any other doubts creeping in about the medium-term future of the European Union that have economic implications. Secondly, I'd like to take this opportunity of focus on Europe to ask about where things stand in terms of structural reform and the kind of changes that -- of which there is a general consensus many European countries need to make. And finally, maybe we could talk just a bit about the European Monetary Union [EMU] six years later. Has it, all things considered, worked as the good thing for the European economy? Or are there countries which might have been better off not being in the EMU in the first place?

So first, on the short-term issue, Steve, you've been in Europe in the not-too-distant past, what is your impression about the short-term reactions about investors, business people in Europe and, for that matter, in the United States, to the rejection of the constitution?

STEPHEN ROACH: Well, Dan, the mood is so pessimistic in Europe right now that I have been characterized as an optimist. [Laughter] Talk about inversion. So my take is that the biggest drawback for this grand experiment from day one has been this dream of political unification. And as far as I'm concerned, as you can see by the breakdown of the so-called stability in [inaudible], the lack of fiscal discipline, and now all these events that you cited. In recent weeks, starting with the elections and going to the leaders' summit, Europe does not have the political will yet to provide this third leg to the school of the optimal currency union. And, look, I think that's OK, because by clearing the decks of all this political haggling -- and that is sort of what has happened right now -- I think Europe can now get on with the heavy lifting and structural reform, led by corporate restructuring.

And I think the news here, honestly, is a heck of a lot more encouraging than you would be led to believe by watching the euro, which is, in large part, I think, an exaggerated downward adjustment exacerbated by a clear soft patch in the Euro-land economy.

But I think -- and we'll get to this in your second question -- that the progress on structural reform, especially in a country like stodgy old Germany, is actually quite outstanding right now, and I think you will see that once this political constraint has been removed, unless the governments do something really dumb and put up walls that would forestall competitive pressures driving structural change and restructuring, I think Europe is definitely going to surprise relative to the expectations that are now evident or elsewhere in our markets.

TARULLO: John?

JOHN LIPSKY: Well, this will be the second surprise. Not only is Steve an optimist, but he and I agree.

ROACH: I just -- I changed my [inaudible]. [Laughter]

LIPSKY: But seriously, there's a lot of noise on the political side. The simple reality is there's a fundamental political ambiguity, a fundamental economic ambiguity in the European Union. The political ambiguity is, is the EU a proto federal state or a permanent intergovernmental organization? And the answer to the constitution, the draft constitution, was, yes. It didn't solve the issue. And that's why -- one of the reasons it was defeated is because folks coudn't see exactly what it was. It was a giant collection of small details and just didn't seem compelling. But the underlying reality is there is no consensus on the answer to that question, so we might as well just leave it aside for the moment and get on with what's going to be done in a practical way.

The second note -- and I guess it's implicit in the way in what Stephen was saying -- the EU has suffered from what I called the Lisbon Agenda fallacy. The Lisbon Agenda was this very aggressive reform agenda that was agreed at the Lisbon summit in 2000 by EU leaders with the goal of making the EU economy the most competitive and most productive by the year 2010 and has been, frankly, a failure.

The implicit idea -- what the fallacy is, is that all structural reform stems from governmental action, and -- but when asked, well, there was substantial improvement in the U.S. in the structural sense during the 1990s, exactly what legislative or regulatory measure would you say caused it, and the answer, of course, is [inaudible] obvious. It was the action of the private sector that brought the reforms, and that's going to happen in Europe. I'm not trying to say the Lisbon agenda wasn't a good idea. It was an excellent idea and hopefully will eventually transpire. But it's going to be driven by the private sector.

Third small point, and that is there's so much talk about the Stability and Growth Pact and the notion that somehow it's failed and that that failure is really of cardinal importance at least in the near term. Point No. 1, I don't think the financial market ever thought that the model finance ministers in Europe would be busy disciplining and fining each other regarding their budgetary position; it's never had credibility in the market. It's going to market and economic and voter discipline, not finance ministers disciplining each other. Secondly, that creates the idea that -- well, let's put it this way. If the problem in Europe were slow growth and high interest rates, then you could say, "What's going on here," and maybe questions about the Stability and Growth Pact and deficits would be of importance. But the problem of Europe is slow growth and low interest rates. So the question is, why is an economy with very low interest rates producing such sluggish growth? And that's where you end up running down the road of structural reform needed, and it's going to be driven by the private sector.

TARULLO: Bill.

WILLIAM DUDLEY: I think John is exactly right. I think the key question in Europe is whether businesses drive the car or the bureaucracy drives the car. And if businesses drive the car, what they do is, through competitive pressure, basically force change on these countries. In countries that have a more liberalized regime, more friendly regimes [inaudible] going to attract investment, and that's going to put pressure on the other countries to follow suit.

Now the danger, of course, in all this is that there could be a political reaction against this at some point, and I think that's what we really have to focus [inaudible] to see if there's that kind of backlash where the bureaucracy says, "We don't like what's happening; we don't like the fact that the countries that are liberalizing their business environments more aggressively -- " and you really see this, especially in countries of Eastern Europe like Slovakia. They have very liberalized regimes for business, and that's attracting investments. So I think that's the key thing to watch.

The second thing I would also say is, one of the things that's really been highlighted to me over the last few months is just the weakness of the political process. You look at Germany, France, and Italy, who don't have strong political leadership, and not only do they not have strong political leadership, you don't have the sense that that political leadership is going to be changed in a major way any time soon, with the possible exception of Germany. And so I think that overhang of leadership, where you're not -- the United States, you would throw the rascals out and you would get new rascals in, and the new rascals would try something different. And in Europe you don't see that happening to the same degree.

TARULLO: Stephen, you talked earlier about the deep pessimism. Were you talking about pessimism among investors, business people, as well as among the political class?

ROACH: All of the above.

TARULLO: So if you and John and Bill are fundamentally optimistic, is that optimism just because you're basically across the ocean and don't see all the weight of the newspapers and all? Or is there something that these types of --

ROACH: Look, I think these elections, quite frankly, to say nothing of the failed summit, were emblematic of just a growing sort of angst building in Europe. And the voters, the businessmen, the investors, the politicians, I think continue to harbor this dream of a powerful united Europe, united on all fronts, even though they recognize and they voted against the specifics of this particularly cumbersome constitutional document. So I think that this is viewed as a setback, and the emotions surrounding that setback have caused a lot of Europeans that I meet with on a regular basis to take this as a setback for the grand experiment.

But let's get to this second point, which is -- I think that is masking -- just focus on Germany, a third of Euroland and widely perceived to be the sick man of Europe, the weakest link in the chain. Germany is different. It has very rigid labor laws. Thirty percent of German workers are now part time and temp [temporary workers]. Those are flexible workers. That number a decade ago was 12 percent. The power of German labor unions has been sharply reduced over the last five years alone. Gone are these industry-wide collective bargaining negotiations. Bargaining takes place company by company. Shortened work weeks are being dismantled in Germany and, in particular, in France, where the 35-hour work week is all but finished.

And then finally, corporate Europe is now moving ahead doing what we did in the late '90s, investing heavily in information technology [IT]. So you have rigid labor laws instead of less rigid, IT-enabled capital spending. You've got a productivity story in Europe. You've got one in Germany.

And the final thing I would add is that corporate finance activity is really taking off on the restructuring front, again, in Germany. In our own business at Morgan Stanley, we've never seen a pipeline in the [inaudible] area in Germany than we see right now. And I just think this political angst obscures the far more important structural change.

TARULLO: John, a few moments ago, you said you thought probably the most important restructuring to be done in Europe was within the producing firms themselves. But if you had to identify two or three remaining obstacles to the restructuring or necessary catalysts from the government for restructuring, what would they be? They would be different from the country, obviously.

LIPSKY: Let me put this in perspective with two factoids. One, you've actually seen the turnaround in the sense that 2004 showed a rebound of productivity growth in the Euro area as a whole after four years of slowing -- in 2003, zero productivity growth. So a turnaround, nowhere near as fast in the U.S., but a turnaround in direction. However, all of that, all the benefits so far have accrued to corporate profitability. Zero -- there has been no acceleration in growth of disposable income. So to the average guy, if you say, "What's in it for me?" the answer is, "Nothing so far."

And so when you say, Europeans haven't increased their spending, their consumption spending, why would you expect them to? They haven't gotten any more earnings. So this is going to take a little while. The one thing that has happened on the governmental side that I think is having a fundamental impact and I think is the source of some of the angst, is the opening of the EU expansion to the ten ascension countries, Eastern European countries basically, which, in economic terms, GDP [gross domestic product] 5 percent of the rest of the EU, but psychologically the impact is very big, because you now -- they're now inside the single market.

And the way I put it is, the notion that, "I'm going to close the factory in Stuttgart and move it to Guangzhou [ China]" is exotic as an idea. But, "I'm going to close the factory in Stuttgart and move it to Slovakia," is like saying "I'm shutting down in Michigan and opening up in Tennessee." This is real.

So you have this sense that there is real pressure -- it's no longer talk -- trying to get things done. But if there's an area -- to come really to your question directly -- I think where things need to be done and can be done is exactly the -- coming back to my observation, slow growth but low interest rates. Why aren't interest rates serving to stimulate growth? The answer seems obvious: The European financial market is still heavily dominated by traditional bank lending and bank relationships. Banks in Europe are too important relative to securities markets. They have too much capital. They produce low return on that capital. They are lending that money to low-productivity users by definition.

UNKNOWN: But this has been true for an awful long time. Do you work for a bank? He works for a multi-service --

LIPSKY: Yes, we're a universal bank. We can service all your needs. In that sense, we don't have --

UNKNOWN: No, no, you don't have a dog in this particular fight. But if you're trying to invoke the role of the dependents on bank lending, that's something that's been a constant in Europe, right? You can't use [inaudible] right now.

LIPSKY: But now -- now we're changing. We're in the midst of change. First of all, in Germany, of course, one of the hot issues --

UNKNOWN: You're invoking this as another reason for optimism?

LIPSKY: I thought your question was, what could happen to [inaudible] this? And I'm saying one of the barriers has been the inefficiency of the financial [inaudible]. And I think that is on its way to improvement.

What you see, and what Steve was talking about and what, if you paid attention, you heard the deputy head of the SPD [Social Democratic Party in Germany], Paul "private equity firms" [inaudible]. But you ask yourself, "Why is private equity all of a sudden so active in Europe?" And one of the reasons is because it's bypassing the private -- the open, public markets in favor of private markets.

Part of the answer is that public markets are not up to snuff. And I think that message has come through, and action is on the way.

TARULLO: Bill, 1999, the European Monetary Union comes into being. A couple of years latter, the actual physical currency is changed. At this point, although, as you were saying before the meeting began, there is a little bit of possibility, a little bit of chance that the whole thing breaks apart. Most people, myself included, don't think that that is a real possibility.

Having said that, on net, has the European Monetary Union been a good thing for the restructuring that John said was important for growth generally, for forcing countries to come to grips with their own situations? Or has it been, for example, in Italy, too much of a palliative, whereby you can take advantage of the liquidity of the euro and not have to come to grips with your own fiscal problems?

ROACH: Well, I think, on balance, you'd have to say it's still a success despite the troubles, because countries are clamoring to join. If it was truly unsuccessful, I don't think you'd have countries wanting to get in with the enthusiasm that they have at the present time. That said, there are some issues with the European Union -- monetary union that still remains to be resolved. Is it possible to have an effective monetary union without a fiscal policy that is really pan-Europe? One of the big differences between Europe and the United States is when one state in the United States is weaker, it sends less money to the federal government, and a state that is stronger receives less money from the federal government. So there is an automatic fiscal transfer across the United States.

You don't have that situation in Europe, and I think that is going to be an interesting question whether that is an important factor in the success of this experiment.

TARULLO: If I can stop you right there, that is probably less likely to happen as a result of the deceleration of movement toward --

ROACH: I think that's very unlikely to happen in the foreseeable future. The other thing I would say is that this experiment is most vulnerable at the beginning. As time passes, Europe is going to get more economically integrated. There's going to be a convergence, I would expect, within Europe over time. You've already seen countries like Ireland, which were considered extremely poor just 20 years ago, now being one of the most prosperous regions in Europe. And as you had that economic integration, some of the internal contradictions and strains within Europe, I think, will fade over time.

But I always felt that the biggest risk was the first 10 years, not the second 10 years, or the 10 years after that.

TARULLO: Anything --

UNKNOWN: I would just say, don't underestimate, Dan, the significance of the central -- one central bank and one interest rate and the one currency. They're critically important as straitjackets in forcing the private sector to drive efficiency to a very different place than was the case when there was fragmentation of the interest rates, fragmentation of central banks, and intra-European competitions for capital and funding.

And the ECB [European Central Bank] is not going away, and I don't believe the single currency is going away. And, yes, there are political and fiscal fragmentation issues, but I think, if I could pick the two most important features of unification that are going to be constructive for Europe in the future, it would be the central bank and the currency.

UNKNOWN: Just let me interject. In theory, at least, the presence of a single currency should push structural reform, right? Because you can no longer use the national currency as an instrument of economic expansion.

UNKNOWN: Yeah, but I don't want to overdo that. Again, I am in agreement with these guys that what's going to drive structural reform is going to be the private sector, and a key here for policymakers and government officials is just not to get in the way of that progress.

TARULLO: John.

LIPSKY: This is an area where I certainly agree that the euro has been a success. I agree it's important in driving reform.

But we shouldn't lose sight of two things. One, it's a hard road in the following sense: We've created a single market in North America for NAFTA [the North American Free Trade Agreement], and yet it never occurred to us that we needed currency union to support or accompany trade union. So it didn't seem to us that you had to have a single currency to have a single market.

The decision in Europe was that you needed a single currency to make the single market credible. Now that was always open to debate. If you remember the conventional criticism was that the area is not an optimal currency area. So you've signed up for sub-optimal policy in the short run. The answer was, "Yes, we know that, but the decision is it will become an optimal currency area over time."

But you shouldn't lose the fact that you've picked the hard route, not the easy route. And you're going to create frictions. And there was a tremendous, to my mind -- you can understand it, I was based in London at the time the [EU's] Maastricht Treaty was drawn up -- but there was an unintended ambiguity created in that multi-state Europe, the multi-state nature of the Maastricht Treaty, which anticipated ascension into and incorporation into the single currency, in a way was expressly intended to keep Spain, Italy, Portugal, and Greece out of the first round. That's what that was all about. And it failed.

But what it did do was created the possibility that the U.K. can be permanently inside the single market and permanently outside the single currency. And that's just an ambiguity they're going to have to live with. And I'm sure looking back they regret it, because now when Italy decides -- if Italy were to decide, "Hey, you know, let's have the U.K. deal; let's redo this," what's the answer? "No, you blew your chance?" I don't think this is fair, because I think at the end of the day, even the guy on the street understands they have to have a single market because as small, isolated economies they don't stand a chance in the global market. So they understand they need the single market, and I think the judgment that at the end of the day, because of the European reality, you need a single currency to make it happen.

UNKNOWN: But, John, the answer for Italy will be they'll get Italian-style interest rates for the most indebted country in Europe, and that's just sheer economic suicide.

LIPSKY: Well, that's a risk, isn't it? [Inaudible]

TARULLO: If EMU breaks down, it'll be because of the countries with better fiscal circumstances --

UNKNOWN: Italy will be thrown out, as opposed to Italy will withdraw --

LIPSKY: That's why I don't think it will happen. But there is this conceptual flaw, if you will, this conceptual ambiguity: How come a large country like the U.K. can be in the single market with all those benefits and never have to join a single currency and accept that discipline?

UNKNOWN: Well, let the record show that the Italian [welfare] minister who proposed the reinstatement of the lira, his name is [Roberto] Moroni. [Laughter]

TARULLO: All right, next topic.

LIPSKY: That's on the record.

TARULLO: He said it on the record in Italy, too. A couple of weeks ago, I was having lunch with a friend who runs a hedge fund here in New York, and he was moaning, as people running hedge funds these days tend to. In his case, he was moaning about, the way he put it, all the savings sloshing around in the world, and it's very hard to find investment opportunities right now. There's just a lot of pressure on us, can't find places to put the money.

That, of course, reminded me of Ben Bernanke's speech, a couple of speeches he gave in March and April, still speaking at the Fed before he went into this transition of being head of the Council of Economic Advisers, in which he tried to explain the persistence and size of the U.S. current-account deficit as resulting from excess savings in much of the rest of the world, particularly in the emerging-market world, as a result of the Asian financial crisis, people building up reserves and the like. But, again, suggesting that a fundamental problem was too much savings in too much of the world.

This seems odd to us in the United States, but it is an explanation that has a lot of currency elsewhere. But last week I had lunch with another friend who works at another hedge fund, and she said, "Well, I'm not sure it's an investment, it's a savings glut as such, but we're not seeing as many good investment opportunities as we'd like and particularly, again, in the emerging markets and now even in the industrialized world, where business investment is quite sluggish."

So, with those anecdotes and Ben's paper in the background, I wanted to again ask the panel three questions. One, do you agree with this, not just the assessment that there are a lot of savings and very few investments out there, I think that's almost obvious. But is that the causal driver of the U.S. current-account deficit and the other imbalances that we see in the world? Second, if it is the case, are things like rising energy prices, the slowdown in China, likely to make that worse rather than better in the short term? And third, does the angst of my friends in hedge funds about good investment opportunities raise the prospect of people starting to take more risks in the search for yield? Bill, you want to begin?

DUDLEY : OK, on the whole issue of is there a global savings glut, we would absolutely agree with that. And it's being driven by a number of factors. It's being driven by redistribution of income from low earners to high earners; it's being driven by redistribution of income from oil consumers to oil producers, which, in the short run, the oil producers can't keep up --

TARULLO: Is that redistribution of income from the emerging market as well, from low income to high income?

DUDLEY : I think so. If you're in China, if you're working in the city versus you're in the rural sector, your income is dramatically higher. In fact, people say in China --

TARULLO: [Inaudible] you're not just talking about the top 2 percent.

DUDLEY : So both those things, I think, are getting to a couple savings glut, and you could actually see that. If you try to calculate global savings as a percentage of GDP -- we've tried to do that -- and it looks like it's a couple of percentage points higher than it has been historically. Now that leads to the question, is there really a shortfall of investor projects? Or maybe there is a shortfall of good investment projects relative to that new higher pool of savings, but I'm not sure that savings rate where it was historically, there'd be a shortfall of good investment projects. If you had more savings, you need to have more investment, and if you need more investment you have to plum for lower and lower return projects to make savings equal investment at this new equilibrium.

I think the second important issue in this is this is last. In other words, is this rising global savings permanent or temporary? And I think there's a couple of reasons to think it might be more temporary than permanent. First of all, the oil producers' windfall is probably going to be reinvested at some point either in more oil development or in consumption.

The second, it's not obvious to me that the Asian countries, especially the emerging markets -- they're running bigger and bigger current-account surpluses -- that that's going to be an attractive path, considering that the outlets of those current-account surpluses seems to be bigger and bigger piles of U.S. Treasury securities, which at some point are probably going to be devalued as the dollar depreciates. So I think that there are definitely a lot of global savings, but I'm not convinced that it's going to last indefinitely.

TARULLO: Steve? This is straight at the imbalance question.

ROACH: First of all, Dan, I just have to say, you know, I'm sort of shocked at all the time that an esteemed academic like yourself is spending dining with hedge-fund people. [Laughter]

TARULLO: I do want to make it clear, these are lunches. [Laughter] Only when they come to Washington.

ROACH: In any case, look --

LIPSKY: And you're paying?

TARULLO: You know, actually, I did pay for one of these. [Laughter]

UNKNOWN: You ought to rethink that one, too. [Laughter]

LIPSKY: Hedge funds are having a hard time right now. [Laughter]

ROACH: I think that we're making far too much out of this global savings glut story. Let's keep in mind that we have a huge shortfall of savings in the biggest economy of the world, which is our own. We have large surpluses mainly in Asia. The disparity between surpluses and deficits has never been larger as a share of global GDP than it is today. What the global savings argument does, I think, is create a smokescreen to obscure the significance of America's savings shortfall and our current-account imbalance.

And, you know, it's coming out of Washington, where there's a tremendous amount of pressure to deflect attention away from our savings problems. I just don't buy it for a second. It makes it sound as if America is doing the rest of this savings-glut world of ours a huge favor by consuming to excess and going deeply into debt to do that.

And so, I really object to this whole notion of the savings glut as being this framework that makes everything seem OK, and I don't buy the idea that there's a shortage of investable opportunities in a world that is actually more dynamic and more driven by technology, that is being more integrated cross the border than ever before. I think that returns in many asset classes have been pushed down, as you alluded to, by yield-hungry investors who are borrowing for nothing at the short end of the curve, courtesy of central banks who are holding real interest rates at unconscionably low levels. So, searching for yield, investors, speculators, whatever, are driving these returns down.

DUDLEY : Well, Steve, why are rates so low? Real rates are low because there is a global excess of savings. That's the Bernanke argument.

ROACH: I think rates are low because Bernanke and his buddies are running an irresponsible monetary policy. This is a foil to take the blame off of them.

DUDLEY : Why don't we have global inflation problems? Monetary policy, globally, is too easy.

ROACH: Bill, we're having one bubble after another. It doesn't mean that we have to have CPI [consumer price index] inflation in a globalized system, but we can certainly have liquidity go elsewhere, and it's doing that. Take a look at your condo price in New York.

DUDLEY: Could we cure your problem by having more consumption than the rest of the world and more consumption in the United States?

ROACH: I'd love it, yeah.

DUDLEY : Without any change in monetary policy.

TARULLO: And Steve, wasn't that Bernanke -- I don't say what his motivation was, but his point and his policy point towards the end of that paper was that, even if there were significant progress on reducing the U.S. budget deficit, he projected a fairly modest impact on the U.S. current-account deficit. In fact, I think what they're suggesting is maybe one dollar for every five of budget-deficit reduction. It was something like that; it was pretty modest.

ROACH: I'd challenge them [inaudible]. I'd think if you raised national savings by cutting the budget deficit or by putting in place policies that would raise personal savings, the need for the U.S. to import surplus savings from abroad would decline and so would our current-account deficit.

TARULLO: But the savings would still be out there, I think is Bernanke's point.

DUDLEY : And so would the economy, too.

ROACH: Look, again, I think there are two sides to the story. We have our problems, the rest of the world is certainly deficient in its own domestic demand, especially domestic product consumption, and there is a need in Europe, Japan, even in Asia, China, to stimulate private consumption. We know that. But let's not use this as an excuse to pretend that we don't have a problem in the United States.

DUDLEY : I think we do, but the point is it's both.

TARULLO: Arbitrate.

DUDLEY : I think two issues are getting mixed up here a little bit. One is the global imbalance issue, and what Ben Bernanke was trying to address is we've heard the story of irresponsible U.S. policy, unsustainability of these imbalances and the disaster they were going to cause for some years, now. And, after all, the U.S. current-account deficit began to grow notably in the late 1990s when the U.S. had a budget surplus.

So what Ben was trying to address was the issue of, how is it possible that the world seems to have gone on quite reasonably nicely here? After all -- you'd never guess it from the discussion -- last year was the fastest year of global growth in about 20 years, with the lowest inflation in 40 years. So, not a prima facie case that something terrible is happening. So I think Ben was trying to ask the question, how do we get this good performance with these allegedly disastrous imbalances? And I think what he was saying is, it happened organically, not that it's ideal, but it's not because somebody made some egregious error.

And, interestingly, Roger Ferguson, vice chairman of the Fed, gave a very interesting speech that I recommend to all of you, you can find it on the website, in which he pointed out there are five potential explanations for -- you can look at this a number of ways, by the way. You can look at it from the global savings issue, you can look at it from -- a little factoid that I think is little known -- if you look at it from the U.S.-centric point of view, the growth in the U.S. bilateral deficits since '97 are basically tripartite. The general [inaudible] it's all China. The answer is, no, the growth in our bilateral deficits with the euro area has been every bit as big as with China and, surprise, surprise, ditto NAFTA. In other words, there is a more complex story here than often -- it's called the press version -- tells you. There are different -- they're very complex issues going on here.

TARULLO: Well, John, let me ask you. Why -- this is just a question, I'm not challenging -- but why is Washington bashing China and they're not going after these other areas where the bilateral deficits are rising, and to the extent that, and you said correctly, they are?

LIPSKY: Well, that's a complex and partly political issue. And let's call it in the big rubric of, you need -- concerns about reciprocity and equal-market access. And whether China, that's having great economic success in export markets, is going to reciprocate by opening its own markets.

UNKNOWN: There's the case of the exchange-rate regime, as well, that draws more attention to China than would be otherwise.

LIPSKY: Right, but, again, let me come back to Roger Ferguson's five reasons why the U.S. current [account] deficit has increased. He asked, could it be the rise in the fiscal deficit as a percentage of GDP? The decline of private savings rates in the U.S.? The sluggishness of domestic demand growth abroad and the faster productivity growth in the U.S. compared to other countries that would tend to draw on capital? And, fifth, growing financial -- global financial integration that makes deficits financable in a way that would not have been possible in the past? And he says, basically, all five are involved. And I think that's right.

I take it one step further to say, OK, of those five, four are moving in the right direction. U.S. fiscal deficit could well be under 3 percent of GDP this year. It's going to be much smaller than has been anticipated generally. Secondly, I'm convinced that the U.S. private savings rate is going to go up in the next few years because you're not going to have a repeat of the windfall wealth gains that drove the savings rate lower in the late 1990s. [Inaudible]

We just have heard a story that productivity growth abroad is actually going to improve, not necessarily that the U.S. is going to do worse, but foreign growth is going to do better. And I think that there's likely that domestic demand growth abroad is going to improve. In other words, four out of those five point to improvement going forward. So not to say that nothing should be done, everything -- this the best in all possible worlds, but it strikes me that the sort of thundering about -- risks exist, for sure. But I suspect that the talk about the threat of the current [account] deficit has been more misleading than helpful.

One other issue here: What's the hedge-fund problem? The hedge-fund problem is lack of volatility, that things are going -- not only are going well, they're too smooth.

TARULLO: Nothing to hedge against?

LIPSKY: Right. So it strikes me if that is happening -- when you talk about lack of investment opportunities, no, I don't think so. I think the problem is lack of volatility, which says that, folks [inaudible] hedge funds are in a hard time, not to say impossible time, providing -- attaining the nominal returns that they have implicitly or explicitly promised their investors.

Bigger picture: I think this whole economy is accommodating itself to the idea of lower sustained inflation rates, and businesses are in the process of lowering their hurdle rates, recognizing that the kind of nominal returns they've looked for in the past are just not going to be there in the future. And rates of return that didn't look appetizing two years ago tomorrow are going to look pretty good.

TARULLO: John, by the way, do you think that the gross mutual federal funds rate is now going to be lower going forward than it has been in the past?

LIPSKY: If you take -- forgive the jargon -- if you take a tailor-rule kind of view of this, the answer should be, yes. In other words, we should have --

TARULLO: Expected inflation being lower.

LIPSKY: Yes. That should mean that the equilibrium funds rate is lower than it would have been in the past.

UNKNOWN: Nominal or real terms?

LIPSKY: Nominal and real terms

TARULLO: Both of them. Anybody else?

UNKNOWN: Yeah, I would just -- John and I have been too nice to each other. And I just -- if Pete is leaving, I just need to say one thing.

UNKNOWN: Pete has left in disgust.

UNKNOWN: No, no --

UNKNOWN: Because I --

UNKNOWN: -- got to be realistic. He doesn't stop for guys like us.

ROACH: I would say the following. Do not -- do not be fooled by global growth, U.S. growth. It looks strong on the surface, inflation looks low on the surface; unemployment, it's come down in the U.S.; it looks low on the surface. To borrow the lines of [former Federal Reserve Board Chairman] Paul Volcker and the great [Blackstone Group Senior Chairman] Pete Peterson, just beneath the surface, these imbalances, the debt, the lack of savings, the fact that, yes, the U.S. economy is running on empty, is a problem that we need to take very seriously. And the savings glut notion does a huge disservice to that problem, in my opinion.

TARULLO: Bill, do you agree with John that, of the Ferguson five, four are already moving more or less in the right direction?

DUDLEY : I'd be a little bit more skeptical about the medium- to longer-term budget deficit outlook. You're getting some cyclical improvement, but what's going to happen in 2010, 2015, when the baby boomers retire? Also next year, 2006, riding a big new benefit, a prescription drug benefit for Medicare that we haven't paid for. In fact, the present value of that benefit is actually more costly than the current actual imbalance of Social Security that everyone is talking about. So I think that I'd be a little skeptical on the budget.

Coming back to Steve's point, I think -- I'm somewhere in the middle here, because I think that Steve is right, that there are serious imbalances in the U.S. economy. And I think that the U.S. economy is going to have difficulty addressing those imbalances because at some point what it's going to require is a lot less consumption in the U.S., a lot less housing in the U.S., and a lot more production of tradable goods and a lot more investment. And that's not going to be an easy transition.

TARULLO: You don't actually mean less; you mean slower growth, though, right?

DUDLEY : Slower growth. Less as a proportion of GDP. And the second thing that's going to have to happen, though, to facilitate this adjustment without having the economy -- the U.S. really weak is, you do need more demand growth, domestic demand growth in the rest of the world. So it really takes two.

And I think the problem here is that people think that this adjustment process is going to be easy. It's not going to be easy, because the Federal Reserve has one instrument, the federal funds rate, and it's going to be very hard to manage these two adjustments, so the current-account deficit and the household savings rate, in a way that keeps the economy on an even keel through this adjustment process.

TARULLO: So your emphasis continues to be that the situation arises from the simultaneous circumstances in different parts of the world. And your last comment raises the issue, obviously, of, so how do you move off of that? And it seems as though, if you're sitting in the United States, and you're saying, "Wow, gee, if we constrict domestic demand, then we have a big constriction on what's going on here with no guarantee that there is going to be a pick up in growth abroad." If you're sitting abroad you say, "What, so what are we supposed to do? We're supposed to let our exchange rates go so that we stop exporting with no guarantee that the U.S. is going to do its side of things either?"

DUDLEY: And the problem is even worse than that because the ability of countries and Japan and Europe to stimulate their economy through the fiscal side is so limited because the fiscal situation already is very out of balance. So it's not as if, you know, there are levers to push in Europe and Japan easily to stimulate domestic demand in those economies.

UNKNOWN: But there is. But there is. Structural improvement is exactly a free lunch.

DUDLEY : But it scares people.

UNKNOWN: Productivity acceleration is exactly what --

DUDLEY : Structural reform will get you there in the long run. But in the short run, what's it going to do to workers and consumers? It's going to scare them. Why do you think people are afraid --

UNKNOWN: It's going to raise unemployment in the short term.

DUDLEY : They're going to want to save more, not less, because they are scared of these structural changes that are taking place.

UNKNOWN: In an aging society.

DUDLEY : So you have trouble getting from here to there.

TARULLO: And you're not so worried about that?

UNKNOWN: No, no, I'm not trying to say there are no problems; there are no issues; isn't everything wonderful? But we have let loose two very powerful positive forces in the global economy that are so far from being spent that I don't quite get the reason for overwhelming pessimism. You've had -- think about -- I've even been using the analogy -- I've been using the following analogy. If you remember the debate about whether technology was going to produce meaningful productivity gains in the United States economy -- at the end of the 1980s, famous -- economist famous joke -- Bob Solow, MIT [Massachusetts Institute of Technology], Nobel laureate, saying you can see computers everywhere but in the productivity statistics. Everybody went, "Ha, ha, ha, very clever."

UNKNOWN: He did win the Nobel Prize.

UNKNOWN: Smart guy.

UNKNOWN: A lot of guys get the Nobel Prize.

UNKNOWN: But, as [economist] Paul David of Stanford University wrote in a seminal article that should win him the Nobel someday, called "Computer and Dynamo" that you guys all know, he said, "Bob, the problem with guys like you is, you've been looking at your econometric model so long you've started to believe they're real." And the way productivity and technology are portrayed in those models has absolutely nothing to do with how things work in the real world. And he said in that article in 1989, "Just you watch. In the next five to 10 years, there is going to be a big acceleration in productivity growth, and all the conventional thinkers are going to sit around for years saying either, 'I don't understand what's happening or what -- '"

UNKNOWN: That almost makes Bill's point, though, right? When you're talking about trying to come off of this center, and if you're coming off by taking measures which will have a five-year yield, it's very hard to sustain that, politically.

UNKNOWN: OK, that's fine. But, but, the but is, what are the forces that have been let loose here? One is, let's call it globalization, deregulation, liberalization, all right? And so what we've done is, we're still in the process of assimilating huge populations and resource masses, countries, economies, into the market economy. And we're so far from done with the positive aspects of that, that it goes for a long way. Secondly, are we done exploiting technology?

TARULLO: But we're not -- I'm not disagreeing on any of the trends. Just talking about as a policy matter how you move off center. We should probably move to the questions --

UNKNOWN: So globalization is the policy choice. Deregulation is a policy choice. Liberalization is a policy choice. Low inflation is a policy choice. These are not -- none of these are facts of nature. And if you make bad policy choices, you're right, you could screw it up. But what's out there are the opportunities. And it strikes me that if you step back, what we've been saying is that the new news is good news, not bad news.

UNKNOWN: John, I'm pro-globalization. If we took a referendum on globalization in America today, would it pass?

LIPSKY: How would you word it? [Laughter]

UNKNOWN: Spoken like a veteran of a lot of political campaigns.

UNKNOWN: What does the word "it" mean?

TARULLO: I want to end this discussion with, if you take Bill's perspective that there are many places that need to be moving more or less at the same time, it does leave us with this interesting institutional question. We've got the G-8 [Group of Eight] meetings next week [in Gleneagles, Scotland], where, I assure you, there is not going to be any movement to address any of these problems. [Laughter] And that's spoken like a veteran of many G-8 summits. But it does raise the institutional question as to whether the right people are actually involved in the right kind of process right now. That is to say we talked today about the emerging-market countries, and the bulk of -- if there is a savings glut, the bulk of the savings glut comes from the emerging market countries. Surely the bulk of increase in current-account surplus --

UNKNOWN: Well, Japan's got [inaudible] --

TARULLO: Comes from -- has come from them. But with the exception of Japan, the other major big-saving, big-current-account-surplus countries are not involved in this. And right now, there is no institutional way to move it.

TARULLO: OK, let's move to questions. And I'm going to start, actually, with a question from one of the Council's national members. Boy, if this man has gotten up this early in Tucson to listen to this, we're definitely are going to ask his question. He wants to ask about the U.S. housing market. Maybe it's some interest to people from the Upper East Side sitting in the room. It appears that the U.S. housing market has skyrocketed in terms of valuation. What do you see occurring in this sector of market activity in the foreseeable future? Are high valuations likely to stick? If so, for how long? Steve, they're not going to stick, I know that's your view. When does the bubble burst?

ROACH: Next week. [Laughter] I don't know. I mean, look, we probably don't have agreement on the fact that there is a bubble. I do believe that we have enough of the housing stock in America in a bubble that it does represent a clear and present danger to the rest of the asset class. Twenty-three states plus the District of Columbia currently have house price inflation in excess of 10 percent year on year. Twenty-five of our 100 largest metropolitan areas have house price inflation in excess of 20 percent year on year. Eleven and a half percent of conventional newly originated mortgage loans are taken down by investors-slash-speculators rather than owners. That number was 2 percent five years ago. Five years ago, we had a dot-com bubble that popped, and everybody was saying, "Oh it's just a few stocks, don't worry about it." S&P 500, the entire asset class, fell by 49 percent over the next 2-1/2 years. The housing values, hopefully, will not fall by 49-1/2 percent over the next 2-1/2 years, or this room would become a youth hostel. [Laughter] But there is broader risk to the asset's value --

UNKNOWN: [Inaudible] good thing Pete's gone now.

ROACH: There is a much broader risk to the asset class than we have been led to believe by our irresponsible central bankers, who deserve blame for this.

TARULLO: John.

LIPSKY: Well, two quick observations. One, if the idea that markets are going to overshoot and undershoot, I don't think that comes as news to folks. Bubble says something is going wrong egregiously, and the result is going to be very damaging. But the assertion of a bubble, to my mind, is not more sophisticated than the assertion that, "You're all stupid. I know the right price for those assets, and you don't." Could be, but let's look for the evidence.

Housing affordability is as high as it's been in 30 years at a national level. Debt-service ratios for homeowners, let's use the Fed's high-tech version, the financial obligations ratio, hasn't moved in a decade. And if you take the last couple of years of observations, house prices are going up much faster than income. But if you take the last 25 years, you will find that for 20 out of the 25 years, house prices have gone up much more slowly than nominal income. In other words, when you look at the macro variables, to say that there is a bubble, it doesn't leap out at you. To say that price -- the rate of price increase is unsustainable -- is, I think, almost self-evident.

But remember, oftentimes, you have to listen closely because -- you know we've all heard end times, the economist joke of [former Council of Economic Advisers Chairman] Herb Stein, that if something is unsustainable, it will stop. So when somebody tells you, it's unsustainable, you've got to do something. I always think, "Well, no, no, it's unsustainable, I don't have to do anything because it's going to stop."

Oftentimes what people mean is, "It's -- I'm afraid it's sustainable, but I don't like it and I want you to stop it." Now, in this case, it seems, as I say, self-evident that the rate of increase in house prices is going to slow down or could even go down a little bit. Is there something dramatically wrong, here? I think this is all part of the process of getting used to an economy of sustained low inflation. And I would be worried about the housing market big time if I thought the Fed was going to fail and we were going to have accelerating inflation. If that were the case, then I'd be worried. But I think the Fed, that has promised us price stability over the near term, is going to deliver.

TARULLO: Bill?

DUDLEY : I think the one point I just want to add to this is, one reason why housing prices are going up a lot is because real interest rates are coming down. Five years ago, 10-year TIP [U.S. Treasury inflation-protected securities] yields were 3-1/2 percent. Today they're about 1-1/2 percent. When you capitalize land [inaudible], if real rates have declined in half, land prices should double, at least in theory. And so that's what really is getting embodied into a large degree into housing prices.

Now where are housing prices going to go? Well, that depends on what happens to real rates. If real rates go up, then that is going to end the boom in housing, and the Fed Reserve is going to have something to say about that. But I think if you really want to explain why housing prices are going up, I think the decline in real rates is the best place to start.

TARULLO: We all resisted the impulse to talk about [inaudible]. Log on when you get to your offices and check it out. OK, questions from the audience. Yes.

QUESTIONER: Ralph Buultjens, New York University. I would like to ask the three members of the panel for their assessment of the impact of the oil price spike on economic growth in the next foreseeable future, short-term future.

TARULLO: Bill?

DUDLEY : I think -- the point I guess I would make is I think it really matters why oil prices are rising. If oil prices are rising because demand is strong, it's hard to get too worried about the growth outlook because of the rise in oil prices. But if oil prices are rising like they were in '73-'74, '78-'79, or '90-'91 because of a supply disruption, then there is every reason to get worried about the growth outlook because of the rise in oil prices.

So far, this looks to be mostly demand-driven, and, as such, I think it's one reason it hasn't damaged the economy very much. It's a reflection of a pretty strong global economy. As John said before, last year was the strongest global growth year in 20. This year is going to be somewhat weaker than that, but it's still going to be a decent year for global growth.

TARULLO: And you're not worried when it's demand-driven, because you think it's somewhat self-equilibrating.

DUDLEY : Exactly. I mean, if the higher oil prices start to affect demand, then demand for oil will lesson, and the oil price will come right back down again.

LIPSKY: And there's a subtlety. Actually, Bill already mentioned it, but just to make sure it didn't go by too fast. Oil prices up 20 bucks a barrel average, let's say, this year. World consumes 30 billion barrels a year. That's $600 billion of purchasing power transferred from oil consumers to oil producers. That dampened global growth not decisively, but there is no way that oil producers increased their spending by anything like that amount, and it's gotten recycled into a very few global financial markets, mainly U.S. dollar markets.

So as long as the rise in energy prices doesn't dampen -- doesn't deteriorate inflation expectations more broadly. In other words, if people don't think if oil prices go up everything is going up, and that's been the case so far, then you have a mechanism by which the rise in energy prices, as long as it remains of the character that Bill says, namely, demand-driven and not supply-driven, what you end up with is a mechanism that slows growth slightly, keeps inflation under control, recycles a lot of money into the U.S. market, and helps keep long-term interest rates and interest rates in general, low.

UNKNOWN: I have nothing to add. They're both of them brilliant. [Laughter]

UNKNOWN: You are tried.

TARULLO: Any other questions from the audience here? Yes.

QUESTIONER: Rita Hauser. Bill, I wanted to ask about Goldman Sachs' rather startling projections about economic growth of China. And as I remember correctly, if my dates are wrong, in 2015, China would be the No. 2 economy and 2025 or thereabouts come into first place.

DUDLEY : It takes a little longer. But, yeah, if you look at the trajectory of China, and you assume that it follows something similar to what's happened to Japan from 1960 to 1990, absolutely. If you look out 30, 40 years, China would be the No. 2 economy in the world. And obviously, there are going to be lots of challenges for China to follow that type of projection.

TARULLO: Geometric total GDP?

DUDLEY : Yes. It's not per-capita GDP; it's total GDP. So there are lots of challenges for China, especially how China makes its transition from the Communist Party control of China to loosening the reins. How is that going to work, over time, as you get an emerging middle class in China? But I think the -- it's very reasonable to assume that China is going to be a very major economic power as you look out over several decades.

UNKNOWN: Hey, Bill, can I ask you a question about another Goldman Sachs forecast? You guys have a forecast of $115 oil over some --

UNKNOWN: Is that demand-driven?

DUDLEY : We actually don't have a forecast of $105 oil.

UNKNOWN: Then you need a new PR firm. [Laughter]

DUDLEY : That's probably true. [Inaudible] wrote a paper about oil prices about two months ago, and he said that these forecasts for oil price, if I remember correctly, was about $55 this year and $60 next year. But he said there was a risk of a super spike to $105 a barrel if there were some sort of supply disruption. That became the forecast in the media, $105. That's all the media heard. And it was pretty amazing, because this was all readily apparent on the first page if you had just gotten a copy of the document.

UNKNOWN: So you're disavowing the official deal with [inaudible]. [Laughter]

DUDLEY : I'm disavowing any knowledge of the media's accuracy in this case.

UNKNOWN: All right. It's always the media's fault.

UNKNOWN: Wasn't there something in your coffee?

DUDLEY : Same coffee I drink every day when I -- [Laughter]

TARULLO: OK, yes, right here.

QUESTIONER: [Inaudible], Pace University. I'd like to probe on what Steve calls European angst. The most visible political movement in Europe today seems to be one that portrays a European model in sharp distinction to, quote, "the Anglo-Saxon model," is sharply hostile to structural reform and so on and so on. And it really -- my question is, have we -- should we be as optimistic as John seems to be? And how strong is this political movement likely to be over the next two years? Thank you.

LIPSKY: Sure, I'll jump in. I'm -- maybe I'm naive here, but it strikes me that the more the verbiage gets kicked up, the more it reflects the opposite happening in the ground. What do I mean by that? Let's take a step back, Germany, where you've had a lot of this kind of rhetoric. What's happened? The [German Chancellor Gerhard] Schroeder -- everybody forgets, the Schroeder government's first finance minister was Oskar Lafontaine, right? And now they are being criticized for having been too aggressive for reform -- on reform, on the one hand, but the CDU/CSU [Christian Democratic Union/Christian Social Union], which looks like it may well take power in just a few months, portray themselves as more aggressive on reform, but better, but more aggressive, than the SPD-Green coalition. And you step back and say, "CDU/CSU, reformers? My goodness, they were in power for many years and we never noticed that before." So you'd say, in practical terms, despite the verbiage, in practice, things have moved very clearly in one direction.

Ditto in France, and it just strikes me that when you look at what's really happening, even at the political level -- forget the verbiage -- despite all this -- I consider that almost a cover story for what's really going on.

TARULLO: One other thing: There is a lot of that sentiment that bubbles up in the polling that's done in Europe. But I, at least -- the reason I'm sort of optimistic on the EU in the near to medium term is because a lot of what citizens are complaining about have nothing to do with the EU and what the EU actually does. There are pieces here and there; they don't like Brussels and all the rest. But a lot of it is familiar to us: reaction to economic change, to globalization, and the like. And if the EU were never to do anything again, people in these countries are going to be subject to the same kind of pressures.

And I think, and I know the nascent political leadership in Germany thinks that as soon as people recognize that it's not a question of whether there is an EU constitution or not, and it's not a question of whether you rationalize EU governance or not or add another commissioner or not, but it's something that they're going to have to confront and that the nation is going to have to confront, that then the kind of forces that three of the panelists have been talking about are just going to move forward, because it's really going to be a question of survival.

UNKNOWN: But then we can't minimize the question. Out of the ravages of World War II was born a European social model that the political -- or the body politic in Europe today still holds to be a very precious value of Europe. And what we're suggesting here is that this model is going to be progressively -- maybe dismantled is too strong -- but progressively eroded in favor of more of a dynamic market-based model with less of a deeply entrenched social contract, along the lines of what we have in the United States. That is a huge undertaking for the body politic --

TARULLO: I actually -- I'm not sure that's right. Yes, the European social -- post-war social model is going to be disrupted. But a very important feature of that postwar model was relative stability of employment within a particular company or industry or sector.

I don't think [inaudible] it's a foregone conclusion at all that the, by our standards, quite generous package of unemployment benefits, maternity benefits of other social benefits, will disappear. But they're going to -- it's going to be in the context of redistributive policies and not being able to stay --

UNKNOWN: But the model is being challenged. [Inaudible]

LIPSKY: You need to see this in historical context. At the time that the Europeans adopted these very generous provisions, their economies were growing -- the European economies were growing faster than ours. And unemployment was exceptionally low.

We used to send -- the Brookings Institution would have studies of how is it possible the European economies can have unemployment rates of 1 [percent] or 2 percent. So that generosity was in the context of very low cost. The idea was, "The poor [inaudible] who couldn't get a job, you better help them because, how can somebody not have a job?" So this generosity, in principle, wasn't possible. What they created inadvertently was a persistence mechanism when their external shocks that raised the unemployment rate never came back down again.

So you've got ratcheting up, ratcheting up and now it's hugely costly. And so now it's being reassessed, not just because they want to be heartless, and it's not just because of international competition, it's because they produced results that were never intended or expected. And they were have to --

TARULLO: And the only way they're going to be able to sustain a reasonably generous package of social benefits is through greater economic growth --

LIPSKY: Absolutely.

TARULLO: [Inaudible] -- comes with the structural reform.

LIPSKY: Absolutely.

UNKNOWN: And I think the point that Dan makes is a very good one. There's the EU issues, and then there is the demographic challenge that Europe faces that is totally independent of the EU, and it's a big challenge because the pension benefits that have been promised to European workers are not affordable to the European government states --

UNKNOWN: Sort of like GM [General Motors], right?

UNKNOWN: That has nothing to do with EU.

LIPSKY: Well, but there again, there again. What is the fact? The fact -- the starting point is very low participation rates, compared to other economies and other advanced economies in Europe. In other words, there is the possibility that reform produces much -- quite rapid and significant improvement in performance.

TARULLO: Last work, now, before we close, I just have to say everybody in this audience knows Steve Roach is a trooper. But I don't think you know how much of a trooper he is because last night he was in Toronto, and after the fourth consecutive plane didn't take off because of all the storms in this area, Steve got

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