Falling Oil Prices, Europe's Quantitative Easing, Nervous Markets: The Global Economy at the Start of 2015

Wednesday, January 21, 2015

Event Description

Nomura Securities' Lewis Alexander, LSE's Philippe Legrain, and CFR's Michael A. Levi, join CFR's Sebastian Mallaby, to discuss the global economy in 2015. The panel discusses oil prices, quantitative easing in Europe, and Greece and Russia’s economies.

This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies.

Event Highlights

Lewis Alexander on global markets:
“…research would tell you that the benefits for oil importers aren't always as great as the cost for the others. …there's also a lot of concern about what are the financial consequences that come with that. I think in addition to that, you've got major parts of the global economy that are suffering with serious risks of deflation and serious questions about the effectiveness of policy. That's certainly true in Europe. That's certainly true in Japan. …it's a nervous time. And that's what markets are reflecting.”

Philippe Legrain on the United States’ position as the only major economy that is strengthening:
“First of all, how high can the U.S. dollar go, and two, relatedly, to what extent is the United States willing and able to resume its role of pre-crisis, of being the…consumer of first and last resort? And I think that is really crucial for determining the global outlook.”

Michael Levi on oil prices and fuel subsidies in emerging economies:
“…with falling prices, you can remove some of these subsidies without having to have that big, immediate impact. And so you've seen smart leaders respond in India and Indonesia…and in a host of other places where you have subsidy forms underway, leaders are looking at reforming those. And those should help these countries be stronger not just now, but for the longer haul. I think when you look at the impact on emerging economies, it's both this immediate piece, but also what the leaders do with some of the political space that's created.”

MALLABY: This is normally called the WEU World Economic Update. Today, it's called the NDU, the Non-Davos Update. We promise that there is no ice outside, at least until this evening, that there is no jet lag for most of you, that you will not slip on the sidewalk as you get out, and it's a lot less expensive here, OK? So be grateful.

We have a great panel to survey the latest in the world economy. Lewis Alexander, frequently on this show. Philippe Legrain in the middle, who comes from the London School of Economics and was until recently an economic adviser to President Barroso, the former President of the European Commission. And Michael Levi at the end, who is—directs the Maurice Greenberg Center for Geoeconomic Studies and is the CFR resident expert on energy, climate, and much else.

So I think we'll start here with Lewis. On a kind of big-picture world economy assessment, the IMF just revised down its growth forecast for 2015 slightly. The IMF always seems to revise down its growth forecast. But anyway. It's a slight downward revision, but it's still higher. The projection is now 3.5 percent, which is more growth than there was last year. Equally, the markets have been very volatile. But the last time I checked the MFCI global index last week, it was still up on the—on the year, marginally.

So the question is, there's a lot of nervousness out there. But, you know, in a big-picture sense, where are we? Is this a good time or a bad time for the world economy?

ALEXANDER: I think it's a very mixed time. One of the things you didn't mention is they actually revised to up the forecast for the U.S. And I believe it was the only country—only major country which they did. And that highlights one of the challenges that we face. It is—we face an unusual degree of divergence between the United States on the one hand and where policy is going there, and what's going on in rest of the world.

I think there's a lot of questions about what does oil mean. The general view is that there are more oil importers than there are oil exporters. And so in some general sense, the fact that we've had a kind of supply shock is a good thing for the global economy. But there are a lot of questions about that. I think the research would tell you that the benefits for oil importers aren't always as great as the cost for the others. And I think that's part of the tension you're seeing.

I think there's also a lot of concern about what are the sort of financial consequences that come with that. I think in addition to that, you've got major parts of the global economy that are suffering with serious risks of deflation and serious questions about the effectiveness of policy. That's certainly true in Europe. That's certainly true in Japan. And so I think it's kind of a—it's a nervous time. And that's what markets are reflecting.

MALLABY: You mentioned that the U.S. was the one economy to be revised upward. That's something that President Obama celebrated last night in his speech. He also made it clear that he wants to make a push, notwithstanding the hue of the Congress, for some sort of redistributive policy.

And I'm just wondering whether there's a potential irony here about the timing of that push, in the following sense: it's true of course that median wages have been stagnating, and the gains from growth have not been flaring down, but if you had to pick a moment in the last five or maybe ten years where there were some signs that that might soften, that problem, I would guess that is now.

Let me just see how you—how you react to this. First is that the labor market has tightened quite a lot. And that normally portends some upward potential for wages. And in the Financial Times this morning, there is a report precisely of that effect occurring in the UK.

Second is that healthcare inflation has been slowing. And that should feed through into other forms of compensation.

And the third is that there's obviously a positive distributional effect from softer oil prices.

So for all these reasons, I'm just wondering whether, you know, the President has pushed on the redistribution issue, when it's actually less urgent than it has been.

ALEXANDER: I guess I'd spin that in a slightly different way. And partly what I would say is when you have a cyclical problem, obviously, that's in some sense the first priority. I think in a certain extent, ever since the recession in 2008 and 2009, the overwhelming priority has been let's sort of deal with the cyclical shortfall.

I think the fact that we are—we still have this problem of distribution is an indication that this is a fundamental structural problem that, frankly, cyclical recovery can't solve by itself.

If you actually look at the late 1990s—which was the last period when we really had a sort of what I would describe as a high-pressure economy in the United States, unemployment rate sort of well below NAIRU for an extended period of time—you did see some moderation of these divergent trends on income distribution, but only to a realty relatively modest degree.

I think to a certain extent the—you know, the way this issue has (inaudible) up and persisted is an indication that this is a deep structural problem, and a cyclical recovery by itself, while it will help, will not solve. And so, you know, in some sense, you have to turn to that—you have to turn to other policies to address that.

MALLABY: Maybe I could go to Michael next. Because Lewis was talking earlier about the way that there's a mixed impact from oil on the U.S. economy. And maybe you could flesh that out a bit. How do you see the pluses and minuses?

LEVI: So first, at the global level—obviously the globe is not an oil importer or an oil exporter. So the question that you have to ask is, how does a shock to shift revenues from countries and people who are likely to spend them to those that are less likely to spend them or from those that are less likely to spend them.

And the general sense is that a fall in the oil price shifts money from those who are less likely to spend, both across the global economy and within individual economies, to those who are more likely to. And that's the basic sense for why people think this is generally a boost.

When you look at the U.S. economy, there are three basic pieces. So the first is how does this affect producers? And historically, the basic sense has been that this helps producers overall a bit, because they have cheaper inputs, but that this isn't the main channel through which oil prices affect the economy. Now, we have a very different situation because so much investment in the United States in recent years has been in the oil and gas sector and supply chain. So I think people see this as being a direct hit to producers.

The second is that it puts more money in people's pockets. And there the big question is, do they spend it? And those who think that this will provide a decent boost to the U.S. economy tend to imagine that they will spend a decent piece of that, which will help the economy more broadly.

And I think the big question mark, particularly if you're looking at the historical data and trying to extrapolate it to the future, is what's the role of monetary policy? A lot of the work going back—a lot of the work is very ambiguous. If you go back over the last forty years and people try to figure out what changes in oil prices do to the economy, it's very ambiguous. But when analysts have large estimates of the impact of a big change in oil prices on the overall economy, they tend to include a large component that has to do with the central bank acting. And in the case of falling oil prices, that means using the flexibility created by falling oil prices to have more accommodating monetary policy. And there's a reason—and I think the others on the panel can speak more to this, to be skeptical that this will have a significant impact in that direction.

MALLABY: Well, I mean, let's just follow that thought through for a second. So, you know, clearly, you're right. The transmission mechanism from cheaper oil, less price pressure to growth is partly through looser monetary policy.

So the question must be where is that scope for effective loosening? So in the U.S. case, it could show up in—in a decision not to tighten so early. So it seems like presumably there is more potential feedthrough there than, say, for example, in Europe where they're going to do QE probably anyway. We'll get to that in a second. And there's a doubt about how effective that will be. Or in Japan, where they are kind of pulling the monetary trigger as much as they can already. Can you --

LEVI: There are other—there are other limits in most places to the decision to loosen. And, again, if you look historically, the case that you really want to draw on is 1986.

So you have two different kinds of oil price falls. You have ones that are triggered by—primarily by weak global economy, and ones that are triggered primarily by an unexpected increase in supply. And the current one is a mix of those. But there's a substantial part that's actually an increase in supply, rather than a weak global economy. And you have to go back to 1986 to see the last example of that.

And when people look at the macroeconomic impact of the oil price fall in 1986, they tend to see that it's considerably weaker than one might expect if you just sort of took a generic impact of an oil price drop. 1986—1985, 1986, growth was actually weaker than in 1984, despite a collapse in the oil price of about 50 percent.

And in that case, there actually is a considerable movement from the Federal Reserve to lower interest rates, take advantage of the opportunity, boost the economy. But it still comes out with weaker growth in those years.

MALLABY: I want to come to Philippe in a second about the QE in Europe. But Lewis, you had a quick --


ALEXANDER: Yeah. Just a—just a quick observation. I think a big part of why long-run interest rates in the U.S. are where they are is because what's happened to oil has affected the market's expectations for the pace of tightening. And so yes, while we are at the zero lower bound, there's an expectation over the course of the next several years that the Fed will be raising rates. And I do think what's happened to the price of oil has affected those expectations.

So I would argue at least for the U.S. case, there is a significant offset that, frankly, we're already seeing in terms of these here financial conditions coming centrally through long-run --


MALLABY: So the U.S. is getting a monetary feedthrough from oil prices.

Philippe, what about Europe? You're skeptical about—you think monetary policy is basically stuck there, right?

LEGRAIN: So I just wanted to make one quick point on the global outlook. Lewis is absolutely right that the U.S. is the only major economy that is strengthening, while most of the rest of the world is slowing. And the rest of the word is tempted, therefore, to try and push down its currency in order to compensate.

Which brings about two questions. First of all, how high can the U.S. dollar go, and two, relatedly, to what extent is the United States willing and able to resume its role of pre-crisis, of being the kind of consumer of first and last resort? And I think that is really crucial for determining at the global outlook.

In terms of the ECB's expected decision tomorrow on QE, I think, you know, the ECB is massively behind the curve. We now have falling prices in the Eurozone. And it's going to take a commitment to do whatever it takes in order to shift inflation expectations, which have become unanchored.

And the fact is is that while it's a big step forward that the ECB is going to announce QE—and it's probably likely to be around 500 billion euros and it'll probably be in proportion to each country's capital cut contributions—that Mario Draghi, even if he wanted to, is not in a position to make a commitment to do whatever it takes, an unlimited commitment that is needed. And therefore, I think that QE is going to disappoint, and that ultimately, the Eurozone is sinking into a deflationary debt trap.

MALLABY: So you're making a point here that the efficacy of QE in some sense is kind of a faith healing game. And if the faith healer is saying, you know, expect me to, you know, pump up asset markets and stimulate the economy with this policy, but the faith healer's assistant—namely Germany—is saying don't believe him, don't believe him, don't believe him—the expectations are not going to work.

So that's one problem. But isn't there another one about just the nature of the financial transmission mechanism in Europe? You don't have deep capital markets. You do have banks, but banks face regulatory burdens right now.

LEGRAIN: Yeah. I'm skeptical about how effective QE has been, even in the United States and the UK and Japan. I think it's inflated asset prices and not so much had an impact on real investment. You know, it's easier to make money from financial speculation than from taking risks in the real economy.

But that's the case even with a government that is fully supportive of the central bank. In the Eurozone, we have the ECB going ahead with limited QE, conditional QE, with the most powerful country in the Eurozone, Germany, vocal in its opposition. And therefore, it's doing it with one hand tied behind its back. And it certainly isn't going to be able to deliver the whatever-it-takes commitment needed to shift expectations.

Had we done this earlier, perhaps. But, you know, I think we're so far behind the curve that you need something bigger and bolder than what's going to happen.

MALLABY: Lewis, are you equally pessimistic? I mean, you could argue that in the Japanese case, at the beginning of Abenomics, the first reports on the success were actually quite positive. I mean, the central bank commitment to double the size of its balance sheet had some effect. The problem was that then consumption taxes were raised, and that killed the recovery.

So doesn't that example suggest that even when you're behind the curve—maybe Philippe wants to come back on this. Even when you're behind the curve, the central bank can make a difference if it is properly supported, as Abe was supporting and, indeed, urging the bank of Japan to do this, then it does work.

The problem in Europe is that you don't have the equivalent of sort of Abe. The political support is not there for—for Draghi.

ALEXANDER: I agree very much with the way you characterize it. And look, I—these things are always difficult, and it's never totally clear how they're going to work.

But if you just look at Japan, there was QE more than fifteen years under Hayami, where it was clear that the bank of Japan was—wanted to get out of it as soon as they could. So they kind of went into it, but they went into it very reluctantly. The difference between that and what Kuroda has done, I think they very much understand the point you just made. And I think the way you framed it is exactly right. If this is done in kind of a halfhearted way without the clear commitment of the full ECB behind it—so there's always this question of how unlimited is it really, then it's much harder to see how it works.

I guess I'm perhaps a little more optimistic that we may be positively surprised this week. We'll see. You're closer to it than I am.

I guess I would argue in the U.S. case, I'm perhaps a little more upbeat on what QE has done. One of the things I would stress is that obviously in the wake of the crisis, a lot of what we were dealing with was balance sheet adjustment. And if it did nothing else other than ease that, I think that was an important contributor to sort of where we are. And so I guess I'm not so negative on it.

I do think the crucial question is is it plausible; right? Ultimately, I agree that they're—you know, Europe is facing very significant sort of deflationary pressures, and it is going to take a substantial commitment—you may not be able to get quite to Kuroda's level. But something that's more than just a grudging 'we're doing this because we have to and we're going to get out of it as soon as we can' kind of approach.

MALLABY: I'm going to come to Greece in a minute. But I want to first ask Michael something, which is that if you think back to sort of the middle of last year, in the Eurozone, one of the things that would seem to be dragging on growth more than one might have predicted if you just looked at the numbers, was that the Ukraine crisis was affecting confidence in Germany and causing a sort of drying up of corporate investment and a downward revision in German performance. Since then, Ukraine is still in crisis and Russia has entered crisis, at least the currency crisis. There may soon be a banking crisis.

So what's your outlook if you—if you just—can you sketch a bit how you see the Russia thing playing out, a classic oil economy? And—and then maybe we can talk about how that feeds back into Europe.

LEVI: And in some ways, worse than a classic oil economy. Because it's a classic oil economy with these financial constraints coming out of sanctions. So I think you had the headlines in December with the collapse of the ruble and this big focus on the currency side and how the increase in Russian central bank interest rates had not succeeded in stemming that plunge. And then there was this immediate focus on the currency side. Less focus, I think, than probably is warranted on what will happen with the broader economy over the next couple of years. A lot of the impact of what happened then will play out over the next couple years. You put interest rates that high, it has a broad effect on the economy. So not—so essentially, distributes some of the pain that would normally be focused in the oil and gas sector throughout the whole economy.

And that inevitably has spillovers into Europe. I think on the geopolitical front, that creates challenges in sustaining unity between the United States and its European partners when it comes to maintaining or strengthening sanctions against Russia.

MALLABY: Philippe, do you want the comment on that feedthrough from Russia into German and Europe?

LEGRAIN: Yeah. I think that the EU has been taken by surprise by the success of sanctions in weakening the Russian economy. They think—European policymakers saw them as almost kind of symbolic. And now that it is causing the Russian economy to go into a tailspin and potentially have a financial crisis, they are quite concerned because, obviously, Europe is much more exposed economically to Russia than the United States is. And that's why there's already talk about the EU potentially not renewing some of its sanctions when they come up later this year. So I think, actually, sanctions have been a great success.

MALLABY: I want to go back to something that Philippe said earlier and put it to Michael and maybe Lewis.

So Philippe made the point that, you know, the euro's already devalued a lot against the dollar. One of the channels through which QE would function would be further devaluation of the euro against the dollar. We've seen dramatic move against the Swiss franc, of course. And all of this is happening at a time when the Japanese would also like to stimulate their economy by devaluing against the dollar. China, with downwardly-revised growth, may be tempted to go back to a strategy of inflating its current account surplus again.

And so the question that Philippe raised, which I think is a very good one, is what are the limits to tolerance in Washington of everybody else trying to grow off the back of a strong dollar? Do you see there being a policy reaction against this?

LEVI: Yes. And I think it's particularly going to be seen in the trade discussions that will be a focus this year.

I do want to highlight one thing that you mentioned, is the China piece of this. And China has had its—it's not pegged sharply to the U.S. currency, but it moves closely with it. And so it's had its currency dragged along to some extent with the U.S. dollar over the last however many months. And that's causing some pain and some concern. And so that's something to watch additionally.

But look, as you look at what's happening in Washington, you saw the President try to turn Congress' focus to Transpacific Partnership and asking Congress to give him trade promotion authority. My colleague, Rob Kahn, writes and talks a lot about how these monetary issues are going to come in substantially in the—in the political debate over trade. I don't think that members of Congress or the American people neatly separate these various dynamics—traditional trade discussions, monetary policy discussions—when they think about how the global economy affects them. And if they think that something's happening in the monetary space that they see is unfair and they're being asked to enter a large trade agreement that is supposed to be a next-generation trade agreement, they'll be—there will be questions about why it doesn't deal with the problems that are being seen on this front.

MALLABY: Right. So—so all this unbalanced economy and trying to piggyback on the strong dollar is negative for the outlook on trade agreements, even if President Obama were to get his trade promotion authority, which he asked for yesterday.

Lewis, you want to comment on that, the likely political reaction and...


ALEXANDER: Look, I—I've been struck by, frankly, how well the currency issues have been managed kind of at the G7 level so far. Obviously, that was a big component of Abenomics. And I think the G7, you know, with a large input from the U.S., basically took the position that as long as it was domestically focused and was not focused on the exchange rate, having a very aggressive monetary policy, which had the consequence of a depreciating exchange rate, was acceptable. And so far, I think that—that has helped. I think frankly, as long as the U.S. economy is doing reasonably well, I think that's a—that is a kind of formula that can work.

Look, I agree, you know, trade agreements are going to be important. And the circumstances for them are going to be different than they were in the past. That was clear in the President's remarks last night. He put it in sort of a very different context.

I think—I actually have been reasonably pleasantly surprised at how all of this has been managed on the currency side. And so I'm not overly worried about that, per se. I think we'll have to see how this goes. If we get into sort of a situation where the dollar continues to go up very rapidly, you start to see some obvious drag from that on the economy that is more than just some marginal slowing, then it potentially becomes a bigger deal.

But the dynamics of this are really quite different. If you look at say, for example, where are Japanese autos produced today versus where they were produced in the 1980s, they're largely produced here. To the extent that it's an auto issue, it's an issue about parts. It's not about the cars themselves. I think that has changed the dynamic. I think one of the reasons you've been able to see Abenomics work without it generating those tensions is precisely that fact.

Now, unfortunately, one of the negative consequences of that is actually the depreciation of the yen actually hasn't generated the benefits for Japan that they had hoped. And that's, you know, one of the sort of flip sides of all of this. But we'll see how this goes. I have been in some sense pleasantly surprised that it hasn't been a bigger issue.

MALLABY: I'm going to ask members to—for questions in a second. But I want to go to Greece before we stop. Because, of course, Greece has on election this Sunday which, you know, on one view could be pretty dramatic. And it's already shaken up the markets a bit. If Syriza were to be elected, it says it would like to restructure the debt. Meanwhile, the European sort of center says it won't restructure the debt. So we're heading for a fight that could be quite destabilizing.

But I think, Philippe, you've got maybe a different take on that.

LEGRAIN: Well, the first thing to say is that Syriza doesn't intend to renegotiate the privately-held debt. It wants to renegotiate the debt owed to Eurozone governments. So markets shouldn't panic too much about that.

Second of all, that the fear that this is going to lead to the Greece being forced out of the euro I think is exaggerated. Back in 2012 the German government seriously was considering trying to force Greece out. But that opinion has changed. In any case, there's no legal provision for leaving the euro. It certainly isn't up to Germany to decide. And it wouldn't be in Germany's interest. Because if Greece leaves the euro, they basically lose all the money that is owed to them. Plus, there is the (inaudible) effect of Greek exit potentially on other countries. Whereas if you do a deal with Syriza on a partial rate write-down, you're going to make smaller losses.

Likewise, I don't think the ECB threat to cut off Greek banks is particularly credible. I didn't think it was credible back in 2012 either. I mean, if you think about it, the ECB only exists because there's a currency called the euro. And they don't want to endanger it and splinter it by ejecting Greece. And it would be very hard for unelected cental bankers to take such a political decision.

So I think potentially the election of a Syriza government clearly is going to lead to market turmoil. Clearly, there is difficult negotiations ahead. Clearly, it could all go terribly wrong. At the same time, I think there is a scope for a deal between the eurozone governments and Greece on debt relief.

MALLABY: Well, let me push you a little bit on that. So as I understand it, the European Central Bank holds some Greek government debt which was purchased when Trichet was president and there was a limited program to purchase sovereign bonds. So some of these bonds are going to mature in the next few months. And Syriza's position is we would like you to roll them over. And the legal answer is, we can't. There's no program to roll these things over. When they mature, you pay us the money, which the Greeks don't have.

So what I'm getting at that kind of in a sort of elastic political mindset, your kind of game theory sound right. Right? The center loses more than it gains. But if the center is in a legalistic mood—and we should remember that the ECB was founded on the principles of the highly-legalistic Bundesbank, isn't there a kind of potential for something that is in nobody's interest to happen anyway?

LEGRAIN: The ECB is a highly-political institution. For an independent bank, it takes great care to—about (inaudible) sensitivities. And it certainly is aware of political consequences of its actions. So is that a card which is part of the negotiations? Yes, of course it is. Is it going to be played with the disastrous consequences that might arise? I doubt it.

So in any case, you know, Syriza can find money elsewhere. First of all, if they stop other debt repayment. Second of all, if they raise more money through T bonds. Thirdly, by cutting other areas of spending. I think there is—while it could go wrong, I think there is scope for an agreement.

MALLABY: Do you feel equally optimistic, Lewis?

ALEXANDER: Look, I—I think we have gone sort of down this road. We sorts of broached all of this in 2012, took a step back. This thing that has been surprising to me in that whole process is the broad political commitment across the euro to sort of stick with this, whatever it comes.

I do think there are challenges to getting there. But ultimately, I think as you've seen the politics of this evolve in the euro area, nobody really wants this thing to break up. And I think it will be difficult. There will be—it will be noisy. But ultimately, they'll find a solution.

MALLABY: OK. So let's go to questions from members. And please raise your hand if you have a question and say who you are. If there's no questions, I will ask a question as well. But OK. We'll give you—oh, I can see a question there. Microphone coming. Remember this meeting is on the record. Yeah. Go ahead.

QUESTION: Thanks. I just had a question whether --

MALLABY: Can you say who you are --


QUESTION: Oh, sorry. Gideon Lichfield from Quartz. Do you have an opinion on whether the new head of monetary policy at the Russian central bank, who starts today, Tulin, has a chance?

MALLABY: Who wants to take that?


(UNKNOWN): I have no idea.

MALLABY: Massive silence of up here. Lewis, your game.

ALEXANDER: Look, I think the challenges facing Russia at this point are—are pretty severe. Obviously, oil at where it is is a very different scenario.

Having said that, obviously, they have a lot more resources than they've had. So it partly depends on exactly what version of the question you're asking. Look, I think if you look at Russia's circumstances today relative to, say, '98, which is a relative benchmark, quite different just from the perspective of the amount of foreign exchange reserves they have, the sophistication of the system.

I do think longer run it's a real challenge. And obviously, if we're talking independent central banks, don't know quite how to interpret that in the Russian context. A lot depends on sort of where oil goes from here, it seems to me. There is a—some degree of confidence that we've, you know, probably seen the bottom, at least in terms of where things are likely to average going forward. I think that's obviously a better environment. If that's not right, then it becomes—it becomes much more difficult.

MALLABY: There's a kind of mystery, isn't there, about the Russian central bank in the last three or four months. Which is that they begin this crisis with absolutely enormous reserves. And, of course, you can run through reserves fairly quickly. And we know that central banks like to practice forward guidance with respect to monetary policy, but retrospective guidance with respect to how they spend their reserves. They always announce that 'oops, we've run out'.

So there's some skepticism about the numbers when the announced—when you know that they are using reserves, the announced numbers of reserves are probably exaggerated. I think that's a fair rule from the Asia crisis and from other crises.

But nonetheless, they had a lot of reserves. So they're using these reserves. And then all of the sudden, they switch tactic and they say instead of using these reserves, we're going to jack up the interest rate to some level which, given the fact that projections on the Russian economy are between negative 3 percent growth for this year and negative 5 percent growth this year, it isn't particularly credible, particularly when you have Putin in power, that a central banker is going to get away with holding interest rates that high forever.

So why shift away from the tool that ought to work—namely, reserves—towards the tool that wasn't credible—namely, interest rates.

ALEXANDER: Again, I—look, I think—I would say a couple things. First of all, the—the magnitude of this crisis for Russia has intensified over the period we're talking about. So there was obviously the initial period at the beginning of last summer when you had sort of sanctions and this was initially in its early phases sort of about that. You then have oil prices which started to fall sort of in the middle of the year. And, frankly, over the course of that, I think people really didn't know exactly how far you were going to go.

With respect to the—you know, your initial utilization of reserves and then switching to a different strategy, I think to a certain extent I think you have to understand that in a circumstance where things were deteriorating quite rapidly, as you kind of—as oil prices fell over the fall, and as the effectiveness of the sanctions, which sort of surprised people, sort of started to hold forth.

I think ultimately how you utilize those is—is something in those circumstances which in almost any political circumstance is going to be—is going to be more than an issue for just the central bank. And so look, these are—these are complicated choices. Obviously, you've got a domestic financial system that is to some extent vulnerable in this context. And the question of how you use it to support that as opposed to purely in a macro sense is a—number one, a complicated set of choices. But it is also one that, frankly, I think nobody is going to leave purely to a—to a central bank.

Look, the Federal Reserve found in the midst of its crisis that there were limits to its independence; right? There were—on—there were things that were purely monetary policy. And then the degree to which you use the central bank balance sheet more broadly, it—you know, the veil of independence sort of strips. So I don't think it's that surprising that this has been complicated.

LEVI: Build a tiny bit on this point that it becomes quite political, given the circumstances. If the Russian government without the central bank acting independently with Putin as a major player, needs to support Russian companies that have—that have financing problems. It's very useful to be able to pick and choose. It's not just—set aside the economics of it. It's very useful for a leader who is in potentially weakening political position to be able to pick various powerful players in the economy to reward, to say you're going to do well, I'm going to help you out, as opposed to just operating through these very broad macro channels, where you don't necessarily get the same political payoff.

MALLABY: Yes. Microphone behind you, I think.


MALLABY: Just look behind you at the microphone.

QUESTION: Oh, I'm sorry. Thank you. Patricia Patterson, Patterson Investments.

It seems to me that everything we're talking about this morning and everything we've been talking about for weeks assumes that the Saudis will continue their policy and produce full-out. Can you envision a situation where they might decide to reverse that policy and reduce their production?

MALLABY: Michael?

LEVI: So I can envision two situations that I don't put enormous odds on. At least in, let's say, the next year.

So the first is just that prices fall substantially lower and they decide to step in. And this would be consistent with history. I think one of the biggest misreadings of what's happened in recent months is this idea that this is unprecedented. It's not unprecedented. It's approximately what they did the last time oil prices collapsed. So the last time oil prices collapsed in 2008, there was a sort of OPEC agreement that fell apart within hours to cut production when prices were around, I think, $70 or so. Around $50 was when they actually stepped in with substantial cuts. But they had a very little impact. The price kept falling.

And if you were to take a lesson to that, it might be 'don't cut production if you don't think you're going to be successful'. It reduces your influence and your credibility. And then when prices fell substantially further, around $30 or $40, there was a very large reduction in supply out of Saudi Arabia and a few other OPEC countries that contributed to halting the slide.

So it wouldn't be a shock. I think it would be a bigger surprise this time, given the statements. You've seen the drumbeat of statements not only out of Saudi Arabia, but others. I think it would be a bigger surprise. But it wouldn't be an absolute shock to see at those kinds of prices then do the same thing again.

There's also all sorts of speculation about Saudi leadership and about potential changes. And the best you can say is no one knows what the odds of a big shift are politically. And no one really knows what the odds are of a policy shift that comes from that, or some sort of disruption within the country. But you don't want to, I think, write that off. And I'm not an expert on Saudi Arabian intrigue, but I would say that people who are say don't—don't write this—don't write this off.


QUESTION: Ron Shelp, author and filmmaker.

When you talk about the Euro bank and maybe buying bonds and so forth, it seems to me as an observer from this side of the Atlantic that Chancellor Merkel is the kingmaker. I mean, she plays a role that's just sort of unbelievable. I gather her austerity policies are still very, very popular. Which makes me wonder, as one of you said, just how far this will go and how long it will last. I mean, have I misread the situation? Or could somebody comment on it? Thank you.

MALLABY: I seem to remember that Philippe might have an opinion about Germany.

LEGRAIN: Well, I mean, my view of the Eurozone crisis is that it's a crisis largely caused by the bad lending of German banks, which in turn is a function of the mercantilist policies that Germany pursues; and that very successfully, it has managed to shift most of the cost of the crisis onto the debtors. But now, the debtors are not able to pay those debts in full.

So you have—either Germany has to shift so that there's a fairer distribution of the costs, or at some point the south rebels, or is forced to default and/or leaves the euro. And those, I think, are the—are the only ways out.

The reason why I think that—I mean, you would think that if your priority was getting paid back, that you would be quite relaxed about QE engaging in exceptional monetary—in the ECB engaging in exceptional monetary policy. Because actually, it would increase the chance of you being paid back. But even then, the German taboo about the use of this. And the false belief that the modernization of debt implies losses to German taxpayers limits even that policy scope.

So you've got a German government which says basically, we don't like QE, we don't like fiscal expansion, just give us our money back. And I don't think that's a consistent position. So at some point, there's going—it's going to break.

MALLABY: Yes. In the back there.

QUESTION: Hi, Baily Kempner from the Abraaj Group.

I was wondering if you could comment on how several of these global factors affect emerging markets. And you might take a view that there's a key difference between oil import versus oil export economies. But, you know, you could also argue that as these economies diversify, that difference is more muted.

I was actually wondering beyond the oil prices whether some of those monetary policies—Russia, Greece, et cetera—how those factors also come in to play with emerging markets, specifically beyond the BRIC countries.

MALLABY: There was an Economist headline a little while ago which went, "what Vlad can learn from Chad". The idea being that oil economies in Africa had suffered less than Russia. Then if anyone else wants to pick up on --

LEVI: Don't get yourself into a war and be under financial sanctions.

Look, and Mexico is a nice example of that, as well. And—and more broadly, I'm going to give you briefly a non-emerging economy example. There are a lot of things that matter, even to oil exporters, other than the price of oil.

So if you look at the IMF's revisions a couple days ago to growth estimates, the downward revision to the Canadian growth estimate—Canada, an oil exporter—was smaller than the downward revision to the European growth estimates, Europe oil importers. Why? Canada's tied to the United States, generally has a sound economy. Europe has a much—you know, has a much larger set of problems. So a lot matters there.

I think there are—you sort of separated things. Obviously, there are some oil exporting economies where 50 percent of their GDP is oil. They have no way out of this. At least the ones that have large reserves have ways of dealing with the fiscal—fiscal challenges.

On the oil importing side, I think you've seen interesting developments where not only are these countries passively taking advantage of what's happening, just by lowering their import bills, but some of them are taking advantage of the policy space that's been opened up. So a lot of these countries have been plagued by burdens from fuel subsidies for a long time that, you know, economists will tell you are bad for the economy. They don't help the people, the poorer people who they're really targeted at. But they're politically nightmarish to remove. And in part because you have this—well, in large part because you would have this immediate increase in fuel cost that people would react badly to.

But what you've seen is with falling prices, you can remove some of these subsidies without having to have that big, immediate impact. And so you've seen smart leaders respond in India and Indonesia. And there's—and in a host of other places where you have subsidy forms underway, leaders are looking at reforming those. And those should help these countries be stronger not just now, but for the longer—for the longer haul.

So I think when you look at the impact on emerging economies, it's—it's both this immediate piece, but also what the leaders do with some of the political space that's created.

LEGRAIN: Yeah. I mean, as an oil importer, falling oil prices ought to be good for the Eurozone. And yet, the economy is so weak that the one-off fall in prices is leading to—already to reduced wage offers. In effect, therefore, entrenching the deflationary expectations. It's like wage-price spiral in reverse.

And that tells you that—the mess the Eurozone is in. Even when you get some good news, it ends up having a negative impact.

MALLABY: Lewis, do you want to comment on potential Latin American travel around the corner?

ALEXANDER: Sure. Actually, I was going talk a little bit about sort of monetary --


ALEXANDER:—policy globally and how it affects emerging markets.

We do have—we are at this interesting point where the U.S. is likely to tighten while at the same time we're going to get QE from the ECB, ongoing QE from Japan. I think there's a lot of uncertainty among emerging markets about how that is all going to play out.

I think I'm pretty—I feel quite strongly that the Fed is going to be slow to adjust rates. That doesn't necessarily mean they will be late to adjust rates. But it will—it will not be an aggressive move. I think that will help those economies that are vulnerable to that.

In particular, I would note that one of the important issues is an awful lot of corporate borrowers in the emerging world have borrowed in dollars. And that has played an important part in generating sort of credit growth in the emerging word.

I think there's a lot of uncertainty around how the combined effects of the depreciation of the dollar and higher U.S. rates are going to filter back through that channel. That—if that were the only thing that were happening, I think one would be potentially quite negative about what was going on in that world. I think in some sense we are—the emerging world benefits to some degree that you're going to have these other sources of sort of monetary stimulus that aren't related to the dollar. There are still going to be some effects there. I think we really don't know how exactly all these things are going to play out. It is one of the important questions for 2015.

I think as you see us transition to the Fed hiking—there's an awful lot of concern about how this will play out. It doesn't have to be a disaster. But it is certainly one of the uncertainties we're facing this year.

MALLABY: But at the risk of sounding like a German policymaker commenting on Italy, isn't it the case that in countries such as Brazil, the commodity boom did provide space for the government to take its eye off the ball, both in terms of microeconomic incentives, sort of allowing corruption of the big state-owned companies and so forth. And in terms of the budget, right? They now have to tighten the fiscal position.

ALEXANDER: I—look, absolutely. As is—as is always the case with emerging markets, generalizations are sort of problematic. It is not one story. And that's certainly true when you look at Latin America.

I would very much agree that I think Mexico in some sense is in better shape. First of all, is a more important energy producer than is Brazil. Although, Brazil has become a very important energy producer. And I would argue to a certain extent under Dilma you have seen—there was—there was a period when, frankly, a PT-led government did not make as much progress as it had sort of early in its life. And to a certain extent, that is coming back to cause problems. And I think there's no question that Brazil faces a very serious period of adjustment going forward. It's not a crisis. This is not 1999 or 1994 or one of those other periods when you had real crises in Brazil. But it is going to be a difficult period.

I think when you look around the rest of Latin America, you've obviously got Venezuela, which is a real basket case. And, frankly, it was a real basket case at $100 a barrel and at $50 a barrel it's that much worse. Argentina is another one that is a commodity exporter that is going through serious problems that's in addition to all the—a difficult macroeconomic environment. You've got a political transition that's coming at a difficult time. That's all going to be difficult.

So, you know, you've got a series of countries that are—are struggling to a greater or lesser degree. It is—it is one of those things where there are better stories and worse stories. But it is in some sense a more challenging environment for the region as a whole. When you combine weaker commodity prices across the board, higher dollar—higher—a stronger dollar, higher dollar interest rates, that is a particularly challenging set of circumstances for Latin America.

LEVI: Lewis points at something that is important and that's to some extent being lost in the focus on falling oil prices. And that's that a lot of this is a broader phenomenon on commodities markets, and so affects a broader set of countries. And that's part because of a common shock in demand. There's this huge focus on the supply side of things. But weak global demand is a large part. In the oil space, you know, a little short of a million barrel a day reduction in projected consumption for 2015 on—just on that—from the slowing of the global economy.


MALLABY:—China effect?

LEVI: That is substantially a China effect, but also a Europe effect.

And for some food commodities, also you had a very good crop last year. And so you have actually supply-side forces causing problems in some other commodities markets, and then the demand side hitting across the board. So you have this broader set of countries like Argentina and, frankly, this broader set of issues for a country like Brazil than you would have if it were only the oil price we were talking about.

MALLABY: I think I saw—yes. A question in the middle there.

QUESTION: Chris Brody, Vantage Partners.

I wonder if you'd talk about the Swiss revaluation. Is it significant? Will it impact Europe? Or is it just a small country and everybody knew it was undervalued anyway?

ALEXANDER: I do think it's significant. It's already had a big effect on markets. And it is a—you know, Switzerland's not a huge economy. But it certainly has had a significant effect if for no other reason, than it's affected how risk is priced. You've seen (inaudible) spike and whatnot.

I—just let me comment on this a little further. I think it's a very interesting phenomenon. In some ways, if you go back all the way to '92 in the ERM crises, we went through a series of crises in the '90s that were really about fixed exchanged rates that ultimately broke down. It really started with ERM crises. It sort of rolled through Mexico in '94. And then you had Asia and all of that.

I think through most of that, there was a kind of asymmetry about it, where we kind of assumed that gee, in a world of diminishing barriers to capital flows and sort of growing global capital, it was—it was very hard for a country to defend a country—an exchange rate that was under pressure on the downside from these global flows.

In some ways what's interesting about Switzerland I would argue is essentially, they made a decision that the potential consequences of dealing with it on the other side were so large, that they didn't want to bear the burden.

Now, there are lots of specific things that apply to Switzerland, including the capital structure of the Swiss National Bank and who was ultimately going to bear the consequences of that. But I do think it's—it's indicative of the fact that we live in a world where global capital is just very large and continues to grow. And it's large relative to other things that matter.

So for example, if you think of the fiscal capacity of Switzerland to support its financial institutions in an environment where there's this large capital flows potentially coming in, those institutions could become very large. And you get the sense in which the just general growth of finance has made policies that not that long ago you would have assumed would have been viable, all of the sudden look somewhat different.

And so, you know, I don't want to overdo the kind of immediate impact of it. But I do think it's indicative of kind of a world we live in, where the capital is very large, it's very mobile. And it does put constraints on—on policies in ways that perhaps are surprising.

MALLABY: That—I mean, that is a very important question, of course, because it also says something about the Chinese experience of intervening to prevent an appreciation. It wasn't quite pegged, but it was sort of pegged.

So in China's case, there was always this speculation that of course the process of fixing the renminbi as it was fixed implied a massive accumulation of dollar treasury assets. And the political debate in the sort of Chinese, you know, microblogs seemed to be of the view that the implied wealth loss to the Chinese state from accumulating a bunch of dollars in the trillions, which are going to be losing value when finally the renminbi exploded, that this—this was supposed to be a reason for them to rethink their policy. But it never seemed to actually push to the point where it weighed that heavily in the government's decisions. It was always a discussion. It was never—it never proved to be a decisive factor.

As I listen to you about Switzerland, I think what you're saying is that in the Swiss case, the open-ended accumulation of external assets, of foreign currency assets which ultimately would lose value, was a factor that—is that—is that what you're saying, that that's what caused them to flip?

ALEXANDER: I—I think it's hard to know exactly what drove them. But I think that was certainly an element of it. I think there was probably a financial stability element of it, as well, as they think about just blowing up the Swiss financial system and the potential consequences that would come from that if ultimately the fiscal authorities have to stand behind --


MALLABY: But you'd blow up the deposit side of the financial system, not the asset side necessarily, would you?

ALEXANDER: Well, but ultimately --


MALLABY: Money flows into Switzerland. It goes into Swiss accounts.


ALEXANDER: Yes. Well, but ultimately, they've got to do something with that—those funds. And you don't know sort of the magnitude of the risks they're going to take.

So yes, I mean, at some level that's the immediate effect. But ultimately, if you blow up the size of the system, it's very hard to know exactly what risks you're taking on. And ultimately, there is a kind of contingent liability for the fiscal authorities there.

Look, I—I think it—you know, obviously, Switzerland is a very different case from China. But in some sense, we are dealing with similar things. And partly it is, I would just stress the fact, that the absolute magnitudes of financial intermediation continue to grow. And we think a lot about gee, we had this big crisis and, you know, we had too big to fail and don't we want to shrink finance? Well, it's not happening. And to be perfectly frank, I don't think there's any good reason to expect it to happen. And ultimately, we're going to have to sort of deal with this world where there's just more and more financial intermediation.

MALLABY: So the implication is that floating rates are more desirable even than they were before?

ALEXANDER: Yes, absolutely.

MALLABY: So does that say something about the sustainability of the euro?

LEGRAIN: Clearly, the Swiss decision has already had an impact on people with leveraged Swissfranc positions. It's clearly having a significant impact on the euro. Because one of the mysteries was why when the crisis—at the height of the crisis the euro remained so strong. And the answer is in large part because the Swiss National Bank, as well as the Chinese, was kept on—kept on buying.

And your comparison, I think, with the U.S. and China is quite (inaudible) in the sense that there were people in Switzerland saying, you know, we don't want loads and loads of eurozone assets, especially with—at the prospect of a—more and more eurozone assets, especially if at some point the peg is going to break. And now the peg has broke and actually, you are going to realize the losses on these assets. But that's—there you go.

But I think more important, actually, is what it says about central bank commitments. I mean, this is a central bank which went out and said we're going to do whatever it takes. And central banks are making all sorts of these commitments throughout the crisis and markets have been believing them. And suddenly, markets have got burned because actually, you find out that commitment isn't really whatever it takes. There's little asterisks and a footnote and disclaimer. And I think that is significant if a market (inaudible) across to other central bank commitments.

MALLABY: Another question? Yes, over there.

QUESTION: Bhakti Mirchandani, One William Street.

What are your thoughts on the outlook for global housing?

MALLABY: I saw that the President wants to stimulate further middle class house buying brackets leverage in yesterday's speech.

ALEXANDER: I—I guess I'll—I'll say one thing, which is housing is in some sense not global. Right? I mean, housing is always a kind of regional story. And so you—you really have to answer that question regionally. There are obviously parts of the global economy where real estate—real estate markets are very strong and arguably overvalued, and that's a real risk. And, you know, China would be the kind of top of my list on that as places. I think there are other places where it's much less of an issue. I would put the U.S. in that category, in spite of what the President's proposing.

So I—you know, I think it is—if you look at the parts, particularly of the emerging world that have seen very rapid increases in domestic financial intermediation, a lot of that's linked to domestic mortgage markets. You do see places where that really has sort of become an issue. But I guess I would start by saying I don't think—I don't think one should really think of that as a—as a global thing. It really is sort of country by country.

MALLABY: I think we've got time for one more. And—yes. Yes.

QUESTION: Thank you very much. You mentioned that Russia --

MALLABY: Could you state your name and --

QUESTION: Mahesh Kotecha, SCIC. You mentioned, the moderator, that Russia has two policy tools, interest rates and—and reserves and that reserves are for effective or, by implication, not as effective as interest rates, given the current situation in Russia. But reserves aren't either. They can be spent pretty quickly.

How long do you give the Russians? And do you think that this issue of the fiscal/reserve/economic vulnerability will play a role in how Russia acts on Ukraine and whether Putin survives?

MALLABY: Well, since I was the one who raised that, maybe I'll take a shot at it.

So I guess what I was—if I remember the numbers right—and if somebody remembers better, they can correct me. I think, you know, in last fall central bank reserves in Russia were excess of $400 billion. You know, that is a lot of money. And the rate of use—there had been a period of active and explicit intervention. The rate of use suggested that this could go on at that rate for, I forget, twelve months, fifteeen months. I mean, it was quite a long way from—there seemed to be quite a long way to run.

Now, Lewis is right that, you know, once you start using them you can accelerate the use. If the oil price moves against you massively, the implied rate at which you're going to use them is going to accelerate. And you don't want to burn through to the last quarter, because then people know you're done. They see the end. They see the whites of your eyes and you're going to lose.

So I get that it's not an endless resource. It just felt to me that at the moment when they switched to a patently unsustainable interest rate hike, that sort of almost telegraphed the fact that the reserves—that fighting with the reserves was not credible. And so just as a matter of tactics, I wondered whether that was a mistake.

Anybody else want to say something? I feel bad as the moderator having answered the last question. But if you're content with my answer, then we'll wrap it up there. Thank you, everyone, for coming.

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