Global Economy Continues to Strengthen, but Concerns Remain

Wednesday, May 7, 2014
Peter R. Fisher

Senior Fellow, Center for Global Business and Government, Tuck School of Business, Dartmouth College

Lewis S. Alexander

Managing Director and Chief U.S. Economist, Nomura Securities International Inc.

Vincent Reinhart

Managing Director and Chief U.S. Economist, Morgan Stanley


Director, Maurice R. Greenberg Center for Geoeconomic Studies, and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations

Lewis Alexander of Nomura Securities, Dartmouth's Peter R. Fisher, and Vincent Reinhart of Morgan Stanley sit down with CFR's Sebastian Mallaby to provide an overview of the current state of the world economy and to identify potential trouble spots on the horizon. Though the U.S. economy continues to grow, concerns remain about a shrinking labor force and the potential for a bubble in asset prices. Elsewhere, inflation remains worryingly low in Europe, while China faces the possible start of a correction in the real estate market.

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

MALLABY: So, good morning and welcome today's Council on Foreign Relations session on the World Economic Update. We have Vincent Reinhart from Morgan Stanley, Peter Fischer newly at the Tuck School of Business at Dartmouth, and next to me, Lewis Alexander from Nomura. And I'm Sebastian Mallaby, here at the Council on Foreign Relations. I just want to tell you that tomorrow there's a meeting in the C. Peter McColough (ph) Series on International Economics with Charles Plosser, President of the Federal Reserve Bank of Philadelphia. We'll see if he makes as much news as Jeremy Stein did yesterday, and that's at 7:45 a.m. tomorrow.

I want to start this morning with a couple—connecting a couple of dots, and asking a few people to comment on this. The first dot comes from a distinguished council member by the name of Seth Klarmen who is also, by the way, a very successful hedge fund investor, possibly one of the most in the last few years. He says, "The Zeitgeist is so damn pleasant, the day so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end and no one wants to exit."

So he's making fun of this moment, and sort of likening it to 2007. You have to keep dancing until the music stops. He's calling a bubble.

Meanwhile, on the way into work, I noticed that Kandinskys and Chagalls are not fetching the prices that were expected. That's the second dot.

So, Peter...

FISHER: Oh, I get to begin?

MALLABY: ...for you. Are we in a bubble? Is it in danger of bursting?

FISHER: Yes. And, so not to mince words, I don't know when it will burst, but I think things are going to be very pleasant until they're not. And credit is growing briskly now. Lew will tell us from a low base, and we all know that. But CNI loan growth, bank balance sheet lending, accelerated as soon as the Fed made clear it was going to taper.

And so there was a debate about whether tapering would be restrictive or not, and Chairman Bernanke told us it would not be restrictive. But it would have been difficult for him to admit it would be stimulative, because that would have called into question what was the point of it, or why did they do it for so long.

But we know monetary policy works principally through expectations. And to have an acceleration of bank balance sheet lending take place exactly contemporaneous with the Fed changing the trajectory of its balance sheet growth, I think is something we all need to pause over, and is surprising people in the market who weren't looking for it. So the fact that it feels so good in markets is, in part, because credit is growing briskly.

Now, that's in the backdrop of an economy that stalled in the first quarter. The U.S. economy is doing pretty well. I'm not gloomy on the U.S. economy. But the demand side of the economy (inaudible) the consumer fell off a cliff.

MALLABY: In the first quarter?

FISHER: In the first quarter. And the idea that we're just not as tough as we used to be, if a little cold weather can stop our economy in its tracks, so I think we ought to look just a little past whether it was just a weather effect. And that should give us some pause.

But the U.S. economy is doing pretty well. But credit is still—is now growing briskly and going to continue to grow briskly. And the Fed is pressing up on credit creation and down on volatility and they're going to keep doing that until they stop. And we will observe financial instability when they stop. So when the music stops is in the future sometime.

MALLABY: So, Lewis, Peter didn't get into some of the details I know he has up his sleeve about specific parts of the market that may be looking a bit frothy whether it's the amount of leverage in structured credit instruments or the MNA market, or equity evaluations, but you don't see it this way?

ALEXANDER: It's not that I don't see that there are things that are extreme. For example, if you just look at regular corporate credit, it's trading at historic heights. It's not that there aren't places where it's extreme.

I think where I would differ a little bit with Peter is when you look at aggregate credit growth, which is the thing that it seems to be most associated with systemic risk, it's not really growing that rapidly. We have—we're coming off a multiple year adjustment in the wake of a crisis, and yes, it is finally growing again. And if you look at it in that perspective that's—that is a notable change. I agree with Peter on that.

I think the thing, if you look at where we are now versus where we were a year ago, the whole structure of rates is 75 to 100 basis points higher than it was then. That is having some obvious effects on things like housing, and so I think—I would take issue a little bit with where Peter is characterizing it in some sense that tapering has had no effect.

But the way I look at it, the parts of the economy where you're seeing those extremes are not—are isolated in some sense. If you just look at credit broadly defined, I would note that, well, you've got corporate credit being priced very aggressively, and you are seeing things, signs of covenant-lite loans and things like that expanding that are particular concerns.

If you look at say for example the non-GSE mortgage space, there is very little credit being created there. And it's unlike the circumstances we faced in the run-up to the last crisis where you look, everywhere you look you saw it. What's notable now is that there are important parts where it's not happening. And so I, you know, from a systemic risk standpoint I don't think the right way to think about it is we're facing some bubble that's about to burst.

There clearly are problems in particular areas...

MALLABY: So you're saying it's not a bubble until it's generalized. If you find areas where...

ALEXANDER: You can have bubbles in specific markets. For example, in 2000 we clearly had a bubble in U.S. equity market. It—you know technically it was very broad in that context, but it was not systemic. It was not associated with a broad growth in credit, the way that particular asset was embedded in the system did not lead to broader problems. So it wasn't that there wasn't a bubble, it's just that it wasn't something that was creating systemic risk. And I think that's the important distinction.

MALLABY: Vincent, would you feel we are at some risk in the next year or so?

REINHART: Monetary policy right now is pinned at the zero lower bound using—now using unconventional policy. At its heart unconventional policy is about suppressing volatility. You provide forward great guidance to squeeze uncertainty out of the money market curve, you intervene in specific markets, take tail risks out of those markets. The Fed is tapering, but it is still a large participant in the MDS market. It is still a large participant in the treasury market.

The trick to monetary policy is slowly suppressing volatility less when the economy can otherwise bear it. And that will be the dislocations over the next two years. A year is kind of a short term—time, because right now inflation is low. We saw some hesitancy in the economic expansion, not our forecast growth will pick up. But the Federal Reserve has some time because its dual objective is—suggests that there is plenty of room for policy accommodation.

MALLABY: Peter, is the M&A market part of your concern? The number of deals, the size of the deals, the ambition of the deals. Feels like a crescendo?

FISHER: No, it doesn't feel like a crescendo. It feels like a healthy part of the cycle. The corporate balance sheets need to do something with their cash and they're going to do something other than buy back shares. I think that's normally a healthy part of the cycle. I don't—I wouldn't say that tells us we're near the end or something cataclysmic, I think that's a healthy part of it.

Now we did get—we've had a couple of—since the crisis we've had a couple of bursts of M&A activity that then faded. And this one looks a little bigger, and maybe it's more enduring, but no, I view that as a positive part of the cycle. But it tell you this might be a compressed cycle, we might rapidly run, but I wanted to be clear I agree with Vincent's characterization and I don't think Lew and I disagree that much. But I think the music stops when the Fed's no longer suppressing volatility, and that day will come, we know not when.

REINHART: You've got to remember we've had an enormous wealth creation. Pension funds are closer to fully funded than in decades. That creates an enormous demand for fixed income, for yield. And so M&A is just pushing on an open door. And will that be associated with yields that look a little overpriced in a couple years? Yes, that's a feature of market activity.

MALLABY: So let's switch to the real economy bit, Lewis, and the number we had on the jobs market last Friday, there was two sides to it. There was a good number in terms of job creation. But a bad number in terms of labor force participation. And I wonder whether you think that points to a sort of dual—this dual picture which is very much in the discussion at the moment with Thomas Piketty and so forth that, you know, you've got on the one hand, you know, growth looks good. And on the other hand people are being left out.

ALEXANDER: Yeah, I think to me the biggest challenge and the biggest problem we face is that there's increasing evidence that while the economy is recovering, and jobs are being created, and employment is rising, there is a big—there are big parts of the labor market that are in some sense being left behind. That includes people that have dropped out. That includes the long-term unemployed. That includes people who are currently working part time when they'd rather be working full time.

Unfortunately, it does not look like—like—those people are going to be able to move back into sort of regular full time employment in a way that will kind of expand potential in an aggressive way, and allow the economy a lot of head room to grow aggressively. And therefore, I fear what is going to happen is that as the economy continues to grow, inflationary pressures are going to start to build. And unfortunately that means the Fed is going to have to start this transition that we've talked about. And it's going to start it sooner than you would like when you look at all those people that are—have been adversely affected by the crisis.

Now, I could be wrong about that. I could be being too pessimistic about the ability to move all of those people into productive employment. I hope I am wrong about it, because that would be a much better world for all of us.

But I think the evidence is growing that that's not the case. And that's going to put us in a very difficult position because the Fed can't solve the problem. Obviously we are facing budget constraints and political constraints that make it hard to address those issues with other policies. And that is something I am worried about going forward.

MALLABY: Vincent, did you think—Vincent, first maybe do you think that there's something that can be done in policy terms about this two-track picture?

REINHART: Something could be done in policy terms. Will anything be done in policy terms? Last time I checked, there's a midterm election later this year, and then the day later, everyone will be talking about the Presidential election. So the odds anything will be done is probably close to remote.

The plain fact is that we had a severe financial crisis that took a large toll to the level of activity. And unfortunately, it looks like the rate of growth of activity—we think the rate of growth of potential output is, at best, 2 percent. And that says something about any earnings prospect that is tied to the path for aggregate supply. It's been rotated down.

MALLABY: But, I mean, I guess the question I was trying to ask is the fact of people being left out of the labor market—apparently, there is a growing amount of people who are hard to draw back in. Is that something you can address with training? Is that something you can address with, you know, there's a debate in Congress about extending, or restoring, long-term unemployment benefits as a sort of palliative.

REINHART: Well, I already gave my prediction, which is nothing will be done. Could something be done? The answer is there's a large collection of potential policies.

We haven't been very good in terms of figuring out training programs. We haven't been very good over the years in bringing the skill set needed to our population. That's a national failure.

Can we do better? Yes. The good news is that we're so far inside the efficient frontier of delivering fiscal policy, we don't have to go in just one direction to get better. Pretty much any way is up. Should you be optimistic that we'll do any of those things? No.

MALLABY: I want to move to Europe in a second. But Peter, one more question on the U.S. It's not just the U.S. But there was a cover story in the "Economist" recently, which talked about, what I guess one could call skill biased aging, another words, high skilled people into their 60s and into their 70s carry on working. And that's good for the future path of savings of tax revenues and so forth.

But less skilled people stop working early. They take disability. They quit in their 50s. And so you've got one aspect of this divided economy is a division between—a division that manifests itself in that cohort, 50s, 60s, 70s.

Do you think that's-- makes us think differently about how demography and the aging of the rich world is going to affect the economic outlook? Because you've got these productive people still working and saving?

FISHER: I think it will. I'm not quite sure how. I think that for at least a decade now, we've all looked at a nice little charts that show the working age population, defined 18 to 64 or something, declining, without any sense of irony that of course people are working longer and longer, whether in Japan, or Germany, or the United States, or the U.K.

So, we've had a sort of false worry about the dependency ratio going the wrong way. I think it will matter. And I think it's a source of particularly youth unemployment that we all, in a certain part of the income distribution and skill distribution, can keep working longer and longer and we're happy to price ourselves down a little bit, and stay working. And that makes it harder for people to find jobs.

Now, if the economy were to ever pick up at the pace that all three of us would be happier, we think that would eventually get solved. But until that happens, it's a worry. I don't know quite how to play it out. I think it's something we should be thinking about.

MALLABY: Well, let's move to Europe, and maybe Lewis can start us off on that. And there seems to be in the periphery, a kind of rather confusing good news-bad news story. The good news being that competitiveness in the periphery is up. Current account positions have improved. Bond yields, the spreads over German debt, have greatly compressed.

"The good news is that we're so far inside the efficient frontier of delivering fiscal policy, we don't have to go in just one direction to get better. Pretty much any way is up."
—Vincent Reinhart

But at the same time, growth remains slow, under 2 percent for the—a bit over 1 percent for the Eruozone as a whole, I think, which is better than it was since it was negative. But it's still not great. And in a context of public debt to GDP of well over 100 percent in several of the crisis countries, are we out of the woods yet?

ALEXANDER: Certainly not. In a sense that—I mean I think that Europe—the Euro area collectively is facing a very long period of relatively low growth. They're struggling with deflation as we speak. And so there's, you know, in some sense, the real side adjustment has a long way to go.

I think what's interesting, in terms of sort of what we've learned over the last couple of years, one of the things that's interesting to me is the fact that the sort of current account and export side of this problem seems to be sort of more important. So, for example, if you look at Ireland, Spain, Portugal that have, I would argue, have adjusted relatively successfully, have sort of moved outside of their programs and while they face all of the problems that you describe, seem to be on a more positive track.

One of the things that's associated with is quite strong export growth. And they've shown a flexibility in that regard to adjust without the exchange rate, in a way that has allowed them to grow. I think you look at Greece—Greece is the other end of that extreme. And you've got Italy sitting there that's sort of the conundrum because it's the big one that matters that also hasn't made that transition yet. And that does suggest a somewhat different set of issues that sort of are going to be important.

The fundamental question whether or not Italy is going to be able to make that transition..

MALLABY: The transition to export driven...

ALEXANDER: Yeah, to be able to—to essentially adjust within a fixed exchange rate regime, do some of the stuff on the structural side of the economy that actually allows you to generate export growth, I think is a very important to how this is going to go on the real side. I think the other thing that has been surprising is quite how successful the OMT and the commitment by the Central Bank was—perhaps those of us who have worked at Central Bank shouldn't be too surprised that was made such a big deal. But I, you know, in some ways it is a remarkably successful program in the sense that Draghi hasn't spent a dime and it did play a very important role in stabilizing the economy.

FISHER: Could I jump in here? I think it's been remarkably successful in keeping euro together and the report card is not yet in on whether two years of a rising tightening exchange rate is going to help them much on the growth side. So, you held the euro together. Draghi pulled a rabbit out of a hat and held the euro together. Whether this is ultimately good for growth, I think is yet to be seen and I'm skeptical.


FISHER: I mean, we're bouncing off lows in the periphery.

ALEXANDER: I didn't suggest that it was good for growth. But in the same sense that I might argue that TARP didn't generate growth, I do believe that you avoided a worst case outcome and I would certainly argue that...

REINHART: Mario Draghi's problem is he sees this policy in two dimensions. There is the amount of financial accommodation that a weak economy needs. And there is an amount of financial pressure politicians need to be kept to the table. And he can't solve both problems.

FISHER: My point is, the tightening of yields across Europe and the periphery, I don't view as a good sign.

MALLABY: Because of the—in what way?

FISHER: It's pessimistic about future growth. It's a sign of how tight things are. It's from people putting their capital bank in government bonds. It's nice that we've avoided bad outcomes Ireland, Portugal, you know, et cetera. It's fine. This is not a good sign.

MALLABY: And Vincent, Peter mentioned the exchange rate issue. The euro has been surprisingly strong, maybe unhealthfully strong. Marty Feldstein wrote an op-ed recently in which he said, "Well, this is a problem Europe needs a weaker euro if it's going to adjust out of it's trouble. The evidence from the U.S. is that QE doesn't need necessarily do a lot for your—for the level of your currency. Therefore, now is the time for Central Bank intervention, direct intervention, in the currency market to change the value of the euro."

Is that going to work? Plaza Accord all over again?

REINHART: Last time I checked, there is a midterm election coming up...


REINHART: ...and it would be a little tough on the U.S. Treasury not to deem that currency manipulation. It's hard enough that the DOJ is fully employed in that enterprise as well. Does...

MALLABY: You're speaking a bit like someone who's spent a large part of his career in Washington.


MALLABY: You've gotten a disease there.

REINHART: It's my adult life. I've been watching dysfunction in fiscal policies. It's hard to get optimistic. Is there things that the ECB should be doing? Yes.

The ECB still has room for traditional policy accommodation. They have room for quantitative easing of purchases of some assets or another, including private assets if that is unsatisfactory to the German high court to be buying sovereigns Their scope for traditional policy accommodation that would be associated with a weaker currency than it would be otherwise.

The periphery has made enormous progress, but it has been enormous progress through real adjustment that was unnecessary if they could have just generated a little bit more inflation.

MALLABY: Good. Yeah.

ALEXANDER: I think the Japanese experiment is a fascinating one and we're going to have to see how it plays out. Because there is a very real attempt to use monetary policy in a very aggressive way to change expectations. It's not directed directly at the exchange rate, but that is obviously a very important part of the adjustment.

And I would argue that it's been successful. If you look at direct intervention over the last, you know, going back to the breakdown of the Bretton Woods era, it's hard to be very optimistic that that channel by itself is going to work, particularly in the euro area where ultimately how much support is the ECB going to have. If you just think about building support for a policy like that, it's hard to see how it works.

So, I agree totally with Vince, that the ECB's got some flexibility on conventional policy it should use. I think the first thing they need to see is get an agreement around the table that, in fact, you want substantially easier policy.

MALLABY: So—so—you're...

ALEXANDER: Without that I don't think you're going to be—I don't think an exchange rate focused policy is going to be successful.

FISHER: Modest disagreement, while directionally—I think what the Bank of Japan has done has been focused on the exchange rate. I'm confident of that. And I think when you threaten infinity, you can get a big move in the exchange rate once. And as Kuroda has discovered, threatening infinity plus one doesn't move expectations much further. And that's part of why the yen, I think, has stalled out.

Now, if he can change everyone's expectations by doing something dramatic in the future and he's waiting to see how consumption plays through after the consumption tax went through, maybe he can. But I think that's a challenge

Translating that to Europe is a very different matter. I completely agree that the ECB has in its DNA the ability to run a more accommodative policy than they've been running So they could be expanding their balance sheet, rather than contracting it.

Do I think the ECB council has it in its DNA to do a Bernanke or a Kuroda? No. But they're not going to—they don't have it in their DNA to double or quadruple their balance sheet. That's just so far out the probability spectrum as to not be worth considering.

And I think that's a problem for Europe. Because I don't know whether just a little accommodation is going to make that much difference.

MALLABY: So I think we're agreeing here that Europe, on the one hand, is looking a lot better than before, but it's not out of the woods. So the question then is, what might be the trigger which reignited serious trouble? Is it politics? Is a backlash against austerity in one of the peripheral countries? Unemployment is 25 percent plus in some of these—in Greece, and I think...

REINHART: There's always an existential risk about the project, right? There come—some week—end (ph) voters in the wealthy countries might be dissatisfied that the transfer of resources to the poorer countries. Or voters in the poorer countries dissatisfied with the conditionality to get those resources, that sets up a political risk. That's certainly the case.

But, to me, it's the slow grind of a poorly performing economy that is going to be weighing on the whole project. In particular, European banks need to delever. They need more capital.

We were going to see a real-time stress-test in the form of the asset quality review. If it's done right, it's going to be a signal that those institutions have to do a lot more work in terms of rebuilding capital. A bank-centric economy will find it difficult to work while that adjustment is ongoing.

MALLABY: Yeah, go on.

ALEXANDER: Yeah, I see sort of two issues. To me, one of the things that's striking is frankly the—how resilient the support for the project has been under very extreme circumstances. So Greece walked arguably right up to the limit and took a step back. Spain, Italy, Portugal have all kind of endured what are very extreme circumstances. The politics of supporting part of the euro has held together.

"I completely agree that the ECB has in its DNA the ability to run a more accommodative policy than they've been running So they could be expanding their balance sheet, rather than contracting it. Do I think the ECB council has it in its DNA to do a Bernanke or a Kuroda? No."
—Peter Fisher

Now that's happened in a crisis, and I think Vince raises the right point, which is, that's how it looks now. If you have five years of slow growth and unemployment hasn't come down, is that still going to be the case? But I have to say, relative to my expectations going in, the political support for the project has been more robust. But that's one question.

The other question to me, when I look at all of the sort of reforms that have been proposed, some of which have gone through, and I ask myself, what is the thing that hasn't gone through that I worry the most about? And that is, they don't have the capacity to do a TARP. So that if they faced a shock that really required a sort of large fiscal commitment to back the whole financial system, they don't have a mechanism to do it.

And in some ways, the crisis didn't really generate that, in the sense that it was primarily in the periphery If you have a problem that's centered in the German banking system, that's a different kettle of fish, it seems to me. And if I look at all those things and kind of ask, what is the capacity that they're missing? It's if they had a banking crisis that was not centered in the periphery, but that was, in fact, centered in the core of the system, how would—like, would they have the capacity to deal with that? That's the place that I'm more uncertain.

MALLABY: Presumably if it was Germany, they would do, and if it was France, they would be more dicey.

ALEXANDER: But Germany has a very large banking—presumably it wouldn't be just Germany by itself. But if it was Germany, France, I mean, the countries that you have thought of as being relatively strong. It's hard to imagine a banking crisis only in Germany, right? But it's one that was centered with, you know, something like our housing bubble, that sort of rocked the center of the system, and you ultimately needed a collective fiscal capacity to really deal with it, that's where—like that's the mechanism they don't have. They've—they have—they've gone to joint supervision, but they don't have a fiscal mechanism to provide support for the system as a whole.

MALLABY: I want to bring the members in a second, but I want to ask one question first about emerging markets. I think it's right that if you take the PPP revisions from last week, you can work out that the six biggest so-called emerging market now produce goods and services on the PPP basis, equal in value to the six biggest richest economies, partly because China and India are so big, of course, but, you have that. But on the other hand, you have a sense of a shake-out, I think, in emerging markets.

We've been through a period when commodity prices and cheap global financing and fast growth in China have all been very positive and they've lifted most boats in the emerging world. And now possibly we're into a time when there's going to be more differentiation, either because of different qualities of policy, or because of different sorts of exposure to a recovery in the developed world.

Vincent, who do you see as the winners and losers out there in the emerging economies?

REINHART: So there's really three sets. There's China, which is a case on itself. And then within the rest of the emerging market world, the Federal Reserve has been doing this six year encouragement to searching for yield and risk taking. That provides an opportunity to improve national balance sheets. Those economies that took that opportunity to do so are well positioned as the Fed re-normalizes its policy. If you didn't, if you have a current account deficit in a budget deficit now, it will be a wrenching adjustments as rates back up. And its an uneven set.


FISHER: What Vince said is terrific. That's a great summary. I would focus—I'm more nervous about exchange rates in this context. But I'm going to digress on to China, where I think—we all have very blithely for several years said, "Well, they have to re-balance from investment and exports to consumption."

And we all agree that's a bit of wisdom. But it's a little too facile. Because they're not going to be able to diversify out of both investment of the shared GDP and exports. They have to get out of investment. They have to keep exports going to keep the machine running smoothly.

And so, they can't afford to let the RMB continue to appreciate against the yen. I think that's what the last few months have been about, particularly if the dollar is going to go higher over the cycle as the Fed re-normalizes And so I think there's some real tension in currencies out there that will separate those three categories. And China being a category unto itself, is something that I think will add strains in lots of places that I worry about.

MALLABY: Any thoughts on which emerging markets might do best?

ALEXANDER: Look, there clearly are some that are doing—that are in better position. Mexico, I think is a good example of a country that's—it has a combination of kind of structural advantages. They've just done this big energy reform in an environment where that has the potential to help them a lot. And generally the structural policy is pretty good. They're part of the developed world they happened to be linked to is doing better than others, so.

I think that in general I would sort of agree with what my two colleagues up here have said. This is different than previous points of vulnerability. It's just—there's going to be a differentiation. It will have macroeconomic consequences, but I don't think it's likely to drive a crisis.

The one—China is such a big thing. I think at some point it is going to generate a global cycle. The property market is starting to correct. There are a number of cities where things like property prices and construction activities are down year on year for almost the first time in, you know, decades. And, I think they have the capacity to contain it. I don't think this is the moment when it's going to really blow up the system, but I don't say that with a degree of confidence that I would like.

REINHART: Remember what you started with too. Emerging market economies are bigger. They're more reliant on trade. World trade is more important and more of our investors are in their local markets. And so while it's this time possible to see more pockets of strength, the pockets of weakness are bigger, relatively to the global economy. So, we will not be immune to the consequences of our action and what that means to their economy.

ALEXANDER: But, Brazil is fundamentally less fragile now than it was in '99. It's, you know, if you simply look at the public finances, they have more dollar assets than they have dollar debts. And that is—that is a profound difference in terms of the dynamics of how this plays out.

Now, they're going to have a recession, or something that feels like a recession. But it's—like relative to crises past, it's a different animal.

MALLABY: Okay. Let's go to questions from the members. Who has a question they'd like to ask? I see one over here.

QUESTION: Thank you. Paula DiPerna, NTR Foundation. Is there any creative rabbit in the hat in monetary, or any other policy, that could address the crumbling infrastructure of this country and its, you know, concomitant chill on quality of life, credibility, et cetera, et cetera?

MALLABY: Who wants to take that? Infrastructure...

FISHER: We should. We should. It's important. And unfortunately too much of the fiscal—long fiscal thrust over the next 30 years is dedicated to supporting consumption. And I'd rather see more of that supporting infrastructure investment.

But it's going to be—that's back to the politics, Vince. That would be a better thing for us to do. Invest in all kinds of infrastructure, whether its building schools, or roads and bridges, rather than paying for our collective drug benefits. But we're making a choice about—we as—our elected representatives have made a choice about how much of our future outlays they want to spend supporting consumption and how few they want to spend supporting investment. And it's a terrible choice.

"I think they have the capacity to contain it. I don't think this is the moment when it's going to really blow up the system, but I don't say that with a degree of confidence that I would like."
—Lewis Alexander

MALLABY: My colleague here at CFR, Heidi Crebo-Rediker, who was at the Treasury until recently – State Department, produced a what we call a policy innovation memorandum with a specific idea about that, which was to set up a unit in the Treasury that would advise state governments in how to access public and private—sort of put together public and private partnerships for financing infrastructure at state level. And her idea is that just the insertion of some greater sophistication in organizing those projects and making that resource available to the states from the center could be helpful in catalyzing more projects.

Byeon. There is a microphone coming.

QUESTION: Byron Wean Blackstone (ph). There's been a tremendous amount of attention paid to Thomas Piketty's book "Capitalism in the 21st Century." I wonder if all this focus on inequality has a solution? Or is it a problem that we should be wrestling with? Can anything be done about it? And is it something that, long-term, will prove pernicious to economic growth?

MALLABY: We could have mentioned at the beginning we were talking about bubbles, and the discussion of Piketty might be in itself a slight bubble.


MALLABY: It's a good question and I want to just add one element to it, which is it is interesting that one of the biggest developments in the—in the U.S. economy, you know, along with the energy revolution, has been this slow down in health cost rises, which is, you know, might feed through into pay packets in the middle and bottom half of the distribution because health costs come out of compensation. And you know, take home wages may benefit from that just when—just after Picketty's book has made us most gloomy.

FISHER: Well, I—that would be a good outcome on healthcare. I'm not quite ready to declare victory on holding down healthcare costs. I'm afraid the healthcare industrial complex is—may have a second breath in its—in its lifespan.

I'm at the disadvantage of having actually read, cover to cover, Piketty's book, that when you go from Black Rock to Dartmouth you get a little more free time. And I think that it's a problem—yes, I think it's a problem for democracy and lots of things. And to say it as politely as I can, one is stunned to come to the end of his book and see that his own analysis supports some other policy prescriptions other than an inheritance tax.

I've got no qualms about progressive taxation. But his own analysis shows what we all intuitively know, that when G is a little higher, even if it's lower than R, inequality reduces. And yet he ignores it completely when he...

MALLABY: 'G' being growth...


FISHER: G being growth. R being return to capital. So his own analysis shows that. And when he comes to the conclusion, he completely ignores it. He also shows, back to the first question, that his own analysis shows, that when public assets are higher, as a share of total assets, that inequality is improved. And he ignores that completely at the end, frankly by brushing off Marx, who had a crazy idea that we should not have any private assets, rather ironic for him.

So he comes to the end, and there's—his own analysis shows that there are three possible avenues of solution. One would be taxation. The other would be higher growth. And the third would be a higher level of public assets. And he ignores two out of three to come to his prescription.

So, his book—his analysis made me optimistic. His policy prescription, I thought, somewhat narrow.

MALLABY: Anybody else?

ALEXANDER: If you look at the—so one of the interesting historical things is right. We were where we are now at the beginning of the end of the 19th Century, the early part of the 20th Century. And when you look at how things changed, there was sort of an endogenous response.

So if you look at things like—one of the reasons the situation improved from that period until sort of the 1950s say, or some point, was we actually did more education. So you actually look at how many people went to college, how many people graduated from high school. There was, in some sense, an endogenous response to what was the skill base problem then.

In some sense, I am—I think that gives one some degree of hope that you could address it through those sorts of channels. I think people have known that education and the skills issues is one of the primary responses to what we have been trying for 20 years to solve that problem. I'm not all that optimistic, in some sense, if you asked me are there five educational reforms that we can do that could help address those things.

But on the other hand, I do think that there's another way of interpreting the historical record that is a little more optimistic I do, as somebody who works in the financial industry, I am struck by the degree to which I think about how this problem works out kind of in finance. And my simple observation is, hedge funds and sort of private equity and those guys kind of set the price for talent. And I must admit I struggle as economist to understand why people put money in their hedge funds with those sort of return structures that they have.

But ultimately, if you ask, why do we have this problem at least in finance, there's to a certain extent, people put their money in hedge funds that generate very large returns for the people that manage the money in that. But that then raises the sort of price for talent throughout the structure. And if you want to sort of ask kind of what's the market forces that generate this problem in our little worlds? That's my simple version of it. And I'm not sure I really understand it.

So I'm, to some degree, sympathetic with what Peter said in terms of I think those other avenues are important I'm a Democrat. He's a Republican. I would support higher, you know, using taxes more aggressively.

FISHER: Who's a Republican? I've never been a Republican.

MALLABY: No, there's one over there...

FISHER: I'm a Democrat, and an Independent


FISHER: You've been misinformed.

ALEXANDER: I've been misinformed?

MALLABY: Now we're getting to a really serious debate. Who has another question?

ALEXANDER: I apologize. I apologize.

MALLABY: Yeah, over here. Thank you.

QUESTION: (OFF-MIKE) of DirecTV. Does Ukraine matter?

MALLABY: Good question. Does Ukraine matter, for both, I guess two ways? For Russia? Russia may be pushed into recession. And also for—we're talking about the Eurozone, and is this a blow that could—is it big enough to ripple? Vincent?

REINHART: So first it reminds us that the world's a risky place. And it's hard not to think that a 10 year Treasury below 2.6 percent yield relates to the fact that we are the safe haven asset. And it just makes it easier, more plausible, for the Federal Reserve to convince us all that they'll keep rates low for a very long time. So that's the first part.

Does it matter for the global economy? Not directly, in terms of the proportion of GDP sitting in Ukraine or Russia. But it will matter material for the Russian economy, which is going into recession and will be challenged by increasingly tougher sanctions. It matters for Europe, already fragile economy having even more energy insecurity. It also just sets a precedent that Western powers don't have a lot of power. And it raises the odds of interventionism more generally.


ALEXANDER: I do think it—I'm surprised it hasn't had more impact on markets. I do think it raises sort of fundamental questions that I think are more an issue for Europe. You know, to a certain extent, if you look at the—all of the political settlements that happened when the Iron Curtain fell, in effect, we forget how fresh some of those things are.

I believe this is right, that Germany did not fully, as a matter of law, accept its borders with Poland until 1991. And at the time of unification, the set of people that were ethnic Germans who had been expelled from what is now Poland and what is now the Czech Republic, were a very potent political force. And so, an awful lot of the stability in Europe that we've kind of come to take for granted, is based on countries having made pretty hard choices about accepting as fact, you know, the sort of settlements that came at the end of the war.

The degree to which that is kind of being called into question here, as a kind of existential thing, I find troubling. I feel like I'm biased in this. I can't help—I kind of look at Putin, and that's the past. That's not the future. And I tend to kind of not think it can be that serious.

But there's part of me that goes, if you're in the Baltics at this point, you know, there is—this is an existential thing for you. And you know, if this goes badly, and it certainly could, it's hard to know what the knock-off effects would be.

MALLABY: Now, Peter, one observation—if I can draw you into this debate because I think it's worth spending a second on. One observation would be was there was a lot of literature on how a rising power, like China, could destabilize the global system that were challenged like Japan did in the first half of the 20th Century. Now we have what is basically a declining economic power, Russia, destabilizing. Because it's declining it feels insecure, and therefore it throws its military weight around. So that's one thought about the situation.

And the other is that the decline may accelerate. So, Putin came to power at a time when global energy prices were perfect for him. Now that may no longer continue to be the case and if we have this emerging market slow down and differentiation that we were talking about earlier, in some ways his geopolitical—the moment his highest geopolitical swagger may coincide with its inflection point in which the decline accelerates. Possibly also accelerating military and political problems, but nonetheless, an accelerated economic decline. What do you make of all that?

FISHER: It makes me nervous.



FISHER: I emphasize the point Vince is making. If the Fed and the other major central banks in the world were not doing their utmost to suppress volatility, we would have noticed Ukraine a lot more than we did. And so the context really matters. And I think that gauze they're throwing over asset prices means it doesn't look like we notice, but we should be noticing for both the reasons Vince and Lew have said.

MALLABY: Well, thank you for that question. Another question? Anyone got another question? Otherwise, I will ask one.

What we didn't get to, which I think is worth spending a second on, is whether the publicized fights on global financial regulation, whether it's the question of the sort of deglobalization of banking, because we're ring-fencing capital in foreign bank subsidiaries in the U.S. and regulators understandably want to know that the lenders in their territory have their own capital. It's not going to be sucked out.

Or whether it's arguments in the European Union about the financial transactions tax. There's a lot of uncertainty still in the playing out of the regulatory debates and finance Maybe Lewis, does this matter for the real economy? Where do you see—where do you see it mattering?

ALEXANDER: Look, I do think the fact that we are not as far along in a transition to a new kind of financial system, which includes new regulations, and new levels of capital liquidity, and a set of major institutions that understand their business model and are kind of functioning more or less normally, and are not constantly adjusting, the fact that we're not further along in that process, I think is a problem I do think that that is something that has sort of held the economy back. And I have to admit I'm sort of—a couple of years ago I thought we were on a track where we were going to kind of progress along that, and we're not as far along that as I had hoped.

I think that, you know, the international aspects of it—I guess I would argue they're not a huge issue right now, in that they're sort of more profound national ones about exactly what we want institutions to do and how far we want to push things. I worry more about the international aspects of it when we have a crisis.

Because, we do have global institutions whose markets are global, and ultimately when it comes time to deal with a problem, it just makes it that much harder. And an awful lot of work has gone into things like, you know, some sort of structure for resolving a global institution. And it does feel like that is not as far along as you would like.

I just—a small anecdote on AIG, as an example of this. People don't think of it this way. But one of the inherent problems with trying to deal with AIG was the way we managed insurance was exactly what you described, so that insurance is regulated locally by states, by municipalities—well, you know, not by municipalities, but by countries. And the fundamental principle is a ring-fencing principle, a principle which says you want to ensure that each little entity has enough capital in and of itself to deal with the policies written in that jurisdiction

What that meant was—for AIG was, if you had a problem that was essentially at the holding company level, if you had called into question the holding company, what the regulators would all have done was immediately ring-fenced their individual pieces. The only thing that had value in AIG were the pieces themselves. And so you were kind of forced to support the entity as a whole because if you didn't, that ring-fencing was just going to pull it apart and just going to destroy any value at all.

So in some sense, you were forced to bail out the holding company, or work very actively to support the holding company, precisely because of that problem. And so I do think that if you don't do a better job of dealing with this, if you face a problem in a global institution, you're going to face that same logic. That if you're dealing in a world where each of the regulators decide that they're going to protect their individual piece, you will have no choice but to, in some sense, support the whole. And I don't think that's a choice anybody really wants.

MALLABY: But it still might make the bailout easier and cleaner, if at least the subs are separately capitalizing, they're okay. You know you've got the holding company to fix, but it's not a...

ALEXANDER: Well, the thing that mattered—the thing that mattered, in some sense, for the economy, was if you let that holding company go, the spill over effects from that would have been huge at a terrible moment. And look, if it's an isolated company—if we're dealing with a problem in an individual institution that's truly idiosyncratic, if we're dealing with a Barings, like, all of this isn't that big a deal.

To be perfectly frank, if that's what we're talking about, there's some massive fraud in an institution and it happens in an environment where it really is just one institution, like that's easy. I mean, it's not easy, but it's like, that's not the real problem.

The real problem is when you're facing the 50 year flood and you've got a problem at a major institution that is typical of a broader problem, that's when it's hard and that's when the ring-fencing logic, I think...

FISHER: I agree with Lew. But I think that's a problem with transition So, he's right. This is a Canadian banking system is highly ring-fenced. It has to be locally capitalized. Everyone knows that's how it works. It's pretty tough. And they're a pretty good trading partner with the rest of the world. I don't think there's anything wrong with the Canadian economy as a consequence. But everyone knows in advance that's the rule of the game.

So, if we all know it's the rule of the game—but the second issue is that as a transition issue, while we don't know what the rules of the game are, a marginal unit of credit in any economy is a cross-border unit of credit. And so, there's a transition we're going to go through while we figure out we're really not in favor of the flow capital we thought we were, collectively.

And that transition, at the micro level, is what Lew's talking about and at the macro level, yeah, it'll matter. Could we get to a new equilibrium? Yeah, we could, if the authorities would get a clean architecture.

REINHART: So there's two design flaws in the international financial architecture. First, in Europe, politicians are still enamored on sovereign, national financial champions. It's hard to get the project of a currency union done right if you haven't gotten past that.

Second, Dodd-Frank did nothing to change the final demands of investors for certain risk and return products. A market economy will provide them, that deep insight coming from if you build it, they will come, right? What we have done is make it more difficult and more expensive for the traditional intermediary sector to provide those services.

It's going to be provided through shadow banking. At the end of the day, then, the presumption if the traditional set of intermediaries have more capital, are more tightly regulated, then you don't have to bail them out. You've priced the safety net. But in a crisis, is it about the strains on the final investors' demands or on intermediaries? I think it's actually the final investors that drive policy, in which case we haven't prevented the next crisis, nor have we prevented the next sets of interventions.

MALLABY: What were—okay. I see your question. I'm going to go to the floor. Okay. The back.

QUESTION: Hi. (Inaudible) just China. Can we call the real estate bubble bursting, is that worrisome?

MALLABY: Sorry. Can you say that again?

QUESTION: My question's on China.


QUESTION: For real estate. Can we call now, since we saw the news about the slump of the real estate market in China, can we see the real estate bubble bursting in China?

MALLABY: Good question. Okay. Real estate in China, is it...

ALEXANDER: It's always—it's always, you know, when things start to turn down, is that bursting? There clearly is a correction going on. And I think it's early to kind of have a sense of just how broad it's going to be. But I think it's a growing concern.

I think what I would say is it still my sort of basic judgment that the authorities have the means to manage an adjustment as opposed to letting it run and become a crisis. And so it's not my expectation that this turns into a crisis. But, to be perfectly honest, it's big enough that if it were not well managed, it could turn into a much bigger problem, and I think that's something to worry about.


FISHER: To take a step back, I agree with what Lew said. For the last two decades in China, the two assets that were able to express volatility, they were, through a tiny stock market, and a real estate market. And their two other sets of assets that haven't been able to have volatility expressed in them and they're fixed income assets and the currency.

And the authorities are in the process of trying to figure out how they can live in a world in which more volatility can be reflected in both real rates and credit spreads and more can be reflected in the currency. And they're going to move that direction pretty quickly.

Now, the area of transition is going to be difficult for all markets in China, just because the transition's going to be difficult. And that's probably the most important thing the authorities have to pull off in the next five years, is this transition. And I agree with that I think they're going to deal with the real estate market, but it will be a better thing for China when they get to a place where volatility gets expressed in all assets. But getting there from a controlled interest rate and currency market is going to be very difficult.

REINHART: And the sequence is going to be particularly problematic, in that there are two different set of problems. One is there is a whole lot of non-performing loans. And the second is, you have to give your citizens more control of national—of their own balance sheets. It's a consequence of having a growing middle class.

And it will be more difficult to deal with the non-performing loans after you've given people the ability to flee from problematic assets. And so, can they get it right? Our estimation is that they've got an enormous number of varied levers of policy and will use all of those levers. Is it a risky endeavor? Yeah, no question.

MALLABY: But, I mean, the bottom line I hear most often on this is yes, Chinese property will correct a lot. Yes, banks will lose a lot of money. But, the government has so much cash that it can, you know—the fiscal position is strong enough that it can basically bail out the system as it has done in the past. And therefore, it will ride it out. Is that what we're seeing gain, or is it different this time?

FISHER: I'd just say that I think they have the capacity to do it. Whether they want to absorb all those losses this time, I'm not—that's not yet in evidence

MALLABY: And how does the, you know, the ambition to internationalize the renminbi play into all of this? Because Peter, you mentioned earlier that you think that a sustained period of yen—renminbi appreciation is not something that they can tolerate because they need to keep driving exports. If they're going to cut back on the investment as a driver of growth, they need the exports.

Okay, so, they're going to need to manage the currency. They can't let it go. And that means they're going to accumulate more dollar assets. At the same time, they say they don't like a dollar based international system. They want to internationalize the renminbi and establish the renminbi as an alternative. And you see these news stories periodically of deals in London to do trading in renminbi and so forth.

How do you see all of that playing out? The clash between the desire to keep the growth engine going, and the ambition to create an international currency on the other hand?

FISHER: I would put the ambition to create an international currency in the 30 year context. And so I don't think it looms very large for them in, you know, the priority of decision making over the next three or four years where the transition looms very large. So I don't mean to say that's not part of their ambition, but I would focus that on, you know, decades, not years. But I think it's a way off.

And I think that it's a very difficult transition for them. I don't know that they're going to be accumulating reserves. If they have to open up the capital account too quickly, and they get too nervous about the exchange rate, the exchange rate may go down, not up, if they get too nervous about exports. And that would be very difficult for a lot of other countries, back to our emerging market distribution problem.

So, I'm not—I don't know the path forward. I don't think it's that simple. So I think the internationalization issue is—I'd put it a second tier priority.

MALLABY: Let me maybe just close it off by raising a country that we've not mentioned, hardly, which is India. And I'll throw this to Lewis, just because I'll pick on him. He's next to me.

Just to say, you know, we had this period about a decade ago, as I recall, that when people talked about, you know, the Indian model may be challenging the Chinese one, as a growth model. That went away. China did fantastically well. India went into kind of a Gandhi Dynasty slump.

But now we see, potentially, a change, right? Both because China seems to have decelerated from 10 percent to 7 percent, and there's a risk that it might decelerate further. And because there could be a political change in India. Is it plausible to think of a renewal of that horse race debate, India versus China?

ALEXANDER: Absolutely. I mean, I think the big constraint in India has always been the quality of the governance, and that's sort of related to the politics. And we've seen some positive trends in that. Obviously, the change of the Central Bank has been notable.

But I think the potential to get a government that seems more committed to doing reforms that will sustain growth over a longer period, I think is a very positive prospect. It's still a prospect, I would stress. And we don't know the outcome of the election, and we don't know how this government is going to perform. But I think there is the real potential for that to be a positive surprise.

On the flip side of that, just to follow up a little bit on what Peter said, I am struck by the degree to which this government in China seems willing to take risks that previous governments have not been willing to. And so it is—it has the potential to actually move them along the adjustment path, which is a good thing. But it does—it is risky.

And so, I think it's going to be an interesting discussion. Because I think you may get—if the polls seem to be right, and we get, you know, a government that sort of follows through on its commitments, I think in India, you could get a notably better outcome. But we could look back, you know, three or four years from now in China and go, gee, they really have made more progress on some of these things than we might have thought. And that—you're not going to measure that as growth seven and a half—you're not going to measure it that way.

And I totally agree about the volatility issue that, the striking thing to me about China is, this is a country that saves this tremendous amount, and invests this tremendous amount, and has a very inefficient financial system. Part of the internal adjustment is about developing the system in a way that will help them allocate that tremendous savings into that tremendous level of investment in a way that makes more sense.

That would be progress too. So it's going to be interesting.

MALLABY: It's going to be interesting. That's a good way to end. Thank you all for coming.

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