With Growth Stalled, ECB Begins Asset Purchase Program

Tuesday, September 9, 2014

Event Description

White House Advisor Caroline Atkinson, Morgan Stanley's Vincent Reinhart, and Emi Nakamura of Columbia University join CFR's Sebastian Mallaby to discuss the latest developments in the world economy. While the economic recovery in the United States proceeds at a steady but low level, the Eurozone countries continue their struggle to maintain a positive rate of growth. The panelists discuss the state of the European recovery, the economic impact of the crises in Ukraine and the Middle East, and the European Central Bank's recent decision to begin asset purchases.

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

Event Highlights

Emi Nakamura on the European Central Bank's decision to begin purchasing asset-backed securities:

"I think that it makes a lot of sense that the ECB is going in this direction. Inflation is way below their target. It's zero in most of the Eurozone, and it's negative in countries like Greece. It's only really significantly positive, for example, in Germany and a couple of other countries. So, I think it makes a lot of sense that they're going in this direction. You know, it's been shown in the United States, with the U.S.'s own asset purchase programs, that these kinds of asset purchase programs can lead to a meaningful reduction in interest rates on risky assets."

Caroline Atkinson on the state of the U.S. economic recovery:

"[W]e know that balance sheet recessions can be very dangerous, but now consumers in the United States—consumers have deleveraged a lot. They are ready. There is scope for them, for further expansion. Businesses have a lot of cash on hand. There is scope for more investment if they see the demand from the consumers, and residential housing still has more room to go to normalize. So, I think there's no reason to—or there's a lot of reason to expect that this steady recovery, which is not, you know, not good enough yet, will continue."

Vincent Reinhart on the spillover effects that Chinese economic development is having on other countries in Asia:

"So, there are advantages and disadvantages of regional rivalries. The disadvantages are what's going on in the South China Sea. The advantage is that the example of very rapid Chinese growth has been a spur to politicians in the entire region. A part about Abenomics is to try to regain the position of Japan in the region. The electoral change in India, in part, is it's time for more significant changes as the relative position of India has shifted. So, it does tell you that there's scope for officials actually to move when spurred from the outside."

MALLABY: Good morning, welcome to the Council on Foreign Relations to the World Economic Update. I'm Sebastian Mallaby. We've got a great team this morning. I guess I'll start over there, in the distance, with Emi Nakamura, Associate Professor at the Graduate School of Business, Department of Economics at Columbia University. Vincent Reinhart in the middle. Chief U.S. economist for Morgan Stanley. And next to me, Caroline Atkinson, who is really Ms. Geo-Economics in the U.S. government. Deputy Assistant to the President and Deputy National Security Advisor for International Economics in the White House.

So, this is a good time, especially actually to have Caroline here, because I think in the last few—sorry, I should have mentioned that the next meeting, otherwise I'll get into trouble, we have a meeting with Jeh Johnson, the U.S. Secretary of Homeland Security, on Wednesday, September, the 10th. That's this week, from 12:30 to 2. And, I'd like to welcome also the CFR members around the nation, participating in this meeting through live stream, and the meeting is on the record.

So, I was going to say that this has been a time, I think, where political events have been starting to exert their influence on markets more even than normal. I mean, they always do, but if you put together both events in the Middle East, which have attracted a lot of attention, we could talk about economically important those are, with events on Russia and Ukraine, and then you add in, as well, even the latest information from the Scottish referendum, which seems to be having an effect on Sterling. I think there is a sense that, that politics is—is back.

So, I want to start a bit with Caroline. And go through each of those issues, maybe the simplest one from an economic perspective is to talk about in a sense the dog that isn't barking, the Middle East is a huge sort of security, and kind of military challenge. What about on the economic side?

ATKINSON: Well, of course, the obvious thing to worry about in the Middle East that one thinks about is what will this do to global oil markets. And we have been watching those very carefully since—since the, the fall of Mosul. But, we found that once after the markets jumped to some extent, they've since fallen back. And I think that the general analysis is that people do not expect a big supply interruption from this current conflict. Of course, we are moving to contain that, as the president has said, and is going to talk about more tomorrow.

And there is also other evidence of, of supply coming on board. And, at the same time, the, the global oil market is very sensitive to markets in general, and to expectations of growth and recovery, and so on. So, Brent, I'm not sure what it is at today, but it has certainly been holding very steady. So—so far so good.

MALLABY: So, in some sense if you think about it from a kind of "New York Times" headline perspective of the various international crises, I would say that clearly the Middle East is the one that's grabbed the most attention. More than Russia, Ukraine. On the other hand, the economic impact of Russia, Ukraine may be bigger, particularly I'm thinking of sort of almost surprising level of influence into German ,the German economic outlook, which is then playing into broader Eurozone? Is—is that right?

ATKINSON: Well, I think that clearly the timing is unfortunate for—for economic growth in Europe. I don't believe that what's happening in Russia and Ukraine is the main issue behind the recent weakness that we've seen in the core of Europe. I think that is more obviously to do with other economic policies within Europe.

Of course, it doesn't help confidence. It doesn't help business investment. Germany has deep ties with, with Russia and so the general uncertainty is—is, of course, an issue for European growth. But, I don't think that's the, at least so far, that is not the central thing that is cooling the Eurozone economy.

MALLABY: Well, then let's go to Vincent for a second. I mean, Caroline is saying that the uncertainty in Germany, which may have come in from a mixture of a fear of sanctions escalation on Russia, a mixture of the sense that NATO may be drawn in more into protecting the Baltic republics, and that might involve Germany in some fashion. Just the general sort of unpredictability of all that. That that is not the main thing that has caused the European slowdown and the big reaction from the European Central Bank last week. Do you agree with that? Or is there something else that's going on that?

REINHART: So—so the general principle is if you're flying the plane slower and closer to the ground, you're more susceptible to adverse shocks, like wind shear. Russia and the Ukraine, the security of energy resources, that—that's wind shear to a European economy that hasn't been performing well for a while, and it's not performing well for a while because it is a bank centric market that is suffering from a, a need to recapitalize banking. And, the unresolved issues of adjusting relative prices in the single currency area, and while you're undergoing fiscal consolidation in many parts of it. So, there's lots of issues about the European economy. The bad news is the international situation has added one more impediment.

MALLABY: So, Emi, whatever the causes of the lack of growth in Europe, the policy consequence was evident last Thursday when the European Central Bank, you know, came out with yet another sort of whatever it takes kind of moment. How much is going to result from all that? I mean, when you're down with interest rates as low as they are already, how much can monetary policy really help?

NAKAMURA: Well, I think that it makes a lot of sense that the ECB is going in this direction. Inflation is way below their target. It's—the Euro in most of the—of the Eurozone, and it's negative in—in countries like Greece, it's only really significantly positive, for example, in—in Germany and a couple of other countries. So, I think it makes a lot of sense that they're - they're going in this direction. You know, it's been shown in—in the United States, with the U.S.'s own asset purchase programs, that these kinds of asset purchase programs can lead to a meaningful reduction in interest rates on risky assets. So, I think they have that example to—to look at as—as sort of a ...

MALLABY: But they're already super low. I mean, peripherals only, but ...

NAKAMURA: But that—that's what I was going to say. So, I mean, the other approach you might have considered would have been some form of forward guidance, but the fact is that long-term interest rates in the Eurozone are already incredibly low. So, I think it makes sense that they're sort of trying everything that they can think of and that forward guidance is - is—is not an easy alternative, particularly given more forward guidance is not an easy alternative—particularly given how low interest rates already are, and also given that Germany's obviously adverse to taking any kind of risk with inflation. But, that said, it's—it's not going to be easy, because we're not in a situation where you have, you know, for example, fire sale prices on some of these assets that we've seen in the United States when they were trying to do it.

MALLABY: I mean, let's take, Caroline, you want to jump in?

ATKINSON: I was just going to say that it's clear, particularly in Europe, but also globally, that there is a shortage of demand and, obviously, monetary policy is one tool. But the other issue in Europe, and, and Vince alluded to that, is that there has been a policy, for a long while, of, you know, austerity or going for fiscal constraint in order, because of concerns about the debt. But we know that if you—your economy keeps slowing down or, or going into negative territory, that, especially with very low inflation, that makes the debt burden larger. And what we really need to see is a, a push forward with—with growth, maybe from investment. In fact, investment in Germany is still historically low, and that's something that—that I think could be thought about.

MALLABY: I mean, it seems that the case for inflation in Europe that's nearer to target is clear, especially when there's so much debt. The question I'm asking though, is whether you can actually achieve that? I mean, does a 10 basis point change, in the negative interest rate that banks get on deposit, I mean, does that matter? 10 basis points? I mean, doesn't sound like a big bazooka to me.

NAKAMURA: It has to be about signaling, I think, to the extent that that's going to have a large impact. I mean, it has to be, you know, part of the, part of the attempt to—to signal that the ECB is going to sort of do whatever it takes to try to get back to this target.


REINHART: It's essentially a promise that says we're going to make our balance sheet big. We're going to keep our balance sheet big. And, ultimately, other nominal magnitudes are going adjust. You always expect movie references from me, and I'm going to repeat one, and that—and that is service comedies of the 1940s and 1950s always had the same scene in which the officer comes in and says, men, I need a volunteer for a dangerous mission. You probably won't come back alive, but your nation will be grateful. Please line up, and would the volunteer please take two steps forward. And, everybody, but the hapless hero takes two steps back.


REINHART: And the hapless hero is the person who isn't suited for the mission. You would have never picked them. But only gets the mission because of the failure of everybody else around them.

ATKINSON: Our scenario is the hapless hero, but ...


REINHART: But I think central bankers, by and large, are the hapless hero. That—that it was the failure on the political front, the failure to come up with coherent fiscal policies. The failure to address the wealth loss associated with the banking crisis. The—the failure of international coordination. That means we rely on central banks probably more than we should be, but they're the only independent actors.

MALLABY: Well, it might even go further than your great analogy in the sense that not only is the central bank being left to act, but in some formulations, including those of your colleagues at Morgan Stanley, is this idea that the future action should be conditional upon action by the government in terms of structural reform, perhaps in terms of more fiscal stimulus in general. That there should actually be a quid pro quo, so that you construct a kind of Abenomics. Remember Abenomics has three arrows, there's the fiscal stimulus, the monetary stimulus and then the structural reform. And that this three arrow approach would be led not by a prime minister, like Abe, who had a big mandate, but by an unelected central banker. I mean, this is what your colleagues appear to be hinting at, hinting is polite understatement actually. They're calling for it.


REINHART: OK. So, so a couple points. Once you let your central—once the central bank decides to buy a complicated mix of assets, they're actually doing fiscal policy. They are, once a central bank allows also large transfers within a, a network of central banks, i.e. Target II reserve transfers, that's fiscal policy. Fiscal policy shouldn't be done by unelected central bankers. It should be done under the instruction, under the guidelines, of someone of, of people who are ultimately accountable to, to the electorate, hence what I think the suggestion is—is, look to the finance ministers to—to find what is appropriate and inappropriate to buy, and then buy what's appropriate.

NAKAMURA: Although the ECB does have an inflation target that is their mandate. So, to the extent that we say the mandate of the central bank that has been given to them by the elected officials is to achieve its two percent inflation target, then you could argue that it's, you know, that it's within their mandate to do what they can do to ...

REINHART: I think it's ...

NAKAMURA: (inaudible)

REINHART: ...their mandate is to get their balance sheet big. How they get their balance sheet big could involve fiscal decisions, and therefore needs some feedback. That would be the argument.

ATKINSON: That's right. But the other issue, I think is that we shouldn't forget the role of the finance ministers, the Commission, and the European political organization in terms of fiscal policy. And, of course, they'd began with, some years ago there was the whole austerity versus growth in the G20 and the G7 that changed in the wake, really, of the European crisis, to everybody agreeing, yes, jobs and growth are the top priorities.

So, then the next thing is, well, how do you get there? And, I think, it's pretty clear. We've seen many cases where cutting budgets and fiscal austerity as the leading tool in a, in a low inflation environment does not get you to jobs and growth. And we in the United States have had a dramatic fall in the deficit ratio to GDP, but that's been pushed partly by fiscal reforms, but also by a strengthening economy. And that realization in Europe is, you know, is what we need to see.

MALLABY: But it seems to me there is an amazing question about sort of European governance there. So, you know, Emi correctly points out, there's a mandate for the central bank to target inflation. So, if they just said, we're doing that. We're going to have enormous Q.E. or enormous purchases of asset backed securities. We're going to expand our balance sheet. They've promised $1.3 trillion expansion in the balance sheet. If they just left it at that—that could be viewed as consistent with, the mandate, and that'd be fine.

The problem with doing that is that the Germans don't like it. The Bundesbank is not happy with it. The Bundesbank thinks that's letting the politicians off the hook on structural reforms. So, the Germans, ironically, want to make the future potential quantitative easing, or something like that, conditional upon actions by the governments to prove that they don't get off the hook.

So, now you have this sort of linkage, or you have sort of, you know, double approach of actions by governments, actions by the central bank, linked together, but the kind of leadership of it, the conditionality that make it link, is suggested at Jackson Hole, of all places, by Mario Draghi, and at a time when, you know, electorates in Europe are not happy about the centralization of power, it's amazing to see a potential centralization in the sort of technocratic sphere.

REINHART: So, you're, you're, the progress in make the Euro a durable currency union has to be operate with a democracy deficit.

MALLABY: You said durable or adorable?


REINHART: More durable. More durable. Is—is to operate in a democracy deficit, i.e. rely on the central bank. Rely on the IMF. Rely on, you know, other entities. Because the major political failure in Europe has been to convince the electorate that the currency union is worth it.


REINHART: And, and, and I think the basic message is you couldn't have an up and down vote. Look what's happening in—in—in the U.K. with an up and down vote on a currency union. And if you want to keep the project going, and don't want to risk the up and down vote, you rely on the institutions to operate more in the shadows.

ATKINSON: But that implies the - that all of this is being driven with a, you know, with a single mind. I, I agree with you that there's a very strong desire to—that a lot of politicians are trying to work out how to make a success of the Eurozone. I—I would think that a lot of the disaffection in Europe, as anywhere, amongst the electorate comes from what is happening to their living standards. What is happening to their expectations for their children?

And that's where, in every country, we need to be paying attention to promoting opportunity promoting jobs, promoting growth, and promoting investment in infrastructure and so on. There's the, the sort of hope side, and the positive side is very important. I mean, again, if you look at - and the role of monetary policy, is, of course, very important to the wealth (ph) - and I don't want to speak any more about it because of the independence of the Federal Reserve, but if you look at the history in—in the United States and it's, for me, going to these international meetings, a few years ago, you know, the United States had been instrumental in this crisis. We were trying to lead people out, but, you know, it wasn't clear that our recipe was the right one. And, as we've gone forward, it's been more and more clear that United States economy is recovering. We dealt with the banking system, as Vince mentions that's a very important one early on. And, and now we've got not good enough growth, but much better than, than before. And in Europe that hasn't, that hasn't come.

MALLABY: There is something I'd like to put to Emi, maybe, which is I think Caroline is exactly right that there was an initial reaction in Europe, which was to say your capital markets in the U.S., all this securitization of everything, that was just as fundamentally dangerous approach to economics. And that's why it's blown up and left us in this mess. Now, if you look at the ECB's policies, it's, oh, we're going to buy some asset backed securities.


MALLABY: We love the securitization take. Let's have more of it. And there's actually a policy push in favor of it. And on the other hand the banks, which are, you know, too big to bailout and so forth, are going to have to be shrunk, and that's part of what the, the ECB is doing as well. So, where do you think historians will, will come down in 10, 20 years' time? On this balance between a bank dominated systems and capital market dominated systems?

NAKAMURA: I think it's a—it's a very interesting question, and—and I think there's a lot of doubt right now as to what the sustainability is of—of European banks. Whether we fully understand the extent to which there are bad loans on their balance sheets, and, and so on. I think that with regard to the ECB, though, that you really have to think about them doing this partly just because that's—that's one of the—one of the last tools that they have available to them.

I mean, as I said, the other tool that you would think of is something like forward guidance. And, to some extent, they've done some forward guidance. One of the things that has become very evident in the recent period in the United States is the importance of—of expectations. And expectation formation, and, and Caroline was talking a little bit about it. You know, how important it is to people, are optimistic about the future to the extent that, for example, you would think about linking monetary policy with things like structural reforms. I think one of the things that you would worry about is that—that people are not going to believe that, that this monetary policy is really going to come to be if - if—if doing it is going to be contingent on—on this structural reform in—in the Euro area.

And, also, as I—as I mentioned, there's the issue of Germany being very concerned about any kind of risk to inflation. So, I—I really think that, that in terms of ECB policy, a big part of is - is—is not really with the objective of, of promoting these, these asset markets as opposed to, to the banking system, but it's really, you know, in the vein of, of just trying to say, you know, we're going, going to do whatever it takes to try to get back to this inflation target.

MALLABY: Whatever it takes by whatever means we can think of, I understand?

NAKAMURA: Yes. Absolutely. Following the U.S's footsteps.

MALLABY: Is there a geographic shift, possibly flip going on in where the crisis is in Europe? So, I noticed that if you look at projections, the top performing economies in the Eurozone are going to include Ireland, Spain, the guys who were really badly hit and then reformed are going to see some benefit. On the other hand, Germany, in structural terms, has gone totally the wrong way. I think it raised the, no, it's doing a couple of things. It's high energy costs.


MALLABY: Raised the minimum wage, perhaps. In terms of sort of labor market affectability, it hasn't been moving forward, it's been going backward. France is a laggard. So, sometimes the core, you could have convergence in Europe ...

MALLABY: ...making, you know, coherent policy, coherent monetary policy more doable, but for the, not in the way the Germans were advocating.

ATKINSON: I would separate out what's happening in the structural area from what's happening to the basics of demand story. We saw that, in the periphery, there was a big contraction of demand and some price response. They became more competitive, and, you know, what goes down, what goes up comes down, what goes down, typically, will eventually start to recover.

So, that is a lot of what is driving the recovery in the, in the periphery. Whereas in Germany they have continued to perform, throughout the Euro crisis, German unemployment was continuing to decline. The economy was, was growing. I think the minimum wage was a positive thing in Germany because it's important also in Germany to have domestic demand. You know, Germany's current account surplus is 7 or 8 percent of GDP. 6, 8 percent of GDP, it's larger in dollar terms than China's at the moment.

So, it is a very, they are a very big net exporter, and exporter of, of their surplus. And that means they're also, their growth is sensitive to what is happening to external demand. And it makes sense for, for Germany to promote more domestic demand, which they've also, I think, agree with.

So, what's happening now is it this issue of how to have the Eurozone as a balanced, as a balanced economy. Obviously, Mario Draghi has the challenge of a, of a monetary policy that works for, for the entire zone. But I think you have to think how, what is, what is happening to the rest of policy. You know, we've been talking a lot about monetary policy, but that's not the only tool, and it's not the political tool.

MALLABY: Let's talk a bit about the U.S. I'm wondering, maybe, start with Emi, and then ask Vincent, too, whether we're getting to a time where, you know, Fed, the Fed can declare victory? That there's been several periods when there's been a false start, optimism at the start of the year, those projections have been revised down in the summer. Now, I think, rate is running around 4 percent. You've got, despite all the methods of the last few years that's been thrown up, premature fiscal tightening, one could argue. Certainly the debt ceiling brinkmanship, all of these challenges, whereby week by week external growth finally, finally we're coming out of this. And we've done it without inflation. We've, so far, not had an adverse reaction in terms of, of a sort of asset market destabilization. Again, and sort of future historian kind of questions. What, graded out of 10, how will the Fed score, do you think, Emi? When people look back on this period?

NAKAMURA: So, I, I think it is probably time for the, for the Feds to, for example, end Q.E. Certainly, unemployment is getting back into a range that people would have historically called somewhere close or approaching at least, the, the natural rate of unemployment. Though, certainly, there's a lot of uncertainty about what the natural rate of unemployment is. And, you know, there's a lot of measures of, perceptions of risks in asset markets like, for example, spreads on risky assets, long-term bond yields, vicks (ph) that suggest that, you know, asset markets think that risk is pretty low. So, so, in fact that you might be worried as a, as a future historian that we might actually look back on this period as period like the mid-2000s, where we would be concerned that the Fed didn't withdraw stimulus, you know, fast enough, and, and by, by large enough amounts.

So, in that sense I think that, that it is time for the Fed to, you know, to end Q.E. On the other hand, I think there's, you know, a lot of evidence probably that—that the recent recession is going to be associated with some pretty long-term changes in, in GDP, and GDP growth. So, you know, if you look where GDP is now, it—it's way below the pre-2007 trend line. Way below. You know, and, I don't think that there's any evidence that we're going to see a very rapid period of growth in the next few years, where we're going to go back to this previous trend line. And even GDP growth, you know, looks like it's—it's lower than it was before 2007.

Now, I should say that I think a lot of this probably has to do with factors that are basically outside of the Fed's control. In particular, there's a pretty big demographic drag in the United States having to do with the aging of the population. Having to do with a very long-term decline in the rate at which prime age men in working, having to do with the reduction in the rate at which women are entering in the labor force. And, and so these are things that, you know, we may, you know, we may see slower growth after this recession, but I'm not sure if we can blame it on the Fed.

REINHART: So, the first point I'd make is an author of a, a coming biography of Alan Greenspan, you should certainly appreciate you never give a central banker a grade too early, because that's the experience of 2005 and 2006.


REINHART: So, I, I'm not going to give, give a number, because you've got to tell me ultimately how the Federal Reserve renormalizes its position in the economy, and we'll view this, view the decade as different depending on those outcomes. Second part is, yes, it's time for the Federal Reserve to begin renormalization. i.e. get out of the business of unconventional monetary policy, but there's still plenty of scope because of the macro economy to keep policy accommodated for a very long time. Inflation's still below goal. There's still unused resources. There's lots of reasons to expect that cost pressures will be muted. What do I mean by getting out of the unconventional policy? Business by October they'll be done with net asset purchases on the Q.E. program, and I would think that over, really the next couple F1C meetings, you'll see them exiting the more aggressive forward rate guidance. And, and emphasizing that the monetary policy decision is data dependent, and made meeting by meeting. I think given our forecast of the economy, monetary policy made that is data dependent and made meeting by meeting is going to allow the Federal Reserve to keep a very accommodative stance of policy in terms of, of, of the overnight interest rate, but it won't have the bells and whistles we associate with unconventional policy.

MALLABY: Caroline commented earlier that, that there's a demand shortfall. So, in the U.S., I noticed that the chief proponent of the structural demand shortfall view, his name is Larry Summers, wrote this week that there might actually be a supply shortfall, too, in the sense that maybe these discouraged workers are permanently discouraged, and perhaps the supply potential of the economy is—is weaker than we thought. He seems now to have both ways?

ATKINSON: Well, you can have, and also that's quite right. Certainly, if, if you're wondering whether there is any scope for demand policies now, and you buy into the view that unemployment is at that the natural rate, then you would say, no, but I think that's hard to imagine given what's happening to, to inflation. And give the, and Larry, and other modes will has argued of the, about the importance of investment, and we know that our infrastructure needs a lot of, of work, and money put into it, and that is something that would increase supply potential, as what in the medium, and long-term, as well as supporting demand in the short-term.

On the, his historisis (ph) argument, he's a brilliant economist, but I also feel that, typically, when things have been going badly for a while, people become very depressed about the future, and believe that the recent, whether it's high unemployment, or relatively slower growth is going to continue. And, and, I'm, I don't think history really bears that out. At the same time, you can have a period when everything is going very well, and everybody imagines it's going to go on being very terrific forever. So, his argument about, some of his arguments, obviously, are right, about the, as Emi says, about the labor force and demographics, and so on, but I believe that the U.S. economy has enormous potential strengths, and we haven't seen enough—we haven't yet seen the end of - of the recovery, which has more room to go.

MALLABY: Emi, you and I were e-mailing last week, and you - you made a point to me about what the Piketty book says about sort of, the extent to which historical trend growth rates tell you anything about the future.

NAKAMURA: Yes, I think, you know, perhaps looking back on - on the U.S., we've been a little bit lulled into the belief that, you know, we're always going to go back to this trend line, and that growth is always going to be stable, you know, around 3 percent or whatever. But - but I think the fact is if you look at history more generally that - that history's really shown that there can be periods of persistently either very high growth, or persistently pretty low growth. And, you know, for example, in - in - in Europe, after WWII, we saw very high growth in a number of countries, you know, what - what the French called the Triumph Glorieuses, so Piketty talks about that in his book.

And on the other end of the spectrum, in Japan, you've seen, after their financial crisis, now - now counting, you know, two decades of - of much lower growth. And I think, you know, much more than a severe crisis this kind of a - a lower growth situation is - is something that - that we need to be worried about, particularly in view of the fact that - that financial crises and banking crises are sort of known to be associated with subsequent sustained periods of low growth, and particularly given that there are these undeniable demographic factors in the United States that are going to contribute to - to lower growth rates of - of GDP going forward.

ATKINSON: But it depends, if you look at the forces now that can support recovery going forward, we know that balance sheet recessions can be very dangerous, but now consumers in the United States - consumers have deleveraged a lot. They are ready. There is scope for them, for - for further expansion. Businesses have a lot of cash on hand. There is scope for more investment if they see the demand from the consumers, and residential housing still has more room to go to normalize. So, I think there's no reason to - or there's a lot of reason to expect that this steady recovery, which is not, you know, not good enough yet, will - will continue.

On Japan, I think there's a fairly good consensus in the economic community that the two decades were not something that Just - that was just driven by fate, but were heavily influenced by policies. So ...

MALLABY: So, on Japan, I want to come to the members for questions in just a second, but I got to get one - one important issue on the table here, which is to ask Emi about something she pointed out to me, which is the very important Japanese waist line circumference tax.

NAKAMURA: Yes, so there are a lot of negative things that you can say about Japan right now. A lot of challenges that Japan faces. I mentioned the demographic challenges in the United States, but they are even greater in Japan. And, in addition, they have an enormous public debt, and - and - and many challenges with regard to policy. But, if there's one thing that makes me sort of optimistic about Japan it is what I've seen as - in some cases just an incredible capacity for collective action.

So, there are a number of examples of this. You know, there's, of course, the recent consumption tax. But there's some other remarkable examples. So, Japan, to respond to, you know, the - the growing concerns about obesity, which, of course, we - we have a concern about that in the United States as well. They actually decided to implement a waistline circumference tax, whereby companies literally have to pay a tax for the fraction of their employees whose waistline exceeds a certain level.


NAKAMURA: Based on the view that the waistline circumference is actually, you know, the best, sort of scientific measure of the health costs associated with obesity. And it's not the only example. I mean, another example I was mentioning to - to Sebastian is - is the fact Japan has, in the last 10 years, actually raised the room temperature in government offices, just 27 degrees Celsius, which is over 80 degrees Fahrenheit. It's remarkable. I mean, yes, you - you are sweating at over 80 degrees Fahrenheit if you're wearing a suit. And, you know, to implement this, the government has had to encourage new fashions among government employees with, you know, short sleeved suits and so on.


NAKAMURA: So - so, you know, with all of the challenges that Japan faces this kind of capacity for - for collective action is - is one of the things that sometimes makes me think that - that Japan could surprise on the outside.

MALLABY: OK. So, let's go to the members for questions now. Please put your hand up if you've got something you'd like to ask. Otherwise, I'll ask something. OK. (Inaudible) in the aisle, right there.

QUESTION: The - the title of this - of the discussion today is "World Economic Update." We haven't heard a word about - heard a word about China. Would somebody like to comment on what you think is going on in China?

MALLABY: That's a good question, and, in fact, I noticed that the - the old talk about sort of India versus China has come back a bit. That, you know, Indian growth rates have improved a little bit, and China's slowed down, and so within India apparently there's more discussion of whether, after all, the English speaking, democratic country might actually, you know? Anyone want to take that up?

ATKINSON: I think in China it's obviously - well, on the India China thing there is a lot of optimism, of course, about whether India will return to a path of reform that has tended, that in the past provided a lot of - a lot of growth. And they, I think, the government recognizes the importance of that, as well as the importance of addressing the continued deep poverty in some - in many parts of India.

In china, others will - will perhaps know more, but the Third Plenum reforms obviously pointed out a good way forward in terms of using more market mechanisms and decisive roles for the market, and so on. There is - there is evidence that - that China - I mean, people were concerned a year ago about what might happen with a hard landing. I think those fears have - have - have gone back a bit. It's clear that the Chinese are going to try to manage their way pretty carefully with their - with their economic growth. But, I'm glad that you raised it, because China is, of course, as the second largest economy in the world, a huge - a hugely important area for - for the global economy.

REINHART: Yes. So, there are advantages and disadvantages of regional rivalries. The disadvantages are what's going on in the South China Sea. The advantage is that the example of very rapid Chinese growth has been a spur to politicians in the entire region. A part about Abenomics is to try to regain the position of Japan in the region. The electoral change in India, in part, is it's time for more significant changes as the relative position of India has - has shifted. So, it - it does tell you that there's scope for officials actually to - to move when - when spurred from the outside.

Now, with regard to China, economists refer to the middle income growth trap. When you grow really fast, you create a middle class, and the middle class has middle class expectations. They want to be more - they're restive at corruption, desirous of having more control of their balance sheet. And it's, you know, what the - the Chinese officials are doing is trying to address those concerns while keeping the growth model going.

ATKINSON: The other issue, of course, for China is that they have realized that some of the ways of growing rapidly have environmental consequences that are also very undesirable and politically objectionable. So, I think that they're also trying to balance how to figure out moving towards a greener economy, and - and reduce emissions.

MALLABY: Another question. Right here. (inaudible)

QUESTION: (inaudible) Stars Capital (ph). So, going back to Europe, I - I spend quite a bit of time in Europe, and what I see is market participants, and the street, is doing very little fundamental analysis on - on credit at this point. Certainly, with regard to sovereign credit. All the focus is on what is the - what is the ECB going to do. So, I guess my question is, what are the unintended consequence? What are the potential risks associated with market participants not doing fundamental work and investing based on the political winds, as opposed to doing any fundamental work at all on the underlying credits? And I - I think the question also goes to the banks. I see the same thing in talking with other market participants. And the street about whether one should buy a bank stock. It's very little to do with the fundamentals of the bank, all to do with the - the politics.

MALLABY: Is that dangerous? Or are we in a phase, actually, in Europe where they're not exiting extraordinary policies, they're actually intensifying them, and so market participants might be right to just watch to the official sector. And ...

REINHART: And that - I mean, at that - you just gave a brief definition of moral hazard.


REINHART: Right? That both - that willingness to do whatever it takes means that you don't have to - you don't differentiate against sovereigns. The fact that politicians still have sovereign national financial champions, meaning you don't have to differentiate about banks. Is there a cost associated with that? Yes. It's enormous. Because it means there's - there's bad - bad credit decisions being made. Are there risks associated? Yes. I - I presume that Mario Draghi's answer you have to focus on the big thing right now, and the one big thing is keeping the enterprise going.

NAKAMURA: You might - you might worry that - that - that there's not even enough fundamental analysis being done when it comes to - sovereign credit risk, you know, let alone individual companies. I mean, long-term interest rates in the Euro area are remarkably low. You know, for - for basically all the countries. Spreads have gone very low. And, so, I think it's - I mean, when you - when you first look at these long - long-term interest rates, I mean, it's really remarkable by any kind of historical standard. So - so one of the questions I think it's important is whether we're going to see a big adjustment at some point, when people start to think about these fundamentals.

ATKINSON: But if you think about the - the sovereign credit risk, I'm not sure if that was what you were getting at - within the Euro are that widening out of spread I - I believe, you tell me, was much more about a questioning of the permanence of - of the Euro, and we've seen very strong demonstration - political demonstration of political support, and backing for - for the Euro, and including from the major countries in the Euro and from the central bank. So, I think that's - I would presume it's not just mindless but it's - it's considered reaction to that.

MALLABY: But, as I understand it, it extends to Lufthansa, which, after all, is an airline, as well being in the heart of Europe. And they borrow at - it's junk rated - but they borrow at almost no spread over sovereign debts. It seems to be beyond just sovereign debt. Let's go to another question, right in the aisle there.

QUESTION: Hi, Alan Rapport (ph), Roundtable. Could you give your view on the impact of the sanctions in Russia? And how things play out?

ATKINSON: Sure. First of all, I think we've already seen a big impact. We've certainly seen a big impact on the Russian economy. And, on, both in terms of the restriction of financing of some major state institutions that have turned to the central bank, reserves lost, capital outflows, and significant downward revision in growth. So, it's clear that the Russian - even though these sanctions, as we have said, have been very targeted, they've been different from sanctions that we've done in the past, and they've been sort of gradually ratcheted up, as opposed to put on in - in a big, blocked way. And they've been targeted at the sectors and the entities, and the individuals that we believe are particularly close to President Putin.

They've also been targeted to go after key institutions in the Russian economy as opposed to with a - with a mind to what is important for European and American companies. But I think it's very clear and that the - that they've had a strong impact already on the Russian economy. The next question is have they had an impact on the political situation or the military situation? And, again, we believe that they have. Of course, it's very hard to know what would have happened in the absence of the sanctions, but we certainly think that - that President Putin and part of his, you know, we had - if - if you step back a bit, when after the Crimea invasion it was not at all clear that there would be a free election in Ukraine, that there would be a new president that could - that could be recognized, that there would be new parliamentary elections, that there could be an agreement with the IMF. So, there have been a lot of steps forward that, in some sense, have been a reflection of part of - of the - of President Putin's calculations.

We know that we're not where we need to be, and there are talks about a cease fire and a peace plan, but we really need to see that, and see the evidence. And to think Europe and the United States have made clear, that we're willing to continue to ratchet up the costs on Russia. It's not that we want to, but that we want to resolve the - the situation.

MALLABY: The Iran template would suggest that one of the things out there in the future could be the use of the swift system to block transfers by Russian institutions internationally. That was done to Iran. It, I suppose, could be done to Russia. Or is that not really possible to contemplate in a bigger economy?

ATKINSON: I think when you look at - when you look at the sanctions that we've done, we've been very careful to target - to recognize that this a large, globally integrated economy, and we are trying to gradually exert a squeeze on long-term prospects, to promote - to increase isolation and to send the signals to key players that - that their economic interests are at stake if they - they - if Russia continues down this political path. So, I don't think we're talking about - I know there were rumors out of Europe, but I think they were swiftly denied.

MALLABY: The - the IMF have given Ukraine support, conditional upon, as always is the case with IMF programs, the meeting of various targets and the budget. There are payments coming up in the next 12 to 18 months which, given the ongoing war, there's no way Ukraine is going to make. So, it looks as if they'll have to be a new program, which would be one driven entirely by geopolitics, rather than by sort of IMF, quote unquote, "Technocratic considerations of economic merit." Is this something where - you used to work at the IMF - should the IMF, in order to preserve its long-term credibility as a technocratic institution sort of be taken out of that loop? Should - should governments, if they want to do foreign policy with Ukraine, and for geopolitical reasons support Ukraine, that should be done directly by donors, not by the IMF? How - how does one think about that?

ATKINSON: I think you're underestimating the reforms that this government in Ukraine has committed to and is already doing. So, those are ...

MALLABY: I'll remind you of this in a year.



ATKINSON: Sure. But that's the beauty of IMF programs. The money comes out, you know, in tranches depending on economic performance. And, so far, there have been - the government, and Prime Minister Yatsenyuk, has taken some bold steps and committed to them, and the parliament has passed them and so on. Of course, you never if - if things will - will continue. So, the - I think it's too soon to say. I mean, their IMF disbursement was just a week ago, or something. So, I think we're in the early phases of the next quarter of consideration of how things go. We hope very much that there will be a political resolution to the conflict, so that then Ukraine can focus on - the government can focus on its economic reforms, as well as, obviously, the political healing that will necessary in the country.


ATKINSON: And I think that it's quite usual. If you look at the history of the IMF, that the IMF is an important player when there is - when there are financial difficulties and financial crises around the world, and that the - that's one of the important mechanisms and tools for the world to promote financial and economic security, which is often tied quite closely with other kinds of security.

REINHART: so, in the movie, "Pirates of the Caribbean" ...


REINHART: ... there's - there's the pirate cove, which is a lot like the IMF's articles agreement. They're not actually rules, they're merely guidelines.


REINHART: And sometimes political decisions have to dominate, and it's - it would be naÔve to look away from the fact that a country is at war to enforce something that was written six, or nine, or even last week.

MALLABY: That's the Vincent "Debt" Reinhart.


MALLABY: Who's got another question? Over there.

QUESTION: Rachel Robbins (ph). You've talked about growth and jobs, and we know that jobs don't always follow growth. And in the development world, the concept has taken hold of inclusive growth. And to what extent do you and others in the developed world think in terms of an inclusive growth?

MALLABY: So, that raises the whole issue of inequality. Anybody? Emi was talking about Piketty earlier.

NAKAMURA: Yes, I think - I think they're very disturbing trends in the United States when it comes to inequality, and - it's very likely that some of these trends have to do with - with fairly long-term things. Having to do with, for example, which groups in society are most benefitted by certain types of technologies. And - and so there isn't - there isn't much evidence if things just go as planned that - that these trends are going - are going to be reversed. As we see the labor market pick up, you know, unemployment, you know, is - is falling and so on, but we're also seeing, you know, pretty big declines in - in labor force participation.

As I mentioned, part of that decline is a pretty substantial pre-existing trend decline in labor force participation by prime age men. We don't really understand, you know, fully why that's happening. But I think understanding that better and - and how it relates to this - to this issue of inequality, and what's happening to - to particularly the lowest skilled men in the economy is - is something that government policy is going to have to think a lot about.

ATKINSON: Just on that, one of the better trends on unemployment recently has been that long-term unemployment, which, again, is something that goes to the - tends to be suffered by those who are - who are worse off has also fallen quite sharply, as the economy has recovered. And, we expect that - that - that can continue.

But, inclusive growth, of course, is extremely important. I think that people have tended to think of the United States as somewhere where there is inclusive growth because there is opportunity. But we know that there have been cases where - this is a challenge where we have to look particularly at, you know, what people sometimes refer to as the skills gap. And where, as part of that - part of the being out of work issue can just be - will be resolved naturally by growth and recovery. It is really important to focus on how to educate people for the workforce. How to develop skills in connection with the - with the private sector so that people are teaching to what is needed and what can get jobs.

And the administration has got a number of - of efforts going in that with manufacturing industry. There's also, as you mentioned, with prime age males, you know, we have a program, My Brother's Keeper, which is particularly to look at issues faced in the workplace by - by young men of color. And, these - this is not on a macro basis. On a macro basis you still need the - the - the overall global demand, but it is extremely important to go for the - to the inclusive growth issue that - that you raised.

MALLABY: One symptom of the growing inequality is actually, yesterday, we were talking about earlier, secular stagnation. One of the factors of contributing to potentially excess savings is inequality, right? Because there's a higher propensity to save at the top. You move more money to the top, there's more savings, interest rates will be lower structurally, so that all links together. I think there was a question just over here?

QUESTION: Dick Foster (ph), Yale University. How is ISIS being financed? And how sustainable is that finance?

ATKINSON: Well, ISIS, I think everybody has said, is financed or ISIL, as we call it, is financed from a number of sources, but obviously from what we're concerned about is going after the sources of finance that come from illegal activities, of which there may be many. And, also, legal activities that - that have been permitted in various countries. So, it's extremely important to - to work to reduce those sources of finance for ISIL. I'm not going to speculate about how sustainable they are. I think what we are seeing is that we don't have illusions about this being a long-term issue, but we also see that we don't - we see that it is a long-term issue that - that is being taken on.

MALLABY: You mean taken on by the U.S. government?

ATKINSON: Taken on not just by the U.S. government. I mean, just that NATO has taken on very broadly. Anyway, the president's going to speak about it tomorrow night.


MALLABY: Another question? Anyone got another question? Right here in the front.

QUESTION: Lester Wakler (ph), Morgan Stanley. We have a situation in Argentina right now where I'm not really sure it's a default. It's like a quasi-default, imposed by a court. But, nevertheless, I was wondering if there's any potential for that situation to impact the economies in South America, in particular Brazil.

MALLABY: And maybe also at the same time, there's the question of how - the world of sovereign debt ...


MALLABY: ... digest the newer ruling. And should we just leave it at that? Or does there need to be the - the - there's been some industry led effort to set new norms around ...


MALLABY: ...sovereign debt work outs. Is that enough?

ATKINSON: Well, I think, just to go to that, that industry led effort, which was facilitated by my colleagues at the Treasury Department, I think is - is very successful - has been very successful so far, and, you know, it will lead to a new kind of - the development of new clauses that would make the kind of hold outs and pari passu linkage, I mean you probably know better than I do - across the different debts harder. We've seen, over a period of quite some time, an evolution in the contract writing between the private sector and sovereigns, which I think is also very positive. I'm going to let others comment about what this might mean to sovereign debt, but I just see the market impact, I think the market has seen the Argentine situation as something pretty special and differentiated for quite some time now.

REINHART: Yes, I think it's impressive to the extent to which emerging markets have differentiated the Argentine experience relative to - to their neighbors. But that's all - all I'll say.

MALLABY: Emi, do you have any thoughts on that?

NAKAMURA: I - I agree, I mean, I think the - there's a lot that - that's special about the Argentinian case. So, we think that, in sovereign debt markets, you know, reputation is incredibly important. Obviously, Argentina has pursued a very different path than other countries, and - and so the effect, in terms of people's perception about what's going to happen going forward is - is very different than if - if you thought of Argentina as sort of a run of the mill country.

MALLABY: Right there. Over here.

QUESTION: Steve Myra (ph) with Beacon Policy Advisors. I'd be interested in your thoughts on you factor into your economic projections and analyses the dynamic changing flows of energy? Both in terms of the rise of supplies, and also potential disruptions, harking back to the Ukrainian question in particular that a lot of people have been focused on the military component. But, probably, at least in my view, more likely than seizure of physical territory would be the use of the flow of gas from Russia and its exports as leverage as a weapon. Thank you.

MALLABY: Who wants to take a crack at that? Last question. Last chance to talk.


ATKINSON: All I would say about the last point is that Russia, or this is a two way trade, so Russia also gets a lot of revenue from the sale of gas. So, I think one had to bear that in mind if you're - when you're wondering about what may happen in terms of - of supply. And, actually, Russia's supply to Europe of gas continued throughout the Cold War. That doesn't mean that there isn't an important focus and need for a focus on energy security in Europe and Ukraine. And, Ukraine itself, some of that can come simply from just a small portion, but some of it can come simply from increased energy efficiency. Ukraine uses quite a bit more energy per unit of output than even its - its neighbors. But, obviously, that is a - that is an important issue.

In terms of the world supply, as we know, the United States is the biggest - now - the biggest producer of oil and gas, which is oil and natural gas, which is quite incredible if you think back a few years. And I think that does - over time that has an impact on. Well, obviously, it has an impact - it probably has an impact on the price, but it also has an impact on energy security considerations.

MALLABY: Well, let's just do one last point on that, and then we'll stop. Does that mean traditional U.S. security concerns like, shipping lanes in the Middle East simply don't prove to be as important as they used to be? We've got a lot of domestic energy supply. We can get a whole bunch from Canada. We can think of the Western Hemisphere in - in a - as our source of energy security here. And it a world where, you know, President Obama has run an experiment of trying to get the allies to lead and share the burden, it hasn't worked out uniformly well. Our allies are not keen to share the burden. There's a lot of disintegration, lack of integration and European decision making. So, it's tough to get allies to share burdens. It's going to be tempted to shed some. And is this an area where, because of changing oil movements or energy movements across the world, we're going to rethink the importance of shipping lanes to West Africa?

ATKINSON: I'll just make two points. Others will have comments. One is that right now, I think, as I said in NATO, at the NATO meeting in Wales last week actually showed quite a lot of - of cohesion amongst allies. And, secondly, the - in terms of oil, it's a global market, so there are still very major suppliers in the Middle East, what happens to their supplies still very important for global oil market.

REINHART: Yes, so our comparative efficiency in - in extracting energy in the middle of the continent determine the spread relative to the global price of energy. It's still a global price. And there's - and while we maybe net energy independent, there very large gross flows, because what we extract in the middle part of the country isn't what we put in the tanks of our cars and trucks and - and ...

REINHART: ... and so, there's - there's still going to be large gross flows and if you worry about gross flows, then you have to worry about shipping lanes. And you're not - you cannot be an oasis.

MALLABY: So, Vincent is saying that the global responsibilities of the United States remain inescapable, therefore the Council on Foreign Relations will remain in business.

MALLABY: Thank you all for coming. Thank you to Caroline Atkinson, Vincent Reinhart, and Emi Nakamura.

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