On the Road to Recovery, or Creating the "Mother of All Bubbles"?

Tuesday, March 25, 2014
Nouriel Roubini

Chairman and Founder, Roubini Global Economics

Joyce Chang

Managing Director, Global Head of Fixed Income Research, JPMorgan


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

With the tapering of the Federal Reserve's bond buying program well underway, and the possibility of future interest rate hikes under discussion, J.P. Morgan's Joyce Chang and Nouriel Roubini of Roubini Global Economics assess the risks that exist in the current global financial system in a discussion with CFR's Sebastian Mallaby. While the risk of financial contagion may have diminished since the time of the global financial crisis, significant dangers remain. The panelists examine the possibility that a prolonged period of zero interest rates by the Fed and other central banks could potentially inflate a new asset bubble.

This session is part of a CFR symposium, Risk and Strategy for the Changing World, which was made possible by the generous support of Rita E. Hauser, and organized in cooperation with King's College London.



MALLABY: ...in the last couple of years.


ROUBINI: Ok. There are plenty of them that have become less scary. We will speak about those that are becoming more scary. One of my things is that the range of economic financial and geopolitical risk that people are worried about, and have to worry about, are changing over time. I would say, compared to a year or two ago I would say, the risks that are lower are several.


The breakup of the Eurozone, of Greek exit, of Italy and Spain losing market access, of other sovereign debt crisis in the Eurozone leading Berlin (ph) off course and debt restructuring. That threat risk has been reduced. Thanks to whatever it takes, OMT, ESM, banking union, you name it. The U.S. fiscal risk that people used-- people were worrying about 10 percent budget deficit.


Now it's down to four and falling, another fiscal cliff, another government shut-down, another debt ceiling leading to a near default. There is a truce, for now, between Democrats and Republicans on those fiscal issues. They're going to come back. But so far the threat risk has been reduced.


People were worrying about the risk of a (inaudible) Japan, 240 percent of the GDP public debt and deflation, and negative growth. Now thanks to Abenomics, they've kicked the can down the road. First monetary and fiscal easing, now some fiscal contraction to reduce the deficit, the beginning of the third arrow, even if the third arrow is not going anywhere.


Medium term you still have to worry about debt crisis in Japan, but for the time being, between the three arrows, that risk is reduced.


Fourth risk, people were worrying a lot about deflation, you know, from Japan to the Eurozone, even in the U.S., Switzerland, Sweden, across advanced economies. Inflation is still low, still below target of 2 percent. But aggressive policies by central banks.


Think about the new jargon the last few years: ZIRP, zero interest with policy rates, you know, QE, quantitative easing, CE, credit easing, FG, forward guidance. We've tried everything to try to avoid deflation of goods and services. And things are improving I would say. There are still risks, but lower than the past.


Those are the economic risks, I would say. The dual geopolitical risks that people are mostly worried about in the last two or three years were the risk of a war between Israel and Iran on the nuclear proliferation. Thanks to the intermediate accord, that threat risk is lower. It's not gone. It's lower. We'll see whether that's going to succeed, whether the Iranians are bluffing or for real. But sort of the fear premium that was in oil prices a few years ago because of that risk has been reduced. That's a positive.


And finally for the last few years, we've had this total mess in the Middle East, the Arab Spring, Egypt, Tunisia, Libya, civil war in Syria, in Yemen, things getting destabilized in Iraq, in Lebanon, you know, even in Algeria, all the way down to Af-Pak that is a disaster.


Guess what? Those things are messy. Many of you know more about it, but the potential impact on having a shock on global oil and energy supply has not materialized.


And since each one of them countries that are systemically mostly not important, geopolitically important, then markets have essentially discounted, this kind of risk cannot be something that affects growth or financial markets, even if they (ph) remain so.


So now all of these risks have been reduced. They've not gone away. Each one of them could return in one form or another. But I would say that those risks are still lower than they were a couple of years ago.


MALLABY: So Joyce, is Dr. Sunlamp being too sunny? I mean, you know, you could push back maybe Europe and you've still got a periphery enormous debt to GDP, very low growth, very high unemployment. Japan could be unstable in the medium term. Is there anything you think he's being too sanguine about?


CHANG: I think the risks have shifted in that we're in a much more bottoms up world now. So I think Nouriel is absolutely right, that at the time of the global financial crisis were macro-risks that would lead to contagion, the U.S. global financial crisis, the fiscal cliff. Sequester really put a lid on some of those risks.


And on the Eurozone, it's the funding problem. I look at the funding this year for the Eurozone, and they're already about 30 percent through the funding. So those were big macro contagion risks.


The risks this year, to me, seem to have shifted more bottoms up risks. And one thing that has happened is that emerging markets have transformed. So it's not about a big balance of payment risk. I mean, there are emerging markets risk that have heated up on the geopolitical side, but they are judged more on their own, rather than as something that could spread widespread contagion through the system.


So the risks that Nouriel refers to that the market had been so fixated on post financial crisis were the global financial macro-risks that would hit all markets. U.S. Finance (inaudible) Eurozone crisis. It wasn't Greece was the entire core and the periphery.


So I think those types of risks have gone away. Now it's much more bottoms up, and we've actually seen that in emerging markets where you used to have one problem that would spread contagion across the board. But that's pretty much less the case.


Russia and Crimea have been separated from, you know, necessarily thinking that this increases your risk in Latin America. And we haven't seen the type of contagion, you know, play out. So that doesn't mean that the risk has gone away. It's just shifted with respect to market reaction to it. And I think it has become more bottoms up in nature, and less about the solvency and stability of the over-all system, than trying to judge the risks on their own.


MALLABY: And specifically, just on Japan, I mean, one of those risks is if growth picks up, and inflation picks up, and Abenomics works to some degree, at some point you're going to see bond rates move up, presumably. And you're going to have this stable world where the government could afford to pay its debt because interest rates were so low.


Interest rates won't be low if you have higher inflation, higher growth at some point in the future. I'm surprised that markets don't worry about that more than...


CHANG: Well, right now at the pace that Japan has been introducing the changes and the pace that the changes will occur—I mean, if anything, the surprise this year is that the bond markets have out-performed equities. Right? You actually had a flight to quality back to bonds, was actually back in vogue, which was really against the consensus in December where everybody thought it would be a straight-forward, U.S. equity market rally, treasury yields rising.


And then you actually had a January where absolutely the opposite had happened. And I think that there is still a sense that the nature of the crisis that we've gone through is going to mean that the changes going forward will have to occur more slowly.


So this is one reason why, I think the question is why the markets not pricing in some of these risks right now? The timing for them is still something seen as something that will play out over a period time rather than that rapidly.


MALLABY: So for those of you were here yesterday evening, there was some discussion of Abe as a change agent which could cause some instability, vis a vis, Japan-China tensions. You're saying that there could be that? Abe could be a change agent on the economic side too, that could lead to trouble in the future, but it's just too early for markets to worry about it?


CHANG: I think it's too early for markets to worry about it. But, just switching to China, I think one question about China is whether it will look more like Japan? And how will China avoid a crisis?


I mean, they will have to have household income grow faster than GDP growth. You know, 20 years ago everybody said that Japan might have a crisis if growth slowed down. But you didn't have that crisis.

"I think [risk] has become more bottoms up in nature, and less about the solvency and stability of the over-all system."
—Joyce Chang

What you did have, though, was a transfer of debt, Japanese debt going over 200 percent of GDP. I think these are some of the challenges now that are in place about China. That if growth slows will the state take on more of that burden? And will they be able to maintain social stability if they can have household income rise more quickly than GDP growth and really get some of those consumption trends, that they've long talked about, to play out.


So I think that, you know, the whole issue of Japanification of the economy, is that going to happen in the Eurozone? Might we even see some of that play out in China?


But these are sort of slower moving issues. But that's one way you avoid the sudden crisis. But you nevertheless have issues of debt accumulation and drawn out macro-changes that occur over time.


MALLABY: Nouriel, you gave us the list of this year's where the worries were less acute. What's your list where they are more acute?


ROUBINI: Well, the list of things that are more acute, or are potentially going to become more acute—by the way, the first list, I didn't say the probability is zero. I said it's fallen, but some of these things may emerge. Gridlock in Congress and other fights after mid-term or Eurozone medium term debt sustainability issue or Abenomics failing, and debt crisis in Japan, not this year, but in three ot four years down the line. Or the Middle East blowing up again.


So I'm not saying those are risks are gone. I'm just saying, are probably, I would say the things that are starting people to worry right now are again, the issue about Fed exit from both QE and zero policy rates. The QE's priced in by the market after the March FOMC. Will start sooner to raise rates? And will they do it faster than otherwise?


That could have an impact on market if it's a significant re-pricing of term premiums, especially on the short end. One risk, of course, is the Fed may be moving too soon, and that rattles markets like yen (ph).


But the other risk that I think that is a relevant one is that even if you take the new baseline of the Fed, they're going to QE throughout the year. They're going to keep rates another six months to the middle of next year. Then they're going to go very slow normalizing. By the end of '16, the Fed fund's only going to be 225 and is going to reach 4 percent neutral, lower than the previous six and a half or 525 by 2018.


So the risk is actually that the Fed exits too slowly. Why? The economy is growing slowly, unemployment is high, inflation is still low. But then, because of that, the risk is that we're going to cause another financial bubble. Right?


There's already frothiness in credit market, frothiness in some real estate market around the world, frothiness even in equity markets like the U.S. tech sector, bio-tech, and otherwise. So Janet Yellen says there's not a bubble today. The issue is not that there is a bubble today, but whether the very slow exit from zero policy rates are going to cause a bubble down the line. After all last time around, it took us only two years to exit from one to 525 between '04 and '06. Too little, too late, too slow. They announced major pace. We create a suffering (ph) bubble, housing bubble, a credit bubble, an equity bubble, and then went all into booming (ph) bubble, and then bust and a crash.


This time around it's going to take us a year to start normalizing, after five years of zero rates, and searching for yields in liquidity. It's going to take us four years to normalize. So the problem is not today, but whether we're going to have a financial bubble down the line.


Now Janet Yellen and Bill Dudley, Ben Bernanke say well we have two goals, economic stability and financial stability, and we have two instruments, monetary policy for the economy, and macro-proof for financial stability. But then people like Jeremy Stein and the hawks within the FOMC say macro-proof is not going to work. It's not worked in the past. It's untested.


You impose liquidity ratios or leverage on one part of the banking system. Liquidity goes to another part. The impose on the tar (ph) banking system it's going to go into the shadow banking system. It's unregulated. The only instrument connected in all the cracks of the financial system is monetary policy, interest rates.


If you have only one instrument, two goals, damned if you do and damned if you don't. Because if you are trying to exit slowly, because the economy justifies it, you'll create the mother of all bubbles. If you try using instead monetary policy to prick the bubble, you'll let the bull market drown (ph) and crash the economy.




MALLABY: Let—let me—let me—let ...




ROUBINI: That's the big risk, not the QE exit, or whatever, no. That's the fundamental risk the fed, ECD, the SMB, the Riksbank, all central banks in the world are facing today. They have a new goal, financial stability, and they don't know if that additional instrument is going to work or not. That's...




MALLABY: The tradeoff, Nouriel, is—I think it's an interesting point because this is also a security conference. And, you know, security people are paid to think about what could really happen that's bad, contingencies, and spend billions of dollars in defense money to get ready for those contingencies.

"So the risk is actually that the Fed exits too slowly. Why? The economy is growing slowly, unemployment is high, inflation is still low. But then, because of that, the risk is that we're going to cause another financial bubble."
—Nouriel Roubini

It seems to me that what you're saying, slightly is that the Fed, as the kind of steerer of the economy, is not willing to pay a price in terms of the slower exit from recession or from suboptimal employment levels. It's not willing to pay that price in order to buy safety with respect to financial bubbles.


So then we have one mentality in the defense establishment, which is we pay a lot of money because we're worried about terrorists. We have a completely different mentality in economic policy. Do you think that's fair, Joyce?


CHANG: You know, what worries me, just to follow up on Nouriel's point, before I get to your question, is that in all of this, you've had a slowdown in growth in emerging markets and developed markets. So during previous periods of crisis or coming out of a war, you could say the economy will grow out of this.


But we've taken down potential growth by, you know, a half to almost 1 percent in developed markets, by 2 percentage points in emerging markets and all of this while you have shifting demographic burdens. It also contributes to more sociopolitical tensions, which all can be a very slow burn, very much in line with what Nouriel has to say.


So it's not this huge tail-risk that you can necessarily plan for, but it is the creeping debt burden, a debt burden that's going up, a growth rate that's going down, demographics that are less favorable, and lingering, you know, political risk and geopolitical shocks that haven't necessarily boiled to the brink, but which are a slow brew. So I think, you know, how do financial markets try to then price this—I mean, virtually all large shocks start as small ones, aside from ones such as a national disaster.



So I think, you know, when I talk to people about Russia and Crimea now, I often hear, well everybody had said Greece was too small to really matter at the start. And then it became something much bigger. Well, what will happen with Crimea? Well, that also becomes something that becomes much bigger for emerging markets for Russia, for example.


So, I think that it's hard for markets, when you have the zero interest rate policy has put this all into such slow motion. And that the growth numbers are making it hard to accelerate those policies. It is hard to actually price it from a market perspective on a daily basis and know how you're supposed to factor that in.


MALLABY: Do you think there's something to this idea of a different mentality in running the economy to the one that we apply in other spheres like defense and security?


ROUBINI: Well, there is a little of that because, you know, of course there are, you know, some big-tail risks. But it's very hard sometimes to price some of those risk in giving really significant probability. Some of it is subjective. Or some of it starts as a small one.


And therefore, unless they become something more acute, like, you know, like take the Eurozone crisis. Unless there's going to be, say, a government increase falling series of coming to power, then abandoning the troika program, and then the risk of another potential exit from the Eurozone of Greece, people know that those things can happen, but they're assigning, I would say, a relatively low probability to all those risks.


Because they seem to be the low probability, or the low probability in the short run, and maybe high probability in the future you're discounting. And I would say probably some of the complacency about some of the geopolitical stuff, where there is Russia and Crimea, there's a new risk as opposed to now, you know, this tension between Asia, between China, Japan, and others, is a combination probably is some recovery however mediocre in advanced economies U.S., Europe, Japan.


This year's growth grows closer to 2 percent, rather than 1 percent. So that's going to lead to some of the growth of them (ph) including those who are slightly more fragile. And also as Joyce was pointing out, for the last few years, central banks have been compressing, reducing, volatility with a most unconventional monetary policies, forever. And they've doubled down on them.


So there's a bit of complacency in the markets as don't worry; stuff happens, and there'll be the economic risk of financial or political monetary policy is going to react, start to cover either kick the can down the road. And that's where, then suddenly, when the fed says, hey we might start exiting QE have a tapering tantrum last year. Or now that the fed says, hey we must start sooner and faster to exit zero policy rates that starts to have some ripple effects.


I would say, that you know, to get some of these kind of em, either political, or economic risk having another risk of episode either for em or even for advanced economy. You need a confluence of many factors. Some global. Some local economic, and some geopolitical.


Because I mean, generally, when you have that shock coming, the day when Argentina devalued the currency 15 percent. The same day you had a bad PMI out of China and you had these noises in Turkey, Ukraine, and Thailand becoming greater. So there was mini-perfect storm when these three things got together.


So I would say, if you think about another episode of risk off, is maybe not just sufficient for the noise out of Russia, Ukraine, to become more noisy, that can be one of the triggers. But then you need one of the global factors to be at play, say, another series of really bad numbers out of China, risk of China hard landing, or suddenly even more so signal that the fed is going start even sooner.


By the way, Janet Yellen has her views, but now you have a fed board where three, possibly four, members are going to be new. Sara Raskin, Ben Bernanke is a big (inaudible) out. Claire Brainerd, Stan Fischer is in. To me they need a third guy. When Raskin is confirmed, then maybe a fourth guy if Jeremy Stein leaves, and the rest of the voting FOMC. So completely new this year, you know.


So one hawk is out, Esther George. Two hawks are in, Plosser (ph) and Fischer. And the new head of the Cleveland fed used to be the policy advisor of Plosser (ph) at Philly Fed (inaudible). So you have two net hawks, so, you know. The fed under Yellen, like under Bernanke, is not anymore a monarchy, is a collegiate democracy. And every one of these guys has their own strong views to express. So people say Yellen was trying to be dovish, and she misspoke in the press conference, but the doves (ph) were signaling to the firms that she was moving in other directions. So those things also can change over time. And they can be a source of surprise.


So you need something global, China, fed, and so on, with something more noisy, Ukraine, and then other fragility in some of the EM become more and then you can have another risk off episode.


MALLABY: And then that would be a return to the type of global risk that you think has abated recently, Joyce?


CHANG: Well, I think that even the January sell-off. We saw that as an opportunity. We actually went opportunistically over weight and that played out. I mean, some of those risks, those mini- risks that all converged on that weekend, actually, you know—Turkey took action. Some of the other risks sort of abated.


You know China is going to be an ongoing issue to watch. It's not just one PMI number. It's how they, you know, choose to manage banking and some of the credit issues in China over a much longer period of time.


So I think markets will actually look at some of this more opportunistically. If they think policy makers have the resolve to respond, or if they think some of these risks will, not necessarily be resolved, but they're also not going to be pushed to the brink.


MALLABY: So we're hearing a lot about markets being opportunistic, about the inability to price risks that are too far out. But let me, nonetheless, ask you two to stand back a bit, and on a five year view, we've seen China take deceleration of growth rate from 10 percent to seven and a half. What do you think of the chances of another deceleration where China gets into kind of 5 percent a year growth zone? Joyce first, and then Nouriel.


Do you think—do you see that as a...


CHANG: Yes, I mean, we have China growth continuing to come down, and coming down to something with a six handle by the end of the decade. So it's not impossible to see a 5 percent growth.


I think the key thing is will household incomes grow faster than GDP. So you can make a parallel to Japan. Japan grew by half a percent from 1990 to 2010, but the household income grew faster. And there was one period of time during the height of Japan, where everybody said oh if Japan slows down, the whole thing will fall apart, but that didn't happen. A crisis was averted.


What happened instead? The Japanese debt burden ballooned. Household income increased, so that averted the social crisis. And I think you can make some parallels with what China is going through versus what happened in Japan a number of decades ago. I also think that China is very different from talking about a developed market. Of course, price—you know, foreign banks only have about a 1 percent market share in China. You have a closed economy and you have $20 trillion dollars of deposits, and a deposit run is not something one would need to worry about in China.


And so you have many mitigating factors in China as afar as the financial contagion. This makes it very different than looking at, you know, past macro-crisis as we were talking about to start, a contagion from a U.S. financial crisis and a Eurozone financial crisis.


So I think the question, socially, for China is whether they can actually change the mix of growth from something that is so capital intensive to something more labor intensive so you can still have that increase in household income. And that's what China, so far, has been able to do, but whether they will be able to extend that if growth slows down, I think that's the question.


MALLABY: Geopolitically Nouriel, I mean the debate about China for a lot of the last decade was you've got this very fast rising power. Can it be accommodated into the international system without provoking some kind of big conflict, because it is growing so fast.


And yet we've seen in just the last couple of weeks that it is the stagnant power, Russia, which turns out to be more aggressive. It's the country which growth is under 1 percent, with inflation of 7 percent, and with a declining population. That's where the leader gets aggressive.


If China were to slow down, first of all, do you think it will get to a kind of different growth soon? And do you see that as potentially destabilizing for the region in which you're about to open a new office?




ROUBINI: We just opened an office in Singapore, New York, London, and now Asia. Well, on China, I would say there are two extreme views and most likely they're both going to be wrong.


One is the consensus that says China, with rebalancing can still grow 7 or 7.5 percent for many years to come and is going to be Goldilocks. And then you have the Jim Chanoses of the world who say growth is going to collapse soon at 3 or 4 percent, economic financial meltdown, even social and political revolution, disaster.


You know, my views are much less optimistic than the consensus in terms of how fast China is going to decelerate. It's not going to be hard landing. But it's not going to be soft landing either.


I mean, the Chinese know that the growth model is unbalanced, too much fixed investment, 50 percent of GDP, too little private consumption at 35, and they've been saying for a decade, and now again with the third plenum, we have to rebalance into the reform and rebalance growth from that to another one that is more labor intensive consumption, consumption of services.


But I think those reforms are going to occur much more slowly than is desirable and optimal, for two reasons.


The first one is that when I was in China in time for the third plaenum delegation met with President Xi and Prime Minister Lee and both were said we need to grow this decade 7.5 percent, because we have a political goal of doubling GDP.


If you're serious about rebalancing, you know that you have to growth going below 7 percent, because you have to transfer labor and capital from resource capital intensive sector to labor intensive consumption, and so on.


So instead every time growth goes below seven or close to below seven, they panic and they go into another credit fueled fixed investment run. They've done it in '09, '10, '11, '12, and they're going to do it again this year. And every time you do it, you have more credit, more bad assets, more MPLs, more bad investments, more bad debts of the private and public sector. That implies in the short run that a risk of a hard landing is lower.


This year they're going to be able to grow 7 percent, maybe not 7.5 percent by consensus, barely seven. But by doing that and doubling down, they'll increase the probability that next year growth is going to be six and a half, and the next year 6 percent, or even lower. It's not the true hard landing of 4 percent, but I think the risk is actually in the short run is reduced because of their policy. But you're exacerbating the kind of stuff.


And the other reason why they're going to more slowly is because the interest groups are in favor of the old growth model are powerful, right? The state run enterprises, the provincial government, the SPBs, the PLA, the state sector, while those are going to be benefiting from more consumption and labor intensive growth are households and wage earners that are politically weak.


And what has happened in China for the last decade is that the share of income growth of household sector has gone from 60 percent to 50, and since 30 percent is saved what's left for consumption is 35.


So it'll take at least a decade to bring it back to what it was before. And unless you change the distribution of income back to consumption and households, consumption share GDP is going to remain stagnant. And they're not doing yet all the policies that are necessary, that means changing all the realty prices under command and control.


People consume too little because wages have been growing less than productivity, because interest on their policies are low and you're subsidizing will ease. Because when you're expropriated with land, you're not compensating for debt and the realty price for foreign and domestic goods is controlled by the government, means that consumption goods imported are expensive.


So you have four key reality prices of distorted distribution of income in a way that keeps consumption low. I don't see this changing anytime soon. The investment boom is going to deflate if consumption doesn't go up as a share of GDP you're going to see growth going towards 6 percent or five.


Now, that's not a real hard landing, but the market today, whether it's commodity market, EM equities, Asia is not pricing in growth next year—by the end of next year, 6 percent in China. I think that could actually be meaningful shock for emerging markets and global markets. Not the real hard landing, for something's meaningful.


If a small PMI in general in China those ripple effects, what happens if Chinese really goes toward 6 percent or lower? I think that's a price—is one of the risks, more even than the fed, is not priced into the market.


MALLABY: So Joyce, if I was to sum up what I've been hearing so far, I'm hearing there's a lot of uncertainty about Japan, maybe on a three year view more than on an immediate view, but nonetheless, out there there is a big problem with its enormous debt burden. China growth is going to slow down. And if it doesn't slow down in the near term, it's more likely to have a problem in the medium term.


In the meantime, you've got Russia clearly belligerent. You've got Europe, which is not in a crisis mode but is basically pretty stagnant. So putting all of this together, you've got a lot of worries out there in the world and a market that simply don't want to look at risk more than a few months out and won't price it.


If you were to ask about a strategy to deal with all this, to pick up on the Lori Freeman (ph), Richard Haass debate that began yesterday, I think what Lori (ph) might say is that strategy—I think Rita said it yesterday evening, you know Mike Tyson's quote, the famous boxer Mike Tyson, strategy is what you have until you get punched in the nose.


So maybe there's no strategy to deal with this mess, but there might be tools. There might be a case for expanding our tool kit, so that when bad things happen, we have options.


And this gets me to my question for you, which is IMF, the state of the IMF. This quota reform is blocked. The U.S. negotiated it under two different administrations, and now Congress won't pass it.


In terms of your interactions with market participants all over emerging markets, do they care about the IMF? Does it matter that the IMF is not in as strong a position as it could be to help?


CHANG: I think the IMF throughout financial crises in developed markets and emerging markets have proven a core competency. And that is when you have to go through the balance sheet exercise, the debt sustainability numbers, and you know, come up with a credible and transparent set of numbers, you often call on the IMF to do that.


Now, a lot of IMF money never ends up getting disbursed. It is providing that framework and the numbers, and look, that—that—wasn't just an emerging market. I mean, the Eurozone, you had to do that for countries like Spain.


So I think the IMF's role is very important in these crises and plus about funding the market through the crisis, because I think that comes from more bi-lateral resources. But it's that framework for the numbers.


And the IMF quota reform, it does seem to me that it's just become overly politicized. I mean, the U.S. would still remain the largest shareholder with veto power. It's become very politicized, and you do need to let more emerging market voices into the fray for this.


So I think it's unfortunate that it hasn't gone through. But I think the IMF's role has actually shown itself as a place where, you know, when you have to go through that exercise of assembling numbers, it's hard to think of an institution that's better placed to do that. And I don't think it's just something specific to emerging markets. I think the Eurozone crisis showed that.


One thing I would add, just to your comment on what are markets to do. One thing that we've written a lot about at JP Morgan is that you've seen this complete convergence of ratings right now. It's almost everything—the new normal has migrated to below potential growth, emerged markets and developed markets, and everything is rated triple B. Everything is rated about one notch above junk.


So you name it, Puerto Rico until a couple of weeks ago, Brazil, Mexico, Spain, Italy, you know, they're all triple B. Right? So what you see is—is that from this crisis, you have sort of the slow burn, a lot of monetary policy support being there. That emerging markets are not in the balance of payment crisis this time around.


You just look at everything that has converged, there has been this sort of convergence to—from a ratings perspective, to a triple B. It's not quite junk, but it's not really a very strong investment grade credit either. And that's kind of where you've actually seen the metrics on risk migrate and the way investors are looking at this.


This is all rated exactly the same. Look at what was rated triple B, Verizon, you know, Puerto Rico was there, Spain, Italy, all of the emerging markets...


MALLABY: But if it's all junk and you've got to put your money somewhere then you sort of...


CHANG: It's one notch above junk.


MALLABY: OK, correct. Nearly there.




CHANG: And you do see what you have had come out of these type of macro policies is that the markets have all converged in this one place.


MALLABY: Well, I think we should go now to members and their guests for questions. So if you have a question, please stand and, or raise your hand and I will call on you. If anyone has a question, otherwise, I'm happy to ask more questions.


While people are thinking about that, I'm going to ask Nouriel a question about sanctions. There's been a lot of debate about whether sanctions on Russia, you know, would work, wouldn't work, whether the west is willing to incur the pain. There's quite a literature on sanctions, I think. What's your reading on how effective they could be?


ROUBINI: Well, yes, there's a long literature actually on sanctions and their effectiveness, and then factor in the account in general and then so on the specifics of course.


One is how much pain you can inflict on the one who's trying to punish, economic trading another one. Two, whether by doing that you're shooting yourself in the foot or not, because if you're imposing lots of losses on yourself then it's less effective and all the political consensus for it is going to be reduced. Three, what is the chances for counter sanctions?


Now traditionally we're imposing sanctions against small little countries, or rogue nations and we couldn't care. Because it's Russia, there's lots of stuff Russia could do financially against us, even if we can do more on them than they can do on us. But then, that's a risk we have to put into consideration.


Three—four actually, you know, whether it's coordination of sanctions. If you do it as the U.S. and your allies in Europe don't go along, then of course it's less effective. So there has to be as many countries as involved in it with less leakages of one sort or another that matters. I think that's an important factor.


The other important factor is that, you know, in some sense, more than the sanction, military or economic, we can impose ourselves, the biggest because we've not that much, say, military leverage. We're not going to go into Crimea or whatever not. And even the economic stuff is constrained.


I would say that the biggest difference is that when there was the Soviet Union was a closed society with limited trade and financial links. So we had sanctions we had restrictions and it didn't matter. Well now the real sanctions are the bond market or the financial market vigilantes, right? You know, they've imposed the 13 percent fall in the stock market in Russia, fall their currency, bond yield rising.


And I would say in financial market can impose much more effective discipline on some of these rogue countries than any sanction we do. Even without sanctions, the perception is that Russia is going to do more and more than the economic damage and Russia is now the verge of a recession.


And you could say the guys that have the political advisor Putin close to him in the Kremlin don't care, but they have plenty of other people in the central bank, in the finance ministry, in the financial institution, the oligarchs were suffering, right? And at some point you'll have to see whether that political dynamic is going to lead them to behave otherwise.


So I think that's a big difference, is right now—sometimes bond market vigilantes are asleep at the wheel, right? Like during or before the global financial crisis. Sometimes like in this episode might be quite effective in getting a little more pressure on a country or on countries. So that's something new and different, given globalization.


CHANG: Yes, and I think that metrics have changed post financial crisis where how do you look at emerging markets? Do you look at it as what happens in the developed market cycle, emerging markets follow? Or do you actually have to look at more on a flow basis right now?


So, if you have 50 billion of outflows from Russia per quarter, which have been some of the estimates, is that actually going to be the metric that moves it? Is the outflows we've seen from emerging market actually was going to the push policy more than saying here's the correlation to the developed market cycle?


So I think you're actually moving from the period where you used to evaluate a business cycle to is it now something that is a different cycle? Is it a cycle about flows? Because of the effects of macro policy over the last few years?


MALLABY: Now are these bond vigilantes people who should be, you know, viewed as team America? In other words, you have a global financial system where the dollar is the core funding currency. And so the power of the U.S. to effect liquidity panics is disproportionate. Or would you not see it that way?


ROUBINI: No, what I'm saying is, you know of course, the sanction may trigger some of that behavior, but even without sanctions, suppose we didn't impose really serious sanctions but the other situation that after taking over Crimea, you know, Russia wants to do more, and try to destabilize eastern Ukraine or Moldova, or whatever or not. And that leads to an escalation of tension with the west, Europe and so on.


Those bond vigilantes are not necessarily U.S. based. They're European. They're Japanese. You know, you have global investors. Some are wealth funds or asset managers, in Asia and so on, that are moving around trillions of dollars of money.


And they can make decisions purely not on political punishment of Russia by saying Russia is risky. And if they're doing certain things, they know that certain things are going to happen and I want to stay away from their bonds, their stocks and their currency.


And that's the behavior that actually, I think, can trigger that type of market discipline. So I would think of it as being a global financial market vigilantes, equity, currency, fixed income, commodity, you name it.




MALLABY: So more U.N. than U.S. I have a question over here.


QUESTION: Barbara Samuels, Global Clearing House for Development Finance. I know the topic is financial risk. But if we talk about the uses of capital and financial opportunity, there are a lot of political imperatives today, both in the developed and developing countries, for infrastructure finance.


And so what do you see as the opportunities using risk mitigation?


For example, in Africa there's the Africa 50 initiative. There's a lot of pressure on the development partners, the DFIs, to use risk mitigation to really move sleeping capital, which would be good to avert the risk of bubbles that you talk about, if we could really get good employment of capital.


What ideas do you have about making that work? Thank you.


MALLABY: Good question. Joyce, you want to have the first shot?


CHANG: I think this is sort of an age-old problem, because some of the amounts that have been provided for this are still relatively small and segmented. And so I think that to many investors it still looks like it's difficult to deploy compared to doing something that's more plain vanilla with respect to taking risks.


You know that it often is something that needs to be restructured in a certain way for a certain amount for a specific purpose, which becomes impractical if you're really trying to assess a risk opportunity and do something where you have liquidity and get in and out of it quickly.


And I do think that when you're at a period where the market is more in crisis, it gets harder to get those kinds of initiatives underway. So when the infrastructure financing sort of everybody looks at it as the next phase, you know, back in 2007 because everybody thought they had the ability to actually then go into that next part of the credit curve.


Then even with the global financial crisis a lot of that got pulled back and it became more about macro-risk, and macro-contagion, and global liquidity issues. And so I think there is more of a point now because there is real interest in the frontier markets. The frontier markets have not been as correlated as some of the bigger countries.


So, you know, last year, if you had been in an emerging marketdebt investor, I mean, your frontier debt out performed many of your core markets, in part because it was not liquid.


MALLABY: Frontier meaning Africa...


CHANG: Not just Africa. I mean, parts of central America, the Caribbean, we're talking about parts of Sri Lanka, other—a lot of it is in Africa. So I think that what investors have learned—first of all I think people believe that there is a story in front in Africa and the Africa growth rates have been much better. But it's still been very hard to get an investment vehicle that you can actually distribute to institutional investors for infrastructure that's easy for them to invest in that isn't a plain vanilla bond, for example.


So there's a whole process these countries are still going through, getting the initial credit rating, getting the road show out there, and then as steps after that, getting the infrastructure financing.


But there's also—it's what you're worried about, you know, is liquidity. The liquidity can work both ways. I mean, not being liquid actually helps some of the frontier markets but for investors, typically during moments like this, I mean, they really value the liquidity. So you sort of have to have the conviction about that particular investor.


MALLABY: But in sometimes the answer to the question may be about accepting private investments, which are really not at all liquid. I think that's (inaudible) when you talk about infrastructure and so forth, it can be structured more when the private equity boom may be more the answer to your question than more tradable bonds.


ROUBINI: Yes. With infrastructure, of course, I mean, part of the solution is public investments. Some of them are private investments. Some of them are going to be private and public partnerships and how you set incentive rights, is a long and complicated issue.


And you know, the need for infrastructure, I would say, is certainly mostly in frontier economies but terms of emerging markets, with the exception of China, there's way too many infrastructure, India is just the opposite.


But even in advanced economies with pathetic (ph) infrastructures within the United States and so on, and in other parts of the advanced world, you know. How you do long term financing of stuff that has subject also to some dimension of either political policy or regulatory or pricing risk is a complicated one. There are thoughts on different solutions.


You know I was just recently here in the DRC, that there is a semi-failed state, you know with the Congo River, they want to do (inaudible), but who's going to build that one when the country may fall apart, going to the world bank and other things like this. So you know, you have to be creative about what you want to do.


I would say only one cover (ph), the G20, in Australia they were all excited about the increasing by several trillion dollars the world GDP in the next few years by mostly, you know, by doing mostly infrastructure. If you calculate the numbers, I think, they're way overstating how much global GDP can be increased, you know.


If everyone does the right thing in terms of structural reform, infrastructure, you name it, will do better than we've done so far. But actually, I think, those numbers are a bit overstated, what will be the impact.


So we have to be realistic about what policies can do. Structural reform takes a long time until the growth effects, and infrastructures are slow motion kinds of things. And again, have important positive impacts, but over the long term.


MALLABY: Another question. Yes. Right here in the middle.


QUESTION: Hello, I'm Leah Pizar (ph). I would like to ask you about the two trade deals that the U.S. is working on. Obviously there is an economic context, but maybe I can ask the three of you of a little of a geopolitical read on what they're all about?


MALLABY: Who wants to take that?


ROUBINI: You mean the TPP and the TTIP?




ROUBINI: You know, I don't follow them closely but I would say certainly, you know, the TTIP was in part an attempt by U.S. as a pivot or rebalance towards Asia to take the initiative of integrating better U.S., North and South America with the Pacific and Asia, and keep for the time being China out of that deal to have a really coherent trade liberalization.


And then you can tell China, if you won't accept those rules then you may join us later, but we don't want you to have the say to interfere right now.


You know, right now I would say that reaching agreement, and could be action agreement is a real agreement as opposed to something like a little mouse, there's that much to it. So success has to be measured not in terms of reaching an agreement, but how substantially.


Right now, I would say with the missing TPA, trade promoting authority, of Congress is not going to happen until after the mid-term election, I think for the time being, TPP is either dead on arrival or frozen on arrival. Because it's going to be very hard to reach an agreement without that trade authority.


The question is whether after the mid-term election, you know, Obama's going to be like Clinton, who decided that one of his legacies would be NAFTA, and fought hard with his own party to get it passed. Or whether, depending upon the recovery of the economy, and a whole bunch of other political things, whether then is not going to have the force and the power to do so.


And if we don't get that trade promoting authority maybe TPP could be dead on arrival and even some of our trading partners, like the Japanese, you have mixed views on whether they really want it.


They said they want it, but at the time, the sacrifices that they have to do to make it acceptable to U.S. or to other countries, are having some political constraints. So on TPP, I would give it a 50/50 chance it's going to be passed.


CHANG: I think, you know, just going back to your question also about IMF quota reform. You know, this seems to be one of those issues where there actually is a fair amount of consensus that supports it, but they just can't get it through.


IMF quota reform, some of the trade issues, and it stalled. And it stalled until after the mid-term elections but possibly until the next administration. Even though there are many reasonable voices and actors in this. I mean, the Congress just doesn't seem likely to take it up very easily.


So I think, you know, just the economics for it are fairly straight forward. But I think there is a lot of collective frustration with the U.S. for the fact that these types of issues are stalled when, you know, every other country has been able to get them through their own legislative processes.




ROUBINI: Yes, one case is that the Democrats on TPP. In the case of the IMF quota is the Republicans. But again, lots of other things, global climate change and other issues, we have a dysfunctional political system, whether it is the gridlock and stuff that there's even in the Senate. What, 78 senators voted in favor of it, but a bunch of Republicans in the house can just lock IMF quota.


And how can we go and tell the Europeans help Ukraine and be tough on it when we are putting on the table, nothing really? Just, literally nothing, not even our IMF quota. It's really...


MALLABY: Question in the back there.


QUESTION: Lori Garrett from the Council. One of the big financial risk issues that's been brought up by one institution after another, most recently Credit Suisse, that has not been brought up here is the widening wealth gap.


What's your read on that? And how much do you see in it as it continues to grow?


ROUBINI: Well, I think there is evidence now that there is a significant increase in income and wealth inequality in many advanced economies. And even within emerging markets, even if the gap between emerging markets and advanced has been reduced due to reduction of poverty in places like China and India. In terms of the reasons why there's an increase in inequality, I would say there are three or four factors.


One is that technological change is becoming increasingly one, capital intensive, two, skill biased, and three, labor saving. So you know, people say there will be a shortage of manufacturing in U.S. because of lower energy cost, but most of it is robotic automation.


So yes, the future will have 1,000 robots of machine and one guy, or a woman, manning all of them and one guy sweeping the floor. And soon enough a Roomba robot is going to clean the floor better than that guy, right?


So if that's the world, it's going to be a world great for capital, for profits, great for skilled labor, but we're not going to create jobs. Not in manufacturing, the same kind of revolution is occurring now in a wide range of services, from financial, to real estate, to retail, to healthcare, to education. So the question is, where are we going to create those jobs of the future?


And who is going to be benefiting from that technological exchange? There is now a model explains that yes, you can have lots of productivity growth, lots of upward growth, but it's going to all be concentrated among who ever has either financial or physical cpital and in skilled labor, and nothing for everybody else.


Secondly, you still have the effects of trade and globalization, whether you like it or not, including 2.5 billion Chindians (ph), Chinese and Indians, are now billions of more other people of other emerging markets of the global labor supply, reduces the wages. And the incomes and the jobs of those are low value of the labor intensive manufacturing, but increasingly of service jobs that are becoming now tradable. So that's another factor at play.


And three, we also have these, I would say, winner take all effects, right? If you are the best economist, the best lawyer, the best banker, the best rock star, the best athlete, in your field, now your market is billions of people, not millions. And you extract most of it, and everybody else in the chain gets less of it.


So I would say those are factors that are actually very powerful. And it's not going to be very easy to change.


And the problem is that if you're having these technological changes, trade and globalization, you're not going to create jobs, blue collar, and white collar, and you have rising income and wealth inequality, eventually there will be a social and political backlash, especially in a world in which the welfare state is shrinking because of the fiscal cost. We've also demographic aging and other long term fiscal issues. It's reaching a boiling point.


I mean, look at what happened in France with Le Pen and the vote that she got. That action may be what's happening with the European parliamentary election in May. I mean, it's really becoming a situation that we don't know how to address it, and it's going to become socially and politically unstable.


And the final point I'll make is the following one. It's a Marxist point. Leaving aside the kind of morality or immorality of inequality, I think one of the reasons—one of the things we've seen is the global recovery has been anemic. And what has been anemic is been mostly there is been no capital spending, in spite of the fact that corporates are highly profitable.


They have trillions of dollars of cash. And if you think about it, we've redistributed income from labor to capital, from wages to profits, from people who have lots of debt to those who have less debt, and therefore what we have been done is with this redistributing income from those with the high marginal propensity to spend related to the leverage with a high debt, to those with a higher marginal propensity to save.


Retain earnings of the corporate sector and if you do that, then there's not enough consumption growth and then the corporate sector says hey there's not enough consumption growth, there's excess capacity. Why I shall do cut backs, and therefore you have low economic growth.


So what is individually rational, that every firm individually want to survive and thrive after the global financial crisis, that to slash costs, cut jobs, and so on. My labor cost is somebody else's income and consumption. So what in the individual level is rational, in the aggregate is in effect a redistribution that is actually negative effect on economic growth.


So I would explain the secular stagnation of this as lack of technology, by the combination of high debt and a redistribution in inequality. This is leading to a paradox of lots of cash on the side and not much effects for consumption. That's one of the side effects of inequality to think about.


CHANG: I think that the other piece of this is just the demographics. There is a debate on whether we have permanently lower labor utilization rates. The more social political tensions that will also occur as we're just getting increasingly difficult demographic burdens, you know, on top of this.

And I think that's where you get back to the whole question of how long will we keep macro-policy as it is. So is it permanently that we have lower labor utilization rates? Because some of the changes that Nouriel was talking about? Or is this something where you actually can do something that's more labor intensive, that will ease some of these income inequality pressures? And then you've got the demographics on top of that so as well.


So I think that this is an issue that seems to me like it's going to be come, you know, more—a year from now, two years from now, we're going to be talking more about this as an issue even though it is on the slow burn side of it right now, in this discussion. But that's one of the outcomes.


MALLABY: Another question. Right in front of me there. In the back, yes. The man, the gentleman in the white shirt, yes.


QUESTION: Peter Gliestien (ph), CIFC. The question about anemic growth, and also the comments earlier about the fed having maybe a so- called new dual mandate, the economy, and macro-prudential regulation.


To what extent does the latter inhibit the former, making it harder for consumers to get mortgages, non-public companies to get financing, and what other comments could you please make about the slow recovery?


MALLABY: So I guess this goes to what we were discussing before is regulation excessive? Is it getting in the way of recovery?


ROUBINI: Well, you know, I mean, it's true that velocity during the global financial crisis collapsed and actually all this QE ending up nothing to credit the real economy, but excessive errors of banks, hording at the central bank, in part because of credit risk and part because of liquidity preference.


You know, situation is slowly, slowly is changing now. We're six years into the deleveraging by households, by banks, and by corporates, and now there is a beginning of economic recovery. I would say that one of the big differences in the U.S. and Europe was that, apart from more monetary and fiscal stimulus in the U.S., the other thing we did was TARP, right?


We told all the banks you get public capital, take it or leave it, and a year from now you should then show me, like JP Morgan, the profits and you pay me back. But we're going to recap the banks by force and that's going to resolve the capital problem.


While in the Eurozone, they're still spending all of these years trying to do the comprehensive assessment, the AQR, the stress test, and then figure out how they're going to recapitalize the banks. So part of the credit crunch is that they didn't deal with the capital problem of the banks early on and now it's still lingering and is a source of a credit crunch.


Now whether on top of these problems of one, need for deleveraging, lack of capital, a need for financial institution, and others who have enough capital and liquidity, there is excessive amount of regulation that now we are constraining credit growth, I would say, maybe at the margin, yes.


But I would say that first we have to rebuild those buffers of capital and liquidity. Two, that deleveraging would have occurred anyhow because of too much debt in the household financial system. And whether the margins, the regulatory burdens are the main source of the problem, I'm not sure.


In the Eurozone, where they have real credit problems, a combination of credit supply, but has to do with lack of capital, not with forcing the banks having too much capital, and lack of credit demand. If we're going to make a recovery, people don't want to borrow, if they have a lot of debt.


Regulation, I would say, matters but maybe and absolute and more. You have to deal with regulation every day, you may have a different view.


CHANG: Well, in our case, trading conditions have changed. I mean, banks have to hold more capital. They can't hold as much in inventory. And that's going to change the way that assets are priced and how they trade and what market liquidity is. So that is something that we're very much in the midst of.


But institutional investors that I talk to are basically saying you have the combination of fewer market players, as you've had more consolidation in the banking system, higher capital requirements, and inability to hold as much in inventory. So that is going to affect your asset pricing.


As you take a look at where spreads were pre-financial crisis, you had a lot of investment grade bonds were trading as little in Europe as 10 basis points, over 10 basis points. And you're not going to get back to that type of pricing again.


So I think you have had a shift in many of these markets. But we've also just had a period where just one of the aftermaths of this crisis has been just the ability of companies to actually raise a lot of money in the capital market. And we seem record issuance numbers in emerging markets even as you have increased concerns about geopolitical risk.


Going back to Nouriel's points about will there be more financial bubbles ahead? So you've had low interest rates have actually made it quite easy, and the convergence of ratings to everything being low investment grade to access the financial markets, you get greater market access.


Although that doesn't happen across the board for every market. So we actually see, in financial markets, record issuance numbers that have been set over the last year, even as you have these lingering concerns.


But I think the trading dynamics in the market have gone through a shift since the financial crisis.


ROUBINI: Yes but you know, corporates have trillions of dollars of cash and not doing cut backs, so that's not a constraint. They can issue some in U.S. where capital markets work more than in Europe where tons of bonds have done so, but do it for financial engineering, share buy backs, and you name it, rather than cut backs.


In Europe where you have a banking system, the small, medium size enterprises have been dealing with a credit crunch, but there is also credit demand problem. But the big corporates have lots of cash and have access to capital markets.


So you know, all of these constraints of course affect, you know, credit growth and so on, even if excessive amounts of financial intermediation, probably some of it is not socially useful in terms of allocating savings to the right investment.


So, I don't know how much regulation itself is really the key culprit, as opposed to the whole wide range of other market financial issues.


MALLABY: Maybe I can just bring this to a close by asking you both to comment on one last thing, which is, the flip-side of that last question. The question was, does regulation impede or return to full capacity economies. The flip-side would be, is regulation actually making the world safer from the next financial crisis? I mean, are there—perhaps it's a two part question.


Do you think that in aggregate there is a reduced likelihood of another crisis because of regulation? Yes or no? And if yes, what is the aspect of the regulations that has made the world safer? That would tie us back to the risk theme of the symposium.


ROUBINI: I mean, you know, financial crisis are never exactly same. But there are some patterns.


And some patterns are of a buildup of financial vulnerability that include excessive credit growth, excessive leverage in the private and public sector by different capital institutions, whether it's households, corporates, banks, shadow banks, and excessive risk taking of a variety of forms that then can reach boom, bubble, bust, and crash, a tipping point. You know, a mainstay (ph) moment and so on.


So I would say the part of regulation that says gradually without killing the recovery we would like to have greater buffer of capital against solvency risk, and greater buffer of liquidity against liquidity run type of risk, and so on. I think it goes in, you know, it goes in the right direction.


But I would say with all the regulatory stuff we've done, with zero policy rates, and QEs, and forward guidance, you name it, we're now feeding maybe, you know, the mother of all bubbles.


And unless Yellen and company's right, that macro-pru's going to take care of all that, in spite of zero policy and slow normalization, if the only instrument is in the cracks of financial system is interest rate one, we're going to normalize very slowly, which may cause the next financial bubble.


And recent work actually done by a bunch of people present in Euro fed actually suggested you could have repricing of risk even when you don't have leverage, because even without leverage you can have unleveraged players increased because of the way they essentially awarded performance based on benchmark.


Essentially you have momentum trading, herding behavior, and then suddenly the fed says we might start tapering. And then you have 10 year treasury going from 1.6 to 3 percent in a matter of months.


So sometimes the dynamic might not actually have to do with leverage curve, a very sharp repricing term premium just because suddenly there's an absolute policy change. And everybody was going in the same direction, even in unlevered way, and all of a sudden shift.


So there are different types of financial risk. You should think about them. Traditionally we're thought, if you control leverage and liquidity, we'll be okay. Maybe things are going to be in the future, slightly more complicated.


MALLABY: So bank regulation, particularly capital regulation is reducing risk but the zero interest rate policy is increasing it. Joyce, what do you think?


CHANG: I think that you had regulation in place before and whether it was enforced and effective is, you know, an ongoing debate. So, I think it goes back to how are investors taking risk and will you have a sentiment changes because macro-policy is forced to change quickly.


So right now the conventional wisdom is that this can happen quite slowly. But the tools are in place and it's in everybody's interest for this to happen slowly. But if you do have a reversal of that, you become much more dependent on just the flow.


And that goes back to tying together all the issues we've discussed about. I mean, are sanctions less relevant than the flow of capital? And I don't think it's just regulation that's going to dictate that.


It could be a political event. It could be a shift in macro- policy. Or it could be something where markets continue to think that it's not going to be synchronized. You could have—emerging markets actually have some distinct trends in the developed markets as well.


MALLABY: Well thank you to both of you. The panel was on financial risk. The next one is on risk in geopolitics. It begins at 2:00 p.m. So please be there. Thank you very much.

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