Stalled by Winter Weather, Economic Growth Projected to Regain Momentum

Thursday, February 27, 2014
Lewis S. Alexander

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

Takatoshi Ito

Professor, Graduate School of Economics, Dean, Graduate School of Public Policy, University of Tokyo; Former Deputy Vice Minister for International Affairs, Ministry of Finance, Government of Japan

Vincent Reinhart

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


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

Harsh winter weather appears to have dealt the global economic recovery a temporary setback, but growth is projected to pick up again later this year. Nomura's Lewis Alexander, Takatoshi Ito from the University of Tokyo, and Vincent Reinhart of Morgan Stanley discuss the current state of the global economy with CFR's Sebastian Mallaby. The panelists focus on the declining labor force participation rate in the United States, the Federal Reserve's tapering of its quantitative easing program, and Japan's ongoing efforts to fight deflation through unconventional monetary policy.

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

MALLABY: Welcome to the Council on Foreign Relations for this world economic update with Professor Takatoshi Ito of Tokyo University, Lewis Alexander from Nomura, and Vincent Reinhart from Morgan Stanley.


I'm bidded to tell you that the next meeting of the CFR is a 12:30 meeting, or the next general meeting about driverless cars. And I'd like to—we do everything here, from the world economy to driverless cars. You could argue that the world economy is a driverless car.




MALLABY: And I'd also like to welcome the CFR members around the nation in the world, participating in this meeting through live stream. So, I've got, as usual, some questions about the big, major economies in the world and we'll go round that. But I want to get two things on the table first, before we get there, just because they're in the news.


And the first is Ukraine. So I want to go down the line here, and basically ask—okay, we've got a country which has got internal political uncertainty. And we've also got external donor uncertainty in that we've got certain officials in other countries either saying they're not going to give any money, or they will, but when you actually look at it, it doesn't turn out that maybe Congress has authorized the money they're promising.


So the question is, in the next six months or so, is Ukraine likely to default? Taka?


ITO: Well, I'm not a Ukraine watcher, so all of my judgment comes from what I read in newspapers and I talk to people in Washington. And the simple answer is yes, and it doesn't seem to be the situation that there is a responsible government in Ukraine to negotiate the necessary terms of the rescheduling.


MALLABY: Okay, Lewis.


ALEXANDER: Yes, in substance I think that they already have, in the sense that they're already accumulating arrears on various things. I mean, government finance in this environment is going to break down and I think it's pretty much inevitable.


REINHART: Yes, as long as you define default generously enough. It could be a technical default because there isn't a government there. There could be some write down of the bank that's before the government accumulates more to be sovereign.


MALLABY: We can come back to that in questions later. And the second thing I want to get on the table is Bitcoin.


Through history, money has either been some scarce metal, the supply of which can't be manipulated very easily, or it's been government backed paper, with the idea at least you've got the coercive power to tax behind it. Bitcoin is neither a fixed metal, nor is it backed by any government. Is it, therefore, as irrational as tulips? Taka.


ITO: The Bitcoin was supposedly invented by a Japanese...




MALLABY: Not—not you.


ITO: Not me, no. So I profoundly apologize...




ITO: ...creating such a bubble. But I think it's a bubble.




ALEXANDER: I agree it's a bubble. The one thing I would say is that I think there's going to be lots of different ways of carrying out payments. And one of the things you've seen consistently is innovation in means of making payments. I don't think we should—the fact that Bitcoin is like tulips should obscure that fact.


REINHART: And tulip is the right analogy, because of the private sector medium. And it's similar in other ways as well.


MALLABY: Okay, so we have two and a half votes for tulips. Right. So now, let's get to the big economies. Let's start with the U.S. I guess if we'd met three weeks ago, or so, we would have been—the conversation would have been dominated by collapsing global markets. That's stabilized somewhat.


But if we look at the numbers on the real economy, Vincent, you and your team at Morgan Stanley have been revising Q1 down a lot, I think, from 2.3 percent growth to 0.7 percent. Part of that is weather. But is it mainly weather, or is there something else going on?


REINHART: Yes, there's a deep frustration. Not only do I have to live through the weather, I then have to go explain it after the fact. And our forecast, stepping back, was that the economy had been stuck in a 2 percent channel. It would pick up to 2.75 percent. Some slowing relative to what initially printed for the fourth quarter is a pretty torrid pace of domestic private spending was expected.


We are not just a data observer. We're a data collector. We have an effort to produce a contemporaneous reading of activities. So we had a lot of regional information. The regional inputs to our monthly indicator did line up with bad weather, with shipping delays, with degree days and all the like. So that does make us think that it is importantly weather. The data softened even underneath that.


So, the basic picture is the economic landscape is frozen over. It's not going to thaw for another month and a half 'til we get a sense of what underlying momentum is. We think it's mostly weather, but you have to leave open the possibility that there's a little more slowing than that.


MALLABY: Okay, so Lewis, I think you've written recently that depending on which measurement you use, the U.S. economy is either operating at full capacity of employment or way below capacity. Can you explain why this is a particularly difficult moment to judge what the potential is, and what that means for the new Fed chairwoman?


ALEXANDER: Sure. There—if you look at the performance of the labor market, there are two very broad themes that are very anomalous relative to other recoveries. One is the number of people that have actually dropped out of the labor force. So this is the problem of the labor force participation.


The other problem is the fact that the level of long-term unemployment. So the ratio of people who are unemployed for more than 26 weeks relative to shorter term unemployment is very different than it has been in past cycles.


What you think about the significance of those two groups is a very important issue. If you argue that those two groups are not relevant for inflation, which I would argue that the data is increasingly pointing to, that suggests that the Fed does not have a lot of room to let the economy run without generating additional inflationary pressures. That's obviously a very difficult position for the Fed to be in.


And the question of can you draw people out of those two groups into employment more rapidly is a crucial question. I think the problem is that the data and the analysis is increasingly pointing to that is a very big challenge. And I think it puts the Fed in a very difficult position.


Obviously, it's a tremendous problem, the fact that you have this long-term unemployment and these people who have dropped out. You want to try and have policies that can address it. The problem is that it's not clear that monetary policy is really the tool that can address it.


MALLABY: Taka, you in Japan, I think you're known as the leading inflation targeter, or one of them, and you've been critical of the central bank in the past, which has underestimated its power. You know, listening to the debate here in the U.S., do you feel as if the people are too timid about the power of monetary policy or appropriately...


ITO: I—I think it's a appropriate and what's interesting to me is the use of the dual mandate to their advantage. Right? So we used to think that inflation targeting is a single mandate thing which the U.S. cannot subscribe to, but the U.S. did adopt inflation targeting in January 2012. And I think that was a bold step.


But at the time I think there was recognition that having the full employment is actually helped—will help to drive the monetary policy to continue stimulating the economy. So using two sort of indicators, not targets but indicators, to get the economy going, even if the inflation rate is too low, or may overshoot whatever. But I think the use of the dual mandate, I thought was brilliant.


MALLABY: Brilliant, Vincent?


REINHART: So I think 2014 is going to be a conversation about aggregate supply. How big was the level lost to aggregate supply associated with having a severe financial crisis and then sub par economic recovery. And then what's happened to the rate of growth of potential output?


The first, how big the gap is depends on the Federal Reserve's tactical position—how much stimulus do they need to get back to full employment. The second one, the rate of growth of output, determines the resting point. How high is the equilibrium real interest rate?


And I think the conversation unfortunately is going to turn out to be dark. There was a level loss associated with financial crisis and subsequent economic performance. And then every way you add it up, it seems like potential output growth is slower.


We shouldn't forget that consequence of the later though, which is it means probably the equilibrium real short rate is also supposed to be lower. So we've rotated the path of future output, which is bad in terms of the net present value of wealth, but we also lowered the discount rate to it.


MALLABY: Go on, yes.


ALEXANDER: I just wanted to add one thing. I very much agree with all of that. There's just one additional point, which is there's also a question of the degree to which you can reverse some of those losses by running high pressure policies going forward.


The judgments you make about that question are also going to be important, because they have—people have made the argument that if you can reverse them, then that is a reason to in some sense continue to push on. Again, I think the conclusion of the research that is coming out, that's all sort of micro-driven on labor markets, is very pessimistic on that as well. And so it doesn't—that argument doesn't get you out of the dilemma.


MALLABY: Let me just ask one more question about—maybe for anyone, about U.S. monetary policy. So there is a debate about output and potential. But there's also the fact that inflation is still below target. And yet the Fed is on this tapering course, and appears to be fixed in this tapering course, but is that—is that because the sense of the efficacy of continued QE has declined and there for even if you might ideally want more stimulus, you just don't think you'll get it in a good cost benefit way?


REINHART: I believe it's a judgment about the efficacy of the stimulus rather than the overall view on how much stimulus is required. That most things in life have diminishing marginal return, QE purchases probably do as well, that you worry about the pockets of excess associated with taking out duration from markets, that there was the judgment that the main accomplishment now of QE is sending the signal and that signal can be achieved more reliably by forward interest rate guidance.


There's a problem though, about central banks. Central banks love optionality. You never want to discredit an instrument that you may need at a future date.


And so there's a certain insincerity about the Fed's communication about QE, that it was more about the economy. That we didn't have to worry about the low level of inflation, so we can exit—exit from QE. I don't think they viewed it as a lessening accommodation. I think they viewed it more as relying on the form of accommodation that works in the models they tend to focus on.


ALEXANDER: Yes, just one additional thing. I think—I do think part of the concern about QE was the impact on systemic risk. And I think while that debate has been played in the past as something that related to asset purchases. I think increasingly the question of does the whole rate structure generate those problems as well is going to become a new issue.


And I think—in some sense many have the same concerns that they had about QE, I think are going to be translated over to the whole structure of rates. And so while these aggregate demand aggregate supply arguments are sort of central to this, I think there's going to be another set of concerns that they're going to have to deal with. I personally think we're doe-faced in material issues of systemic risk, and that should be a constrain on policy.


But I think that is where the debate is going. There are clearly people on the committee who are concerned about it. And so that's going to be a whole other issue that I think we're going to deal with over the next six to 12 to 18 months.


REINHART: But to Taka's point about the Fed and inflation goal, inflation is below goal. Inflation in the U.S. is pretty inertial. The force's slack on inflation is pretty weak.


Although I think the important conversations about aggregate supply for 2014, Janet Yellen doesn't have to mention the unemployment rate in 2014 to accomplish and accommodate a policy, because the low starting level of inflation provides enough justification in and of itself.


ITO: I think there is a difference between QE1 and QE2, and between QE2 and QE3. And QE3 is like QE1, in that it targets the low end of the interest rate, especially on the mortgage rate. And this has been a success, because it stimulated the housing demand, and housing price has been stabilized and going up more recently.


So in that sense, supporting that sector has been a huge success. And whether that spills over into the rest of the economy is the question. And I think it is spilling over.


MALLABY: Well, I mean, the most aggressive QE experiment right now is actually now in Japan, I think.


ITO: Yes.


MALLABY: You've advised Prime Minister Abe in this incarnation, and also in the previous time he was prime minister.


Talk about, first of all, the monetary part of Abenomics, some people call it Kuroda-nomics.


Is that going to plan? Or is there a risk, you know, the growth numbers are now slowing. You had a big bump initially, big effect initially. Now it's slowing down. Are you worried with the consumption tax hike coming in April that the central bank, which has looked like Superman last year, won't look so great in 2014.


ITO: Yes. So, monetary policy was called the First Arrow of the Abenomics, and I would say it was a huge success. So it completely changed from deflationary defeatism from the central bank to proactive by inflation targeter. And that market welcomed it. And then the yen depreciated by 20 percent and saw prices increase by 60 to 70 percent in the period of mid November 2012 to May 2013 when the taper program started.


So, then it's plateaued since then. And now the people are calling—some people are calling for additional precautionary easing of the monetary policy. It may come; it may not come, depending on the economic forecasts of this year. But I think on the whole, the First Arrow monetary policy has been a huge success.


MALLABY: This precautionary, that means a second wave of accelerated...


ITO: Right. So the growth number of last quarter was not that good. And our consumption tax, which is a VAT, tax rate hike, is coming on April 1, in six week. And people worry that this VAT hike from 5 percent to 8 percent may slow down the growth substantially. I don't think it is going to be a substantial decline. So that's the debate...


MALLABY: But if it was a substantial decline, you're saying that central bank has the option of accelerating.


ITO: Yes.


MALLABY: It's already said it would double the balance sheet. It might do even more than that.


ITO: Correct. So Mr. Kuroda has been very clear that, if needed, needed to achieve 2 percent, he's ready to do additional actions.


MALLABY: One more question for you, and then I want to have Vincent and Lewis comment on the same thing. So, if we're in a world where the central bank already says it will double the balance sheet, and that in fact it might do more, if it's necessary to reach this 2 percent inflation target, what are the risks of something disorderly happening?


I mean, in this country we had a debate whether about QE would be destabilizing. To some extent we're hearing that it's being—we're backing off QE before we reach the inflation target in the U.S. because of some worry about systemic risk.


What about Japan? You've got this enormous government debt. The system is being stimulated as much as one can imagine by money. Is there a risk either for the currency, for the debt?


ITO: Then we have to look at the Abenomics in totality. So it's an aggressive monetary policy for First Arrow and flexible fiscal policy as a Second Arrow, and the growth policy as Third Arrow.


So First Arrow set the stage. And Second Arrow pushed in the beginning with the monetary policy to get out from the deflationary mind to a growth path, which was a huge success in last year. But the—with those setting the stage, the Second Arrow started to bend to conservation, and they confirmed that all of the planned tax increases will take place.


So the fiscal is going to be more conservation and monetary is still similar. So it's a policy mix of that—that kind. And in the mean time, the growth policy is supposed to come and push all of the potential growth rate to go up, in time to support the slight conservation of the fiscal part.


Fiscal conservation is needed to have the sustainability back. So how to get the tax revenues without getting the economy to go down? So that's the First Arrow and Third Arrow to support.


MALLABY: The Third Arrow being the structural reforms. And you need that to come in and yet, examples of structural reforms actually having been adopted are hard to point to so far, right? There's discussion, but not.


ITO: Yes. It seems very slow and I—I do have to admit, it seems too slow. But there are small concrete steps, like abolishing the rice paddy production quota, and...


MALLABY: That's happened. That's not just...




ITO: That happened. And also there's concrete steps to reform the government pension fund to—that has a huge impact on the capital market. So there are small measures. People say it's not big one arrow but a hundred daggers.


MALLABY: Lewis, do you worry this whole process could come unstuck some how? Is there a risk in instability?


ALEXANDER: Well, I don't think there's any question to the degree of difficulty out here is very high. I mean, when you look at the fiscal sustainability, you look how week growth has been over the years. It's just a big challenge.


I think the obvious thing you would worry about is if you've got higher rates and not higher nominal growth. Right? Ordinarily you'd think those things go together. Say for example, if inflation expectations were actually to build, that should in some sense be reflected both in interest rates, but also in nominal growth, which would raise the tax base and generate effect (ph).


If you don't get those two things together, that's the sort of nightmare scenario. Now, I think they have a lot of means to control. And I think as the professor has indicated, the First Arrow has been very successful. I think the Second Arrow of the fiscal consolidation is sort of on track. And the question is can they really deliver growth both in real terms and sort of the nominal growth that would come with that.


I'm optimistic, but there are clearly risks.


REINHART: So, this is a great experiment in monetary economics. You've had a central bank there for two decades, said it wanted to generate inflation, now has an administration willing to tolerate the currency depreciation that's going to help that process along.


The thing to remember is that the central bank doesn't actually create extra output. It shifts demand. It can pull demand from the future inter-temporally by keeping interest rates low. It can pull it from abroad internationally by keeping its currency low.


If the Third Arrow isn't successful, there's really not any extra output to bring forward and that will be associated with slow growth. If the U.S. isn't successful in continuing to grow, one worries about the political process in the tolerance of a weaker yen internationally. That's a real risk.


As for the orderliness of the process of quantitative easing, it really depends on remember what the central bank is doing is taking duration out the hand of the public, and putting it on its own balance sheet. What do those former holders of JGBs do with the resources?


To the extent that they turn and invest it into domestic equity, you can have the wealth creation and support the capital spending and consumption generally that it works. The problem comes the day that it turns entirely to the external sector because of questions about the fiscal sustainability and domestic conditions. Doesn't seem like that's...




MALLABY: So you mean Mrs. Watanabe gives up her JGB. She turns around; she goes and buys equities outside. The yen weakens more than you want. That's...


REINHART: And questions about the fiscal position may come into play. But to the extent that they turn and buy domestic equity and domestic credit that's equity supportive of domestic accounts...




ITO: Yes, so people have been putting money into deposits. And that has been a huge success because deposits paying zero interest rate but the prices are dropping at 1 percent. So real return is 1 percent while someone who invested in equities, they have lost huge. So there is a mind among the Japanese investors that deposits are safe and stocks are losing propulsion.


So we have to change this perception. So it's a—we—we need to jump from bad equilibrium to good equilibrium. You cannot do piecemeal thing to push the equilibrium position. So, you know, it's not only monetary policy but those capital markets reform, and we introduce so-called Misa (ph) accounts, which is after tax income you invest in the stock market and for five years you're exempt from the capital gains and the...


MALLABY: Perhaps you can remind your countrymen that in this country the death of equities was the cover story on a business magazine in 1979. And for the next 20 years U.S. equities did rather well. So these things can turn around.


Let me get to Europe a little bit before we go to questions, another country that—another zone that's potentially debating these threats of deflation. The good news in Europe is we do have massive growth. Modest, but its there. The bad news is, if you just take Italy you've still got youth unemployment of 40 percent, government debt to GDP at 130 percent. If Italy goes down the tubes the whole Eurozone does, and so it's hard to argue that we're out of the woods.


So the question I want to ask you, Vincent maybe first, is should we worry about, you've got all this debt. If you combine that with deflation, you're in real trouble. German wage numbers seem to be very, very soft.


The fear of the case a year ago when we were debating this was, look. You've got a little bit of inflation in Germany. You keep it down to sort of zero in the periphery. The periphery becomes more competitive and that's the way you work your way out of this thing.


Now German wages are not cooperating with that picture and you're in sort of dodgy equilibrium. Is this—are we going to be back in a crisis in a few months?


REINHART: So, the basic issue being, you need internal adjustment. It's an ineffective currency union, so you have to have relative prices shifting underneath that. If German inflation sets the high water mark and it is low, it just means that you're going to run into the problems of cutting wages outright, cutting prices outright, which is more difficult.


Uncharacteristically optimistic, there has been some internal adjustments. Spain and Ireland are doing better, starting from a very low level but—but—but the belt that—is—is a clearer sign. When you look back, the amount of resources governments have been willing to commit to the Euro project actually is pretty—pretty amazing.


And so there is an ongoing existential threat, i.e. there's always the possibility that the coalition breaks down, or a weekend vote turns out to be different than—than the authorities are willing. There is—but it—but it—the ECB's chief advantage is somewhat similar to Japan. What kills you when you have a currency crisis is capital flight.

"There is a mind among the Japanese investors that deposits are safe and stocks are losing propulsion. We have to change this perception. We need to jump from bad equilibrium to good equilibrium."
—Takatoshi Ito

But capital flight is internal to Europe. And as long as long as they're willing to—to allow large conditional transfers in the form of target to imbalances they—they can contain the pressure.


So I would characterize it not as a situation likely to—necessarily likely to get worse. Muddle through seems to be the bad—bad—best bad with a slightly positive incline, an opportunity for the ECB to use conventional policy. And an ongoing existential threat because politicians haven't gone the—haven't really defined where they want the Euro to be.


MALLABY: Yes, so the ECB will use conventional policy with respect to the deflation threat but they're at the zero bound, right?


REINHART: You're not quite there yet. So they still have some conventional easing to do.


MALLABY: Quarter point? Okay.


ALEXANDER: Yes. When I hear conventional policy in this environment I think of forward guidance and asset purchases...




REINHART: We're kind of in a new world in that respect.


ALEXANDER: Look, I—I basically agree with Vincent in a sense that I don't think this is an acute issue. Frankly, one of the advantages of being in a world where inflation is pretty well—is pretty well anchored is it doesn't go up or down very quickly in either case. And so I think the risk of getting into a true deflationary cycle in Europe is not all that large.


The two big surprises have been the fact that the ECB has been as successful as they have been at sort of stabilizing the financial side with what were, to be perfectly frank, kind of amorphous commitments. The other surprise has frankly been that the politics has sustained what has been a very caustic real adjustment.


So I think there was always the skepticism about how much internal adjustment you could get without the exchange rate and what was consistent with the politics. And the surprise has been, they've been willing to live with more pain in some sense than you would have expected.


I don't see those things turning around. I do think the ECB has room to do more. I'm puzzled why they haven't done more. I think they would obviously benefit from a weaker exchange rate if they could figure out how to get that. But I don't think we're likely to be back in crisis any time soon.


MALLABY: Taka, people often compare Europe now to Japan in the 90's and they see—do you think that's a relevant lesson?


ITO: Yes, so when the Eurozone inflation rate is—has been coming down, people talk about Europe turning Japanese, right? So, it's going down the deflationary path. I think the probability is low because I think the ECB—I would say even the ECB has learned the danger of getting into deflation. So I'm sure that before it hits negative territory, it will change their policy and maybe go to zero interest rate or even the QEs.


So the probability is low. But the possibility is there. And they should be aware that's a territory they do not want to go into because we have had this 15 year deflation in Japan. It was a pain.




REINHART: I would just underscore the stability of the system the fact ...


ALEXANDER: I'm ashamed to admit this, but four years ago I wrote something for—it's called Foreign Policy. And—and—and this is amazing. This isn't just an economic crisis. It is a security crisis.


You cannot have youth unemployment rates this high. You can't-- remember that the job losers are the ones who just first got jobs. That means there's an immigration issue. This is a large continent with open borders. It could go out tomorrow doubling the numbers.


And there hasn't been the, you know, hasn't been the political tensions and instead governments in the rich countries have committed an enormous amount of resources to the project.


MALLABY: So optimism on Europe—let's now go to...

"So I think there was always the skepticism about how much internal adjustment you could get without the exchange rate and what was consistent with the politics. And the surprise has been, they've been willing to live with more pain, in some sense, than you would have expected. I don't see those things turning around. I do think the ECB has room to do more. I'm puzzled why they haven't done more."
—Lewis Alexander



ALEXANDER: I'm not sure that was optimism.


MALLABY: Okay, relative to your baseline four years ago. Perhaps I misunderstood. So, I'd like to get questions from members. Remember, this is on the record and if I can—I can see a question right over there. Wait for the microphone please, and stand and identify yourself.


QUESTION: Thank you. We've talked quite a bit about...


MALLABY: Can—can you just say your name?


QUESTION: Oh. Earl Carr (ph). We've talked a bit about monetary policy here in the United States, and there seems to be quite a bit of controversy. There are those who feel that the Fed's quantitative easing policy has been quite a success. I believe Professor you mentioned that quantitative easing, particularly QE3 has been successful, in particular looking at mortgage rates.


However, there are those also who believe that the key benefactors of quantitative easing has really been the private sector, in particular, banks. So I'm curious from the panelists, who have the real benefactors been of quantitative easing?


ALEXANDER: I think this is a general problem with monetary policy in general. It's—it's—to a certain extent, monetary policy works broadly through risk appetite. And there's a very important channel for monetary policy always which is the value of financial assets.


Obviously financial assets are not distributed evenly throughout the economy. And that has, in some sense, a distributional consequence. But I don't think there's—it's not as though there's some clear alternative. It's not like you could have stimulated the economy in some way that didn't involve that.


And so I think you have to acknowledge that yes, if you are operating through the value of financial assets you will inevitably have a distributional consequence. But that's not to say that we aren't better off for having done it. Because had we not done it, the economy would have been worse off. Fewer people would have had jobs. Labor incomes would have been lower.


And so I—you know, in some ways I'm—I struggle a little bit with that question in part because it's not obvious to me that there was another way to have done it. And so, I—I acknowledge the issue but I don't think there was—I don't think that's an argument for not having done it, if I may put it that way.


MALLABY: Another question. Yes. Right here please.


QUESTION: Ed Cox, Republican State Party. With respect to the labor participation rate, on a macro level, how much is it a matter of demographics and on a micro level of our job training programs as opposed to those in Germany for example?


ALEXANDER: There clearly is a big element that's demographics. It's simply the fact that the Baby Boom generation is aging. So Baby Boom generation, or people born between '46 and '64, the peak birth year is '56, so you can think of there being this front wave that's sort of moving through the age group.


If you were born in '46, you're kind of 68 now. If you were born in '56, you're 58 now. So those people are moving into the age when they're going to be falling out of the labor force. So, that is part of what's going on.


But it's clearly only part of it. I don't think there's a simple explanation for it. If you actually look at our experience, it's quite similar to what European countries went through, say for example the deep recessions that the European economies had in the 90's and what not, also generated big declines in labor force participation.


I don't think there's an easy, obvious answer. One of the puzzles about this recovery is the fact that the hiring remains very depressed. And I don't think there's an easy explanation for that story.


Look there's no question that other countries do active labor market policies better than we do in some aggregate sense. I think that's absolutely right. I think it's really hard to know how much of this you can explain that way.


REINHART: Yes, so just controlling for demographics, we can account for probably a third of the decline in the labor force participation. The other third—two thirds, that doesn't mean it's all cyclical. There's probably some cyclicality to it.


But you also have to think about things like returns to skills. Because of globalization and technological progress, those who have high skills are getting higher rewards. Those who have lower skills are getting lower rewards.


That means that—that—when you think about age cohorts, young people have to stay in school longer to learn those skills. And if they don't have the opportunity to learn those skills, they think about the informal sector. Older people, if they had those skills can retire earlier or if they don't have those skills look more favorably towards government entitlements.


And that is probably part of the that two thirds that are not secular—it's a challenge because there's nothing monetary policy can do for the portion of workers who are leaving because they're getting older or they don't see return to staying in the economy. And it's not obvious exactly what we can do, because the record of job training programs is uneven. To put it mildly.


MALLABY: Yes, have a question right over there. Sir, I'll come to you right after.


QUESTION: Thank you. Mike Hoden (ph). On this demographic point, as certainly our Japanese friend will understand, the aging of the population is much a function of low birth rates. And as you know, Japan will soon have 40 percent of its population over 60. The OECD is starting to look at the aging population as a source of economic growth.


So contrary to your point, sir, isn't one of the structural questions, how do we keep people healthy, and therefore active and working, beyond 60? The 20th century notion of retirement simply cannot work structurally.




ALEXANDER: In Japan you are looking—beginning to look at the Silver Economy, as are several of the European countries, including Italy.


MALLABY: If you could you please just pass the microphone to your right. Okay, for the next question. Yes. So, go ahead.


ITO: So, you are right that we are emphasizing to keep the labor participation high for aged and also for women, because we have a huge gap in labor participation for the women in their child bearing and caring years. So those are two groups about to retire, and women, as a source of keeping the labor force higher than otherwise.

"You also have to think about things like returns to skills. Because of globalization and technological progress, those who have high skills are getting higher rewards. Those who have lower skills are getting lower rewards."
—Vincent Reinhart

And I think the Japanese elderly are willing to work, and healthy enough to work, most of us. And I think there is a forced retirement in Japanese universities and bureaucracies at the age of 65. I think that should be raised.


MALLABY: You're arguing that for the good of the country, in fact for the world economy, you should be allowed to keep your job forever.


ITO: Right. But you have exactly the point. There are ways to use this aging society to the advantage.


ALEXANDER: If I could just—this is something that Vince mentioned, which I think is important here, which is if you actually look at who among the older groups that are dropping out here in the U.S., it's primarily people with relatively low skills. And so part of the challenge here is, you know, for people who, frankly, do reasonably well, that's not really the issue.


The issue is, frankly, older workers that don't have skills, that sort of line up well with how the economy is evolving. And that is a very difficult challenge. And so I very much agree with the notion that we should try, in some sense, keep people in as long as we can.


But that does not get us around the fact that—a very simple way to think about it is, are you a substitute or a complement for a computer? If you're a substitute for a computer, this is a bad world for you. We need to have more people who are complements to computers. But that's not an easy thing to do and it's particularly not an easy thing to do among older workers.


REINHART: And it's also related to some of the other challenges we have as a nation. The differential skills gap implies increasing income inequality. Since those high skills are usually associated with capital, it also probably means a declining labor share of income. So that this is a serious challenge you've got to address.


MALLABY: Yep. Go ahead.


QUESTION: Hi, it's John Makin, American Enterprise Institute and Cornwall Capital. I have a comment and a question on the participation rate, Vincent, I think that the Fed has encouraged the participation rate amongst elderly workers by driving the return on alternative accumulated wealth to zero, and thereby forcing them to go to work or take risk.


But my comment—my question is this, I think the Morgan Stanley forecast for the first quarter is intriguing. That suggests that sometime in April we will be reporting numbers that suggest that growth is below 1 percent. Meanwhile, the Fed is blissfully predicting 2.5 to 3 percent.


My question to you is this, will we see the development of the Yellen put in April or May should the economy and markets respond negatively to a sharp slowing. That is will the Fed alter its path of policy?


ALEXANDER: So first, there's the point of fact. It is certainly true that there are more letters of complaint into the Fed about low interest rates than high interest rates. And it came from savers. But the Fed also helped foster an enormous increase in equity values that have made people wealthier and made retirement plans more assuredly sounder.


So it's of that part—is—is mixed. Our forecast—it's really a tracking estimate of GDP. It's just how do you add up the numbers that are coming. We think that fourth quarter GDP will be revised down to 2.5 percent growth, and that first quarter is tracking something about seven tenths. That does set up the Fed for what's happened in the previous four years, serial disappointment. Start with a high forecast and then have to move it lower.


I think the first point to note about that as opposed to prior years, they already have momentum on their major monetary policy initiative tapering and it would be a while before they would probably slow that process, if that forecast came true. And if in fact growth stays low then Janet Yellen will push out on the Data First policy tightening. She'll try to convince you to forward rate guidance, that there's no need to—to raise rates any time soon.


And having said that, the tapering decision is data dependent and made meeting by meeting, they may have to stall out the tapering just because they're shamed by the data. That's not our forecast. We think that we are in the process of moving up to a 2.75 percent growth channel. That—in line with that seven tenths weak first quarter, there's a good size rebound in the second quarter.


But the Fed's going to be challenged. But I would actually think Janet Yellen's life is easier with a little slower stat at the beginning of the year. Why? At this stage of the monetary policy cycle the hardest thing for a central bank is to push out against market participants getting ahead of themselves. Coming to expect data to—expect interest rate increases that are sooner and more aggressive than is consistent with sustaining economic expansion.


I think the Fed—you know, if you think about it, in December and January we had misses on non-farm payrolls of 120,000 then 70,000. Those are the positive misses instead of negative misses, that is non-farm payrolls of 310 and then 250. Janet Yellen would have a lot of trouble now pinning the front end of the yield curve convincing people not to get ahead of themselves.


MALLABY: Yes. There's a question up here.


QUESTION: Evelyn Leopold (ph), a journalist at the United Nations. Would you kindly discuss the long-term economic and social implications of youth unemployment, both in this country, and in most European countries, except for Germany where they do have an extensive apprenticeship program. And attached to that are discussions now of raising the minimum wage. Does that make any difference? Or should people who can't pay a living wage go out of business?


ALEXANDER: I'll start off. You know, first of all I'm an economist. Under the broad context of that question, of course I'm not competent enough to address.


Look, there's a lot of research that's been done about the impact on lifetime incomes of essentially people beginning their careers under adverse labor market circumstances.


So, I think there is a very real concern at this point that young people are coming on to the labor market now, who are having trouble getting their first job. There will be permanent effects for them, of that consequence. And I think that is part of the reason, to be quite frank, the Fed has been so aggressive in trying to get better labor market outcomes.


The problem is what are the limits of that? And I do think part of this thing that Vince and I have been talking about in terms of long-term—where is potential output, are related to those potentially permanent problems.


I would note that a lot of the research that's being done on the U.S. about things related to this now, in some sense follows on research that was done first in Europe. And so we are seeing more similarities in that area between our experience here and what you've had in Europe.


Look, this is a big problem. And you know, it's one where I think unfortunately the degree to which you can address it with the sort of blunt instrument of let's generate more aggregate demand through monetary policy—you know, we're going to have a debate over what are the limits of that over the next year. And to some extent, if you're going to have to address it another way, you're going to have to find other policies.


Quickly, on the minimum wage. I—you know, there is sort of an active debate you know—a debate within the research community over how big the effects are on employment. I tend to come down more on the micro evidence that suggests that those effects aren't that large. I would note that this is one—this is one small part of a much broader problem.


Right. One of the things that is striking, when you look at the income distribution problem, is how broad it is. So one of the things is—is—I think, quite notable is, if you look at median incomes by education level, I think before 2000, those had been sort of widening. So the median income for people at the high end—the sort of college education, have been rising relative to a high school education.


That's actually changed since 2000. The median income for the most highest educated groups has actually been falling. And what's striking is, what you're seeing is great—you know, a greater and greater concentration of wealth and income at the very highest levels. And so—and the minimum wage is going to address part of that but it's a much bigger problem.


MALLABY: Anyone else have a comment on youth...


ITO: I think the youth unemployment problem is a reflection of the mismatch of skills of that young workers can offer and the firms are looking for. And this is related to the computer substitute, computer complement problem. But the educational system has be adopted to the new world of globalization and IT worlds to educate properly the young people.


And I think that Europe is failing to do that. Japan is failing to do that. And U.S., I'm not sure, is failing? So, I think those more vocational training is probably good. And more changing the—those emphasis general education or the liberal arts should change.


REINHART: So I think one thing the U.S is very good at is generating variance. That is our education system has a very high variance. Why is that actually good means well, okay, there's a low-tail and that's the part of us where we're not delivering skills to the young people who need it. It also means there's high skills – a high-tail.


That's the technological innovation. That's our top tier universities. That—that is why you—you shouldn't bet—count the United States out as being able to generate total factor productivity. Uncharacteristically optimistic.




MALLABY: Let's have a question over there.


QUESTION: Thank you, Leticia Gutierrez (ph) Ashna (ph) Partners. Back to Japan, past the impact of the tax hike, for which there are clearer levers to sort of offset and into the Spring, with negotiation.


Can you help us understand the lay of the land of the key actors you see influencing this process? And obviously you know, for the sustainability and virtuous circle Japan will hope to see wage inflation, what—can you help us frame this?


ITO: So the wage in Japan has been declining for at least 10 years. And that was consistent with the prices going down. So we want to change it, both prices and wage front, and success of the First Arrow is that Abe clearly indicated that getting out of deflation was the first priority.


And now, and Governor Kuroda is very explicit on achieving 2 percent target. So yes, prices are going up, and it's on track. And probably we will reach 2 percent inflation rate in ER02 (ph). Fine.


Now wages—also, wages have the inertia, and since it has been going down, there's a force to still going down. But the government is now putting out a lot of efforts to convince the large corporations to raise the wages. So this is not the wage increase which is not justified by productive gains or the inflation. But it is to go along with this inflation targeting, at least to keep the real wage constant.


Of course, the companies vary. Some companies have large profits to account for to distribute to labor. There are companies who are suffering still from the high yen period. And with their own problem. So, it won't be uniform increase. But I'm sure that higher profit companies are willing to go along with the government that yes, this is the time to increase wages.


So this can be contrasted to the earlier experiment in the early 1970s when the inflation rate was high, that we all wanted to lower the inflation rate. The key was to lower the wage, so tried to convince the unions to restrain from asking for the high wage increase, just because inflation expectation was high.


So this is the reverse of that. You know, we tried to promote inflation expectation to go up and to go along with it. Wage inflation is important. So I think the effort is well grounded and therefore will succeed.


MALLABY: But so, Taka, between '71 and '74 in the U.S. when there was this attempt to politically manage incomes policies, it didn't work. You think in Japan it's a different kind of society so when the government tries to persuade the private sector to change wage settlements in response to it's inflation target, you think Japanese society will respond to that better than the U.S. did in the 70's?


ITO: I don't think it's the societal culture. I think it's just a fact of economics that there are companies who have done extremely well despite the yen depreciation. And with their own cost cutting and other belt tightening, they can afford to distribute to the labor.


And they have the huge cash. And we're asking what are you going to use this cash for? Investment or dividends or wage increase? So, it won't be a hardship or distortion that they distribute the wages, especially when they're convinced that inflation is coming.


REINHART: And their might be an asymmetry of try—of—of trying to talk wage growth down versus talking wage growth up. So, I'm not sure the Richard Nixon episode is necessarily determinative here.


MALLABY: Good. Okay. In the back.


QUESTION: (Inaudible). There seems to be two forces. The one is the emerging market (inaudible) and the other is economical growth in some developed economies (inaudible). So which one will operate the other? And does that change your prediction of world economic growth in the year?


MALLABY: Thank you. I didn't quite get that. Did you...




ALEXANDER: So our—our forecast for the U.S. is conditioned on a global economic forecast. It's nested within that is an important stabilization in emerging market economies. Some emerging market economies will find it difficult to weather increases in U.S. interest rates but we think that is contained enough.


And at the end of the day it really is will China continue to grow at a robust rate. If that's the case, then that will support the advanced and emerging market economies along the Pacific Rim lever to China. It will keep commodity prices well maintained. And it will be a backdrop that U.S. firms will decide to add to capacity.


So you are right. Our forecast depends on emerging markets. And within that it says most will be able to weather the back up in rates and that China finds a point where they can offer society a little bit more financial stability but steady growth.


ITO: My friend in Washington—I'm quoting a friend in Washington—that when emerging market has a boom, both the smart money and dumb money goes together in euphoria. But when money comes back, the smart money comes back first.


And so, the point is that this emerging market currency depreciations, it is discriminating. It's discriminating that really emerging market economies with fundamental problems have depreciations and relatively sound emerging markets still hold. So I don't think it's right to blame the FRB or any others but they have to fix their own problems.


MALLABY: So the...


ITO: That—that includes China, I think.


MALLABY: So the Indian Central Bank Governor Raghuram Rajan who is blaming the Fed for destabilizing the Indian economy is essentially...


ITO: That's for domestic concerns.


MALLABY: ...dealing with his domestic politics. Okay. Great. Well, on a political note, we'll end it there. Thank you very much to all the panelists and thank you for coming.

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