The State of the Global Economy

Thursday, April 30, 2015
Kostas Tsironis/Reuters

Lewis Alexander, managing director and chief U.S. economist at Nomura Securities, Peter R. Fisher, senior fellow at the Tuck School of Business, and Ellen Zentner, managing director and chief U.S. economist at Morgan Stanley, join CFR's Sebastian Mallaby to discuss emerging economic trends and review the world economy in recent months. The panelists consider the longevity of low interest rates in the United States, the state of U.S. household spending, the divergence in deleveraging between U.S. and European households, and China's ongoing macroeconomic readjustment.

The World Economic Update highlights the quarter’s most important signals and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy.

MALLABY: ... so innately brilliant that you can ask them about anything, from Latvia to Latin America, world economic update, and they just know the answer off the top of their heads.

That's kind of true. I mean, they are brilliant. But I do actually send them an e-mail a few days ahead of time and say what's on my mind and what they might—what they might be asked to talk about.

But what I didn't know until now—this is a secret—what I didn't know is that I didn't know if they read the e-mail. I mean, it might just go straight to their junk folder. Maybe they just ignored it. Are they diligent, or are they, you know, kind of doing other stuff?

And I didn't know the answer until this week. I sent out a normal e-mail and I got a very nice back—response back from Peter Fisher. And what he said was, "These are very interesting questions, and I can't wait to find out what my answers will be."


OK. So now...

ZENTNER: You make it up on the fly.

MALLABY: That's it. So on my left here we have Peter Fisher, who is a comic...


... and a senior fellow at the Tuck School of Business. In the middle is Ellen Zentner, managing director and chief U.S. economist, Morgan Stanley; and then Lewis Alexander, managing director and chief U.S. economist at Nomura Securities, right.

We're going to start, I think, on the serious part with a thing that caught my eye in The Wall Street Journal last Saturday, which I read as the latest sort of iteration in the secular stagnation debate. And what it pointed out was that the stock of global wealth since 2000 has more than doubled. So you have this massive stock of wealth, which could be viewed as sort of excess savings, which are pushing down interest rates.

But then, of course, at the same time, as we all know, we've got—as well as the sort of wealth overhang, we've got a debt overhang still. And that's also constraining spending, pushing down interest rates. And the two things seem to work together; so wealth overhang plus debt overhang.

Lewis, is there—are both these things true? Is there a bit of a tension? Am I talking nonsense? How do you see this debate?

ALEXANDER: I guess I have a hard time thinking about it as a wealth overhang in the sense that I do think of this more as a sort of flow issue. It's savings versus investment. And the primary thing, it seems to me, that—that's the natural way to think about the basic question of why are interest rates so low.

And I think there are obvious reasons why savings is high. Partly it's the overhang of the recession and people becoming more risk-averse. I think, on the investment side, you've got a combination of things, including—one of the most striking things is the slowdown in potential growth around the world.

I thought the IMF did a nice piece on this in their world economic outlook. And what was really very striking about it was their—they showed that essentially potential growth around the world has slowed in a more or less synchronous way. And it's—partly it's demographics. Partly it's productivity.

That has implications for investments. And I think that's a big part of the story. I think there are lots of questions about how one thinks about it, but I think those are more the issues per se than—I have a very hard time thinking about wealth overhang as a problem.

MALLABY: So stocks of wealth doesn't matter. It's flow.

ALEXANDER: Well, ultimately what are the stocks but the accumulation of a flow? And in some sense there's an allocation question. To a certain extent, another way you can think about it is the fact that people are choosing to hold their wealth in things that are perceived to be relatively safe is another part of the story. That means they're not investing in real capital. That means they are investing in things like sovereign bonds, which are perceived to be risk—relatively low-risk. And that's sort of pushing down those rates.

So you do get this combination of less real investment, because people don't seem to want those kinds of risky assets, versus there seems to be this tremendous demand for sovereign assets, independent of what the central banks are doing. That is getting you this kind of mix of low investment and very low interest rates.

So I would say people's preferences for how they hold that wealth matter a lot, but it's hard for me to think of the stock of it as a problem.

MALLABY: So Ellen, let's come to you. If the question is the flows, and part of that is—a big part of that in the U.S. is household flows. This is something that I think you've studied quite a lot. Do you think deleveraging for households still has some way to go? Is it—or is it mainly accomplished?

ZENTNER: I think what we've seen is that in the U.S., households have done an amazing job of deleveraging, particularly when you compare us to our, say, European counterparts. And I think we can largely say the deleveraging process among households in the U.S. is complete.

What we're looking at now in terms of the household balance sheet is about 75 percent of it is parked in mortgages. About 11 percent of it is held in variable credit, credit cards, and then student debt, auto debt, other loans taking up the rest of it.

What's encouraging to me is that as the Fed embarks down the path of higher interest rates, we look at what will happen to households. How will consumers react, or how will the house—what happens to the household balance sheet in a rising-interest-rate environment?

And going back to the 75 percent that's parked in mortgages, 90 percent of those—90 percent of outstanding mortgage debt is held at a 30-year fixed rate. And the effective rate on all outstanding mortgages is below 4 percent. It's around 3.8. It's at an historical low. So that means that roughly 65 to 70 percent of the balance sheet is parked in the fixed-rate, low-mortgage-rate environment.

But when the Fed starts to raise interest rates, it's not going to do a whole lot to the balance sheet. So you don't get that knee-jerk reaction from households in terms of higher interest rates really increasing their ability or hampering their ability to repay that debt.

What higher interest rates will do, as they're designed to do, is slow interest-rate-sensitive sectors, slow demand for interest-rate-sensitive products, slow housing, slow durable-goods demand, and that sort of thing. But I think what we've seen is that deleveraging over all these years past the financial crisis has actually set us up so that households are very well-cushioned when we go back into a rising-interest-rate environment.

MALLABY: OK. So that's a positive story. There has been deleveraging. And the remaining debt is largely fixed rate. Now talk about a bit the income side for households. I mean, do you see wages eventually starting to pick up more? Is that another part of the optimistic story?

ZENTNER: Yeah. You know, I have to tell you that for more than a year I've been sitting in front of clients saying stronger wage growth is here. And it hasn't been here. I think full employment has been much lower than where anyone suspects it would be. The Fed has become more realistic and lowered their estimates for where they think full employment is.

Like all things, I think, in the economy after the financial crisis, we have to dig deeper into it and get at the more micro detail, what's going on at the sector level. The relationship between tight labor markets and stronger wage growth still holds. We know this because—let's look at the transportation industry, where there's been a shortage of truck drivers and wages have gone through the roof there in order to attract workers. The relationship still holds.

What we're seeing at the sector level is that where we have tight labor markets are the areas where we've created the majority of jobs. And where we've created the majority of jobs have been in sectors that pay well less than the median wage in the U.S. So as those labor markets have tightened for those sectors, wage growth has gone up. But it's not enough to move the needle.

What we are seeing now is that we're getting a—more breadth, more diffusion across sectors, and sectors that pay higher than the median wage where labor markets are becoming tight and wage growth is poised to pick up there. And that's enough to move the needle.

And so I'm going to sit here again today and tell you that stronger wage growth is here. We actually think we're getting wage-growth data later this morning that's going to show that. And I think that that will go far in giving the Fed the comfort that it needs to still raise rates this year, even after this dismal first-quarter growth that we've been getting. That gives them the confidence that this—the stronger aggregate demand will be there if the wage growth is there.

MALLABY: So Peter, Lewis is saying don't be distracted by wealth overhangs. Ellen is saying households are in better shape than one might expect, and as wages do pick up more, that'll reinforce the story.

Do you want to be optimistic too, or are you going to...

FISHER: No, I'm going to be...

MALLABY: ... rain on this?

FISHER: I'm a little more disquiet. Let's imagine we're historians 500 years from now, stumbling onto the factoid you began us with that we thought wealth doubled in a 15-year period. That would really be something. You'd be looking in your history book thinking, "So there was a period of time where they thought they'd doubled the stock of wealth on the planet in just 15 years." That would sort of jump off the page at you. You'd think, "That's really amazing."

Well, part of the answer is that balance sheets have two sides to them. And there are lots of balance sheets in the world. So there's their assets and liabilities. And if we grew the liabilities, we probably had to grow the assets. And then the assets are someone's claim.

So we think we got wealthier, but we borrowed a whole lot from the future. And we did it explicitly by laying on more debt, and we created a bunch of assets that we then tell ourselves, "Gee, look how much wealthier we are." And we did it implicitly by driving down the discount rate, and so we could—the asset we're borrowing those cash flows embedded in the assets into the present.

So I just wonder how many people here think the actual stock of productive assets on the planet doubled in the last 15 years.

MALLABY: Right. So it's not a wealth overhang, but it's wealth illusion that you're worried about.

FISHER: Yeah, just how we're accounting for it. We've put it on some balance sheets and we've rented it out to each other and we've changed the price of it by bringing down the discount rate. And so we're all feeling a little better.

It happens to be 15 years in which the central bank of the United States has tried twice in 15 years to consciously push down the discount rate as far as it could go to create a wealth effect, to make us feel richer, to see whether we would spend more. And that's kind of accentuated the distributional problem we have.

So it gives me some disquiet. I just don't think we have doubled the stock of—we're all wealthier. There are some—there are great inventions. I think Twitter's just amazing. And I don't mean to be a skeptic entirely about innovation. But I just don't think we've doubled the amount of productive income-generating capacity on the planet in 15 years. That's a little too quick.

MALLABY: So one more for you, and then I'll come back to the others. But you were saying some months ago—I think you were here in the beginning of—maybe three months; I can't remember. But the point is that you're all—you were not only skeptical about whether the wealth was real. You were also worried that debt markets were getting frothy.

Do you feel that they've dialed back, or are you still worried about the rate of credit growth?

FISHER: I'm worried about it because I don't see what's going to constrain it. I'm not quite worried about the apple cart getting tipped over tomorrow morning, although we should think about that. The risks are more symmetric than we think. So wealth might still keep growing.

But the problem is—that haunts me is that I haven't yet figured out how we end the credit cycle other than one of two ways. Either the central bank raises real rates more than we expect, or we all borrow too much money. And we just know what the latter felt like. We just did that in `07-`08. And I don't see the central bank yet has a theory of how it stops itself from taking us there.

So I'm not—it's not so much the here and now of it; is I don't see a theory, even though I know Stan Fischer is working hard at it in his new financial stability subcommittee at the Fed. I don't see where they're going to come up with that.

MALLABY: So this leads us to kind of a two-part question about Fed policy now. You know, one is short and one is longer term. Let's start with the short term.

I mean, Q1 growth in the U.S. was practically European. It was .2.


ALEXANDER: Well, you can take that a number of ways.


MALLABY: And so, I mean, you know, the statement said it partly reflected transitory factors. Do you think that's right? I mean, "partly" has got to be right. But what's the balance between "transitory" and (inaudible)?

ALEXANDER: So I guess I'd—in that context, I'd highlight three things.

Weather has been part of it. I think that will come back in the second and third quarter. That is a piece of the story.

There's another piece of it which I would also argue is transitory, and that is this very rapid decline in investment in oil and gas that we're seeing. That is—you know, you're going to see a 40 or 50 percent decline in the amount of drilling activity in the U.S., and that's going to happen in the first half of the year.

That's big enough to have a material effect on the industrial side of it. And so you're seeing that sort of play through. But that should be done by the summer, right. There's only so far those things can fall. And so even though that's on a slightly longer clock than the weather effects, but that is another one that is temporary.

The third one, which is sort of harder to gauge, is the dollar and its impact on growth. In the last two quarters, trade has been a big drag. Frankly, the models would tell you that that's a little early for the dollar to be sort of driving that. And so there remains a question about how big a drag that is going to be.

I think the net effect of those things still gets you to growth that's in the kind of two and a half to 3 percent zip code in the second half of the year, which is enough to tighten labor markets. And that is the sort of criteria for liftoff. I think those are the set of things that the Fed is looking at, and we'll sort of see how they play out.

If it turns out that, in fact, the economy is more vulnerable to a strong dollar than people expect or things like housing is worse or it turns out consumers really don't spend any of the money they saved on lower gasoline prices, you could get a worse outcome. But I think those are the sort of near-term questions.

MALLABY: I remember very clearly that you predicted this effect on oil-related investment several months ago.

Ellen, your note yesterday said something like "There could be something sinister lurking out there in the economy." It sounded like a sort of horror-movie tag line. But that wasn't actually your bottom-line conclusion. Where do you think this balance is between transitory and horror movie?

ZENTNER: Well, I think the concern is there's something more sinister lurking in the data is what Lew was pointing out, is that as a policymaker you're looking at—you're staring this slow GDP growth in the first quarter in the face. And you have to ask yourself, "Yes, how much of this is transitory?"

And so it will be expressed in a rebound in the coming quarters. And how much of it is more lasting? And that's the question that policymakers had around the table yesterday. We'll get the details of how concerned they were when the minutes are released, always three weeks after the meeting.

When I look at yesterday's meeting, the time between the March FOMC meeting and the April FOMC meeting is the shortest period of inter-meeting period. There's just not enough data. So while you can be fairly sure that you're going to get a rebound—and we think we will also get a rebound in activity—you don't have concrete data in hand in order to be absolutely certain.

So I think what the Fed did yesterday was they very accurately depicted a very sobering take on current conditions; you know, left their forward-looking assessment as they're confident that growth will return to a moderate pace over the medium term. And that's about all they can do.

I think what we'll find out from the minutes is how pervasive is the worry around the committee that we don't get that rebound? So we have to watch the data closely. And I would say that in terms of what would be the game changer for the Fed this year, what would cause them not to raise rates, and it's the dollar. It's the wild card for the Fed.

Now, in a way, by talking up the worry around the dollar—and in the statement they never make a direct reference to the dollar, but they'll talk about exports have declined. That's a back-door way of discussing the effects of the dollar.

In a way, by expressing public worry over the dollar, each time they've done that, they've been able to buy some reprieve from the pace of appreciation, which has—was absolutely alarming from August through March, or up until early March.

And so we've had the dollar come off since March. And that actually might be what the Fed needs in order to move ahead with raising interest rates. A leveling out of the trade-weighted dollar was one of the criteria they listed at the March meeting for them to have confidence to raise rates this year. And they're watching it closely.

You can't have confidence in your outlook, you can't have enough certainty that prices will turn upward, if that kind of rapid pace of appreciation of the dollar resumes. So they have to watch it closely.


FISHER: A few quick points.

First, the seasonal adjustment on Q1 has been screwed up for 20 years. It was screwed up when I was at the Fed. This morning's Wall Street Journal has a story pointing out the last seven years, I think, of Q1s have all been soft. So we're not getting the data right, and we just have to—I think the Fed is—that's one of the transitory factors the Fed is implicitly alluding to.

Second, I think the dollar is a very risky game for the Fed. Clearly the dollar rallied in anticipation of the Fed tightening. And if you don't follow through on the tightening, what's going to happen to the dollar? We see what's going on the last few days.

So it's a very difficult game for the Fed to play to be too fixated on the dollar when the dollar was moving because the markets were expecting the Fed to do something, which is a great testament to the most difficult aspect of the Fed's exit. It is not how to manage their balance sheet. They've got lots of gimmicks to manage their balance sheet.

And we really don't have to bother with targeting the fed funds rate, which brought meaning to my life for 10 years. But every other central bank on the planet worth anything doesn't bother targeting the interbank overnight rate. They just announce what the short end of the yield curve is in a fixed-rate RP. And everyone can anchor the yield curve off of that. So we don't need to fuss about that.

The timing will matter. But what really matters for all of us is when the Fed can stop targeting so many asset prices at the same time. They've been targeting house prices and mortgage values and equity markets and exchange rates and 10-year yields. And we can tell by what happened in the so-called taper tantrum that they don't think that they're going to influence asset prices when they change our expectations with how accommodative monetary policy is.

And this is—it's just not going to work. They've got to let go of targeting all these asset prices as the means to the end of influencing our decisions or nothing's going to happen, or they're going to blow the place up. And I always thought of the taper tantrum as the Fed having a temper tantrum. The market—it's entirely predictable. When the Fed changes its stance on accommodation, asset prices react. And a member of the FOMC referred to the market as feral hogs because volatility went up a little bit.

MALLABY: (inaudible)

FISHER: I think that shows their inability to separate themselves from asset-price targeting.

MALLABY: I'm having a feeling that it's not just the asset markets that react to this kind of stuff. It's actually Lewis Alexander over there.

ZENTNER: Take a deep breath, Lew.


ALEXANDER: So Peter and I actually agree on most of this, but we...

MALLABY: Rubbish.

ALEXANDER: ... kind of use somewhat different language. So I'm going to...


ALEXANDER: I'm going to reinterpret what Peter just said in a slightly different way.

Look, it is a fact that a primary challenge for monetary policy is through financial conditions. And that means asset prices. You cannot, as a central bank, think about what you're doing outside of the context of financial conditions.

I do not believe the Fed is targeting the asset prices that Peter suggested. I do think they are very sensitive to financial conditions. And therefore, when financial conditions move, they react.

Now, one might argue it comes to the same thing. And Peter and I are, in some sense, in broad agreement that the risk we face going forward is I think the Fed knows they have to allow financial conditions to tighten. And that is a risky business, given where we're coming from. And for those of us in the room, one of the primary things we have to think about is how are financial conditions going to evolve as the Fed goes down this road.

I would—I would add another thing in which I think I'm in agreement with Peter on, which is I don't—I think central banks generally, and the Fed in particular, has a hard time thinking about volatility. And, like, one of the hardest things they face—on the one hand, right, they kind of know that it's a normal thing in asset markets, and in some ways volatility is actually good from a systemic-risk standpoint because it encourages people not to take excessive risk.

On the other hand, it scares them, right. And I think one of the ways they have gotten things wrong in the last 10 years is being—by being too sensitive to the way their actions affect volatility. I think that was very much true in the run-up to the crisis.

If I would criticize the Fed for the run-up to the crisis, to me the biggest issue was they were so obsessed with being stabilizing during that period that they encouraged a lot of the risk taking that ultimately became a problem. And, you know, they have blown hot and cold on that issue more recently.

Some members of the Fed have, I think, talked about this in a sensitive way. But you saw in the taper tantrum, in some respects, their clear—it is something that they—that scares them in some ways. And, like, how they manage that problem is, I think, a very important aspect of them getting it right.

FISHER: Just very briefly—and we've been having fun talking about this stuff for 25-odd years—the Federal Reserve has put the might of its balance sheet, until a year ago, behind the proposition that they knew the right 10-year yield was lower than it was. And they bought duration and sucked it out of the market and took it onto its balance sheet. And now we get the pleasure of listening to members of the Open Market Committee wonder about the conundrum of why long-term interest rates are so low. If that's not asset-price targeting...

MALLABY: You guys can continue this...

FISHER: ... I don't know what is.

MALLABY: ... afterwards. Can we...

ALEXANDER: You keep (ph) a long list of targets, Peter.

MALLABY: I wanted to ask about Japan and Greece before we meant (ph) to go to the members in the audience.

On Greece, which I think Lewis has a view on, it feels to me as if we really are reaching some kind of end game here; that despite the supposed reshuffle of the government, Varoufakis is still the finance minister. The rest of the Euro group cannot stand the guy. And Greece is running out of money. And they might be able to fudge the IMF payments coming up, but then you've got the much bigger repayment to the European Central Bank. And if they don't pay that, it's pretty difficult for the European Central Bank to continue to finance the banks there.

So do you see an end game coming?

ALEXANDER: Yeah. No, no, no, I think you're absolutely right. There are decisions that are going to be made in coming weeks that will be consequential.

I think the simplest way to think about this is the platform on which the current Greek government got elected is basically inconsistent with what the rest of Europe is going to offer. That has been—that was true at the election. There has been no real narrowing of that gap that's happened up until now. And we are facing kind of where the rubber meets the road within weeks on that.

Now, it is our—I think that can play out in a number of ways. I think you're already seeing the prime minister suggest a referendum. And I think that is essentially an acknowledgement that they are not going to get from Europe what they ran on and that ultimately the Greek people are going to have to decide how they respond to the fact that they can't get what they want.

And I think what was—what seems like the most likely outcome at this point is that the deal that Europe will offer Greece, which will be well short of what the current government has said it is demanding, will be put to the Greek public in the form of "Do you want this and staying in the Euro, or do you want something else?" And so essentially we're going to have a rerunning of the implicit debate on this that was run in the last Greek election.

Now, it's my expectation that ultimately, when faced with that choice, the Greeks will choose to stay in the Euro. I think—if I've looked back over the European crisis, one of the most striking things to me is the degree to which, you know, publics have accepted very, very, very, very, very large costs in order to stick with this project.

I do not see—I mean, it's certainly possible that the Greeks could make a different choice, but ultimately it seems—that seems like the more likely outcome to me.

Now, there are lots of other things that could go along with that. As you say, the cash-flow needs are getting pretty extreme. It's possible that we could have some version of capital controls, arrears being built up. And, you know, those—that's a kind of slippery slope, right.

If you start imposing capital controls and you don't get a quick resolution, what does that really mean? Well, it means that a Euro in a bank in Athens is not freely convertible to a Euro anywhere else in the system. That's a currency separation. You stay in that situation too long and the question becomes how do you get out of it.

And you could have a kind of sliding into the breakup of the Euro that was never anyone's first choice, but just comes from the consequences of "We can't solve this immediately; we do capital controls notionally as a temporary thing," but that ultimately, if you can't get out of it, you may go—right—it may—you may look up at some point and realize you've already done—you've already essentially generated the Greek exit.

I don't think that's the most likely outcome. But there are lots of ways this could play out. I do think, you know, what's going to happen in the next two, three, four weeks are sort of—we're reaching a sort of crucial point on this.

MALLABY: Let me ask one more question before we go to the members, for Ellen, which is sort of how some of this stuff feeds back into the U.S. You've got, on the one hand, with Greece the potential for some further instability in the Eurozone.

On the other hand, Japan—they just had a meeting of the Bank of Japan where they acknowledged that QE has not produced the inflation that they wanted. They are still way below target (inaudible), which might suggest further QE and further currency effects feeding back into the dollar.

On the other hand, they've bought up, in my understanding, so much of the JGB market that there's a sort of question about the mechanics of how you would proceed with even more aggressive QE into the future.

So I'm just interested in, as you look at the world, which of these—which areas feed back through the dollar or other mechanisms into your outlook for U.S. growth.

ZENTNER: Well, I think the way we have to look at it, and to bring up financial conditions again, is that how these global factors affect financial conditions in the U.S. is what will ultimately matter.

Now, Japan is coming to the realization or admitting that they might not be getting the reflation as soon as they had expected. How patient are they willing to wait for it? Have they just moved the goalposts, or will they provide more action?

I think that fits into the broader global theme that we've been seeing play out over the—certainly the last—in earnest in the last six months or so, and that is the global battle against lowflation. I mean, since December, more than 30 global central banks have done some sort of easing or monetary-policy easing or currency intervention in order to try and reflate their economies.

And that is something—that is a burden that the Fed has had to bear, or the U.S. economy has had to bear, because we have a little bit of inflation to share, and we've had to share it with other economies around the world via appreciation of our currency.

And so that's a theme that is far from over, and it's something that's been holding down core inflation here in the U.S., at least. If you look at inflation here in the U.S., it's not a domestic issue. You've got this sort of tug of war between domestically driven prices, price pressures and services that are upward, and then downward pressure on core-goods prices that are coming from abroad.

And the two are sort of butting heads. You've got a collapse in core-goods prices but a fairly lofty rate or healthy rate, around two and a half percent of services, prices. So that's the dichotomy the Fed has been looking at, caused by this global battle against lowflation theme.

On Greece, I think one of the best things there is that it's been a disaster for many years. And because of that, we've moved assets away from Greece. There's not as much of the unknown as there was in early 2010, where Greece reared its ugly head and everyone's trying to figure out who's exposed, where the linkage is.

Sovereign debt in Europe is exposed. We're not so exposed directly in the U.S. But how all of those factors play out and how they ultimately affect financial conditions in the U.S. goes back to the conduct of monetary policy and how comfortable will the Fed be to raise rates, and how quickly, because they'll constantly monitor financial conditions as they evolve.

MALLABY: Great. So thank you.

Let's go to members; a reminder that this is on the record. If you have a question, please raise your hand and wait for the microphone and identify yourself. Is there any question? Otherwise I'm going to ask about—yes, I can see one there. Thank you.

QUESTION: Dee Smith, Strategic Insight Group and Dallas Committee on Foreign Relations.

I'd like some thoughts on China and what's going on there and how that affects the rest of the global situation.

MALLABY: Great. I feel less guilty that I didn't bring up China.

ZENTNER: I noticed he looked directly at Lew when he asked that question.


ALEXANDER: Sure. I'll jump in.

So clearly China is slowing a bit. And there's an adjustment that's going on that's related to some of the financial excesses you've seen there. So there's a correction going on in the property market that's also related to local government debt, which has been a channel of fiscal expansion, which they've been trying to sort of pull back on.

This all comes in a broader context where the new government is trying to again sort of shift China's growth—strategy for growth away from one that's sort of dominated by investment. I think that inevitably is going to involve some slowing.

I think you're starting to see some financial stresses associated with that. So we've had some bankruptcies there, which are kind of a new thing for them. You've seen support come from the central bank to the financial system more broadly.

I think it's sort of inevitable that as they try and make that shift, you're going to see some combination of slower growth and higher financial stress.

I think the question is, can they generate this combination—this sort of change in strategy, somewhat slower growth, backing away from very sort of strong sort of financial support, without generating kind of more noise?

We think that's likely. But I think the risk that it might not work out so well is a real one, and people ought to sort of think about it.

So the way I kind of think about China is it's this very unusual kind of mixed economy where the state obviously still has a big role. Essentially most of the financial system is still effectively state-owned, and certainly state-controlled. You obviously have these large state-owned enterprises that are still a big part of the economy.

Basically what that means is the Chinese government has a lot of means of control. And so they have a lot of tools that they can use to kind of get the outcome that they want.

But what's happening over time is that as the economy grows and develops and liberalizes, the private part of the economy is growing relative to those things that the state controls all the time.

I believe at some point in my—what's left of my professional career that we're going to have a global recession that's driven by China. And it will come when the point—when the Chinese face a set of problems domestically that their tools do not allow them to control in the normal way.

I don't think we're there yet, but I think that's the question you have to ask. There clearly is a correction going on in the property market, which is—frankly, given the excesses there, makes sense. I don't think that's going to get out of hand into something broader. But that's kind of the question.

MALLABY: On the question of whether China is evolving in a more private direction, a friend of mine last night was saying that he went to interview the chief executive of a Chinese government-owned company who said to him that executive stock options were a very good idea.



FISHER: Well, I think—I agree with Lew's points. And I would emphasize that in the long run, relevant to China and Greece, all balance sheets get rational. And we don't quite know the pace of that. But the Chinese balance sheet is facing difficult times, as I think Lew was saying.

And I think I've said this here before, but let's just make sure we all understand the math. Fifty percent of GDP is new investment. So if next year they only build the same number of brand new highways, hospitals, roads, bridges, tunnels, factories, schools—brand new—next year that they did this year, half the economy stopped growing. That's what it means when half your economy is coming from new investment.

So you can still be pretty optimistic about China's future in the sense that there's room to grow and not think they can grow investment. In fact, it's probably going to start shrinking sometime soon. It's—that is, it won't remain a 50 percent share of GDP. And that's the challenge that Lew is referring to.

And then the assets they've been creating just probably don't have that income behind them. They're just probably not performing at the same level that we expect. And that balance sheet is going to have to get rational. And that's the global recession that'll be caused by China at some point in our professional lives, sooner or later.

MALLABY: Ellen, you want to comment on China or not?

ZENTNER: Financial conditions.


No, I think all those points that are made are good. You know, our FX strategists are asked all the time about "Will China just do a one-off devaluation? Why not just do a one-off devaluation?"—that that would go so far into—toward weakening their currency and boosting their economy, and they would be able to rely on that to boost exports in manufacturing and investment sector rather than having to just grapple with how to do it fiscally and through other monetary-policy measures.

You know, the issue there is that China wants to become a more credible entity. And if you want to be eventually seen as a reserve currency or you want people to have more confidence in investing in your economy, you can't do those types of things like a one-off devaluation that surprise people.

And so I think it's led them to sort of maintain more reasonable policies or stretch whatever more reasonable policies they could do and move away from those sort of punch-you-in-the-face measures like devaluations.

ALEXANDER: Very quickly, just for this audience and my colleagues up here, I don't understand how you become a reserve currency unless you run a massive current-account deficit for a long time, nor how you reserve currency unless you permit volatility in your exchange rate, because you become the shock absorber if you're a reserve currency.

So for me, one of the great conundrums of Chinese policy is some of them want to be a reserve currency, but I don't see how they're about to engineer a big current-account deficit that would give the world enough of the stuff to make it a real reserve currency.

Well, one option is you open up your capital account so people can actually invest abroad. So it's—right. It's not just a current account, right. But if they allowed all that Chinese savings to be invested abroad, that would create, in some sense, room for the rest of the world...

FISHER: And what would happen to the exchange rate if they did that right now?

ALEXANDER: It would go down. Now, I...

MALLABY: (inaudible) over time...

ALEXANDER: We're a long way—we're a long way...

MALLABY: ... that would...

ALEXANDER: Over time, that's got to be part of the issue.

I think there's also an interesting—I haven't done this calculation, but I think it would be an interesting one to do. If you asked the question, "In what currency is financial intermediation around the world growing the most?"—I suspect if you did that calculation, you would be surprised to find what a large share of actual financial intermediation around the world is happening in Renminbi, from just purely how big the domestic financial system is and how rapidly it's growing, right.

And ultimately, I think that matters for this calculus (ph). I suspect you and I agree we are a long way from them—right, the Renminbi becoming a reserve currency. I think they are clearly trying to do things that put them on that road. But this is a—this is a long road.

For me, the biggest obstacle is a different one, which is—it's sort of related—which is, to be a reserve currency, you have to be—it has to be something where people who are not part of that economy want to contract in that currency. And ultimately, that's about rule of law, because your willingness to do that depends on trust in not only the currency itself, but a whole set of institutions around it that include, very importantly, that. And to me, that's ultimately the biggest obstacle for China.

MALLABY: Another question. Yes, right here. The microphone's just coming.

QUESTION: I'm Maurice Tempelsman.

Let me (inaudible) back to Peter's opening comment that the growth of wealth in that period of time, recent period of time, was basically illusory. I don't want to misquote you, but that's the direction you were heading (ph).

That same period has also seen one of the most dramatic shifts from the rich to the poor; maybe not totally overlapping. One of the great advantages in looking at the developing world rather than the developed world is one doesn't have the institutions, one doesn't have the statistics, that we always use in order to make our case and justify it. It's much more empirical. You see it. You feel it.

Can you comment about how you feel about this transfer of wealth, particularly in the context of your original statement about the creation of wealth having been illusory?

FISHER: Well, I want to be careful. I didn't mean it all was illusory. I'm afraid just some amount of it. A doubling seems a bit much to think we've actually improved the productive assets. So I think we know some of it was big financial engineering and some of it's real. And you can see it when you visit developing parts of the world, that the people's standards of living are moving higher. And it's a pleasure to see.

Now, the sign on the transfer from rich to poor—I wasn't sure which one you were interested in. We have rising income inequality, rising inequality of wealth. Was it the transfer from the poor to the wealthy that you were interested in, or was it the transfer of flows from developing economies, the reverse-capital-flow phenomenon that troubles many of us?

QUESTION: The latter (inaudible).

FISHER: Well, it is a conundrum. It's a difficult thing to feel confident about, going back to Ben Bernanke's savings-glut hypothesis. I'm afraid, back in the early ought-oughts, I thought of that more as we were having a glut of consumption and excessive income here, which produced a savings glut elsewhere on the planet. So I wanted to look where the cause was.

But I think that part of it was clearly state-generated—I'm interested in my colleagues' thoughts—that never to repeat the currency crisis of `97-`98 in Asia. So they were insuring themselves. They were going to buy a lot of these western assets in order to make sure that never happened again. That's certainly part of it.

But part of it is now related to everyone seems to want to get into the act of holding the best assets on the planet. So we're hoarding the best assets. How else to describe when you have negative yields in bonds and corporate share buybacks and corporate debt buybacks?

So some aspect of the low-interest-rate conundrum is we all collectively, sovereigns and individuals, seem to place a very high premium on owning the best assets; so much so, we're prepared to take very high prices and negative yields on them. And that's beyond the insuring them from a future currency crisis.

And I don't—I don't know how to put that all together, but I'm just sort of observing it. I think that's part of what's going on, for the latter.

MALLABY: Let's go to another question. Yes, Marty.

QUESTION: Thanks. Marty Feldstein.

I want to go back to the U.S. and to the puzzle that the consumers are not spending. We've seen three months in which real incomes are rising at an annual rate, real personal disposable income of about 6 percent, and yet consumer spending is rising at 1 percent or less than that. That may help us to understand why wages, as conventionally measured, are not rising so much, because real incomes really are rising.

But why is the consumer saving all that money rather than spending it? And is that different among different subgroups of the consumers? I guess that's a question for Ellen.

ZENTNER: Thanks, Marty. I couldn't have planted a better one.


So before the—let's talk about before the financial crisis. Incomes were growing strongly, but it was being driven more by permanent income, so stronger wage and salary growth.

If we had had this drop in gasoline prices at that time, the marginal propensity to consume out of that gas savings would have been enormous, because it would have been just manna from heaven dropped into our laps to be spent indiscriminately around the economy. Why? Because we had this steady income stream, guaranteed income stream. Financial expectations of households were very high. So any extra dollars were just that—extra dollars; could be spread around.

You fast-forward to today and we had very, very sharp drop in gasoline prices, so real aggregate income rising strongly. And we did get an initial knee-jerk reaction. Households went out and spent at a 4.4 percent annual pace in the fourth quarter. But that—what was surprising was that that pace didn't continue in the first quarter, even though gasoline prices had dropped even more sharply before bottoming in the first quarter.

And what we found was that household sentiment surveys were telling us that households said, "OK, I felt great when gas prices first started dropping, but now I'm skeptical that gas prices are going to stay low. As I know, they can just turn up tomorrow and race back higher. And so maybe I should start taking that gas savings and putting it toward paying down debt, getting ahead on bills instead." Why? Because you don't have that strong wage and salary growth as a foundation for your household that makes you treat those extra gas savings as just simply extra.

What's encouraging is that just of late in the surveys we've seen household financial expectations start to pick up again. And households are saying, "Wait a minute. Now gas prices hit bottom, but they stayed low. And so we're becoming more convinced that maybe lower gas prices are here to stay for a time." And so that is—that alone is going to give them more confidence to go ahead and maybe let go of some of that gas savings; spread it around the economy a bit.

On the back of that, we think we are getting the stronger wage and salary growth, which is going to then give you that effect of permanent income and confidence around that (inaudible). So we don't think this high personal savings rate that we got in the first quarter—I mean, it jumped in one quarter by one and a half percentage points. We don't think that's going to be sustained throughout the year. We think it's going to float back down and return by the end of the year somewhere close to the 5 percent that it's averaged over the past couple of years.

And so to me that's—that's encouraging for the outlook when we look the next few quarters out, that growth—another piece of the puzzle of why we think growth will be stronger beyond this surprising first quarter.

MALLABY: Jeff (ph); microphone coming.

QUESTION: (inaudible) Insight.

I'd like to hear a bit more—you talked about its impact on the first quarter—about energy market—supply, demand and prices going forward and their impact on the U.S. economy. And in particular, if we do continue to increase supply, is part of the exchange-rate story in the end going to be not just the Fed, but the Dutch disease?


MALLABY: Who wants to take that?

ALEXANDER: Wow—Dutch disease in the U.S.

FISHER: Jeff (ph) who?

ALEXANDER: It's—the numbers on what's going on in—what has gone on in the energy sector in the U.S. on the production side is pretty impressive. So we are now producing at a level that is higher than at any time since sort of the peaks we reached in the early 1970s, and the acceleration and production over the last couple of years has stripped—has gone well beyond what people expected.

Now, there are a lot of uncertainties about this. This is driven by kind of a new technology. And one of the things that has driven this is, as we've done this hydraulic fracturing in shale oil, we've gotten better and better at it. So part of the reason this has been such a surprise is we haven't actually increased the number of wells we're drilling, but the amount of oil you're getting out of the wells you're drilling has continually gone up.

But there's this other phenomenon, which is these wells—the rate of deterioration once you drill them is very high. And so it seems like we should expect a more—a more kind of direct connection between drilling activity and production than we've seen in the past.

That's important, because we've seen this collapse in drilling activity. Most of these projects seem to have a kind of green-field breakeven rate somewhere between $55 and $80, which is kind of the range we're in. And so we've, you know, cut the recount (ph) by 50 percent. That is going to have an impact on production relatively quickly, more quickly than it has done in the past.

So we're in this kind of interesting place where the drilling activity actually has more effect on moderating global supply and demand balance than was the case in the past. In the past (inaudible) once you drilled the well, it would produce forever and, you know, you kind of got that capacity, like, basically prices had to move to clear it. It's a kind of different dynamic now.

It puts the U.S. in this kind of odd position where we're oddly hedged to oil prices. So as kind of the work we've done kind of suggests the benefits you get from lower oil prices is sort of offset by the negative effects of what happens in the sort of drilling activity, and in a sort of weird way.

You know, if oil prices were to collapse from here—well, on the one hand, it'd be good for consumers, ultimately. But on the other hand, we'd lose a lot more drilling activity. On the other hand, if oil was to go back over $100 a barrel, you'd kind of lose out on the consumer side, but there—you know, we'd ramp the rig count up again. And in a kind of weird way, we're oddly kind of balanced in that sense.

It does have a big effect on the current accounts. And it's—I think it is a piece of what's going on with the dollar. I don't think it's the predominant piece. I think it's very hard from—I think it's much more a question of the Fed's hiking in a world where, frankly, the rest of the world looks at it, like, in a very different place.

One of the things I would just stress in terms of the dollar, if you just look at the divergence in terms of what major central banks are doing, you have, you know, the two primary other central banks, Japan and Europe, doing the most expansionary thing you can imagine them doing, and the United States, we're talking about raising rates. I don't think, in that environment, you need to go very far to kind of understand what's going on with the dollar.

MALLABY: But putting together what you just said and what Ellen said earlier, the short-term impact on the forecast of the oil price coming down sharply is that investment reacts very fast. So you have a negative hit to GDP. And consumption takes a little while for consumers to be confident...

ALEXANDER: Yeah. It's complicated, right, as Ellen indicated.

ZENTNER: Right. That's the opposite of what normally happens.

ALEXANDER: Right. As Ellen indicated, you did kind of get an initial boost. There was a little bit of strength you kind of saw. So if I had to, like, do the balance last fall, I'd say it was modest positive. The investment contraction is going to be the first half of this year. We've seen it in Q1. It's going to extend into Q2, right. And so I think for that period it's going to be negative.

I think beyond that, assuming it stabilizes, it's probably positive, for the reasons Ellen laid out.


ALEXANDER: So it is a kind of—the timing of it does matter.

MALLABY: Another question. Yes, over here.


MALLABY: Microphone.

QUESTION: (inaudible) still JTS.


Do you think the realignment of the government in Saudi will affect energy going forward?

ALEXANDER: I'm certainly not an expert on Saudi politics, but what I—I think what you've seen is continuity. And—well, like, before—I mean, first of all, it's the same people that seem to be in control of energy policy, number one.

Second of all, they clearly have had a strategy of saying we're not going to be the swing producer. So they clearly made a choice and said they're not going to be the ones that are going to keep oil at $100 a barrel. And they have continued to sort of pursue that—go down that line.

So I think it's more continuity than change. But as I say, I'm no expert...

MALLABY: Generally what I have heard from CFR colleagues who follow Saudi—I'm hearing on the—not the oil side, but on the sort of political side, quite a lot of concern about, you know, Yemen is the sort of Saudi Vietnam. Getting sucked in there would be a huge mistake. This young team—the defense minister has just been promoted; no experience, trying to prove himself. Saudi wasn't super-stable in the first place.

So I think that's—to me, that would be the channel. It's not directly on oil policy itself. It's, like, does the political question feed through into their ability to be stable (inaudible)?

Another question. Yeah.

QUESTION: Hi. Ignacio Ruiz from Moody's.

If we can go back to Asia for a moment, I think it was in The Economist that I recently read the piece about how personal debt has gone up recently in several of those economies; quite a few.

I wonder if you have a view as to how solid their household balance sheets are and if you expect—(CLEARS THROAT)—sorry—some kind of correction on that front and what that would do and how much it may impact the global economy.

MALLABY: Household balance sheets in Asia was not on my cheat sheet.

ALEXANDER: We didn't...

ZENTNER: That wasn't (inaudible).

(UNKNOWN): How about (inaudible) Lew do it?

ALEXANDER: I will—I will say something that is maybe relevant to the question you asked without actually answering your question.


One of the things I've done recently is kind of look at broad credit trends around the world. And one of the things that is striking is that what you see in the industrial world, there has been a correction. But you've seen this tremendous growing in the emerging world, particularly in Asia. And if you ask me, from a broad sense of credit trends, as credit as a leading indicator of sort of risk in the financial sector, where do you see it? Asia leads the list.

And so I do think there are good reasons to be concerned. If you look at a country like Korea, Korea has a long history of having kind of high household debt. It's been a problem in the past. Korea actually isn't one of the ones that has sort of led the growth.

The places where you've seen the strongest growth are places like Hong Kong, where the numbers are really quite striking. You've seen this tremendous acceleration of debt. It comes at a very high level. So in the case of Hong Kong, you have a case where the credit provided to the private sector, both household and businesses, has grown very—is both growing very rapidly and is very high.

Obviously it's a financial center, right. But you see that around other countries as well, including Indonesia, Malaysia, to a lesser extent in the Philippines. But I do think that is a broad issue that is one of the things I worry about. And so if you think about the broad question of if we're going to have a tightening of financial conditions that starts with the Fed, where are the risks, I would certainly put that one of the risks is finance in Asia.

FISHER: If I could just reverse roles with Lew for a moment, if you'd asked me just independent of cycle, what would be something good to happen in China that would help grow household consumption, it would be to have households use more credit, not go around with paper bags full of cash when they go to the hospital or go buy a car, but actually have a sense they can lever off their future income. That's one of the things, among many, that's held back consumption as a share of GDP and has held back services in other things.

So we're starting from a low base. But given it's an early part of their cycle for them to get into household credit, they're likely to singe their fingers.

ALEXANDER: Yeah, that really was a reversal.


FISHER: See, Lew got very uncomfortable.

MALLABY: I have time for one...

FISHER: (inaudible) Lew.

MALLABY: ... one last question. Right here, yes.

QUESTION: Betty Marchand (ph), (inaudible) Holdings.

Nothing's been said about the impact of the Middle East wars on our economy and the need for our next budget to take into effect how we're going to help rebuild some of these failed states. So would you comment on the Middle East?

ZENTNER: I know Lew is an expert in that area.


I'll just—I'll just...

ALEXANDER: Thank you, Ellen.

ZENTNER: He seems to be in all areas non-U.S.

ALEXANDER: (inaudible)

ZENTNER: No, the—but I will add, before Lew, just that—I'll tell you one way for GDP accounting that is affecting the U.S. is that fiscal—federal spending is actually a slight positive for GDP this year, and a lot of that is coming from an expansion of defense funding.

So in that sense, in GDP accounting, it's a slight positive for the U.S. economy.

ALEXANDER: Yeah, let me—let me talk about it as an economist who thinks about the U.S. economy.

The first thing I would say is if you think about how what is a horrible situation in the Middle East sort of affects the U.S. economy, the most direct effect is oil. And in an environment where we're—you know, we've just had a dramatic collapse in oil prices, it's hard to get too excited about that. So if you ask, like, the most direct question, "Why aren't people more concerned about chaos in the Middle East?" the answer is the most obvious and direct channel doesn't seem all that threatening.

And as I sort of mentioned earlier, the U.S. is kind of oddly balanced with respect to that. So imagine, you know, worst-case scenarios—close the Strait of Hormuz; Brent goes to $200 a barrel; like, great for—you know, great for Oklahoma, Texas and North Dakota, right. And so it's—it has sort of those effects.

I think, in terms of the budget, regardless of what one thinks of as the right policy, I'm skeptical that you are going—that our political system is going to generate a large acceleration in defense spending. I just kind of look at the politics of this and, like, I think, you know, a good outcome would be arrest the rate of decline, right.

And so I'm skeptical that we are going to—regardless of what you think is good policy, that we are going to put into our budget a lot of money to fix the Middle East.

MALLABY: (inaudible)

FISHER: In the spirit of that, I think, again—let me end where we began, with my historian 500 years hence. If you'll permit me, I think they're going to look back and wonder why it was not better recognized in the West that World War III took place in Africa and then it sort of spilled over into the Mideast. And we just haven't thought about it that way.

But in terms of lives lost and wars fought, it's certainly of the right scale in terms of genocides and other things; first Africa, now spilling over into the Mideast. And—but because we don't have a consciousness of it, we're just not going to have a Marshall Plan. We don't think of it that way. And we're more budget-constrained.

And so I want to sort of—I'm agreeing with Lew here. It would be nice to think we would do something, a Marshall Plan for the Mideast, but peace hasn't broken out. So it doesn't look like that's going to happen.

But back to home, 50 percent of the Pentagon's budget is for health care. So 50 percent of what we think of as going to our nation's defense is paying for the health care of the civilian and military labor force that works for the Pentagon. And that fact is completely obsessing Pentagon planners right now. They're hitting a wall.

So when we talk—when the budget cutbacks come to them, what do they do? And so this constraint, it's real and it's across the federal government. And for me it's a thematic, what we're spending in terms of support for consumption. However valiant we think health care consumption is, in terms of GDP, we're handing out lollipops.

MALLABY: I'm about to be accused of being as lacking in discipline as the American entitlement programs.


So I'm going to stop this right now.


MALLABY: Thank you to all three of you.



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