Uncertainty in Global Markets: Oil, China, and the Fed

Uncertainty in Global Markets: Oil, China, and the Fed

Sergei Karpukhin/Reuters

More on:

Global

Economics

Energy and Environment

from World Economic Update

Nomura Securities International’s Lewis Alexander, the Financial Times’ Gillian Tett, and the American Enterprise Institute’s Vincent Reinhart join CFR’s Sebastian Mallaby to discuss recent developments in the global economy. By focusing on the three current seeds of uncertainty in the markets—oil prices, China, and the Federal Reserve—Mallaby guides the three experts in a  discussion about global economic trends.

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

MALLABY: OK. Thank you to everybody for coming. Good morning. I’m Sebastian Mallaby. I work here at the Council.

Next to me I have Lewis Alexander from Nomura; Gillian Tett, U.S. managing editor of the Financial Times; and the tireless fellow over there is Vincent Reinhart. I thought, when I saw Vincent, that it must be that, having watched the populist votes come out in strength in Iowa, you know, that fury against tie-wearing individuals, you’re kind of going with the flow. (Laughter.)

But Vincent has a story that he swears by that, you know, he went to a restaurant. He gave them one suitcase. At the end of the meal he gave them the other one. He didn’t somehow notice. He wakes up in a hotel room. It’s the wrong suitcase. There’s no tie in it. We believe it. We do believe it.

REINHART: The clothes were better, actually.

MALLABY: (Laughs.)

REINHART: It felt wrong to ruffle through the—

MALLABY: So in many of these World Economic Update discussions, we kind of go around the world and discuss different regions on their own terms. But I feel like the last month, despite a good day for the markets on Friday, has been unusually the case of, one, where everything is sort of knit together; that global markets are responding to three kinds of worry—the oil price, the China uncertainty, and the debate around the Fed’s potential next moves and the U.S. outlook.

And what strikes me also is that if one wants to play devil’s advocate a little bit, each of these things would appear to be sort of exaggerated fears. So China has real issues, but the government has enormous ammunition to deal with them. Oil is supposed to be—a low oil price has winners and losers, but there are winners, so why is it such a bit deal? At the Fed we’re talking about, you know, would it be tightened by 25 basis points, 75? But the magnitude doesn’t seem, on its face, to be big enough.

So I guess the question I want to get at bit by bit in this discussion is whether there’s an overreaction.

We’re going to start with oil. We’re going to start with Gillian. So Gillian, the standard view would be that a low oil price would be cause for economic worry if what you’ve got is basically weak demand, because, of course, weak demand would be a symptom of broader issues. But it seems to me that in this case supply, strong supply, is at least sort of three quarters of the issue, whether it’s the failure at OPEC to agree on output restrictions, Iran rejoining the market, shale, and so on.

What’s your take on this? Why is this weak oil price upsetting the market so much?

TETT: OK. Well, first of all, thank you for having me along today. I feel a bit of a fraud, because as a journalist I’m used to asking the questions and hiding behind rude questions rather than having to actually answer them myself.

But when I look at the oil price, what I see is not just an oil price, but the oil price as a symbol for the fact that when you try and make sense of what’s happening in the world today, economics is not just about economics and not just about numbers. In particular, I think we need to recognize, when we try to make sense of what’s spooking investors, we need to recognize that we have to join up any macroeconomic analysis with finance and macroeconomics with politics. And that sounds like an incredibly obvious thing to do, is something that was widely forgotten pre-2007, and even today I think many investors are pretty unprepared for doing it in its totality.

And by that I mean two things. When you try and work out why a low oil price is spooking investors, it’s partly because we’ve replaced a Western credit bubble—subprime mortgage bubble, if you like—with a second bubble created by central banks, QE, which essentially much of that money went not into the West but went into the emerging markets. And what we’re seeing now is that bubble begin to implode. The factors coincided with weak oil prices is putting a lot of pressure on a lot of emerging-market countries.

And so those two issues are wrapped up in the minds of many investors when they look at what’s going on. So people aren’t just fretting about low oil prices. They’re fretting about the knock-on impact on a number of countries, whether it’s Russia, Nigeria, Brazil, et cetera, et cetera.

And secondly, when you look at the oil price, oil price has always been about politics, and unpredictable policymaking and fantastically opaque policymaking in terms of OPEC. The only thing that’s worse than an opaque cartel is an opaque cartel that’s broken down at a time of great geopolitical uncertainty when nobody’s in charge. And that, coupled with the oil price, I think, is one of the reasons why this is spooking investors.

So the key point is—I read a bit recently about siloes, so apologies for plugging it, but we have to get out of our silo thinking. We have to recognize that economics, finance, and politics is very, very tightly entwined right now in a way that most investors are not used to trying to analyze. And the oil price is really a fundamental symbol of that nasty trifecta that we’re trying to get our heads around.

MALLABY: So Lewis, the way I hear Gillian’s answer is sort of, in a way, confirming of my hypothesis, which is that there’s a lot of mood music, a lot of politics around the oil price, which is spooking people, but the oil-price shift in and of itself doesn’t logically lead to great uncertainty.

But you’ve argued at these meetings before that there is a sort of time thing here where investment crashes by oil producers faster than consumption picks up. Is that what we’re seeing?

ALEXANDER: So, yeah, let me say a couple of things about that. First of all, when you talk about the oil price, it’s supply; it’s not demand. I think you have to distinguish two things. The fact that we’re talking about numbers in the 30s as opposed to $100, which is where we were a year and a half ago, that’s clearly predominantly a supply issue.

But if you look forward and ask the question what is actually going to sort of establish the new floor, it’s the interaction between supply and demand going forward. We’re in a situation now where the world is producing more oil than it’s consuming. And the basic question going forward is what is the process that’s going to bring that back into balance. And that is going to be some demand and it’s going to be some on the supply side.

And so I think this question is about sort of what’s going on in the emerging world. And that growth story is very much a part of that, even though, in the broader sense, yeah, we’re dealing with a supply shock. So that’s one thing.

Second of all, I do think, when you think about the benefits and costs of lower oil prices, you do have to think about the decline in investment that’s associated with a much lower oil price. We have seen a collapse in drilling activity in the United States. We’ve seen pull-backs in major development projects sort of around the world, anywhere where there’s a producer. That has happened, I think, much more quickly than people expected. And in many ways the downdrafts from that, I would argue, have been stronger than the benefits from lower prices for consumers.

I would argue very strongly for the U.S. that lower oil prices last year was a negative for the U.S. economy. I think that is going to continue to be the case through the first half of this year. It works partly through what’s going on domestically. It works partly through our exports to places like Canada.

Now, obviously if you’re talking about someplace like Europe, where it doesn’t really have a domestic-production side, it’s a bit of a different story. One of the puzzles, I would argue, over the last year and a half is the fact that even those places that are purely—it’s purely—ought to benefit from it, those effects don’t seem very large. And I think there is a bit of a puzzle there. But I don’t think it’s that hard to sort of explain sort of the role of oil in this world.

MALLABY: So Vincent, I guess part of what Lewis is saying is that there’s a timing thing where investment reacts much faster. But there’s also a debate, I think, about how—the old wisdom on oil was that when you shift—when you have a transfer through low prices from producers to consumers, the consumers spend the windfall more than—the effect that the elasticity is bigger on the consumption side.

That may be changing, I think, with producers who used to maybe smooth the effect of the low oil price by spending down savings. They don’t have that much in the way of savings anymore to spend down. Sovereign wealth funds are being liquidated rather quickly. Saudi Arabia’s budget presupposes an enormously high oil price just to break even. So, in other words, there is a reduction in demand from this lower oil price that offsets the increase from consumers.

REINHART: Well, what you’re seeing is base effects matter. And if your rule of thumb was generated somewhere in the mid ’80s or the mid ’90s, it doesn’t quite apply when the U.S. is such a large producer. And that gets you the temporal effects, that, yes, on net, consumers benefit from lower energy prices. It’s a reduction in an excise tax. But by and large, when you look at the incidence of that tax, it is on lower-income households, who are basically hand-to-mouth consumers. They’re not going to benefit from that till they actually have to spend less at the pump. Well, they actually don’t spend less at the pump until the middle of the driving season, you know, in the middle of the year.

The producers, in the U.S. in particular, are more forward-looking or they’re more—they’re forced to be forward-looking by their sources of funding. And an important aspect of the contraction that Lewis noted was exactly that credit got harder to get if you were—you know, you were an oil producer.

The other aspect to recognize is, you know, in the discussion, is this supply or is this demand? We don’t know either. And it’s reasonable, when you see a big change in price, to impute some to both. And so part of the reaction is, OK, it’s probably supply, but does this actually tell us that China is weaker than we thought? And that’s more important in spooking markets than the effect on the price itself.

MALLABY: Go ahead, Gillian.

TETT: I mean, when it comes to trying to look at the micro—the macro-level implications in a country like the U.S., both on consumers and producers, you know, I think there’s a crying need to do right now what wasn’t done in the last credit bubble, which is to get out—wear out the shoe leather and go look on the ground at what’s actually happening in terms of changing patterns of behavior. Because I think the question about the degree to which consumers are unwilling to spend a cash windfall, given the debt overhang, given the memories of what happened in the credit crisis, is fascinating and I think hasn’t been studied enough.

But also the question of what the producers are doing right now is fascinating, because as you start digging into what’s happening to many of the shale oil and gas exploration companies, you know, one thing that may be incredibly important in this cycle is the fact that a lot of this debt—a lot of these bonds were sold with very few covenants. It’s very hard to see what’s going to be the trigger in some cases of actually creating bankruptcies, a kind of cleansing process you’d normally expect with American capitalism.

You may be heading for a world of zombies for quite a while while people, you know, stagger on and where the banks don’t actually do anything. And that again could change the equation. I mean, some of the patterns and models seen in earlier cycles aren’t quite so applicable this time around.

MALLABY: And that raises, Lewis, I mean, the general question about the financial spillover effects from this oil-price adjustment. I mean, some of what may be going on is best understood, you know, demand and how it’s affected on consumers and producers. It’s just simply portfolio effects, where, you know, Saudi Arabia’s wealth fund is dumping assets around the world. Malaysia is selling property in London. A whole bunch of high-yield bonds are now yielding a lot. (Laughs.) They’re really high-yield.

What do you think of these financial spillover effects?

ALEXANDER: So they’re notable. They’re getting larger. And I think they’re at a point where you do have to think about it in terms of the outlook for the global economy.

I want to stress very strongly, though, that this is not 2007 or 2008, but, you know, we’re seeing a tightening of financial conditions through credit. We have—six months ago I would have argued it was much more concentrated in the energy sector itself. It has broadened out since then. You’re starting to see it in some of the survey measures of credit availability.

So, say, for example, small businesses are actually reporting that it’s harder to get credit. We think that is related to some of the questions that are coming back on banks. But I think when you kind of dig into it and look at the magnitude of these losses, they’re material but they’re not things that I think are going to sort of disrupt the system.

You bring up the point about sovereign wealth funds. And you’re absolutely right that, in some sense, official accumulation of financial assets, whether it be central banks or QE or reserve accumulation by emerging-market economies, either directly or through sovereign wealth funds, has been a big deal. And we are going through a period when those things are changing. And that is very much changing.

In some sense that’s part of the financial volatility we’re dealing with. But I think it is going to have an impact on the outlook. But I think it’s—I get a little hesitant sometimes when we kind of start hearing people talk about this is another sort of big financial crisis. I think it’s hard for me to get to that.

Gillian, just in terms of how quickly the correction is going on in the U.S., I’m struck by the fact how quickly the actual production side on the investment is—sort of just look at the drilling activity. It’s collapsed. And that is—I think that is something where the real effects of these changes are happening very rapidly. And, yeah, it’s going to take some time for people to—the investment bankers to figure out, like, how this is all going to go. But I don’t think—as I look at that sector, I don’t think that there’s some obstacle to adjustment, but if anything it’s happening very quickly, as it should.

I guess I’m a little more convinced that it is a supply story as opposed to the way Vince did, and just in the sense of if you look at—you go back over the last five years and ask where have the surprises been. You know, there are forecasts for demand and supply. The thing that’s sort of been overwhelming is the upward surprises in production in the U.S., right, and that if you go back and ask how is the world different today than people thought it was going to be, the biggest single thing you see that’s different is U.S. production is just a lot higher than anybody thought. And I think that affects—

MALLABY: And OPEC not coordinating.

ALEXANDER: Well, but to be perfectly frank, OPEC hasn’t been coordinating since 1985. Since 1985—effectively since 1985, it’s been Saudi Arabia.

MALLABY: OK. But Saudi Arabia stopped playing that role in October 2014.

ALEXANDER: But partly it was because they looked at what was going on in the U.S. and said, on the one hand, you’re seeing a major technological change in the U.S. It’s increasing production. Potentially that technology has the potential to go other places, number one.

Number two you’re also seeing the whole climate debate happen. And if you’re sitting there in Saudi Arabia, with the most reserves in the world, you’re asking yourself the question, like, what are these reserves really going to be worth over the long run? And so it’s—there are a bunch of things that are going on. I think it is more—I don’t think of it as an OPEC question. I think it’s a what is Saudi Arabia’s strategic perspective, which is not—I think of that as different than—from OPEC, say.

REINHART: Which is not just an economic-policy question. It’s also a foreign-policy question.

ALEXANDER: Sure. Of course.

REINHART: And my only point was we don’t know anything about demand. And so, therefore, it’s reasonable to wonder about demand in an environment when you see such a significant change in price.

ALEXANDER: Sure. And going forward, it’s very important.

REINHART: So Carmen, a co-author, and I, for the most recent American Economic Association papers and proceedings, looked at 200 years of capital flows. And what I want to emphasize is this really is a double bust we’re living through. It’s not just that commodity prices have weakened, and not just oil prices. It is many commodity prices. But emerging markets are getting less capital inflows. And the best predictor of subsequent sovereign defaults is a double bust, when commodity prices crater and capital inflows stop.

TETT: Which goes back to my point that basically this is a trifecta of finance, economics, and politics, which are basically crystallizing around the oil price and make it so unnerving for investors.

But I’d make one other point following on from Vince’s point, which is that, you know, it’s going to be the unpredictable contagion effects that really create shock this time around. So the fact that sovereign wealth funds are selling assets all over the place in some surprising ways is one of the areas that’s creating ricochet effects through the markets.

Secondly, of course, to hammer home the point that bankers keep making, the market structures have changed significantly since 2007, partly because of regulation. We don’t have market-makers in the market to the same degree. The potential for volatility and crowded exits is incredibly high, and that could add to the sense of unexpected shocks ricocheting through the markets and creating more contagion.

MALLABY: Let’s move to China, the second thing which I think has been spooking markets a lot in the last month. Lewis, in the past you’ve said at meetings like this that you fully expected, in the course of your career, to deal with a financial crisis that starts in China and goes worldwide but that you didn’t expect it quite this soon. Do you still think it’s not here yet?

ALEXANDER: My base case would be that, yes. I don’t—I still would argue, as bad as the adjustment is there, the financial system is still fully backed by the government. I think you have to make a judgment about what the fiscal capacity of the government is relative to potential losses. I still think that suggests that they have enough to control this and that this isn’t the moment for that to happen.

Having said that, there’s no question the risks have gone up. And I don’t say that—I don’t feel that as strongly as I would have felt earlier. And I think it’s something to watch. Look, I think it’s—the transition that China is going through is a very, very, very, very important one. Obviously it’s just slower growth, but it’s also the composition of that ground. So a lot of the weakness in commodity prices is related to the fact that not only is China growing slower, but it’s growing—it intends to grow in a way that is less resource-intensive. And that has these very broad implications.

And I would argue a big part of what financial markets are dealing with is just getting used to the notion that we used to have a world where China was growing, you know, 8 to 10 percent and, you know, in a way that was very resource-intensive. We’re transitioning to a world where those growth rates are going to be notably lower. And realistically, looking forward, there are going to be—you know, we think they’re going to be sort of rounds to 6 this year but going lower.

You just sort of do the math on those things and it makes a big difference on long-term asset prices. And I think markets are going to take a while to get used to that. You add to the fact that it’s not just China. It’s the fact that potential growth pretty much everywhere you look, with the possible exception of India, is slower. It’s demographics. It’s productivity. And in addition to that, you’ve got the Fed that is trying to transition the U.S. from having grown faster than potential to growing potential.

I think you’ve got an environment where things are slowing for a whole host of reasons, and markets are having trouble figuring out exactly how to go from the old world to the new.

MALLABY: So Gillian, Lewis’s base case is still that China doesn’t get into more of a crisis. I guess one set of people butting against that are those who are shorting the currency. There’s been coverage in the FT and elsewhere about Soros and others taking big positions on that.

How do you think that ends up? Is this a one-way bet that the speculators win, or is it one where the government has the ammunition to squash them?

TETT: It all depends on your time scale, you know. In the short term, I think the speculators probably won’t win. In the long term, the government has a lot of challenges. And when I look at China, what hits me between the eyes is the parallels between—with Japan in the 1970s and ’80s in the sense that, you know, as with Japan, you have a country which has enjoyed very rapid growth on the back of channeling its financial resources towards industry, providing cheap labor to industry at the expense of consumers, using essentially a state-controlled financial system; a kind of war-footing economy, if you like, in financial terms.

And the economy, as with Japan, has outgrown its financial system. The government has delayed reform until far too late. There are some very big, painful transitions that have been made, which it’s started. But right now China, like Japan, finds itself in this transition point, this limbo land, where you can neither trust markets as being a good signal of value and pricing nor can the government control things by fiat anymore and control the price of money simply by ordering things via bureaucratic diktat. So it’s kind of in this horrible limbo land.

What we saw from Japan is that this creates bubbles. It can go on for quite a long time. What we also saw from Japan is that what’s very pernicious is not the fact that a bubble bursts. It’s when the bubble bursts and you get deflation. I mean, the Japanese financial crisis became very nasty because of deflation. Thus far China doesn’t have it on any significant scale. But if that occurs in the coming years, that’s going to be very nasty indeed.

MALLABY: Vincent, part of what’s going on, it seems, is that the Chinese, if they want to exert control on capital outflows, partly driven by their own citizens, need to crunch down politically. The more they crunch down politically, the more they incentivize people to want to get money out. How do you see this playing out?

REINHART: Well, it’s the problem of either interest-rate or control defenses of capital flows. It just makes it worse. It just increases the incentive for the private sector to try even harder to get the capital out, particularly if you see this as a medium or longer-term issue.

Look, it’s a middle-income growth trap for a reason in that it’s very difficult, in a controlled system, to get—as you develop a middle class, the middle class wants some control of their own balance sheet and they’re restive about corruption. But that’s exactly contrary to forced allocation of capital across a big continent. And so the very tiny tip of a pyramid—that is, the officials in China talking about, you know, 1.3 billion people—have to figure out how to give some measure of control of balance sheets and some economic freedoms to their burgeoning middle class and still keep in charge. And that’s a very difficult transition.

TETT: I mean, the thing that’s fascinating and potentially tragic about China is that I would argue never before in human history has a group of policymakers been quite so self-aware and reflective and thoughtful about the parallels of history. I say that because a few years ago I wrote a book about the Japanese financial crisis and the lessons from Japan’s history, which became a bestseller in China. And it was kind of nice, except for the fact that no one in China actually ever bought the rights. (Laughter.) It was entirely pirated. But, hey, it became a bestseller. Somebody somewhere benefited.

But anyway, a stream of Chinese officials came to see me afterwards, asking, well, we’ve read about, you know, Shinsei Bank, about all these Japanese banks. We’ve read about the story of the Japanese bubble and why it burst. We can see the parallels. How do we avoid it? And I spoke to official after official after official about the parallels. This was about 10 years ago. And yet the reality is China is where it is today.

And so the fascinating question is, you know, with all these super-smart Chinese officials who’ve been educated, you know, in American universities, who are so self-aware, so smart, probably some of the smartest policymakers on the planet today, can they actually avoid the crunch?

MALLABY: Well, I think discouraging people from reading financial history is a very bad idea, Gillian. (Laughter.)

TETT: I’m quite sure that China will pay you for your rights.

MALLABY: (Laughs.)

TETT: And if you want a sign of how China is growing up, my book 12, 13 years ago about Japan basically was pirated, and I got no advance at all. The second book I got a tiny advance, which at least was token. And the third book I got—you know, it was a slightly better advance. So China is growing up in terms of copyright. (Laughter.)

MALLABY: This is a measure of change in—

REINHART: So there’s history—

TETT: I’m sure your advance will be bigger than mine.

REINHART: This family experience on financial history, and one that was relevant, is in Carmen—my wife Carmen and Ken Rogoff’s book. They talked briefly about the default of Japan and immediately got comments from ministry officials. No, we would never have defaulted. And they—and Carmen just sent a front page of The New York Times from that snapshot saying, you know, “Japan defaults.” There’s just a different understanding of history, you know, in the two. But there’s also just a question of, again, yes, they’re as smart, as well-educated, self-referential, and all those. But it is the top—the tiny, tiny top of a pyramid.

They’re trying to manage the biggest rural-to-urban transfer of people in world history. That is hard to do. And you don’t necessarily control that. And in some sense, I think the concerns about equity prices in China is a part just how much are officials really in control.

MALLABY: Lewis.

ALEXANDER: I don’t know the answer to Gillian’s question, but let me give you a perspective of an outside forecaster. The thing that makes it so hard is I do not understand the government system. So, I mean, the inherent problem is I think we’ve all had contact with very smart Chinese in one form or another. The problem is, as I look at the place, I don’t understand how it works. I don’t understand how they make their decisions.

And if they are going to open up the system to more market forces, which effectively is what they’re doing, they are going to be subject to this problem, right. It is—and the inevitable aspect of financial crises, which is there are transitions from a period of confidence to adverse selection, where you go from thinking you understand it and kind of going this all looks good to, oh, my God, it’s not what I thought it was.

At that moment, like, the crucial question is how quickly can you get to the point where you feel you understand what you’re doing? So in my experience with emerging-market crises, the critical moment is when can you credibly define the down side? Like, when do you get confidence that you know enough that you know how bad this could be?

The problem in China is, because I do not understand the process of how they make decisions, the data questions—look, economic measurement is always hard. It’s particularly hard in an economy that’s changing. But they face this problem that as long as things are going well, it’s kind of OK. But at some point we’re all going to have to look at this in a very hard way and ask ourselves—we’re going to have to get comfortable that we understand what the down side is. And it’s going to be very hard to do.

TETT: Coming from, you know, Nomura Securities, you know, remember back to the 1980s and 1990s in Japan, “The Enigma of Japanese Power.” People thought they knew roughly how Japan worked, and then suddenly that was ripped apart. And that added to the sense of crisis.

MALLABY: So a very fat book called “The Enigma of Japanese Power,” which many people bought and few people read—(laughter)—was one opaque system, China another one.

But the Fed, just to quickly segue and get to that before we open up for questions. You know, the Fed has made a big effort to be more transparent, more open, more readable. And yet, the grammar and syntax of the Fed’s decisions have been, you know, parsed. And I’m not sure it really delivers the certainty that people expected of this big communications experiment. Maybe we’ll go to Vincent for this. I guess the question here is, are people overreacting to this? The speculation around the Fed seems to drive markets. When we’re talking about 25 basis points either way, the markets are chasing their own tails?

REINHART: So do you feel well-served by the increased transparency of the Fed—(laughter)—and the face that a typical FOMC statement now reads where you need a graduate-level education to understand it? I mean, that’s a big issue. I think more than anything is the sense that Federal Reserve officials really are sincere when they say all decisions are data dependent and made meeting-by-meeting. They don’t want to contract to a path for interest rates because the world’s too uncertain, and that markets react in ways that are not consistent with sustaining financial stability when you contract to a path for rates.

So they’re out there saying all decisions are data dependent. They are made meeting-by-meeting. But an important thing to remember is Newton’s law. A body at rest stays at rest. A body in motion stays at motion. They waited a long time at the zero lower bound, probably overstaying the time at the zero lower bound because it’s hard for a group to come to the decision that let’s all—let’s all decide to raise rates. They had to be completely convinced. Once they’re completely convinced, it means there’s probably a little bit of catch-up to do. They understand that they waited a little too long. And that same process of having entered a tightening regime makes it hard to decide to stop the tightening regime.

So I think the short answer is markets probably have overreacted to the sense that the Fed won’t raise rates anytime soon. They’re in a tightening regime. And so they have to be convinced not to raise rates. And that’s a higher hurdle.

MALLABY: I’m ready to go to the floor, but if you want to—I want to give both of you a chance to say something about the Fed is you would like to.

TETT: I just want to say one thing briefly, which is another way of saying what Vincent has expressed, is that the Fed has tried to be both data dependent and time dependent over the last couple years. And many markets have been acting as if they hoped that it could do that—i.e., say it’s going to depend on the data, but actually raise rates within a certain time frame. And that’s clearly impossible if you don’t know what the data is going to say.

MALLABY: Yes. Yeah, OK.

REINHART: Financial market participants are way more needy than the economists at the Federal Reserve are willing to provide.

TETT: Like a teenage girlfriend.

MALLABY: So with that, I want to invite members to join the conversation. Just a reminder that this is on the record. So if anyone has a question, please raise your hand. And if you don’t, I’ve got some more. Yes, I can see one right over there, Jeff. The microphone’s just coming.

Q: Jeff Shafer.

Let’s focus a little more on the U.S. For three or four years now productivity growth has been running about a half a percentage. Are you in the camp of people who think it’s going to turn out reasonably, or are we going to live with this for quite a while? And what do you see as the implications for the course of the economy and inflation?

MALLABY: Who wants to take that?

ALEXANDER: I’ll take a go. I’m of the view that the best way of forecasting productivity is as a random walk. (Laughter.) We have a—we have a lousy record of forecasting these things. I suppose another way to say it, is if you look back over the last sort of 50 years over which we have the best data, there really have been two regimes. There’s been a kind of high regime and a low regime. And what we really do is we seem to back and forth occasionally between them. But we don’t really have a very good understanding of how we bounce back and forth between those two regimes. And in that context I’m reasonably pessimistic. I don’t see a particularly good reason to expect it to go up.

The conundrum really is, you know, we kind of live in this world where there’s obviously a lot of technological change going on, and why doesn’t it show up in the numbers? That is a complicated question. I’m pretty convinced that we’re not missing a lot of income. So there’s obviously lots of complicated measurement issues. I don’t think it’s that there’s a lot of income being generated that we’re not capturing, which means if there is a mismeasurement it’s between the split between prices and real quantities. And it may well be that there’s actually more real—there’s more real stuff being produced and less inflation than we thought. But when you kind of dig into that, it’s hard to—it’s hard to really nail that one down in a way that feels compelling.

But the bottom line is, we aren’t generating tremendous nominal income growth. And I think that’s a problem. And I do think it affects how I think about a whole host of things—potential output, where interest rates are going. It affects things like how you should think about long-run fiscal issues, because it kind of pushes you in that lower trajectory. So I do think it’s a very important issue. The people who are more optimistic, certainly it could happen that we should switch back to the high regime. There’s no particular reason to believe that that’s impossible. I just don’t see a particularly good reason to think that that’s the most likely think that’s going to happen.

MALLABY: A few months back we had Hal Varian, the chief economist at Google here. And I think the thing which emerged from his visit was partly that technology creates consumer surplus, which is different from products that you sell for money. And so you get a lot of benefits to consumers that don’t show up in any of these data, productivity or otherwise. It’s still doing people good.

Gillian.

TETT: No, I was going to say that’s absolutely, absolutely the case. In fact, the productivity statistic should be stapled or pinned to the desk of every single economist and journalist right now as a reminder of just how little we actually know about what’s happening in the grassroots of the economy in terms of, you know, the technological impact on the data. But there’s another factor which the BIS was recently looking into, and Claudio Borio, the chief economist, there put out a very interesting paper recently looking at the impact of the financial crisis, and the kind of hangover effect. And if you were looking for any reason why productivity may possibly begin to pick up in the coming years, it said: As this financial crisis affect starts to recede, some of the distortion that was created from the financial crisis on the productivity data may begin to fall out. Possibly, you don’t agree, but.

ALEXANDER: I’ve thought about that question for the U.S. And there’s been a lot of—there’s been a lot of work, very good microwork, that’s looked at can you—can you understand what’s going on in the U.S.? And I think the financial channel is one that people have looked at. And it’s hard to make the case, I think, on the U.S. side. But that feels very important. But one of the things that’s striking to me is the U.S. economy’s much less dynamic that it used to be. If you go back over 25 years of just sheer the level of turnover, so to call it creative destruction, was much higher. And that declined into the crisis. And that is not a result of the crisis. That is something that was happening before. And so I think there was sort of a broader set of things that are going on that are—that are kind of hard to explain.

Another interesting thing that’s sort of related is there’s a nice paper that was done at the board that just simply looked at the nonfinancial corporate sector and asked whether or not the nonfinancial corporate sector was a net user or provider of funds back into the statements and investments system. And the interesting result was that things seemed to change around 2001—again, well, before the crisis—where before that the nonfinancial corporate sector was a net user of funds, which is kind of what you’d expect. Since then, they’ve been a net provider of funds. It’s not just the U.S. It’s a global phenomenon. It’s another one of these things that I think’s related to sort of global savings and investment balance, since it’s related to why interest rates are where they are.

But partly it’s telling you that the investment opportunities that the nonfinancial corporate sector sees are perhaps not as great as you might think, or they’re different. So I am—I am struck by the difference between, say, Uber and the automobile industry, right? When people invented automobiles, you had to do a lot of real investment to sort of realize the idea. Uber, everybody already had a smart phone. They already had a car, right? You didn’t—you created this incredible business without actually doing any—much real investment. And I think that is a better model for kind of the world we live in. But it has to do with the nature of innovation today is kind of not generating the same kinds of things it has in the past.

TETT: But that should make the world more productive, not less.

ALEXANDER: Absolutely.

REINHART: No, we get technological innovation in the industries that don’t use a whole lot of capital. And therefore, they don’t generate the demands for goods, even as they’re making more good. But the first thing you’re supposed to, you know, teach in the very first macro course is GDP isn’t welfare. And so the fact that we don’t measure it well doesn’t necessarily mean that people aren’t living better. But by the way, if it is the fact that we’re producing more output than the statistics suggest, then the Fed is even shorter of its goal of price stability, because it means that prices are increasing a lot less.

And it isn’t just the U.S. experience. We started talking about China, but you know you look at the IMF’s World Economic Outlook, six out of seven of the countries have had their forecast of potential output growth marked down over the last couple years. And I agree with Lew and agree with Gillian, we have no idea what productivity is doing. There are different regimes. It’s hard to measure. But we are a lot more confident about demographics. And demographics are generally turning adversely.

MALLABY: Another question maybe? Otherwise I will ask one. I have one, actually, which is—OK, I see one here, OK.

Q: Michelle Smith.

This time last year we were reading a lot of concern that emerging markets had reached peak reserves. This year we’re reading a lot of concern about commodity prices and also about capital outflows. How much comfort do you take form emerging markets foreign reserves and their state and their ability to provide resilience to the challenges that emerging markets face right now?

REINHART: So I have three-quarters trillion dollars less comfort this year than I would have had at the same time last year, because foreign reserves can get blown through. And that’s what we learned in 2015. Carmen and I and a co-author just finished a paper that noted that the accumulation of foreign reserves across emerging markets is also associated with a slowing in capital investment. So if you accumulate safe assets, i.e., official investments, you are crowding out something. And that is productive capital—you know, productive capital. So emerging market economies are in a better position than they were. I don’t think there’s any question. You know, the stock of reserves is a buffer. But you can blow through that buffer pretty quickly and that buffer’s costly.

MALLABY: So just—to reframe the question—which way do you think the system is going to evolve? Because we’ve had this iteration where after the Asian financial crisis in the late ’90s, emerging markets responded by massive reserve accumulation to self-insure, because they didn’t want to do a Suharto and go cap in hand to the IMF, and then have a revolution. OK, so they accumulate enormous reserves. And most people say too much reserves. What do they need all these reserves for? And now we observe that in some cases it looks as if they can be blown through and they may not actually have been enough. So in the next iteration, do people just accumulate even more reserves in places like Brazil or Russia? Or what happens?

ALEXANDER: So I guess I’m not at the point where I would conclude that they’re not enough. I look at a country like Brazil that, as we’ve sort of said already, is facing kind of a historic challenge, right? A significant—a historically significant change in terms of trade. So Brazil is a kind of commodity-driven country. And it’s facing, like, an incredibly serious domestic political crisis. But I did my dissertation on the Latin debt crisis, and have kind of followed it over the years.

Frankly, if you would have told me, you know, major, major political crisis and generational negative terms of trade shock, and asked me what would have happened to Brazil, I would not have said: Well, the debate is kind of is the real going to be 420 or is it going to be 470, right? I mean, yeah, Brazil’s having a recession. It’s a difficult time. But it is night and day from the crisis we have seen in the past. And that is every much a function of the fact that they have a tremendous amount more reserves. So the federal government is a net creditor in foreign exchange, as opposed to a net debtor, which it always was before. And so I think we’re in a much, much better place, as kind of Vincent said.

Now, there are limits to this. And one of the things that’s striking is the financial overhang around the reserves has grown tremendously. When we were kind of thinking about this in the wake of the Asian financial crisis and we were kind of advocating for, gee, countries that will hold more reserves, we had no idea we were going to get the magnitude of numbers we’ve in fact seen. And it is challenging in an environment where the financial kind of infrastructure around it has kind of grown up as well. We’ve also had this incredible increase in domestic financial intermediation in these countries, which is the thing that sort of generates my—the biggest concern for me.

So the fact that you’ve seen this very rapid increase in the domestic financial systems in all these countries is a vulnerability that, you know, we certainly didn’t anticipate in that respect. Look, it’s hard to argue—I think it’s hard for me to imagine the reserve levels are going to get notably higher than the peaks we’ve already seen. I just think it doesn’t make sense. But I do think—but I do think it’s buys you a lot of resilience. But ultimately, you’re going to sort of have to think through these sort of other vulnerabilities. But I guess I’m still of the view that we’re significant away from, like, chokepoints we’ve seen in the past.

TETT: If the reserves aren’t big enough, then the most natural next step will be capital controls. And one of the interesting sort of 10-year questions is that if we do end up with an emerging market crisis in the next year or two which is particularly nasty, and if it turns out that having capital—having huge reserves has not been good enough, will we over the 10-year horizon see a return to more intrusive capital controls going forward?

REINHART: The answer is, I think, almost certainly yes, because it also aligns well with the fact that so many advanced economies have large levels of government debt. Capital controls are also associated with financial repression. And the reason I didn’t put a “much, much,” like Lewis, in terms of in a better position is, as Lewis notes, there is a lot of financial private sector activity surrounding what governments are doing. And private sector mistakes become public sector obligations at a time of stress. And that’s a big risk.

TETT: And that in turn—I know I’m being jealous, asking questions—but raises other question, was, you know, was 2007, if we look back in 10-years’ time—will we look back and conclude that 2007 was a high-tide mark—high-water mark for globalization?

REINHART: As 1913 was in retrospect, I think is sort of the—

TETT: Well, I’ll keep asking the questions so you can answer them. (Laughter.)

REINHART: That’s experience.

MALLABY: A question over there.

Q: Arthur Rubin.

Just to follow up on the thread of conversation you’ve been having, how would an out-and-out default buy a major parastatal company—and I’m thinking PDVSA or Petrobras, less likely Pemex—play into that equation? How does that change the dynamic both on the sovereign side and, more broadly, in the way that the rest of the world looks at putting capital into emerging markets?

MALLABY: I’m looking at the man with the dissertation under his belt. (Laughter.) You all have dissertations, but I mean the relevant dissertation.

TETT: Mine’s on Tajik wedding rituals, so you know. (Laughter.)

MALLABY: Tajik wedding rituals?

TETT: Yeah.

ALEXANDER: So, look, I—something like that would be a major shock to the system. I think it would be something that would lead to sort of further withdrawals in capital. On the other hand, it would depend a lot on how it’s managed. I think one of the challenges you face with any sort of state-owned company is: Where is the line, right? Is this sovereign or is it not? In most of the kind of emerging market debt crises, one of the crucial issues has always been, like as sort of Vincent suggest, right, at what point does stuff that might be considered private become public or not?

I think there’s always been this sort of question of when can you kind of try and impose discipline by allowing somebody to actually go broke, right? I mean, there was a—and that’s always a tricky question. It becomes, in an environment where the whole system doesn’t look fragile, there’s a strong argument to be made that, gee, you ought to let things go, have some sort of bankruptcy process and let it work. The challenge is always knowing, like, how resilient the system is going to be to that. At the moment, you know, my guess is people are going to want to—things would have to get pretty bad for people to believe that that’s the—that you would want to let that go at this moment. But on the other hand, you know, my impression is we’re not that close to that at this point. But it is—those are going to be tough policy choices. At the moment, I wouldn’t feel like the spillovers would be so horrendous from that, but that’s a tough call.

REINHART: It’s always known as the Lehman question—(laughs)—which going into it looked easier than coming out of it. And I think the short answer is we say, gee, they didn’t have as much reserves as we thought they did. It would be a—it would be a test. It would be a test of all emerging markets, because the shock isn’t just country-specific. It is an asset class.

TETT: Can I add to that, and say one of the things that caused the chaos of the Lehman Brothers collapse was the fact that investors in London woke up overnight and discovered that the legal framework surrounding treatment of investor assets of Lehman Brothers, particularly between London and New York, was completely untested, unclear, and wasn’t what they expected. So to extrapolate from that, I think one of the key questions everyone should be asking right now in relation to both sovereign bankruptcy and quasi-sovereign bankruptcy is, is there actually a clear-cut legal framework in place that people can trust which will clarify what happens to investor assets and creates waterfall structures?

And what’s quite alarming to my mind, is that on the sovereign bankruptcy stage there’s a crying need right now for a faster workout process and more clarity. I mean, the Argentinian government’s going to finally, finally, finally meet with mediators this week in New York to talk about this, but heaven knows that’s taken long enough. If you look at Puerto Rico right now, that is a complete and utter total mess. So it’s not just the economic fallout of any potential bankruptcy, it’s the potential for legal uncertainty and lack of clarity and new precedents to be set. And let’s hope that somebody starts to try and clarify this before we actually get the crunch.

REINHART: Well, so the good news is we’re waiting for the Brazilian courts to—(laughter)—

TETT: We can have a private conversation later, but yeah, this is very important for moving forward. Yeah.

REINHART: But part of it is, we actually never actually learn from crises. You know, we say, let’s make more resilient the workout regime, let us figure out how to put those firewalls in place. But there’s an enormous amount of improvisation in dealing with financial crises. And part of the problem investors face when they see something that might create a financial crisis is you don’t know exactly what officials will do.

TETT: Well, that’s a job creation program for financial commentators.

MALLABY: Roger has a question down here.

Q: Yeah, the dog that didn’t bark is Europe. I mean, I realize that these commodity producers are a mess and China has all these long term and short term challenges. But I think Europe’s in a pretty bad mess right now too. A friend of mine wrote a book called “Brexit” a couple years ago, and now he’s got a second edition and we put him on television. (Laughter.) And that’s not the only stress and strain. What’s happened in the Polish election is worrisome, as what’s happened in Hungary over the last several years. And there’s Putin still in Europe. What do you think about Europe and the global outlook?

MALLABY: OK, so today was not only the results of the Iowa Caucus, but also the document which will probably frame the referendum in Britain whether or not to leave the EU. I think that could actually be the populist vote. Of all the populist outbreaks around the world, if that went against EU membership, could have ripple effects that starts to unravel something really big. But who wants to comment on Europe and whether they’re—

ALEXANDER: I’ll jump in and be the sort of naïve optimist. I was surprised that Marine Le Pen didn’t do better in the regional elections in France. My observation about the European project is it actually makes progress when it’s challenged. And I’m very mindful of the fact that the immigration issues are serious and going to be very hard to deal with. I was actually—the second week in January, I was actually on a marketing trip through Europe. And one of the things that was sort of interesting is seeing how the Schengen system has evolved.

At one point I took a flight from Paris to Milan. And when we got off the plane in Milan, there were two policemen inside the jet way, between the jets and the terminal in Milan, that were checking passports. I had the most serious border check at immigration I’ve ever had going from Poland to Edinburgh, right? And I literally was like 10 minutes with a person checking my passport at customs, and then I got through that and there was a plain-clothes policeman on the other side who, like, asked me all those questions again.

And so I’m—look, the Schengen system is sort of fraying at the edges. But look, I don’t know how you look at what the Euro crisis has been without sort of concluding that the draw of it, the draw of European immigration, is just incredibly powerful. And, yeah, it’s a crisis. And yeah, growth is going to be weak. And I—you know, there always, you know, a hundred obstacles to it. But it in some ways—I’m just—I just look at the last three or four years, and I’m just struck by how remarkably resilient it is.

MALLABY: OK, I’m shopping for a pessimist here. I mean, Italy has been in recession for five of the last eight years—

TETT: Yeah, can I—can I offer?

MALLABY: Yeah.

TETT: OK. Everyone thought Europe might break up on the single currency, dead wrong, because at the end of the day a single currency is something controlled and shaped by the technocratic elites, the central bankers. What I find striking today in Europe is the depth of anger—real anger and soul searching, triggered inside Germany by the immigration crisis. Yes, maybe Merkel and the government can control this, but I look at my German friends—my decent, well-meaning, kind, dare I say it, liberal friends, and look at the state of shock that they are feeling right now about what they perceive as the fundamental attack on Germany.

And I think about how on Earth they’re going to control this crisis without resorting to a completely breakup of Schengen. And then, ask on how Earth you keep the eurozone—the eurozone or Europe together in the face of that, if possible, is going to be very tough. And for what it’s worth—because then it’s basically not in the hands of technocratic elites. It’s something which ordinary people are now being sucked into in a way that was not the case with a single currency at all. And on Brexit, I think it’s 50/50. And most people—I mean, I was in London recently. Most people I speak to here who are involved in the debate right now would put it—put the odds somewhere around that as well.

REINHART: So I agree with Europe, in that the European project advances event by event. And that’s because the event is a crisis and that allows the technocrats to advance things in a way that wouldn’t actually stand up if you put it to an up or down vote on the electorate. And if you want a pessimist, then I think the three things to note is demographics are just terrible. Debt has accumulated, and that will be a burden and limit political choice going forward. And the zero lower bound, we know, is an attractor. You can get to it, and it’s hard to get off it.

ALEXANDER: Can I just say two things? One is, euro was a nitty-gritty issue for the Greeks, and they did get a chance to vote on it. So, yeah, at some level it was technocratic, but that got as personal for everyone as you can get. And pushed to the limit, they voted to stay in. Second thing I would say about Germany, I think, to me, it matters a lot that the chancellor of Germany is an East German. You forget that the Germans understand in some ways the issues about families that are sort of seeking a better life, trying to go to a different place, the difficult choices that those things makes. And I get it. I mean, what happened in—you know, sort of what happened over New Years in Germany was a real shock. And I’m sure its generating a lot of tension. But I also think the Germans’ own experience with being divided and understand, like, what the choices those choices made, gives me some hope that they’re going to find a way around it.

Look, as I said, I recognize I’m the kind of naïve optimist here. But I have to admit, in looking at the European project over 50 years, there have been any number of challenges that it’s faced, and it has generally overcome them. And you know, it’s easy to—we have a—there’s a typical problem we have on this side of the Atlantic, and it’s to some extent it’s this side of the channel, that it’s hard to understand—hard to really appreciate the momentum behind it, and continue to be optimistic about it. It’s weak growth, and, like, the problem with recessions.

REINHART: So the vote about the European project you should worry about is not the countries benefitting from access to a big market, it is the countries that are a backstop in that big market. And they have a—they haven’t done the up and down vote.

MALLABY: What do you mean by that?

REINHART: I mean, i.e., the fact that Greece—the citizens of Greece see benefit associated being in the euro area is not the same as the citizens of Germany wondering where their savings are going.

TETT: (Unless ?) Lewis is right.

MALLABY: Well, it’s time to wrap up. But I would just say that we began with three big sources of worry that seemed to have been upsetting markets—oil, China, and the Fed. I think it’s fair to say that there are doubts whether either—any of those should really be taken as seriously as markets appear to have taken them. But we’ve ended up with another issue, which maybe markets have been overlooking. And they will be rolling their heads in the future, and at another WEU we’ll be talking about that more. So thank you to Roger for the question. Thank you to the panel. (Applause.)

(END)

Top Stories on CFR

Saudi Arabia

Saudi Arabia

Relations between the two countries, long bound by common interests in oil and security, have strained over what some analysts see as a more assertive Saudi foreign policy.

Cybersecurity

China is once again conducting cyber-enabled theft of U.S. intellectual property to advance its technological capabilities. A new Council on Foreign Relations brief provides recommendations to combat this new old threat.