World Economic Update

Tuesday, June 7, 2011

CFR's Matthew J. Slaughter and American Enterprise Institute's Vincent R. Reinhart discuss the factors contributing to slow job growth and financial recovery for the United States, as well as global fiscal developments since the financial crisis.

SEBASTIAN MALLABY: I'm Sebastian Mallaby. I work here at the Council on Foreign Relations. Welcome to this World Economic Update. This is on the record. Please turn off those cellphones and things that go beep and vibrate, et cetera, because they mess up the sound system.

We're going to do this World Economic Update with two great panelists.

We've got Vince Reinhart. He is the one with the sunny, optimistic outlook on life, you can see by the color of his shirt. Vince is an economist at the American Enterprise Institute and formerly the head of the Federal Reserve's influential Division of Monetary Affairs.

And then Matt Slaughter over there, who is the assistant dean of Tuck Business School at Dartmouth, also an adjunct senior fellow here at the council and formerly a member of the White House Council of Economic Advisers.

So we'll get stuck in. Maybe we'll start with the optimistic person in the middle.

So let's start with the U.S. outlook. We've had, a year ago roughly, the threat of a second dip, brought forward Quantitative Easing 2. Now we have chatter about the third dip. Should there be QE3?

VINCENT REINHART: In any group in which I am the optimist --

MALLABY: (Laughs.)

REINHART: -- there's a serious problem.

And when -- in thinking about the outlook, my organizing principle is paper I wrote with my wife Carmen for the Federal Reserve Bank of Kansas City's Jackson Hole symposium back in August. It was called "After the Fall." We looked at the 15 most severe financial crises in the second half of the 20th century and compared what happened in the decade after to the decade before. And the bottom line is economies grow much more slowly persistently for a long time after a severe financial crisis.

Why? A financial crisis is importantly about unfinished business. There's debris of problematic assets on intermediary balance sheets. Households view those obligations as problematic mortgage loans. The government tends to make sure it never happens again, and that means you do things that may be good for the long run -- like raising capital requirements on intermediaries -- but you do it too fast, you do it in a way to add to business cost. And then, lastly, the boom was fueled by leverage. The disappointing ex-post performance is weighed down by de-leveraging.

So we're in the midst of an economy that's not growing that fast. We're about somewhere around our capacity to produce in terms of expansion, but we haven't made up for the losses in the recession and the sub-par recovery. That's one in which the unemployment rate stays high.

In that environment, what's the Fed going to do? I actually don't view QE2 as avoiding the double-dip. QE2 was about encouraging risk-taking; that Federal Reserve officials looked around, they spent most of 2010 waiting for that rally in equity markets that must be inevitable given the low level of real interest rates, given the standard postwar experience of a snap-back. They waited and they waited, then they got impatient and embarked on QE2: give a little nudge to risk-taking by soaking up $600 billion of riskless Treasury securities and get investors out toward more risky investments. And you talk to a Federal Reserve official, they'd say the local low in equity markets was August 2010 when Chairman Bernanke firmly put QE2 on the radar.

What's that say about QE3? Well, remember, they took a long time to get to QE2. Had the federal funds rate been 5 percent in May of 2010, they would have cut several times over the course of the summer. That means they have doubts about the instrument, quantitative easing or the manipulation of the central bank's balance sheet. If they had doubts about QE2, they have more doubts about QE3.

So here's the real risk. If you believe an outlook like after the fall, we are going to expand; we're going to expand sluggishly. We're going to expand at a pace somewhere around our potential to produce -- some quarters low, some quarters high -- but that's not one in which we make much progress for unemployment. In that environment, the inertia to central banking, the doubts about the instrument named QE3 will be long in coming.

MALLABY: Can you just explain, what's this distinction between encouraging risk-taking and stimulating the economy? And doesn't, by definition, more risk-taking means that more risk-taking business gather lower cost of capital, and that seeds through? What's the -- what's the distinction there?

REINHART: So my only distinction was, Fed Reserve officials were not looking at an outlook that had double dip in it, absent action. It was an outlook in which the unemployment rate stays high, and there may be downside risks that inflation, already at a low level, falls some more. That was unacceptable, but it was not a recession. What they did was encourage risk-taking to get a better growth outcome.

And you're right, here's the problem with central banking: You have to work through markets and attitudes toward risk. You either lower the cost of capital, or you improve the attitudes toward employing that capital. The Fed had already lowered the cost of capital as much as they can by lowering their policy -- normal policy instrument, the funds rate, to zero. Quantitative easing is about getting the risk appetites up.

MALLABY: Right. So Matt, you've -- you know, whereas Vincent's been on the inside of the monetary policy arm of government, he's been on the inside of the fiscal policy arm of government -- I mean, do you see other policy tools, or maybe perhaps just ceasing to use policy tools for a while? What would be the right response from the executive branch to the softening in the economy now?

MATTHEW J. SLAUGHTER: So, great question. I'm happy to -- if, Vince, if I could evoke the Winnie the Pooh characters, if -- Vince, were you Tigger, do you think, with that decision, that I'll be a little bit of Eeyore? So what I'll add -- I'll answer that by -- in a little bit of a roundabout way, Sebastian.

The thing that worries me, to add to the insights that Vince shared, is where we are today is in many ways -- you know, the American economy sort of lost the decade of the 2000s, and this is -- for reasons, frankly, that economists like me don't fully understand. But if you think about the deep technological forces, the forces of globalization, we're all sitting here today, we have 108.9 million private sector jobs in the United States today. That's the same number that we had about 12 years ago. It was -- (inaudible) -- manufacturing, we have 11.7 million manufacturing jobs in the United States today. The year the United States first achieved 11.7 million manufacturing jobs was in April of 1941. So there's been kind of this lost decade. A lot of it has to do with the financial crisis and the deep recession, but not all. Going in -- even in the years leading up to the crisis, we didn't have that strong a job growth, actually, in the United States.

And paired with that income growth in the United States has been literally zero to negative for the large majority of American workers over the past decade. If you look at the pre-tax total earnings, it only was, on average, very high-income, high-skilled individuals that had any real income growth over the past 10 years. So most American households are sitting around, realizing there's -- we've had no net job growth for about a decade, and when they sit around and look at their W-2s and their paychecks, they're not earning anything more than they were a decade ago.

So I think -- that informs, I think, the fiscal conversation, because we look at public opinion surveys -- people are worried. You know, there's always been some cyclicality when you look at public opinion surveys about the outlook for households and prognosis, these kind of medium- and long-term questions about, how do you think things are going to be for your personal household finances over the next handful of years, or these longer-term questions like, do you think your children's generation will be better off than yours? (What we've seen in the past couple years, in part because of the crisis, but in part because of these forces that were building before the crisis, is just unbelievably dramatic lows in terms of the outlook that American households and families report for their economic future.

So I think the monetary easing is one channel that tries to help stimulate private sector job creation and capital investment for both big and small companies, but it's only one input. And when you look at surveys of CEOs, of both large and small businesses, for quite some time now, one of the big things they've been saying is policy uncertainty, a lot of that is fiscal. So it is uncertainty over individual tax rates, over corporate tax rates, over energy costs, over health care costs.

And the reality is, those things just matter. They matter for the tangible decisions that a lot of you in this room make and that in the aggregate, when we see last week's jobs report and how sobering it was, and how sluggish job creation kind of across the board, you just see, I think, the revelation for a lot of firms in America; they don't quite know what's coming next.

So in terms of policy, you can imagine if -- this is not just the administration, it's the Congress putting in place a broad set of policies to try to stimulate demand, growth and capital investment, a lot of it linked to the, as Vince rightly points out, the much faster growth outside of the United States.

It's one thing to voice a great aspiration to double American exports; it's another thing to actually put in place the really hard policy changes of trade mobilization, investment mobilization, immigration mobilization, that would allow you to meaningfully achieve that goal. And we haven't done that yet.

MALLABY: So what you're saying, partly, is there was an agenda of creating a good climate for growth that existed before the crisis, having to do with immigration reform and so forth, that we lost sight of for a few years. And we should come back to that kind of issue more than thinking about the kind of more crisis-management stimulus response that's been the hallmark of the last couple of years.

SLAUGHTER: Yeah. I think, especially on the fiscal side, for better or for worse it's not clear that the international investor community will allow us to continue to run the kind of fiscal deficits we've had. We have Moody's and S&P issuing various kinds of warnings and not so good outlooks for the United States. So I'm not -- I, like others, wonder about how to think about Treasury rates with the 10-year yield at 3 percent, given that outlook.

But my sense is just -- we're going to try to have a set of policies in place to try to have aggregate demand growth coming more from capital investments, coming from exports. Those are the things that kind of -- to use the metaphor of rebalancing the U.S. economy and the jobs that we need that are more linked to those activities. That has to be a whole different set of policies.

And part of what I worry about is we literally now have about, you know, six, eight weeks before the August congressional recess, after which many observers say there won't be meaningful policy conversations in the United States until early 2013.

REINHART: So actually, Sebastian, the way I would put it is, your willingness to take a sharp turn at a high speed depends on the confidence in the car you're driving. But when it comes to economic policymaking, we can write down a list of the optimal policies for monetary and fiscal policy, for reg reform in the international domain. But that gets put in place by a political system. And it's a political system in which the voters are unhappy. They've had a decade of poorly -- poor performance for the median household.


REINHART: They've seen income inequality get worse. And then, they've seen a financial crisis in which they -- you know, they hear "too big to fail" which they interpret as, I'm too little to help. The system seems unfair. How are you going to generate the consensus to be -- make aggressive policymaking that allows you to take care of the near-term softness in the economy, and address the longer-term structural problems?

The answer is we may not be able to deliver that sort of thing. And to the extent that we let our focus on the next two quarters worth of growth distract us from longer-term responsibilities, we may in fact just be making the cost of dealing with them ultimately, which we'll have to, all that higher.

MALLABY: Dealing with them. What's the "them"? Sorry, you explained --

REINHART: Large budget deficits and unsustainable path for fiscal policy, longer-term productivity and our ability to increase incomes for the median household, our place in a world economy in which we're not going to be as important. There are some serious longer-term issues that we have to come to grips with.

MALLABY: Some of those issues were surfaced in a paper the council published a few months ago by Nobel laureate Michael Spence, about the structure of the U.S. jobs market. And basically, he divides the economy into the tradable sector and the nontradable sector. And he finds that between 1990 and 2008 nearly all new net job creation took place in the nontradable sector, with tradables contributing almost nothing.

So he kind of links this to globalization, to the shift of bits of the supply chain to offshore production centers. And he basically challenges the narrative that says globalization is good for the United States.

Matt, you've written on this a lot. Has your thinking evolved as new data comes in? Or do you feel that -- how do you feel about this?

SLAUGHTER: Yeah. Great question. So it has in the following sense: One of the things that we don't fully know, and this echoes a bit of Michael's work, is over the '80s and '90s what you saw in the United States was globally-engaged companies -- that is, those involved in exporting or importing or those that are part of multinational firms. As they grew abroad, as they grew global production networks and set up and expanded affiliates and things, that tended to really complement what they did back in the United States.

So you saw in the foreign affiliates of U.S.-headquartered multinationals, for example, their employment over the '90s abroad grew by a few million. Their employment in the U.S. grew by about 4 million. So it tended to be that when you expanded abroad, that had synergies and linkages back to operations here in the United States.

The 2000s was different. What we saw was continued growth abroad in capital investment, in R&D and employment in the foreign affiliates of U.S.-headquartered multinationals. Here in the United States, (on some ?) measures their activity continued to grow a lot, their research and development, their capital investment. But importantly, their employment stopped growing. In fact, it shrank. So over the 2000s on that, U.S.-headquartered multinationals, their employment shrank by about 3 million.

Now, why is that? Frankly, we really don't know yet. The academic research is -- we don't quite have current enough data. We don't kind of have the analysis that I'd like to see to know why that's happening. But in the aggregate, it's clear that something has happened in terms of how the U.S. and global economies in Iraq, such that these really high productivity, high-growth firms in the United States and that matter a lot about the global-engaged companies -- I care about them because they tend to be the ones that generate a lot of the aggregate productivity gains, the ones that drive income growth on average at least -- they're not as engaged in the United States as they used to be. So a lot of these issues that Vince rightly pointed out, part of what I worry about for globalization is, if the U.S. doesn't quite get the right policy mix, it matters a lot more today than it did 20 or 30 years ago, because the outside options for a lot of global companies is so different today from what it was 20 or 30 years ago and how the mind-set of a lot of the firms that I see and work with, you know, they have -- as Vince pointed out, they have long-time horizons, and they look at the uncertainty and the -- and the acrimony in the United States today, and that clearly shapes the long-term plans for a lot of these firms in a way that is going to be with us for a while. So that's why kind of a lack of progress in some of these policies just today is going to be persistent, I worry, for a long time.

MALLABY: Let me try an analogy and you tell me if it's just sort of stupidly simplistic. So if you're running a business unit and you hire more people and you delegate some of your tasks to them, you increase your own productivity, because you focus on the task that you're particularly good at and you're (exploiting?) -- (inaudible). So that's just sort of the first stage of globalization. You have multinationals outsource stuff abroad. Their productivity goes up; they can create more jobs.

But at a certain point when you're running that business unit, you outsource too much, you're out of a job. All your deputies are doing everything for you. And you've got to hold on, in the end, to something, and we may be kind of encroaching into that zone where the productivity gains from division of labor go down and the -- and the sort of -- the shared displacement goes up.

SLAUGHTER: So I like that analogy. And the one thing I'd add, not to make it a little more recent, but it's just I think part of what a lot of -- what global -- one of the key dimensions of globalization increasingly is, how many firms based in advanced countries like the U.S. realize the opportunities globalization presents isn't just increased revenues through selling the stuff there or reducing my costs because I can have some sort of cost arbitrage through outsourcing. It's the ability to engage with really talented, dedicated, motivated individuals in these countries. How many firms based in the U.S. go there thinking, boy, I thought I was going to improve my performance by reducing costs, and how amazed and astounded they are at the talent and the dedication and engagement of colleagues they can hire there. And in the aggregate that I look at that, I say there's no law of physics that says the United States is going to have this perpetual lock on these high-quality good jobs at good wages. And I think that's something that's been -- that has been growing for many years. It -- these forces of the global economy predate the financial crisis. And I think the financial crisis for a lot of firms has made them think even harder and maybe move faster in thinking about what those opportunities might mean, because they worry about how the U.S. might come out of the crisis given all the points Vince has made.

REINHART: So one part of your example is, as you delegate your assignments and you train good people, you're also training your competitors.

MR. : Yeah. Oh, yeah.

REINHART: And I think that's what we do -- (inaudible). And particularly in some markets like China that you go, you don't have a lock on that market; you have to fight to keep that position.

MALLABY: I want to ask you about Europe, Vince. You know, if it's uncomfortable to be a central banker in the United States, it's even more uncomfortable in Europe by quite a long shot. And do you think we're reaching some kind of inflection point in the debate there where on the one hand you've had people who've always argued that you have to have a restructuring, that grief just owes too much, you can never pay it back, you've got to reduce the debt, so you've got to write it down.

On the other hand you've had, you know, the kind of alternative view, which is, OK, there's too much debt. Let's have a real bailout. The matter seems to be politically off the table. And we're getting to this point where the Germans now are saying, we need to write some debt down. And the ECB is screaming and walking out of meetings, in the form of Trichet recently in Luxembourg. I mean, how does this play out, then?

REINHART: So I work at the AEI. And at this point, you're always supposed to quote Herb Stein -- (laughter) -- who said, you know, if something's unsustainable, it stops. The debt load of Greece, the fiscal path, is unsustainable. It has to stop. The problem is Herb never left any notes about how it would stop or when it would stop.

So we know something's got to be done. The deep impulse of the European fiscal authorities is that whatever's be done, it be viewed as an ongoing success of the European experiment, meaning that it represents some form of restructuring, whether soft or not. So what do you do? You transfer resources from the rich to the poor countries. You force your -- encourage your financial institutions to hold more of that debt. You encourage your central bank to hold more of that debt, so that you create a window in which you can figure out how to do a restructuring.

What does that depend on? That depends on the willingness of the electorate of the rich countries to send transfers, and the willingness of the electorate of the poor countries to accept the conditionality that the rich expect of you. And it could break down either from the top or the bottom, or the -- is the leadership in front of the voters in Germany, is the leadership in front of the voters in Greece? And the biggest problem in sovereign debt is, you can't pre-commit the next government.

Now, why does the ECB care? The nature of the problem is the central bank, because it has a flexible balance sheet because it's got a responsibility for financial stability, is always left holding the bag when something goes wrong. The act of doing a soft restructuring, encouraging your financial institutions to hold more debt, buys you time but also weakens those institutions. And when the restructuring comes, it takes the form of severe pressures in financial markets that the central bank has to offset.

The temptation to have the central bank more -- buy more sovereign debt in order to absorb the pressures is also great. And at the end of the day, it would come out of the central bank's balance sheet. And it would test, then, the cohesion with the European system of central banks because it would be a loss they have to share.

Deep down, the thing you have to understand about monetary and fiscal policy is fiscal dominance. If, ultimately, a budget is unsustainable, a central bank with a responsibility for financial stability is going to have to step in and absorb the problem. President Trichet would much rather prefer that fiscal policy come in -- come to order in a way it doesn't reach that point. That's getting to look increasingly unrealistic.

MALLABY: So one should interpret his walkout from a meeting as out of desperation, and a sign that, you know, the kind of -- the more fierce he looks, the more he's getting to -- closer to the point where he's going to blink, that ultimately the ECB will cave and agree to accept compromised debt -- even more compromised debt -- as collateral. It'll just carry on.

REINHART: Ultimately, a central banker is an agent of the principals. The principals are the government. If you give the central bank a responsibility for financial stability, they're going to have to absorb a lot of bad things on their balance sheet if bad things happen.

MALLABY: Is this why Axel Weber decided he didn't want to run the European Central Bank, and --

REINHART: I think the phrase "poisoned chalice" came up. And you know, the point is, Europe is in a window in which there is the opportunity for significant precedent to be set in terms of how the central bank views sovereigns of different credit quality, but still members. What is the membership? What are the attitudes toward asset purchases?

I think we have hectored the Chinese over their nominal exchange rate and how they've conducted monetary policy. And that has crowded out a richer dialogue to think about how we can try to create linkages between our two countries that try to benefit more workers and households in both places.

And one example is just China has made some progress but still has much more room for progress on protection of intellectual property. And we in the United States, we have a lot of great companies and a comparative advantage in IP-intensive industries. If we could work with China to try to, in law and in practice, improve protection of intellectual property rights, that would literally create -- you know, the estimates that our government has put out -- up in the neighborhood of 2 million new jobs in the United States.

So how we in the United States think about what -- the fantastic growth in China and India and so many other countries around the world -- that's been great for human welfare, but I think we're continuing to struggle with trying to find a narrative and a set of policies that will try to allow that growth to be translated into jobs and opportunities for a lot of households in America and not have them view it as something that's yet another concern in addition to QE3 in addition to the stock prices and that sort of thing.

MALLABY: I should mention that Matt's done a lot of work on the task force that the council has been doing on U.S. trade policy, which I guess will report fairly soon.


MALLABY: Anybody got a question? Right over here. Microphone should be coming behind you, I think. Please stand and state your name and affiliation.

QUESTIONER: I'm David Beim from Columbia Business School. Could you specify what, in your opinion, is the most probable outcome of the Greek debt crisis? It's not foreseeable, but of all the possible futures there might be, which is the most probable in your view? There seems to be an irresistible force and an immovable object.


REINHART: So I get to give my second-favorite empirical regularity in the book. If you look at the history of the empire and the commonwealth, you see that there are very few debt defaults. And political scientists have written papers about how maybe that's religion, Napoleonic code versus common law, distance from the equator, but here's the regularity. There are a whole lot of restructurings. For most of history, default is an event the strong declare on the weak when they lose their patience. And if you're in -- the member -- members of the same club, you're less likely to lose your patience; hence, you restructure rather than default.

Greece is in the club. As long as the political problems of where the voters are relative to the elite in -- at the top and the bottom don't intrude, that suggests that you get some form of restructuring, some form of extension of terms unfavorable to the investor both in terms of maturity and coupon, in a way to buy enough space that the fiscal transfers are large enough to put Greece on a more sustainable path. Part of that will also be buybacks: you buy the debt at default -- at very low prices and you give it back to the issuer at even lower prices and then you share the losses.

Here is Jean-Claude Trichet's great fear. The easiest mechanism currently in existence in the continent is the ECB. They can buy under the table, they can buy in markets, they can buy them at -- buy Greek debt at very depressed prices and swap it back for some other security that's even less favorable terms.

So I think the likelihood is you mark down the terms of existing debt and do it because you've already encouraged your financial institutions to hold that debt, and you remind them that their continuing existence depends on the attitude of the government. You have investors take that loss, and then you have a press conference and say the European experiment is ongoing; we're able to absorb this without default, without a change in membership.

MALLABY: If I could just follow up on that, because it seems to me just as with Trichet, you have this image of, you know, saying "no" louder and louder; you know, walking out of meetings, and actually that's a sign he's going to cave. So too with the European Union politically. It seems to me you've got people saying we must assist with this integration of Europe, and what that means if you need a European-wide treasury minister, you need a fiscal union, you need three new institutions, you need cross-border bailout facilities for financial institutions. I mean, the list, from the Euro- -- from the pro-European integrationist side, the list of conditions necessary to keep the experiment on track is becoming so extravagant that you want to read it as a counter-indicator.

REINHART: So I think the natural impulse is to integrate more for those -- for people of that bent to begin with. And I believe the rule is, a crisis is a terrible thing to waste, right -- that you can imagine outcomes -- they can imagine outcomes in which Europe is a more cohesive whole, that the euro is a better reserve currency, and they'll be rewarded accordingly. So the light at the end of the tunnel that -- to them, is -- yes, large fiscal cost, but a more cohesive Europe.

The question is, do the voters really want that? And that, I think, is a serious issue, and it's as yet unresolved.

SLAUGHTER: The one thing I'd add to that is, I'd -- I would hope -- the optimistic part of me -- and I'm by disposition a Tigger; I'm very optimistic about a lot of things -- I'd like to think Greece -- you know, it's interesting. Greece has provided for Western civilization so much history and thought, right, over the many millennia -- is Greece and many of these European countries will be leading indicators for the underlying kind of growth challenges that a lot of Western countries face of -- we've got aging populations, slow productivity growth. Are they going to be able to come -- not just on the dollars and cents of fiscal stuff, but are they going to kind of come up with a new social contract, in some sense, that will allow them to restore sustainable economic growth?

That's part of what I'm looking for as well. And whether there's the political will for that, I don't know, but I'm hopeful that maybe Greece could find a way to do it that other countries will be able to emulate in the coming years.

REINHART: So here's a laboratory experiment. Do politicians respond to market discipline in a way that -- helpful over the longer term?


REINHART: And I don't know the answer.

SLAUGHTER: Yeah. I mean, it's an open question.

MALLABY: (Chuckles.) Let's go right over here. Microphone coming.

QUESTIONER: Stephen Blank. This is directed at Matt, who -- really talks about jobs. I attended a meeting recently, just a couple weeks ago, of the Michigan state manufacturers association. The most interesting thing which was said was that there are 100,000 jobs in Michigan that can't be filled because of lack of skills. We talk about the need for creation of jobs. What about this issue? What do you have to say about that?

SLAUGHTER: Yeah. So it's a great question.

Long before the crisis, the National Association of Manufacturers, a lot of other kinds of industry associations have done surveys of member companies. And the single biggest threat to their kind of business model in the U.S. a lot of them have cited is lack of skills and an aging workforce.

So for a lot of key manufacturers in America, their median kind of core production workers, their age now is about 55 to 60. So they're approaching traditional retirement years. Now, paradoxically, the crisis may change that. But the reality is, one of the biggest constraints manufacturers in the U.S. cite is lack of skills.

So I think the answer to this is kind of a short-term and a long-term answer. The reality is, this is part of globalization. We cannot sustain kind of moderately skilled production jobs in manufacturing and in services in the United States at the compensation levels we might like to have given the competitive pressures of globalization.

So there's two ways we as a country can adjust to that. In the short term, we could employ more of those people, but the reality is, their wages will go down. So when you look at two-tier compensation systems that have come into place through the Big Three or the Big Two -- auto bailouts -- but that's been more and more pervasive across a lot of large manufacturers in America. I don't fault the firms that do that, but the economic reality is, a lot of these executives say this is the compensation rate at which I can employ people in America, given their skills, given the physical infrastructure in America. And I'm going to link those two, education and infrastructure.

The longer-term solution is addressing the skills challenge of the American workforce, addressing the infrastructure problems a lot of firms face. Siemens USA -- Siemens USA is looking to hire about 2,500 to 3,000 STEM workers in the U.S., and they can't find people that have the skills that they need. So if we as a country, obvious -- through our reform of our education system or through immigration, can't provide the skills for those firms to hire those people here, globalization will increasingly allow them to hire them outside of America.

So this is one of those issues that literally and metaphorically makes my hair gray. And I just -- I don't hear hardly anybody, frankly, in Washington, D.C., as a U.S. citizen, focusing on these kinds of issues with the kind of sustained effort it would take, because you can't turn it around in a month. That's like a decade-long project or more. I mean, the education clock ticks generation by generation, largely.


MALLABY: Question over here in the front.

QUESTIONER: Hi. Juan Ocampo, Trajectory. Just a quick follow-up on the infrastructure -- what are the major things that are keeping us from, you know, being able to improve that and allow Siemens to get those jobs? And are there developed countries, not BRICs or anything like that, but maybe Sweden or someone else that over the past decade has done that sort of thing better, that we could learn from?

SLAUGHTER: So, great question. I think there's -- and again, the problem is the American Society of Civil Engineers graded the U.S. infrastructure in 2009 -- they do about every five years -- they gave in the aggregate U.S. infrastructure a grade of D. As an educator I kind of thought it was a gentleman's D, when you dig into the kind of underlying data that they cited.

Like, this is kind of -- you know, roads, ports, bridges, water systems, sewage systems, levees, stuff like that -- it's the lack of political will to find either the public or the private capital to fund what you need to make the infrastructure investments. So tax cuts don't pay for infrastructure investments. The present value shortfall that the society estimated over the 2009 to 2014 window for funding what would be needed to raise our infrastructure to kind of an adequate level is a little north of a trillion dollars.

So I get -- you know, we've got these fiscal environments but, like, if we can't find the ability to differentiate types of spending -- and if you look at roads, for example, the primary mechanism of funding infrastructure investments in the federal road system is the federal gasoline tax, which is today at 18.4 cents per gallon, which as not been raised since 1992.

So we can continue to make that choice. That would -- the solution that other countries have brought to the fore on this is what are oftentimes called in this space public-private partnerships. You allow private firms to come in and provide the funding, the operation rights, the maintenance rights, the construction rights for these infrastructure projects. That it, private toll roads; that is, you know, London's Ring Road, and things like this. And you have congestion charges and stuff like that.

Other countries have made really good progress on some of this. You know, I don't -- I literally hear nothing on this in Washington, D.C., other than we're going to cut the -- a lot of the conversation in D.C. is cutting the baseline infrastructure spending in America by 35 percent.

REINHART: If you want to address the real cost of a financial crisis, is that after a financial crisis, three years later, public debt is 83 percent higher than before. Guess what? That's because tax revenue's low, you tend to do fiscal stimulus, you tend -- there are bailout costs. That has to crowd out something. And among the things it crowds out is those investments that have high returns; like infrastructure, like education. And so we're going to be living with the consequences of our failures in regulation, our failures in risk management, for a long time to come.

SLAUGHTER: And I just got -- it's like the planes, trains and automobiles test. I mean, if you fly around the -- I have to travel to China next week. I will land at the Shanghai airport hopefully on Tuesday. And you go through the Shanghai airport, and it's stunning how efficient, clean, modern it is. And I contrast that with so many of the major international airports in the United States, where it's sobering to embarrassing.

QUESTIONER: Frank Wyle (ph). A short, easy question. What's going to happen if we flirt with and go past August 2nd and the debt ceiling?

SLAUGHTER: I don't know, but I'm scared to know. (Laughter.)

REINHART: So August 2nd is the date at which the U.S. Treasury would run out of cash in its account at its fiscal agent, the Federal Reserve, if uncertain tax revenues and uncertain expenditures follow forecast and the secretary limits himself to all previously used accounting gimmicks. (Laughter.)

In a crisis you have a list of things to do. The lists start out with easy things done before, perfectly legal accounting (leave-out ?). Then it grows increasingly unpalatable, down to the bottom which is do something illegal. Here's the choice Secretary Geithner has: He could violate the 14th Amendment of the Constitution that says -- that basically says the U.S. will repay its debt, or he could violate the main body of the Constitution that says, only the Congress can issue debt with the full faith and credit of the U.S. government.

You don't want to go down in history as the un-Alexander Hamilton. And so what happens on August 2nd is likely the secretary works down a little further the list and -- do something that has no precedent -- no precedent. But his general counsel will reassure him, probably doesn't get him impeached.

Remember, however, that in the mid-1990s, every -- some congressional Republicans were talking about impeaching Robert Rubin. Why? Because in the previous debt crisis, he worked a little further down the list of things you can do. That's why the debt ceiling is a terrible vehicle to play a game of chicken, because both sides recognize you cannot take it to the very conclusion, which is running out of money and defaulting on debt. Neither side quite believes the agent, the secretary, when he says when he'll run out of money. And to me, basically Congress right now is like a bunch of kids beating each other up in the backyard knowing that at some point, mom will step out on the porch and say, you better stop it before somebody gets hurt. They're counting on the secretary to absorb the near-term risks.

SLAUGHTER: I'm sorry, who's mom? Is that the People's Bank of China?

REINHART: (Chuckles.) Well, there's bad news there, too. (Soft laughter.)

So what happens August 2nd? Probably not much of anything. The secretary decides that it is possible to prioritize spending and some contractors and employees don't get paid, or the secretary finds that there are some more assets you can sell, or finds that it is, in fact, legal to remonetize gold with the Federal Reserve, or that there is some authority to borrow from two government entities, Fannie Mae and Freddie Mac.

This is a game of chicken. Everybody should remember the prototypical game of the -- archetypal game of chicken is from the movie "Rebel Without a Cause." And it ends with Sal Mineo going over the cliff because his coat gets caught in the car door handle. (Laughter.) Chances are either both sides realize they got to do -- the highest probability is we don't get to that -- to there before, that they do take July 4th as a firm deadline and both parties give something because neither want the event of default, or we get to August 2nd and the secretary pulls a -- pulls a rabbit out of the hat and Congress finally does something. There is a small risk of something really bad happening.

And there's no such thing as an accidental default. Investors don't look past that. They just see the event of default. There are just lots of risks associated.

SLAUGHTER: The other cost I'll add is I'll point out -- and I did some Congressional testimony on this a few weeks ago -- is just this issue is crowding out conversations about getting the three free trade agreements passed, trying to get a Doha deal done, thinking about corporate tax reform, thinking about infrastructure. You know, the -- our elected members in Congress have only so many hours in the day, and this issue -- I don't mean to belittle it, but the theater and the game of chicken and whatever the metaphors are, it's crowding out all these other things that our country is not addressing to try to get job growth and income growth going again.

MALLABY: I just ran an old test in my mind. The -- you know, preeminent economists who can name support actors for James Dean, and in that positive Venn Diagram, there's only one passing and (his name is Vincent?). (Laughter.)

Anybody got another question? I have a question --

QUESTIONER: (Off mic) -- a follow-up.

MALLABY: OK, sure.

QUESTIONER: I read recently that we've crossed the line -- (off mic) -- we crossed the line. However, interest rates will -- the market's going to react. And probably we can't come back across the line, so (we've ?) permanently injured and that the costs over the next decade of increased servicing of the outstanding debt would exceed maybe the whole budget in due course. How do you factor that into -- into the discussion?

SLAUGHTER: So the United States issues the reserve currency. Foreign official entities own basically half the amount of Treasury debt outstanding. Treasury debt is the acceptable collateral for everything; it is what you put into your account when you're asked for more margin; it is the lubricant to the financial system because there's no default risk on it.

In the event of a default, then everything gets rethought. And those stable, safe demands switch immediately into reverse. Reserve managers happen to be the most herd-like risk-averse group of ambassadors on the planet. And they're holding Treasuries because Treasuries never default. Default is something that would fundamentally shift the demands for government securities and mean that we will have -- face higher interest rates for a long time to come. Wouldn't be forever, although.

Another -- maybe my third favorite regularity is that -- was it -- there are serial defaulters. There are countries that have defaulted seven to nine times. Well, the only way you can default the second time is if investors accepted you again. And investors do accept you again.

So the answer is, default would be a horrible thing, it would cause severe dislocations in markets -- absent the, you know, three-hour default because of a technical, you know, issue about signing legislation or the like -- would be a terrible thing. It would rethink -- it would cause market participants to rethink the role of Treasuries in the financial system, and it would cost the U.S. Treasury more for a long time. Ultimately, it'll recede in the mirror.

MALLABY: Vince, I sometimes wonder about a parallel between emerging markets, central bank challenge of now, and the 1970s in the U.S.

So in the U.S., if you asked why inflation got out of control, there are a number of factors, but one of them was that the central bank was not really properly independent. Nixon kept on beating up on Arthur Burns, you know, attacking him for -- claiming -- he claimed at one point that Burns was pushing for a personal wage increase while pushing wage freezes onto the rest of the economy. This was entirely made up, but this was part of the dirty tricks stuff. There were relative price shocks, because there were food shocks and oil price shocks in the 70s, just like there have been recently now. And that scrambles the picture on what you should do about inflation, distinguishing core inflation from headline inflation.

So there were a number of factors that feel a bit similar then to now. Do you think that, just as the U.S. central bank failed to contain inflation in the 70s, though -- we're seeing the same thing play out in emerging markets right now?

REINHART: So a key -- so the policy went off the tracks for a couple of reasons in the 70s. Political pressure is one. No clearer representation of that is, if you look at the share of Fed Reserve holdings in total Treasuries, as you see it go up and up and up, more than we are now, for all the wailing about quantitative easing too -- so certainly, political pressures.

But in some sense, the biggest problem was having the wrong model, not recognizing that the energy price shock had a big permanent component, that you couldn't look past it, that the energy price shock had also a very large, real component in terms of what it did to our economies' capacity to produce, and having the wrong model and trying to get back to that 60s performance when it wasn't the 60s.

So the concern about emerging markets is, they've got -- may have the wrong model for the next decade, because the model that's worked very -- thus far, very well is export-led growth. And the way you do export-led growth is, you manage your exchange rate relative to the anchor. That means you basically have to follow the monetary policy of the anchor, because you don't want pressures on your exchange rate.

Well, export-led growth may get you to a better place, but it's not one that's necessarily sustainable. And if you still follow the model of export-led growth when it's the advanced economy still struggling with financial crisis and already large growth gap opens up, it means that emerging markets are importing a way too accommodative monetary policy for their own domestic good.

And so, if you -- in the list of challenges -- and for advanced economies, the list is very daunting -- for emerging market economies, they've got to move to a different model. And it's a model in which they're less dependent on the export sector and more self-sustaining centers of demand. They do that, then that's good news for the global economy because advanced economies need someplace to sell stuff.

SLAUGHTER: Yeah. And I think, on that -- so that's an interesting parallel, Sebastian. The other thing I'd draw a connection with is, you know, the U.S. suffered this unexpected deep productivity slowdown starting in the early to mid-'70s, right, that I think was not in the model of a lot of people. And policymakers in both China, India, and a lot of other countries -- but take China in particular: average GDP growth of 10 percent per year from '78 up until about today. It's unclear that that's the underlying speed limit rate of growth for China over the next five to 10 years, depending in part on the blend of aggregate demand, depending on whether they can continue to liberalize and introduce market forces, especially in services, in a lot of industries that haven't been as liberalized as agriculture and manufacturing have.

So that's something that -- our central bankers here and in Europe have challenges, but the -- you know, the monetary authorities in China thus far have been doing a decent job, but that's a challenge they're going to face for quite some time.

MALLABY: You know, Vincent mentioned the prospect that you could (have?) this rebalancing, where emerging economies, which will still outgrow rich ones by a wide margin, you know, shift towards domestic demand.

If they do that, and their exchange rates are appreciating, they need to do a couple of things. They're going to be importing more. They're going to be importing more capital goods, right, because they want to compensate for the loss of productivity of their workers implied in that rising exchange rate.

Does this mean that, you know, the German model, which was hot in the early '90s -- as I remember, when Clinton came in, he was very keen on copying the German model. Does it come back now in basically a model where you export manufacturing goods, focused on machine tools? That's looking pretty good right now.

SLAUGHTER: That may be part of it, I think. But also -- it's also, I think, just consumer durables and non-durables is part of what China hopefully -- what the Chinese government has said they want to grow -- how they want to grow their economy more in the future.

So consumption as a share of GDP in recent years in China was about 35 percent. In the U.S., in the past few years, consumption as a share of GDP has been 70 percent. This is part of how you get, you know, undersaving here, arguably oversaving there. But if they could shift that, part of what it's going to mean for a lot of U.S.-based companies, in principle, is the opportunity to sell the software, the movies, the clothes, the -- a whole span of things above and beyond industrial capital goods is clearly part of it.

But again, that's going to require us to have investment and trade and all kinds of policy agreements with China to allow our companies and our workers to take advantage of that. And we're not -- if we're still talking about 6.2, 6.1 on the yuan-dollar exchange rate, that doesn't touch all these other potential growth opportunities.

MALLABY: Maybe give the last word to Vincent.

I mean, I guess part of the question here is whether the nature of the debate about globalization shifts a bit. So you've had a period -- if you go back a long time, you know, trade arguments were central to that argument. And so whether it was speaking up on Japan about non-tariff barriers or the "battle in Seattle" in 1999 over trade liberalization.

Then I think we went into a period where exchange rates were the central part of the globalization argument, whether it was China's alleged manipulation, or capital controls coming back -- (inaudible). I mean, do you think that in the next 10 years, we'll kind of -- will the oxygen be sucked out by fights about the shape of the monetary system or fights about, sort of, more the trade and kind of real economy agenda?

REINHART: Part of it depends on the performance of the advanced economies. There's an important role for scapegoating those who are doing well if your domestic economy can't generate (eight ?) jobs.

I think there's enormous challenges. The key one on the financial side is the reserve currency status of the U.S. dollar. We get enormous benefits associated with being the reserve currency. At a time of stress, it also puts enormous responsibilities on us. An important part of the expansion of the Federal Reserve's balance sheet was to provide dollar liquidity to foreign institutions. It is not obvious to me that anyone in Congress understands the extent to which the Federal Reserve extended its balance sheet for foreign entities.

Meanwhile, the Europeans are going to look longingly at that reserve currency status and the exorbitant privilege. Depending on how the sovereign-debt crisis works out, the euro may either disqualify itself completely as a reserve asset or make a more attractive reserve asset. And now we're into a multipolar world because China's expansion will take an importantly greater financial dimension.

So I think on the financial side, we're going to be much more focused on the battle for (rents ?) among three centers. How that gets resolved then, I think, for a while is going to crowd out the trade portion of the discussion. But if you still have a large growth imbalance and some financial-sector adjustments didn't change that, then politicians will look for alternatives. And that's the trade agenda.

MALLABY: So there will be plenty more to talk about at these World Economic Updates. Thanks for coming. Thank you, Vincent Reinhart and Matthew Slaughter. (Applause.)







Top Stories on CFR



Public Health Threats and Pandemics

In the absence of U.S. leadership, multilateral responses to COVID-19 have been inadequate to date.

Public Health Threats and Pandemics

For more than a century, countries have wrestled with how to improve international cooperation in the face of major outbreaks of infectious diseases. A pandemic of a new coronavirus that originated in China in 2019 underscores the urgency.