World Economic Update

Thursday, September 6, 2012

Experts analyze the current state of world economies.

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

SEBASTIAN MALLABY: OK. Good morning. I think we can get started.

For those of you who don't know me, I'm Sebastian Mallaby. I work here at the council.

A couple of housekeeping things. Please remember that this is on the record, this meeting. And you're supposed to turn off those BlackBerrys and iPhones that go bleep and mess up the sound system. I guess if you have a Samsung device, the Apple lawyers will be waiting for you on the mezzanine. (Laughter.)

We have a great group for this World Economic Update meeting. I guess we have the old timers and the old, old timer. (Laughter.) -- Vincent Reinhart over there on the far side from Morgan Stanley is, of course, regular here; ditto Lewis Alexander from Nomura in the middle; and John Lipski was a kind of anchor person at this meeting series when it was going a while ago, and he is now at SAIS and was just recently at the -- number two at the International Monetary Fund.

So we obviously have from this side of the audience a good appreciation of the quality of the panel. We may also have an appreciation of the precariousness of the economy. This could be a leading indicator. And it runs obviously from the meeting in Europe going on right now to next week's meeting at the Fed to questions about the Chinese slowdown, and we'll try and get into all that.

But I thought we'd start with Europe, since the -- sort of the delta on that may be -- may be the biggest. And it would be unfair to predict -- normally, you can ask economists to predict things if they're not going to be disproved for at least 47 minutes. But in this case, I guess the press conference from Draghi will be in about half an hour. So I (won't ?) ask for predictions.

But I'll ask it in a different way. I'll say, Vincent, if there is some kind of indication that there will indeed be bond purchases at the short end from the European Central Bank to support programs of countries that do have programs, how much do you really get out of that?

And then let me put the question this way, as the contrast will be LTROs that the ECB did at the end of the last year and beginning of this year. With the LTROs, the ECB jammed the trillion euros of liquidity into the banks in two operations, so you could see the money in the banks. In this case, what the ECB saying, it seems, is we will support on a conditional basis economic reform programs that will stop in midstream at such time if they don't comply with the economic conditions. So it's a very conditional promise. How much confidence will investors, do you think, get out of that?

VINCENT REINHART: So first, with regard to the long-term lending or repurchase operations, it is true they were delineated, but they were also indirect. They were indirect government support because they required financial institutions to then used those firms to support government. And it is true that over the LTRO period, banks in Italy and Spain bought more government debt than their governments issued.

What may be happening -- and I hope you've all turned your BlackBerrys off so that I'm not wrong by the time this sentence ends -- (laughs) -- is the ECB is showing a willingness to build a bridge. You emphasized the lack of specificity. I think market participants will emphasize the open-ended nature of it; that is, the bridge will be as long as it takes for politicians to build the infrastructure required to make it a more durable institution. They have a lot of heavy lifting to do. In no way, shape or form is it a guarantee that they will accomplish it, but I think the open-ended part is what you should emphasize, not the lack of specificity.

MALLABY: That would suggest -- and maybe I'll go to Lewis next -- that would suggest that when Draghi says I'll do whatever it takes, people really believe it. I mean, they think he's not going to say, you know, whatever it takes on condition we've had, et cetera. There have been so many pledges that have proved to be disappointing. Why do you think -- Lewis, do you agree that this one has a different quality to it, that whatever it takes really means whatever it takes, that we will be there to support a program as long as is needed?

LEWIS ALEXANDER: I do agree because I think what's inherent in what they're talking about is an evolution of the constraints that the ECB sees on its own policies. I think in the past, this sort of direct support for sovereigns was sort of viewed as beyond the pale, and you're seeing a kind of an evolution of how the ECB sees its core mandate, that allows it to build that bridge. And I think that's a very important change for the better.

It's also important in terms of the constraints in terms of the critics on the ECB board and the degree to which they create a kind of a veto over any sort of more active policy. If, in fact, what we learn today is that -- or in the next couple days is that the ECB is prepared to go ahead even though there are a prominent minority that sort of is in opposition to this, that's, again, a very important easing of constraints on how they can respond, which I think is very important.

And so, look, as Vince said, this can go wrong in all sorts of ways and this is no guarantee of the ultimate outcome, but I do think this marks an important change.

MALLABY: Well, let me put on the table and get some general reaction on this one way in which it could go wrong. And that is, it seems to me, supposing Spain agrees to come forward and asks for a program, which of course they haven't done yet, but if the politics allows for that to happen, then Spain is eligible for the purchases of sovereign bonds, but you still have a situation where deposits are fleeing the Spanish banking system, so banks are, you know, constrained in terms of how much they can extend credit. The price of credit is very high in Spain. And that seems to me to suggest a very painful route out of recession. You know, can a program work in the face of -- well, if the public sector and the ECB is supporting the sovereign but the banks are credit constrained, can you work your way out?

JOHN LIPSKY: Well, let's come back to what Vince said, that there's a lot of heavy lifting that's going to be involved, and that's for sure. It strikes me there's a lot of attention being paid to the ECB, and that's reasonable and sensible. They're the folks who, when the crunch comes, can show up in the morning with a lot of cash at the window.

But I would focus more on the other things that are -- that the ECB said its actions are conditional upon, and those are very nontrivial. One, we should remember that on September 12th, there are two important decisions that are coming up -- one, the Dutch election, and second, the German constitutional court. I would have been surprised if the ECB was going to be very specific about what it would do in advance of the German court's decision, which bears on the legality of the European stability mechanisms, actions to provide, among other things, direct support to banks, not going through the sovereigns.

So the ECB says, we're willing to step up and do what it takes if country X engages in an adjustment program. It hadn't specified what that means. Obvious question: Does that mean an IMF program or not an IMF program? Second, will the ESM be ratified and will it be active in, well, providing direct support to the banking system, e.g., in a country like Spain?

So in a way, although the attention has been on the ECB and what it might and might not do, it strikes me that it's the preconditions to EF -- ECB action that is really the critical issue: the quality of the program and its nature, the ability of the ESM to provide direct support to banks.

MALLABY: What about -- maybe I'll insist on this question -- my scenario with the public fight in Spain. Vincent, Lewis, do you want to weigh in on that?

ALEXANDER: Look, it's obviously a -- it's sort of an important issue that, if it continues, is ultimately going to be something that could sort of drive this. I think the points John made are absolutely right, and there's a lot of other things going on. And one of the other things he even mentioned was we've got the European Banking Union coming up that's also sort of an important piece of how this all goes forward, which bears on that.

So essentially, if you -- if they can construct this banking union, which will include the infrastructure that allows you to do deposit insurance, those are sort of important microelements for how you deal with all of these. And those things are fundamentally uncertain. So there's a -- you know, I agree with -- you know, on both sides, there's an awful lot of moving pieces here that have to go forward.

I would come back to the notion, though, that -- like in the sense of what's changed over the last month -- to me, the biggest change is a different attitude on the part of the ECB in the -- in terms of the way it sees its mandates, and I think that's material in terms of the potential outcomes.


REINHART: The basic question you have to ask yourself is, what is the euro about? Was it a social decision or was it an economic decision? If it was a social decision, then it basically tells you that politicians have an unlimited pain threshold, they understand their voters, and they're representing their interests. If it's an economic decision, then deposit flows do matter. They have to worry about the consequences for growth; they have to worry about the consequences for support of their national financial champions. And at some point, some -- on some future weekend, leadership will get a phone call that surprises them, and they may make a different decision than they made previously.

It really does rely on what is your vision in the future. Did they go into this as a social decision or an economic one?

LIPSKY: But Vince, this -- it doesn't have to be an either/or. Isn't part of the complication that the answer is, is it this or that? The answer is yes, it's social. (Laughter.) And it's economic and financial.

REINHART: So you could fully -- it depends on what is the endgame; what do you see as the future? And you can see European unification in the end on a north-south axis or an east-west axis. The north-south axis is Italy, which is basically two regions with a common flag, held together by transfers from the rich to the poor -- but you could argue plausibly that -- both regions having pulled up the total. On the other hand, east-west is German unification -- two regions pulled together, large transfers from the rich to the poor -- and 12, 14 years later you say both pulled each other together.

If in the end the whole idea of Europe was a social decision to bring about the better economic one, then the costs now of bearing with the crisis are probably manageable. If, on the other hand, it is still an almost unlimited sequence of transfers to stitch the whole thing together, that's a much different determination.

MALLABY: But in some sense, the fact that you even have to pose this question -- is it a social project or is it an economic project -- you're saying that you don't know the answer. And nor do any of us. I mean, we know -- it's -- we're looking. And to the extent that we don't know which it is, there is uncertainty about policymaking and there's uncertainty about the sort of determination where something like Draghi's pledge will be played out over the extended period of months.

REINHART: And that's exactly the fuel on their speculative attack of a currency union. If you're not sure of the motives behind the design of the principle, then financial markets are going to take a run on the institution, and they're going to find out whether the pain threshold of politicians is limited or unlimited.

ALEXANDER: And -- if I could just -- it's, I think, interesting to think about German unification in this context. Wall came down on November 9th, 1989. The monetary union was implemented on July 1, 1990, and full political unification was on October 3rd, 1990. In less than a year, they went from a cold start to full integration. And that -- well, obviously, the fact that they were able to do that and very well, not flawlessly, but extremely well, suggests that the institutional constraints over doing those kinds of things are not the real issue.

Well, of course laid behind that was a more or less instant political consensus around where you are going in the end, right? That was almost from the beginning never in doubt.

And in some sense, the question Vince is raising just in the way you framed it is we don't have that here. And, you know, the more you hear European politicians sort of struggle around what really is the political commitment to the end game, you get sort of all of those doubts come back.

MALLABY: I mean, one prism, one example of these doubts about whether the project has really got the political oomph behind it to work I guess is this question of banking union, because there is talk of a banking union; there is talk that this is the quid pro quo for allowing the ESM bailout fund to help the banks directly. But the definition of banking union goes from sort of the fig leaf of the European Central Bank supervision of the biggest banks, which is one version of it, through sort of European Central Bank supervision of all European banks, and then finally, at the extreme, to deposit insurance, which implies such a sort of fiscal -- potential fiscal transfer that I think most people think it's politically implausible, at least in the next period. So how do you see this, John? I mean, isn't there a -- so much uncertainty around it that again --

LIPSKY: Right. Look, Sebastian, let me take a step back and give at least some perspective on this. The two -- when you think about the critical comments or the doubtful comments about the sustainability of the project, of the MU project, they really center around two issues, number one, that the -- that the eurozone is not an optimal currency area, insufficiently economically integrated, and second,that it lacks the flanking -- let's call them fiscal or governmental or governance -- institutions necessary to running a currency union. Both of those issues were evident to the participants from day one. The idea was not that they -- with a doubt about the zone being an optimal currency area. The decision was to try to make it an optimal currency area, and the currency was going to be the fulcrum that was going to force the integration and reform that was going to make it an optimal currency area.

What was not foreseen was that the mechanisms of discipline that were supposed to drive that, which was the no-exit clause for -- once you get in the euro you can't get out, and the idea was you're forced to adjust, who knew at the time that (EG ?), Greece, Portugal, Ireland would have access to huge amounts of credit at extremely fine terms? In other words, it was market discipline that failed primarily, or at least significantly, in this context.

Secondly, the problem with the fiscal -- with the governance, called the governance issues, which were understood right from the start, that there was -- as everybody said, there was no clear consensus about is the ultimate goal a United States of Europe? Is the goal on the one hand, or is this just a customs union? This isn't so dissimilar, as many have pointed out, to the -- to the formation of the United States.

But the -- here again, the idea was, let's not try to reach agreement on the end result, because there is no consensus, but let's take it a step at a time and let's develop the institutions necessary as the problems come up.

What was not foreseen was that the context in which huge decisions would have to be taken was the mother of all financial crises and emanating, essentially, from the United States. So the pressures are far greater than were anticipated, and they're being forced into making big decisions. We're going to find out if they're willing to make the sacrifices necessary to sustain it.

And just to finalize, yesterday Bill Cline at the Peterson Institute presented an interesting study of Spain and Italy, whether their debt is sustainable, and the conclusion is under most plausible scenarios, the answer is yes. Under those circumstances, it would seem to be surprising if the project would be abandoned, in essence, in that context.

MALLABY: Vincent, next week we have an interesting meeting for the Fed. One friend of mine who watches it says that he thinks the variance in potential outcomes is higher than most (meetings ?) he can remember. I don't know if you agree with that. But how -- tell us how you think about the debates on unconventional policy following the Jackson Hole speech.

REINHART: So I think there is one undecided member among the FOMC participants. That's Chairman Ben Bernanke. (Laughter.) And that's why the variance is higher. When you're trying -- when you're trying to forecast the behavior of 12 or 19, the variance shrinks in; when it's one it's larger.

And the reason is, because Chairman Bernanke cares about a consensus of all 19 policymakers, not just the 12 people who vote, because everything is precedential, multiyear in nature -- he cares about the political legitimacy of the institution and does worry about what happens and what that implies for the probability of a Federal Reserve reform act of 2013, which is not a trivial possibility.

And then third, he's got a group of people who are doubtful of the efficacy of their policy instruments or their ability to use them in a sufficient magnitude. The last time they set their policy instrument was in June, which was to extend "operation twist." And on the basis of that, they forecast that we would have an unemployment rate that tracks above their long-run estimate and inflation that was everywhere below their goal.

That tells you it's a policymaking committee resigned to poor economic performance and doubtful about their instruments. They've got a couple. We think that the natural thing for them to do is work on interest rate guidance. That is next week add another year to their forecast and say, guess what, we're treading water for another year. It's appropriate to stretch out their promise to keep interest rates low.

What they're on the record for is extending their "operation twist," their purchase and sale of Treasury securities to year end. That gives them a perfect opportunity in December to revisit their balance sheet. In December, precedent suggests that two out of three times they'll know who's president of the United States. (Laughter.) They'll know who's running the House. They'll know who's running the Senate. They'll have a lot more clarify on the fiscal cliff. And they'll also have just heard the opinion of the American people about how interventionist they want their policy officials to be. And so they can make a much more informed decision about their balance sheets -- so rate management to deal with what is a pressing problem: unemployment rate too high, unacceptable downside risks to inflation. But that's holding the bridge until December where they do balance sheet.

MALLABY: One of the things, Lewis, in the chairman's Jackson Hole speech was this defense of the idea that quantitative easing really worked. I think my personal sense from looking at studies before had been that it worked the first time and less in the second time, and this sort of diminishing curve of -- (do you think ?) to be resisting that or de-emphasizing that?? (Wherein ?) the truth lies?

ALEXANDER: No, I -- no, I think it's always been clear that the first round of QE, which came in 2009 when markets were still very disrupted, was naturally going to be more effective than if you do it under more normal times. Frankly, if you go back to 2010 and look at his speech, he made that point then. So I don't think this notion that it's been less effective in the more recent times than it was in the first rounds is anything particularly surprising or new. And I think -- my own -- my reading of it was that the chairman kind of went out of his way to stress the fact that it still is effective. And ultimately, that is a tool which they have available to them to use as needed.

I think there's -- I think it's pretty clear that they, as Vince said, are frustrated by the fact that they don't have more effective tools. As a consequence for that, they're looking at everything they can imagine that they might do otherwise -- for example, what the Bank of England is doing with its Funding for Lending program. I think there is also this sort of interest in, is there a way to sort of evolve the communication around rates or perhaps the way you implement QE that might make it more effective by tying it more to economic conditions in the future.

I think while the -- while those things are all going on and they are kicking the tires pretty hard on all of that, I'm -- I don't think they're likely to come up with answers that they haven't come up with before on them. So I think we're sort of basically back to those two choices. And essentially, that's the way the chairman framed it, I think, in the way he reviewed the performance of the last couple of years.

LIPSKY: If I could -- but these two guys are -- as expert as anyone on the -- working to the Fed -- reading the chairman's Jackson Hole speech, I thought he made very large claims for the impact of QE. He said it -- that that output was 3 percent higher and unemployment 2 million higher than it would have been without. Those are very large claims. And I thought -- if you read his last sentence, I thought that came -- from the speech -- that came as close to a declarative sentence on future policy as I think I've ever heard a Fed chairman give. And if the -- unless there's any -- what I thought it said is unless there's some change in the economic outlook, we got to do more.

REINHART: There's no question they're leaning forward. And the presumption is there'll be policy accommodation. And the question is what is the right sequence for that policy accommodation. For central banks a natural order is you work on rate management and then you work on balance sheets. So I read the last sentence as saying, those things are coming unless the data are surprisingly to the upside and the likelihood of that is pretty low.

Wrote a couple papers with then-Governor Ben Bernanke on quantitative easing eight or nine years ago. Most things in life have diminishing marginal returns. It's not surprising that QE does too. QE is a lot like sterilized foreign exchange intervention. When markets are disorderly, when you don't have a lot of capital, when traders don't have conviction, you don't have the possibility of capital coming in from other markets, then the actions of the central bank can have large effects. When, however, markets are orderly, when traders have conviction, when there's possibility of capital coming in from everywhere, they typically don't have much effect.

And -- now that -- the last point is, this is a crisis in financial markets, financial institutions. It was also a crisis in economics and finance. Our models don't work particularly well. The idea that you can assert 1 percentage point consequence of QE and then put it into one of those models and then grind out a solution that says there are that many more employed as a consequence, is probably a stretch beyond what we're capable. (Laughter.)

MALLABY: One more question, loosely related to -- (inaudible) -- on financial regulation, which -- (inaudible) -- Lewis, maybe for you. I guess the sort of most striking development in U.S. financial regulation recently was this decision by the FCC to back off on money market funds. Do you see that as -- I mean, you know, we've had some regulatory action on banks, shadow banks much, much less. Money market funds are a central part of the shadow banking system. And the FCC's busy saying: We can't do it. Does this leave -- it's now up to the FSOC or what happens next?

ALEXANDER: No, I think this is a very important kind of issue that the FSOC has to address. In some ways, they've made the case already that money market funds are a systemic issue. I think there's been a lot of work on that and a lot of consensus around that -- some of it done by some people in the audience here.

And I think now the fact that the FCC has been unable to address this, one of the things FSOC was put into place to do was address these situations where you have a systemic issue that isn't being addressed by the primary regulator. And so now this is very much in the FSOC's agenda. I think it has to be. And there's obviously, you know, a complicated set of questions about exactly how you do this.

How -- you know, one option is to essentially put it back to the FCC by making a systemic designation for the activity as a whole, the first response of which would be to then put the onus on the FCC to address this issue again, which may be the right way to go. Alternatively, you could actually designate money market funds as systemically important institutions themselves then have the Fed take over sort of the regulatory role.

But in some sense this is exactly the situation that -- one of the situations that Dodd-Frank was designed to address. And so I think in some sense it is a -- it is a unique opportunity for that whole structure to essentially show its worth. So I think this is -- this is an important issue.

MALLABY: Will the opportunity be taken?

ALEXANDER: (Laughs.)

MALLABY: (Inaudible) -- was that they have to do it. Will they do it?

ALEXANDER: I'm no longer directly involved. (Laughter.) I think if you look at -- if you look at first -- if you look at the first FSOC report, see, it's very clear that one of the principle systemic risk issues they identify is money market controls. I think the situation they are in now with the FCC having not acted, I think demands action.

And so obviously we're going to see who's -- who wins the presidential election, who's controlling -- you know, who's essentially chairing the FSOC going forward. I think by the -- just by how long it takes to work these things through, it probably won't be Tim Geithner. If it was Tim Geithner I'd feel pretty confident in predicting that they would address it. Given that this is going to be probably on somebody else's watch, I'm a little less confident. But I think the answer is yes.

MALLABY: Just before we open up and invite members to join the conversation, I want to put one question to John about China. And that is that, you know, China in some sense has had a couple of successes in terms of its sort of perceived participation in the global economic community. One was right after the Lehman Brothers collapse. There was a global coordinated stimulus, and China contributed handsomely to that one. In terms of trade imbalances, China's trade imbalance has shrunk a lot. So these are two good things.

But it does strike me now that we've been discussing what the central banks could do in Europe and in the U.S. Sweden has just cut -- this morning, I think. There's a lot of action around the world. And yet Chinese growth by Chinese standards has come down a lot. And policy action in China, on some readings of it, has been surprisingly cautious. Do you think we're kind of coming up to a moment where China may be nudged by economic leaders in other countries saying, come on, you should do your share here to prop up global demand?

LIPSKY: An interesting question. Of course a central factor -- two key unknowns. One is, how slow is slow in China? If you take a look, for example, at the recently updated IMF forecast, it's calling for essentially a soft landing, 8 (percent) to 8 1/2 percent growth in China. Certainly that's not double-digit, but that's not shabby either. And in the context of relative success in rebalancing the economy towards stronger growth in domestic demand and less reliance on net exports, because that's consistent, in -- at least in the IMF forecast, with a continued current account surplus under 3 percent, which is, of course, dramatically down from where it was before the -- before the crisis.

The second unknown -- but as I say, what's unknown is, is that right? Is this a soft-landing trajectory in which you'd have to say things are -- obviously there's difference in the prosperity of given sectors. We've seen the recent manufacturing data in China suggest a significant slowdown, which would give pause and create question of whether that soft landing view is too sanguine. And if so, I think there's a general sense that there are policy levers available to the Chinese authorities if things are going much softer than they had anticipated. And if that is the case, then I suspect there will be not only external calls for policy action but, even more importantly, domestic calls for action in the context of the second unknown, which is the leadership change that is coming up in a -- in a matter of months.

With the new leadership, as I understand it, on the -- committed to a rather activist set of economic policies along the lines of the '12 five-year plan already adopted as formal policy -- and for those who haven't read it, if you read it, I'm sure most folks here would read down that list and say, right, right, right, right, right. It's liberalization, market orientation, et cetera; reform of the fiscal system, reform of the banking system, the financial system. Let's see if it all gets done. But for right now, the key question is, how slow is slow? If this is a soft landing, then they're going to be fine. If it's worse than that, then there certainly will be calls, as I say, domestically for things to do.

MALLABY: OK. Let's see if there's any questions from the members.

Right here on the aisle. The microphone should be coming, so please speak directly into it and --

QUESTIONER: Marge Avarilla (ph). I wanted to ask the panelists -- returning to Europe, to what extent do you believe that labor market reform emanating from Brussels will be a significant factor in the fix for Europe's woes?

LIPSKY: Well, that's a -- may I? That's a -- that's a favorite of mine.


LIPSKY: I'll be real quick. I always called that vision -- I called that the Lisbon -- the Lisbon agenda fallacy. The notion that market -- that labor market reforms begin with legal changes and then emanate to market changes is -- get things backwards. I think how the -- how labor legislation changes is, companies become under pressure, they put pressure backwards on their workforce for improved performance in the standard ways, and if that rubs up against legal constraints, then their pressure comes against -- to the -- to the legal authorities, to legislatures to make the appropriate changes so things can get -- can get going. I know of very few times of which I can think of important changes coming first at the legislative level without already having created -- without a swell of support from the -- from the -- let's call it the corporate or business sector. I think that is happening, and of course, the place that is the poster child for that process was Germany under -- in the Schroeder government.

LIPSKY: So I was on a panel, the title of which was "The Financial Crisis in Europe: a Blessing in Disguise," -- (laughter) -- the theory being that market pressure would then lead to reforms and that would be so growth-enhancing that they would -- the crisis would pay for itself. My answer was if it's a disguise, it's a very good disguise. (Laughter.)

MALLABY: (Inaudible.)

QUESTIONER: Andrew Gundlach, Arnhold and S. Bleischroeder. That answer might lead into this next question, which is you really have two approaches here, the U.S. approach, which is Keynesian and easy money, and the argument is that there hasn't been enough spending, and the European approach, which is really Austrian: there's no credit available, and there's deflation forced upon most of the population. And the question is which one, if you're not an economist, rather financial historians, which one is going to prove to have been a better approach? And what are the unintended consequences that you worry about in each?

MALLABY: Maybe we'll go down the line here and have a -- (inaudible) -- from everybody. (Laughter.) (Inaudible) -- pointing it out, because there's people -- he doesn't want to start.

REINHART: So let me --

LIPSKY: Well, I don't think anybody's policy has won any gold stars.

MALLABY: (Inaudible) -- let's go to Vince.

REINHART: Are we going to start this way? So let me give the answer that Lewis won't give, so therefore -- (laughter) -- we'll have some diversity of opinion. Wrote a paper with my -- one of my -- (inaudible) -- Ken Rogoff of Harvard looking at the experiences since the Napoleonic War of 22 advanced economies, and here's the bottom line. Episodes of debt overhangs, where you have gross debt more than 90 percent, are very costly. The growth discount is on the order of 1.2 percent slower real GDP growth per year as long as you're in the debt overhang, that those episodes are very long; median duration is 23 years. So if you wind up with high debt, by the time you get out of it, the level of debt is at -- level of GDP is a quarter lower than it had been if you'd never got there.

And it isn't always about rates. It isn't about market discipline. Eleven out of the 26 cases of significant debt overhangs, it wasn't market discipline forcing that contraction; it's something else. So I understand that the unemployment rate is high in many advanced economies, unacceptably high. We need more policy accommodation. We have to do that in a way that gets us to a path for which we have a -- consolidate our fiscal accounts.

ALEXANDER: If you frame it as U.S. versus Europe, one of the crucial, crucial, crucial distinctions is, of course, the U.S. benefits as a safe haven. And so in some sense, we have the flexibility to deal with Vince's problem over time, in a way, that other countries don't. If you compare us to Greece, right, we have the luxury of time in a way that they don't. And I think that that drives you to different answers.

Now, the obvious point that -- you know, in some sense, the work that Vince just described creates for the U.S. is you can't do this forever. You do have to pay attention to the long run. There's got to be some sort of solution that strikes the balance between those two things is, I think, important.

But if you look at where the fiscal debate is in the U.S. at this moment, what's striking about it is it's only about the pace of consolidation. The -- in some sense the Keynesian side of that debate is frankly not in play at the moment. It really is the question of how fast we're going to do consolidation, not whether or not we're going to do stimulus now and consolidation later.

And I think that -- it's certainly (effecting ?) upon -- is on the forecaster, but we -- you know, the United States is in this sort of very different position. You might argue Japan, somewhat different circumstances, very high domestic savings rate, managed to sort of face a different set of constraints in that environment.

But I ultimately agree with Vince that, like, you have to deal with this problem, and you can't get around it. But we are operating under somewhat different constraints.


LIPSKY: Yeah, which is everything is fine until it's not fine. But --

ALEXANDER (?): I didn't say not -- I said we'd have --

(Cross talk.) (Laughter.)

MR. : Anyway, the -- of course all the --

MR. : Do you really want to go there Vince?

(Cross talk.)

LIPSKY (?): All that, including Vince and Ken and Carmen's study, was music to the ears of the folks at the IMF, who have had this view for some time, that this is -- this is how these situations have to be -- have to be dealt with. But certainly Lew is right; everything doesn't have to get fixed today, but it's got to get fixed. And the -- and the key -- and the key is --

MR. : Absolutely. Absolutely.

LIPSKY: And the key is that it has to be -- that people have to have confidence that it will be fixed. And that's the -- that's the tricky part, namely, how can you -- how do you demonstrate convincingly that even though you're not fixing everything at once, because you can't, that you will fix it over time. And there --

MALLABY: You're talking specifically about fiscal deficits --

LIPSKY: Among other things.



MALLABY: Yeah, go ahead.

ALEXANDER: I mean, I think one of the -- one of the things which I think is important to think through when you look at the U.S. right now is, if you look at the history of how we've dealt with these things, to some extent, we went through one of these cycles in the late '80s and early '90s. We got our fiscal accounts on what seemed like an unsustainable path in the last '80s. It became a retail political issue. It generated, among other things, Ross Perot running for president.

Now, that ultimately led to a set of political choices that put us on the path of where we were in the late '90s, which was surpluses. Now, there were other things going on as well, like a surge in productivity growth and a variety of other things, so it's not -- it wasn't all policy choices. But the point I would make is, retail politics in the U.S. drove you to a solution.

I would argue we're in the same place. What is more than anything else driving fiscal policy in the United States right now is the tea party, right? It's driving it in the sense that they are saying, we are on an unsustainable path and we have to fix it now, regardless of the sort of the Keynesian concerns.

Now, it's a -- we have a political system in which it is hard to get things done, by design. Our system was designed to make it hard; that's what checks and balances mean. So it is a messy process for us to get to that consolidated path.

And yes, I totally agree with you, John; there's got to be confidence in the long run. But I would argue the thing that ought to give one confidence is -- what's driving this is not market pressure, it's not the IMF imposing on it, it is politics on the ground.

And so yes, the next six months is going to be incredibly messy. I think there's a decent chance we're going to go right off the cliff because people aren't going to be able to make a -- reach an agreement at the end. Yeah, right. But I think the thing to remember is what's driving us, more than anything else, is retail politics that wants to get us on the consolidated path. And I think when you think in the long-run context, that's the thing that ought to give one some degree of confidence that we're going to ultimately fix this problem.

REINHART: So there are two constraints on fiscal policy. There's market discipline and there's voter discipline. When we talk about market discipline, it is like service in the military -- long periods of tedium and intense bouts of panic. I could've pointed to Greek spreads three years ago and said there's no fiscal problem.

So -- but I think Lewis is exactly right. Locally, there's no market discipline on the United States. There is voter discipline. That's why we're seeing change. Thing to remember about voter discipline is, it's mostly incoherent. (Laughter.) You look -- everybody hates deficits and debt; everybody loves their own programs. If you do the detailed surveys and ask, how would you fix the problem, the first answer is cut foreign aid. That's, what, two orders of magnitude off to deal with the problem. Politics is about channeling voter anger to an appropriate end.

What I compare this -- the U.S. system is -- since we continually generate voter discipline -- like the little circular Roomba that cleans my living room floor. It has no intelligence. It bounces off the walls. Eventually it gets to the point where it covers everything. We'll get to the right place -- (laughter) --

MR. : Yes, I agree.

REINHART: -- we'll get to the right place. (Laughter.) It will take longer than it would if there was an intelligence guiding the process. So in that sense, we're not like Japan, where there's both an absence of voter discipline and market discipline. But it's going to be expensive.

MALLABY: So the Kennedy School of political economy courses will soon have the floor-polishing theory of -- (laughter) -- U.S. decision-making.

Anything more from the members? Who's got a comment or a question? Otherwise, I can see the flow moving here. John --

LIPSKY: Yeah, I could add to what Vince said, which is, in fact there are -- even though this vision of the Roomba may be not completely comforting in the short run -- (laughter) -- that actually there are a number of factors that seem quite positive for the U.S. economy in the medium term, certainly -- the energy outlook, which is -- it's very -- it's very striking that, near term, you have very high energy prices and medium term, the -- all the experts tell you that the outlook for energy costs in the United States is differentially favorable, not only favorable in the absolute sense but favorable in a relative sense. And at the same time, we've seen the corporate sector obviously do significant deleveraging; banking system, significant deleveraging. The underpinnings -- it seems the financial underpinnings of the corporate sector are very sound.

It's interesting to me that people have talked about the paralysis of uncertainty. That's a -- that's a press favorite. In fact, as we all know that business spending on equipment and software has actually grown at a solid pace, if everybody was paralyzed with uncertainty, it's sort of hard to understand how that was -- how that was happening.

And at the same time, even though we still have questions about the near-term outlook in the housing sector, I think it's obvious the trend rate of new house -- new household formation in the U.S. is probably someplace between a million and 2 million a year. Who knows? But it's -- since 2008, we've been producing about -- conceivably half the new units that are necessary to fill sort of the generic demand trend. All of that suggests that there's -- there ought to be, if we can get the impediments out of the way, that the medium-term outlook ought to be quite satisfactory.

MALLABY: OK. Any questions from membership? I have one, though I see one over there. OK. Thank you. Byron.

QUESTIONER: It doesn't seem -- Byron Wien, Blackstone. It doesn't seem to me that we're going to solve this problem without very significant structural changes on both sides of the Atlantic. There's no evidence that the Democrats are going to be sufficiently aggressive in cutting entitlements and there's no evidence that the Republicans are going to be sufficiently aggressive in raising taxes. And we're not going to solve the budget deficit problem without doing both, or at least I don't think so.

So what -- it seems to me that you as a panel are too complacent about this -- (laughter) -- you know, that you think that eventually, you know, we'll solve the problems because we always seem to. But there's evidence that we're in much more trouble than we've ever been before.

We had $6 trillion in debt in 2000. We have $16 trillion in debt now. It's going up at a trillion-dollar -- more than a trillion dollars a year. And Congress won't do anything about it because we can borrow money so cheaply. They won't do anything about it, in my opinion, till interest rates go up, but by then it'll be too late. So I'm worried there aren't enough structural -- there isn't a motivation for structural change.

And the same thing is going on in Europe. All they're doing is temporarily solving the problem there by providing funds. They aren't really dealing with the structural issues. They talk about it, but if you look at what's going on in Italy and Spain, it's just not enough. So my feeling is, you're too complacent. Am I being too critical? (Laughter.)

ALEXANDER: I am not going to -- yeah, I think that was mainly directed at me and not my two colleagues, who are -- (laughter) -- I think, more -- less complacent on your scale than I was.

First of all, let me agree that the circumstances are much worse than they were in the 1980s, and the concerns that both these guys expressed about, right, if we were -- get to the -- if we were to get to the point where the market paid attention to long-run fiscal sustainability in the United States, that is a very big deal that none of us wants to deal with, number one.

Number two, there is no question that we are headed -- in a kind of a political environment that is very contentious and very partisan, with both sides staking out positions that are hard to move.

But I think I would point to the following signs for somewhat more optimism. First of all, it's clear from all the reporting that the president and Speaker Boehner came pretty close to a significant deal last summer that included significant changes on entitlements on the part of the president and some revenues on the part of the Republicans. Now, that -- you know, that -- obviously, that deal did not come forward, but there is a basis for some optimism that they've worked through the details closely enough to sort of think about those options.

Second of all, I take as progress the fact that Chairman Ryan has put forward a budget that has a -- actually involved going out and getting the Congress to vote on spending cuts that are, you know, nontrivial, right? I -- they're not necessarily that I would choose, but the fact that they've taken the action of actually forcing the Congress to vote on those things is a sign of some movement in this area.

I think this is something that is going to take multiple years to get us there. And I would come back to the notion that ultimately, what is driving us is a dissatisfaction on the part of the American voters (on ?) the fiscal path we are on, and that that is going to be reflected, as it has already been reflected, through our elections. That is, I think how you -- how I take, you know, what happened in 2010 more than anything else. And so I think you're going to see that reflected going forward.

And so -- look. I -- the -- one of the things I spend a fair amount of time thinking about is systemic risk. And the -- sort of the mother of all systemic risk is if you get to the point where you see some transition away from U.S. Treasuries as the safe haven asset. There is nothing that tops that in my mind as a systemic risk.

Now, having gone through what we went through in 2009, I mean, I -- you know, where every day -- every -- and every day when we had a bad day at the point, I checked to make sure that Treasuries rallied, because the day when you have a bad day and risk and Treasuries don't rally is the really bad day. (Laughter.)

And I have to admit, I kind of look at what's happened over the last three years, and I kind of ask myself the question, OK, like, what is it going to take for foreign investors to look up and say they don't want to own Treasuries? And I don't want to get there. And I want to do everything to prevent us from getting there. But it's hard not to look at what we've come through and argue that there is some resilience there.

REINHART: So I really -- I really am flattered that I could be on a panel and viewed as an optimist. (Laughter.) And I think that my statement isn't about any local optimism. I think it's just a mistake to undercount a market economy that historically has been very resilient, and so historically we've risen to the challenges.

We have to make as a nation three realizations. Number one, the average tax rate has to go up. Number two, you don't necessarily get the average tax rate up by raising marginal tax rates in an inefficient tax system. Number three, the biggest overvalued asset in the world right now is the net present value of entitlements that our citizens think they're going to get because we don't have a fiscal system that can actually deliver that. Those are three really hard things. It isn't obvious to me that we have a political system that generates those solutions really fast.

If you want to look for good news, the good news is this election is most likely going to be contested on two distinct visions of fiscal policy. The even better news is we are in -- terrible at delivering fiscal policy right now. We are so far inside the efficient frontier of fiscal policy that any which way is up. (Laughter.) And so it is possible to define two distinct, coherent, credible visions for what we should do that get us to a better place. They differ on your view on the size of the government, the -- you know, the progressivity of tax system, the role -- the role of the safety net. But we can do it. And we just have to -- we'll get there eventually. It may wind up being very, very costly, and it'll -- it could be a close-run thing.

LIPSKY: OK, here is my bit. The -- look, it seems to me that there are -- there are several factors here that -- obviously, there is a set of downside risks here, downside risks in Europe, particularly (happening in ?) Europe. But it seems to me, first of all, there is a notion, public -- I would say a popular notion that the rise and debt and deficit in the United States was due almost entirely to discretionary decisions by the U.S. government, which is simply not the case. Most of the rise in debt and deficit reflects the weak performance of the economy -- automatic stabilizers. At the same time, even though federal -- and as a result, the deficit ought to be geared towards a renormalization of the economy. In other words, it'll improve if the economy, in fact -- in fact, improves. And I think (you gave ?) couple reasons why you think that that's still likely.

There is a window -- but at the same time I would say there is a real window of opportunity for improvement in fiscal policy that, if it is not met, is a real danger. And it's easy to define. Federal debt as a percent of GDP has increased by 50 percent since the beginning of the crisis, and federal debt service as a percent of GDP has increased by zero since the -- since the beginning of the crisis. This is not going to last. Forget the -- forget anybody losing faith in treasuries. If there's a renormalization of the economy and a renormalization of real interest rates, federal debt services at percent of GDP is going to go up by 2 (percent) to 2 1/2 percent in the next -- by the end of the next administration.

So if they don't make progress toward improving the medium-term fiscal outlook in the next two years, it's going to come back and eat them alive, because they're going to be struggling to hold the deficit down just paying the debt. So this isn't going to -- this isn't going to go away.

And Myron (ph), you may be right that the -- that Congress is -- they're -- everyone's too myopic to do anything about it. I hope you're -- I hope you're wrong, and it's -- let's see what happens. In Europe, I would say the short version is is there a plan? I'd say the answer is yes, there is an explicit plan what they should be doing. What you're basically seeing is an argument about who's going to pay. And I just don't think it's -- it makes sense or is reasonable to expect that while they argue about who's going to pay the bill, they're going to go over the cliff, i.e., as I call it, the Wile E. Coyote moment. (Laughter.) Could happen, could happen, but as you can see, some decisions have been made in Europe over the past few months that a year ago would have seemed impossible. Now, doesn't mean it's going to -- it's going to succeed, but I think there's reason for thinking the heavy lifting that we started out with Vince talking about is, in fact, going to get done. (Inaudible) --

MALLABY: I think we've got time for one more question. I saw somebody earlier just there --

QUESTIONER: Hi, David Malpass with Encima Global. We haven't talked about taxes, so we have a tax (clip ?) at year end. If -- as Vince says, average versus marginal rates, does that inevitably get us to consumption taxes as the population ages?

MR. : (Inaudible) -- do you want to try that?

REINHART: I don't think inevitably. That's obviously one solution. I think -- just following up on John's list of good things, one of the things that I'm encouraged by is all the discussion that's actually going on about fundamental tax reform, that sort of -- that's part of but really independent of the fiscal story. And I think we have a tax code that is very inefficient. I think you've had -- the president's come out with a white paper supporting essentially risk -- revenue-neutral corporate tax reform. You've got the House doing hearings on that now, which is the necessary preparatory work.

So even in a -- even in a kind of a world where Obama gets re-elected and you have a Republican Congress, I think there's a decent chance we're going to get fundamental tax reform, and I'd add that on to the list of John's things.

Does that -- do we ultimately get to a consumption tax? I'm an economist, so I can certainly make the argument for why we're there. I don't think that's really part of the debate right now. We're a fair -- a fair way away from that, but we'll see.

I do think one of the risks, which I think people are sort of discounting, is the notion that for essentially bargaining and strategic reasons, we will go off the fiscal cliff, right, in the sense that the advantage of doing that is then the tax rates reset back to where they were at the beginning of the Bush administration. And then you can have a different debate, which is a debate about let's do a big tax reform that includes cutting taxes for most people. And that is a more attractive debate for both sides to have than the current one.

And so I -- and, you know, there's a lot of been -- work been -- (inaudible) -- now like what's the economic consequences of going off the cliff? Well, a lot depends on whether or not you think it's permanent or temporary. If you think you roll into Jan. 1 with no deal on all of those things are there forever, that's a very bad world. But I would argue that's a bad assumption. If we go on the cliff, there will be a -- (inaudible) -- of negotiations that will get us a big tax bill early in the year that will -- (inaudible) -- I don't think that's going to include a consumption tax, would be my prediction. But I do think actually tax reform over the next year is one of the sort of potential upsides.

MALLABY: I want to --

REINHART: Let me just say it here: a consumption tax layered on top an -- of already inefficient tax systems should be very frightening. A consumption tax part of a total reform should be welcome.

MALLABY: Let me just wrap this up with asking for a one-word answer from each of you -- (laughter) -- in --

MR. : Surely you're kidding.

MALLABY: In three years' time, how many members of the eurozone will there be? You're allowed to say 17, 16 or fewer. John.


MALLABY: (Inaudible.)

ALEXANDER: 16 or fewer.


MALLABY: OK. (Laughter.) Consensus. Thank you very much. (Laughter, applause.)

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