World Economic Update

SEBASTIAN MALLABY: So welcome to the council. I am Sebastian Mallaby. I work here at CFR. We meet at an interesting time. I don't mean that in a nice way. (Laughter.) We have the taper upsetting markets. We have the prospect of a Chinese growth slowdown. We have the prospect that Japan is maybe not irrelevant to the global economy, and maybe even Europe is in a lull that will not prove permanent.

But -- we'll get to all those things, but I want to introduce people first. First here is Simeon Djankov, who was until recently the finance minister of Bulgaria, Bulgaria being in the EU but not in the eurozone. You've been on the inside of all the debates and decisions that the euro system has been making. For the most recent period before that, Simeon was a regulatory economist, a senior economist at the World Bank, creator of the well-known Doing Business indicators on business conditions around the world. Then we have Lewis Alexander, who is the chief economist for the U.S. at Nomura, and before that senior counselor at the Treasury. And Vincent Reinhart, who is the chief U.S. economist for Morgan Stanley and before that had a long career in senior positions at the Federal Reserve Board.

So Vincent, let's start with you. We'll start with the U.S. economy. I think you recently revised up your growth forecast both for this year and for next year. Talk a little bit about what's driving your optimism about the real economy while the financial economy is heading down a cliff.

VINCENT REINHART: Part of it is the calendar. Part of it is surprise. Calendar is the financial crisis is receding and that the drag on the level of activity associated with having to delever and derisk and reregulate finance is lifting. And so we would expect to see the expression of the resilience of a market economy once we get past the fiscal consolidation. Then comes the surprise. We have something like on the order of 1 3/4 percent swing in the structural budget deficit, mostly front-loaded in this year, and it looks like the U.S. economy is going to expand on the order of 2 percent in the first half. So that does suggest that there's some underlying momentum and that once we get past the full effect of the fiscal drag, growth can pick up, to the neighborhood of close to 3 percent by next year.

MALLABY: So you mentioned the fiscal drag as being less of a threat. Lewis, do you share that sense that -- first of all, do you share the sense that the growth forecast needs to be revised out and this fiscal drag a bit --

LEWIS ALEXANDER: Look, I think generally the Vince characterized it I very much agree with. I think there is a bit of a question in my mind about whether or not the fiscal drag we've actually experienced, or whether or not it's an issue of timing. So we have seen household savings rates fall quite sharply in the first quarter. There's a basic question as to whether or not that's sustainable.

But the overall picture I would very much agree with. And in some sense, when you think about the volatility that's been generated by the discussion over Fed policy, I think you have to remember that it comes in a context of it's an improving economy that's generating the whole discussion.

MALLABY: So let's get to the Fed and its meeting this week, and I'm going back to you two because you've both worked there -- Vincent most recently. Would you say that in some ways Bernanke's comments last meeting were a mistake, in the sense that he has managed to spook the market before he really seems to want to taper, and so he's brought forward the market reaction more than he needed to have done?

REINHART: So execution issues are always problematic in a big committee, a democratic committee where you have a lot of governors and bank presidents out expressing all sides of an -- of an issue. I think deep down your characterization of bringing forward -- volatility bringing forward is bringing forward some of the adjustment that ultimately has to be made.

If financial conditions otherwise remain supportive of spending as Treasury yields back up because their view of the economy is looking a little better and equity markets can support that, then the Federal Reserve is in fact getting some of the adjustment done before it actually touches the policy rate.

Now, were there execution problems? Did they talk too much about tapering and add an unnecessary element of volatility? That's probably the case. I think they talked so much about tapering because they wanted to convince us and themselves that it's actually a more flexibility instrument than it really is because therefore it wouldn't send a signal about their broader intentions to keep rates low for a very long time.

MALLABY: So given that, do you think that at this week's meeting the chairman will seek to adjust the impression he left last time, or will he kind of feel burned and not want to go back into that snake pit?

REINHART: So they really don't have to do a heck of a lot other than acknowledge a fact. And the fact is inflation has fallen. Inflation has fallen even further below their long-run goal of 2 percent and their interim threshold of 2 3/4 percent. If they say that inflation's fallen and they're worried about the anchoring of inflation, that'll send a signal that they're going to stay accommodating for a while. That'll get people to dial back tapering.

MALLABY: So, Lewis, just acknowledge inflation -- is that enough for the Fed or are going to --

ALEXANDER: Look, I think there are multiple ways they could do it. That's certainly one. What they say about the state of the labor market matters. What they say about the relatively slow growth in the second quarter and whether or not that's temporary or permanent will also kind of shape all of these things. What they say about financial conditions will matter.

I guess, you know, the fundamental question is the degree to which they really want to go forward at this point or not. I think in some sense if it was a mistake, they've had plenty of opportunities between now and then to correct that, and they haven't really done that. Obviously, this will be another opportunity to do that, but my sense is they're closer to this than you might think.

I would very much agree with Vince that tapering is not really a very flexible tool. I think there is this perception that they're trying to create in some ways that it's sort of just like the old Fed funds rate in the good old days when you could move it up or move it down. And I think that's a bit naive when it's pretty clear that the neutral rate of asset purchases is zero.

MALLABY: So let's come to other countries now, Simeon. This is not the first time the end of an easy-money cycle in the U.S., the prospect of tightening, has big effects on the rest of the world, whether it's the early 1980s and Latin American debt crisis comes to the fore or whether it's the '94 tightening cycle and you get Mexico defaulting at the end of the year -- or coming close to default.

In this particular instance, do you see a consequence for Europe that the whole lull that we've had in European markets in the last year may feel somewhat less resilient in the face of the end of quantitative easing in the U.S.?

SIMEON DJANKOV: Certainly that is the case. In Europe, especially over the last two or three months, there have been more and more voices that the European Central Bank's policy, essentially mimicking the quantitative easing here in the U.S., is actually legal under the treaty. And as you know, there is a constitutional case in front of the German court, very much argued by the opponents that since it's illegal, Germany shouldn't participate in it. The fact that tapering may take place here in the U.S. helps these opponents in Germany -- and not just in Germany; all of northern Europe strengthened their case. But really, what is happening now and will be happening until the mid-fall is German elections. Everybody is waiting to see what the results of German elections are. And as a result, we don't expect any activity, not that Europe is very active at any one time, but we don't expect much activity until about mid-October.

MALLABY: Is there any crisis in the markets that could happen between now and the September German election, which could force some policy action?

DJANKOV: A small crisis I think is very likely to happen, which is Slovenia. Slovenia is one of these smaller countries that not many people are following, but just like Cyprus exploded after a year of delaying and delaying, delaying until the presidential elections, they -- now everybody is hoping that Slovenia will manage to wait and go bankrupt after German election. (Laughter.)

But realistically -- but realistically, the situation there has worsened quite significantly over the last year or so. There is a relatively new government. They need help. And whether they may sustain this very bad situation until October and then get the help, I give it a 50-50 chance that there will actually be a problem during the summer.

Notice that every summer since 2008, there has been a problem in Europe when people are on vacation and least expect it. My guess is that there will be problem in Slovenia before the elections, and that will then unravel this comparable -- comparative lull that we've had since about April or so.

MALLABY: And if you think about this sort of -- you're know, there's a slight danger in everybody waiting and waiting for the German election and the expectation that after the German election, when -- very likely, the chancellor will be the same person, there will suddenly be this policy thaw, and grand new initiatives will be rolled out. Do you think, in fact -- well, I guess two things. What should Germany propose after the election, in your ideal world? And what will they?

DJANKOV: Germany over the last few months especially has been very hurt at telling everybody else that they should reform just the Germans have over the last decade or so in terms of labor market reform, pension reforms, in terms of export competitiveness. This is easier said than done because Germany is one large market with its specificities, and the rest of Europe is not that export-competitive, especially the southern part. But Angela Merkel has been pushing this to basically everybody who visits her or she visits in Europe, so far without great results. I think --

MALLABY: So to reform like we did.

DJANKOV: Reform like we did. But the issue is that it's one thing for Germany to do that; it's another thing to go to one of especially the smaller southern European countries, like, let's say Portugal, and say you become a great exporter, and you ask yourself the question, what products do we know that Portugal has export? Just name one product other than pork, let's say. (Laughter.) Well, they don't have -- don't have many such products, and it's very unlikely that in a short period of time they will manage to break through.

But I think the ultimate issue that nobody -- and in my four years as finance minister, participating in all of the decisions -- has brought to the fore is that unlike the U.S., Europe has rapidly aging population. Every country without exception last year was losing workers. The last incident, late last week the predictions for Germany came; it turned out that they have 2 million people less than they thought and that just in the -- in -- to the end of this decade, they'll lose about 7 million people working age, which is all of Bavaria, to give you an idea of how much workforce they'll lose. And this is an issue in every country, long-term competitiveness, long-term growth, that so far has not been addressed.

MALLABY: I feel a sort of Oscar Wilde moment there. You know, to lose 1 million people is careless -- to lose 1 million is unfortunate and 2 million is careless. (Laughter.)

So maybe we'll go to Vincent on that. I mean, starting with the same question I asked Simeon, I mean, is it possible that this lull in Europe, which was ascribed to OMT -- which always surprisingly struck me as surprisingly how well that thing worked, given the doubts about Europe's ability to execute on OMT, the fact that it was going to be conditional on country behavior, that they would -- but yet it worked its magic. Wasn't the magic really coming from the Fed, to some extent?

REINHART: No, I think it tells you the power of central banking and that it's very difficult to express an opinion contrary -- doubtful of a macro policy by shorting the security the central bank could buy. And if ultimately the ECB could step up and do it, then that would pose lots of difficulties to the enterprise.

I mean, basically the biggest lack, the -- you know, failure for the German leadership is telling us what Europe should look like. We need a vision of that shining house on the hill, right, and then, having done that, provide the bridge, finance, to get us from here to there and also recognize that not everybody's got -- can be the exporter. Somebody also has to purchase those goods, and that includes Germans. An export-led growth model doesn't work in a closed system.

MALLABY: I'm going to come to Lewis in a second, but I want to add a quick one for you, Simeon. So what Vincent just said was, we need leadership in Europe, we need the vision of where it's going. And I'm told that, you know, a big reason why we don't get it is essentially Germany, for historical reasons, hates to be a leader. If you say the word "leader" in German, it's "Fuehrer," and they don't like that. So there's this huge sort of embarrassment and reluctance to actually exert sort of enlightened leadership.

Is that sense in Germany something you observe, as a European, when you go there? Do you feel as though it comes partly from the views of other countries in Europe, which are telling the Germans, don't lead too strongly?

DJANKOV: No, it's certainly the case both Germans themselves feel that they don't yet have the historical right to lead Europe, and I've seen this many times, even on small decisions where Germany has clearly taken the decision but very informally asked the Finns or the Dutch -- you wonder why the Finns always say the most outrageous things in Europe over the last -- (laughter) -- it's because the Germans ask them to do it most of the time. (Laughter.)

So you certainly see this in a lot of the decision-making, but it also is the case that when Germany says, OK, now we are going to lead, that all of a sudden France, Italy, the southern part of Europe especially says, well, why are they going to lead? You know, we know what their leadership took us to in the -- in the past. So it's both ways, as you said.

But if I can return to one point that we've argued a lot in the last one or two years in the council of finance ministers, heads of state in Europe, which is this example. So Germany currently gives itself as the example and says, you all should be like us. But it's obvious that especially the small economies cannot be like Germany. Not everybody can be an expert.

But there is an issue of the example of the examples to follow, because prior to the crisis, if you asked people the question, what are the European examples, they were very clear. For small countries, it was Ireland, so a small out -- open-oriented, foreign direct investment-driven economy; a good labor force and so on. Midsize country, Spain -- this was given as an example. So it's reformed rapidly. It attracts a lot of new industries, growing real estate market and so on.

And now Ireland and Spain are gone, and for small and medium-sized countries, which is basically almost everybody in Europe other than Germany and France, you don't have a good example to follow. So if you ask, well, who should we be like, and there is silence in the room.

MALLABY: Let me ask just so -- yeah --

REINHART: There could -- I think you also want to remember the benefit Germany is getting from this enterprise, right? Because there's a euro, Germany's not Switzerland. It's got a weaker currency than it would have otherwise. The euro area, in some sense, is an elaborate subsidy mechanism to German manufacturers and their financial intermediaries to lend or finance. So there is an economic aspect to this as well.

MALLABY: Yeah, and ironically Switzerland is the country which maybe approximates Germany's vision of its own leadership potential. (Laughter.)

Lewis, do you -- if you had to predict, let's say, you know, on January the 1st of next year, will the European markets look calm, or we'll be back -- be back in another crisis phase?

ALEXANDER: Look, I think we -- I certainly have been surprised at the ability of Europe to manage through, you know, the crisis in the Italian elections, Cyprus and whatnot. And my -- I -- whereas I, you know, a year ago, I would have been much more pessimistic, the success of the OMT and whatnot, I think, suggests that we're in this for sort of a longer haul.

I think, having said that, the thing I worry about is in some sense the point Vince raised, is we don't have a vision of the long run, and I think that that, you know, is not just a German problem but it's frankly an inconsistency between the German vision and other visions within Europe. And in some sense, we haven't made enough progress collectively figuring out what that is.

I actually think the Germans have a vision, which is one that they're more inclined to give up sovereignty than, frankly, some of the other major countries. And they -- it would be in some sense easier for them to define that vision, where they have transferred more authority to some sort of European one-entity. I think it's others that have more problems with that.

And so we don't have that long-run vision, and we also don't have, I think, full confidence that there is a transition path from where we are today to that -- whatever that long run might be. And this is where, you know, continued slow growth, political consequences thereof, you know, can these countries really stick to it? I think we're clearly in a less acute phase now than we were before -- you know, last summer, before OMT was put in place. But there's still plenty of risk.

DJANKOV: If I can add something, one statistic that we didn't discuss here -- and perhaps in the United States it's not a big issue but in Europe it's becoming the number one issue -- which is youth unemployment. You by now have some countries where two thirds of the young people under the age of 35 or 40 actually don't have jobs. Spain is like that; Greece is like that; in Cyprus, it's very rapidly rising. Two thirds, so 60-some percent of young people in Spain and Greece do not have jobs.

Well, that tells you something about the long-term potential of this economy. But it also tells you something -- tells you something else: Well, if young people don't have jobs, what do they do? They go out to the streets and strike.

And this is why you see more and more every day strikes happening in countries on a number of issues, so no longer just the issues of unemployment and where this crisis is going, but on social issues and political representation issues, that basically, people are saying more and more around Europe, we don't like any of the parties. So we're not going to vote for any of you because we don't like what you've done, not just with this crisis, but in the last 10, 20, 30 years. And that becomes quite dangerous for the social model that Europe so far has managed to maintain somehow.

ALEXANDER: I just want to, you know, agree that it's not the same issue here as it is in Europe, but it's a big question mark. Because when you look at U.S. labor markets, what's striking is in some ways, the thing that it's done the best is the unemployment rate. You look at broader measures of the utilization employment, things like employment population ratios or whatnot, you look at simply gross labor, you get a very much worse picture of how we're doing.

And one of the fundamental uncertainties, when you look at the Fed right now, is they say that ultimately, what is driving this is the outlook for the labor market -- what exactly are they talking about? Because depending on what you look at, you're going to get a very different picture.

And so while I would agree that it's a different issue in Europe, it's -- that issue exists here as well. And I think part of the confusion over what the Fed is really doing came from the fact that I think a lot of us kind of looked at this broader picture in the labor markets and were surprised by the notion that the Fed seemed to be closer to making a decision to reduce the pace of its asset purchases than a broader take on the labor markets would have suggested.

MALLABY: And Vincent, yeah, you and your wife, Carmen, have written a lot about debt overhangs, and -- well, maybe not a lot, but with impact -- (laughter) -- (inaudible) -- it's the quality, not the quantity.

The -- so one crude characterization of Europe's struggling with its problems would be to say that on the -- in terms of southern country current account deficits and competitiveness, there has been progress, but in terms of debt burden relative to GDP, there has not, because GDP has basically shrunk for several quarters in a row.

Do you see the -- is there a way out of the -- of the debt, the level of debt that you've got in the crisis, or potentially crisis countries? Do they have -- does there have to be more restructuring in the future? How do we resolve that?

REINHART: So there's three ways out: One is restructuring. If you have a problem -- you could always work the numerator down by write-downs. The second is grow faster, but that doesn't seem to be in the cards anytime soon. And the third is financial repression, to use government policy to keep the cost of borrowing lower than it would be otherwise.

And that -- and that's actually part of the misunderstanding about the -- about the periphery, about the need for a fiscal consolidation. It isn't -- it isn't just what it does to the national income accounts, if you reduce government spending or raise taxes. The fact is, in many of these countries, they've -- the governments fund themselves by taking more and more space of banks, which are already undercapitalized and not serving those economies. So there's a very real crowding out of lending space associated with governments.

DJANKOV: The comment, excuse me, on restructuring -- restructuring is quite tricky in Europe, because a lot of the bad debt is actually in mostly French banks -- somewhat Italian banks. So any time that you start discussing restructuring, then the French immediately say, no, there must be another way, and then point to the other ways. (Laughter.)

But one needs to realize that French banks hold a lot of bad debts. At the moment, Greek debt, Portuguese debt, Spanish debt -- Italian banks also own a lot of bad Spanish and Portuguese debt. So if that starts going on, you quickly can get into a situation where you have two large countries that Europe as a whole cannot deal with. One is Italy and one is France.

There is no amount of -- currently, stability mechanisms and so on that either one of these countries can be saved, so to speak. Europe can possibly save Spain if things get worse, but not France or Italy. And that's why people are very cagey about touching the issue of bank restructuring or also debt -- government debt restructuring for that -- where would it go? And it would go mostly to France.

REINHART: You've got to remember that a financial crisis is essentially an enormous wealth loss. And then, governments then have to first admit the wealth loss. Then they have to allocate the wealth loss, and then they have to absorb the effects of the wealth loss on their economies through other policies. Europe's not even at the admitting part.

And there's different models of who gets to allocate the loss. The model for the periphery is just, all should be German taxpayers. The German model is that all -- it all should be the periphery. And in -- but until you admit the loss, you can't even begin to think how to allocate it intelligently. Which means you're not doing anything else on other policies to absorb the effect on the economy.

MALLABY: I want to bring in emerging markets before we go to the members for questions and comments.

Lewis, do you think -- is the reversal of emerging market currencies and markets recently just a phase that, you know, once you get through the tapering trauma, it'll sort of stabilize. Or was there something structural that's happened where emerging economies have run -- gotten used to running big current account deficits, financing them with portfolio in-flows, because money -- we're seeking yields somewhere. Is it a deeper thing?

ALEXANDER: Look, I think this is -- this is a bit of a turning point. I think we have gone through, with emerging markets, a very positive period for a number of years. And I think if we really are at the beginning of the turning of U.S. monetary policy, then ultimately, that is going to create a more difficult environment. And it's not just what's going on in the U.S. I think the other big thing is, if China is really ratcheting to a slower rate of growth, which is, I think inevitable, and one that is less driven by things like domestic investment, that has a broad range of implications that affect a number of countries.

And, you know, having sort of watched emerging markets for many years, it does feel like we are at a bit of a turning point in that sense. Having said that, the vulnerabilities are substantially less in some respects than they have been in the past. So there is less external financing, more internal financing. And that makes a huge difference. I think --

MALLABY: There you're talking about the currency composition, that emergency markets have got debt in their own currencies --

ALEXANDER: Right. So, for example, Brazil, a country I've followed for many years -- what's striking now is, they have more dollar-denominated assets than they have dollar-denominated liabilities. It used to be that one of the fundamental dynamics with respect to Brazil was, if you needed a currency to adjust to deal with a current account surplus, the problem is, it would deteriorate the fiscal accounts, because they were a net external debtor.

Now, it works the other way. And that is a hugely stabilizing relative to the past. Having said that, Brazil is -- continues to be very exposed to global terms of trade so that if China's going to slow down -- and that means iron ore prices are going to be lower -- then that's going to have sort of first order effects on places like Brazil. But it does feel -- I think there's -- an awful lot of policy progress has been made over the last decade or two. I think we are going to see some of the benefits of that, and that's in this cycle, but it does feel like we're at a bit of a turning point.

MALLABY: So I mean, you've followed, I think, Turkey for some time. That's an example of an emerging market that has been extraordinarily hard at some times -- now may be in trouble. What's your sense of the underlying dynamics there? I mean, is it the miracle place or the crisis place? What's -- if you looked at the basic drivers of growth, where will you come down?

DJANKOV: I think Turkey is one of these countries which is actually very exposed because it runs a large current account deficit; second, because it is mostly foreign currency denominated. Thirdly, we forget, but Turkey on the one hand exports to Europe, and Europe now has been for nearly two, in some cases three years in recession. It has depended very much on the Middle East to pick up the slack. The Middle East, the situation is not improving, either economically or politically, to say it mildly.

So Turkey is in a situation where the export markets don't work for it. It grew by about 8 1/2, 9 percent for a few years in a row. Last year it went below 2 percent. This year their own forecast is for about 3 percent. But you see in Turkey what I mentioned earlier, that with this growth, which is mostly driven by large infrastructure projects, Turkey actually has very high youth unemployment, something in the order of 38 percent, I think, even with this growth, mostly because the growth is focused in the few large cities and everybody else actually doesn't have -- doesn't have many growth and job opportunities.

And these protests that we are now seeing, they're partly political protest but I think they're partly what we've discussed for the rest of Europe, an issue that you don't -- the young people don't see prospects. The economy somehow doesn't work for a large part of the population in a country like Turkey as well. I think it's very exposed. And if Turkey goes that way, its not just a problem for Turkey, but is given as the only example to the Middle East of, if you like, a democratic Muslim country. And if Turkey doesn't do well exactly in this period, who do you point to?

MALLABY: Let me ask one more question before we open it up, for Vincent. I'll throw you a question about Japan. You know, is this mixture of quantitative easing and stimulus and so forth -- when you look at the prospects for that in Japan, how does it feel compared to the U.S.? I mean, would you expect it to work as well, less well?

REINHART: So it's an amazing experiment in monetary economics; that you have a central bank that for two decades said they wanted to generate inflation, now has a government that seems determined and willing to allow the currency depreciation necessary to generate that inflation.

That's a hard challenge because the Abe administration has to find G-7 counterparts willing to tolerate an appreciation of their currency. They got to keep a voter base that has actually been pretty comfortable with deflation, the oldest population, which (leads to ?) unfair intergenerational trade. And they have to do this through ultimately structural reforms so that it becomes output, not just prices. And I think more than anything, we're seeing execution issues. It's just slow-moving in policy, and markets are open 24/7 trying to move in anticipation of that.

Ten years ago wrote a paper with a guy named Bernanke, looked at a quantitative assessment of Bank of Japan policy. And we said, good news, Bank of Japan policy is now going to get traction: they set their zero interest rate policy to a conditional commitment; they said they'll keep at zero as long as there's effective deflation. And nine months after that paper was published, they embarked on the quickest shrinkage of a balance sheet in post-war central banking history, where they sold -- where they shrank their holdings in JGBs (ph) by 30 percent.

So more things are pointed in the right direction as a bank and a government. On the other hand, backsliding has been common.

MALLABY: OK. So at this time let's go to the members for questions. If anyone's got a question, please raise your hand. I can see one right over there. So please state your name and affiliation into the microphone.

QUESTIONER: Rachel Robbins, most recently with IFC. I'd be interested -- Hi, Simeon.

DJANKOV: Hi -- (inaudible).

QUESTIONER: I'd be interested in the panelists' views of China's urbanization plan to move hundreds of millions of people into cities. And what do you think that will do over the next decade or two to the growth in China?

MALLABY: Who wants to take a crack?

ALEXANDER: I'll take a crack at it.

Look, if you look at the -- you know, I haven't looked at these numbers in the last six months, but basically you still have a very large part of the Japanese (sic) population that lives rurally, something like 50 percent.

MR. : Chinese.

ALEXANDER: Chinese, sorry. And if you look simply at the pace of growth, if you look at the income levels and look at other emerging economies and where they have been in terms of urbanization given the -- some of their income levels, it would strongly suggest that a logical thing for them to do is to have an urbanization rate of not 50 percent but something like 70 percent within that two-decade horizon.

Now, you kind of work backwards from, OK, what does it take to actually move a quarter of, you know, over a billion people into cities, in terms of the infrastructure you have to build? It's really quite daunting. I know no country's every really sort of managed something quite that quick. And so if you look at things like how much steel they produce and all of that sort of stuff, it all kind of adds up to this big process.

Now, the problem is, you don't have to slow it down very much before a lot of things sort of move in the other direction. And I think one of the things that people underestimate is the degree of social unrest that this process in China, broadly defined, is generating. Urbanization is part of it. Part of the -- part of the way you see this comes from things like local governments using imminent domain to take over land to sort of do these big projects that will sort of make this all work.

It's -- I think in some sense it is -- I guess what I would say is, I think those objectives are consistent with, you know, their growth objectives. If you really think they're going to grow 5, 6, 7 percent on a continued basis for the next 20 years, it makes perfect sense to think that part of that process is going to be this rapid urbanization. But it's challenging in all sorts of ways. It has environmental implications. And whether or not they can manage, frankly, the social costs of this in their political system is the hardest thing, I think, to judge.

I'm never -- I've never covered China as my job, but I've -- you obviously have to observe it a lot. And the Chinese I talk to, the thing -- the biggest disconnect I see is over the notion of is the political process going to keep up with the pressures that this generates. It's -- you know, it's a very material question for the global outlook going forward in all sorts of ways.

REINHART: I mean, it is called a middle-income growth trap for a reason, and that is -- as you -- as you follow the biggest rural urban migration in Earth's history, you're creating a middle class, and the middle class has middle class values, including resentment toward corruption, resentment toward waste. It also relies more on market-like mechanisms, which are much harder to control. And there's always demographics as well. This is the -- this is going to be the oldest population, and it is one in which there is really very little social family network because of the one-child policy. This is -- this is challenging.

MALLABY: I wonder whether there's something also -- and maybe Simeon could comment on this -- about the extent to which infrastructure buildout, which you get with urbanization, is a good growth strategy or not.

DJANKOV: It certainly has been tried so far in China. First to mention, but over the last about 20, 22 years, China has moved about that number of people. SO in some sense, we are now seeing it now, (pre-announcing ?) it, but actually that's what they've done in the last two decades.

Also, a number of other countries have done it. Turkey's an example, and it's also an example of when you rapidly move a lot of people to the cities, urbanization, you politically get some surprises. Now, China and Turkey are somewhat different in terms of their political system, but perhaps not all that different.

And here you see a surprise in a matter of 10 years. One decade of this policy of Erdogan, of building large infrastructure, getting the people from the villages to first build that infrastructure, or building cheap housing for them so that they can move to the larger cities -- well, it takes a decade of these people who first are very happy and then increasingly become unhappy with some parts of the social policy. I think something like this very quickly can happen in China, especially if you are moving this large numbers of people.

And the issue then becomes its medium-term good growth policy to build a lot of things. It increases GDP while you're building them. But there is only so much that you can -- that you can build -- decreasing returns to scale.

And at least in Turkey, this is actually very obvious. If you look at the last decade of huge buildups, how over time, first the population's view on this becomes less and less positive, and also how GDP growth starts falling after the first five years; also, once you have covered the most important economical projects -- economically projects, and then you're building just to be able to move these large parts of the population to the cities.

MALLABY: OK, I see another question right here.

QUESTIONER: Thank you very much. (Inaudible.) The question of unemployment -- youth unemployment especially -- what is the way out? I mean, you talked about the problem. It's widespread, it's large and it's structural. So, what do you see as the evaluation of this, and what are the social and other consequences?

DJANKOV: Over the last couple of years, we've had a number of discussions in the context I mentioned of heads of state -- European heads of states, finance ministers, and, frankly, haven't come up with anything particularly bright as a solution.

One smaller solution has been to say, well, who in Europe has less youth unemployment other than Germany? There are a few other countries like Denmark, like the Netherlands -- that have one feature which the rest of Europe doesn't have, which is vocational training. So, basically, early on already in the last years of high school, you divide, if you like, the people who'd be going to industry from the people who go onto more advanced studies. And that system seems to produce a lot less unemployment basically because you get comparative advantage, let's say, early on.

So, now there are a number of countries in southern -- in Southern Europe -- Spain, in particular; Italy as well -- that last year have started very -- changing their educational system and having this vocational training of the 15-year-olds. So, rather than waiting to 23, 24 years of age after university, you start -- you start early on. That, to me, is a small answer. Over time, it will reduce youthful unemployment somewhat, but certainly it is not a big answer.

The biggest answer, I think, and something that we have spectacularly failed in Europe to address is the issue of in which countries can you -- which currently do not have much economic activity -- how can you spur this economic activity? And asking simple questions like which business would like to start operating in Greece? So, just think of -- I gave you the example of Portugal, but do you know any great brands that are export-driven other than feta cheese, yogurt and so on -- not that many.

But why is that the case? And you go back to look at the regulatory environment. Even the basic regulatory environment -- what does it take to start a business in Greece? And the numbers are just astounding. It's something like 30 times more expensive for a very basic business -- grocery store -- to start it in Athens than to start it in Berlin. Just the upfront costs are way, way higher for somebody who is young and says, OK, I want to be in business, to start operation.

These kind of issues which is ultimately a competitiveness -- a regulatory competitiveness issue has not been addressed in Europe at all. And when you try to address it, you know what the answer is? We don't have the right structure of the European Commission, so we don't actually have a commission of who's in charge of that. We have a commission that deal with finance issues. We have a commission that deals with internal market issue, but that's not an internal market issue. There's nobody to take charge. Seriously, you ultimately get to that discussion if you will be rejected

MALLABY: OK. A question right in the middle over there.

QUESTIONER: Steve Blank. Let me more from financial to material things.

The last couple decades, we've watched an expanding globalization of trade in the world -- obviously, much out of China's elaborate supply chains linking all parts of the world. Are we likely to see a contraction of this in the next few years -- more -- what -- (inaudible) -- might talk about -- perhaps the triad -- with less T-shirts, fewer T-shirts coming out of China and crossing the ocean -- or with more -- and with more localized, regionalized production. Is that -- is that a model that we're likely to see in the coming decade?

MALLABY: Vincent -- slow food, slow T-shirts, deglobalization.

REINHART: I think it's very tough to slow that process up. Poorly-performing economies are not good for national governments' attitudes for free trade. That, you know, that said, that's always a risk.

But specialization has some important benefits. That said, can easily see at least a little bit of re-shoring in the United States. In the middle portion of the country, we are good at extracting a form of energy. We don't like to shift Shell Oil and natural gas. That does give us a local comparative advantage to which we are taking advantage and in which we should see a buildup of manufacturing there. But it's going to be an interconnected world. It's -- and I think the process of globalization can be set back a little bit, but the level is still going to be quite interconnected.

Where I think we're seeing much more of a push-back is on financial deglobalization, that is, increasing reliance on national sources of funding for governments and increased barriers to international finance. That too is hard to go back to -- to push it back too far, but that process is -- has stopped and reversed some.

MALLABY: Lewis, you want to -- (inaudible) --

ALEXANDER: Yeah, no, I would -- I would just agree with Vincent, just make the observation that on the trade policy front, actually, against all the odds, in some sense you actually see a little bit of optimism. And I don't want to overstate this, but the fact that Japan has signed up for the TPP negotiations in Asia, I think, is important. I think the fact that the EU and the U.S. are actually talking about sort of getting serious about a trade agreement is notable, and in an environment where, frankly, for the last 10 years there's been very little to be optimistic about. And I think the basic point that Vince made, I would very much agree with, is it's -- that's not a tide which I think is likely to roll back.

MALLABY: Another question? Over there.

QUESTIONER: Thank you. Hi, Neely Gilbert (sp) from Ateran (ph) Capital Management. I wonder whether our panelists think that some of the fears around the beginning of tightening in monetary policy and the associated increase in long rates may be misplaced. When we look at periods of monetary history where we've seen the beginning of these cycles, they've actually tended to be associated with economic growth and rising markets because the markets are responding to good news, and the Fed is eventually reacting to it, or other central banks. So, you know, when you look at 1994, which you mention, Lewis, after a stumble in the bond markets and some trial and error, we know that that led -- that was a period of great expansion for the U.S. economy. Similarly, housing has always been important, as it will be for this expansion. So are some of the fears misplaced, or at least early, around the next stage for monetary policy and interest rates?

ALEXANDER: I guess I would make the observation that it really depends on whether or not we're right about the outlook for the U.S. I mean, in some sense, if you look at the last three years, we had "QE1," and that stopped, and then the Fed felt ultimately had to do "QE2." "QE2" stopped, and then ultimately they had to go back and do Operation Twist. We've had, over the last several years, several sort of stops and starts on all of this.

I think it's my view -- I think Vince would share it -- that we are looking at a better outlook going forward, and if that is the -- if that is the context for this, ultimately, then I think it'll prove -- the way you characterize it will prove correct. And you can think about the bond market as in fact anticipating a stronger economic outlook. But we have to be right about the -- about the underlying economy for that to work out that way.

REINHART: Yeah, we ask many different questions that all have the same answer: Can the Fed exit QE gracefully? Are equities fairly valued? Is the fiscal position of the U.S. sustainable? Well, actually, if we're picking up to a growth rate in the -- almost to 3 percent, the answer is yes, yes, yes. On the other hand, if we don't get the capital expenditure that amplifies the swing in spending and we muddle through at 2 percent, then those questions have much harder answers.

And I think to the basic point is over the last 30 years the -- when the Fed tightens, it does so because the economy is improving and the outlook looks sustainable. That is supported by otherwise easing financial conditions, i.e., equity markets going up. And the only problem is market participants tend to get ahead of themselves. At this stage of the cycle, they expect tightening sooner and by more than the Federal Reserve actually intends to deliver. And the communications challenge is to push back against that so as not to get an unnecessary tightening in financial conditions that snuff out what you want, a sustained economic expansion. That's the -- that's the balance that Fed officials are trying to strike.

MALLABY: But isn't there a point here that in a cycle involving conventional monetary tightening, the Fed is more able to do it when it feels confident it's the right time to do it? In the cycle involving quantitative easing, there is a danger that it's simply exhausted with the use of a politically controversial tool that it's not sure how it works, and there's debate as to whether, you know, it's a good idea or not. And so you might just give up, not because the economy really justified it but because you're just exhausted.

REINHART: So if there are so many different margins in terms of the costs, the benefits of each policy, then you are right in the sense that your decision on your balance sheet may also be influenced by the political economy or what you're doing to market mechanisms associated with -- you know, more than half the ownership of Treasury securities are in official hands. Those are margins the Fed's got to balance.

Actually, I think they mostly lost their faith in QE as an instrument given they've already pushed the term premium on 10-year Treasury securities deeply into negative territory. And more than anything, what they have to defend, what they have to protest, if markets get it wrong, is that they can actually delay tightening with their conventional policy instrument, that is, the funds rate, until well into 2015.

MALLABY: Another question. Yes, over there.

QUESTIONER: Elizabeth Bramwell.

Following up on the growth of the United States, you know, what are the assumptions behind the economic growth increasing? You know, I see "Obamacare" coming, and I think it's disruptive, especially for small business. And there are all these rules and regulations that are still coming. And if you knew that interest rates were artificially low now, you thought they were going to be 3 percent or something in two years, you know to take that into account. So, you know, what are the basic assumptions?

REINHART: So in our forecast, it's a combination of three things.

One is the lingering drag on growth associated with the financial crisis is lifting because financial intermediaries have deleveraged and derisked, and households have deleveraged some, and we've gotten through a good portion of the re-regulation envisioned in Dodd-Frank. So that drag on growth is lifting.

Second, the fiscal consolidation may have a little more of a (tail ?) to come, but mostly the hit to growth associated with the swing toward the increase in the structure adjusted surplus is mostly behind us and that we will therefore mean that as that drag is lifting, we will see sales and sales expectations.

And the third element is firms will start spending on capital goods. Once they do that, then that will amplify the swing associated with the lifting drag, and we will get to a sustained growth in the neighborhood to 2 3/4 to 3 percent. That requires capital spending to pick up. It is the case that regulatory environment is -- has changed, but indicators of economic policy on certainty have come down a lot just in the last six months. And firms have a lot of cash on their balance sheet, and historically, when they see sales, the expectation of more sales, they start spending. But that is the critical assumption of the forecast.

MALLABY: One more question.

If there's no question, I'm going to --

Ah, I can see a question right here. Wait for the microphone. One second.

QUESTIONER: Evelyn Leopold, a journalist at the United Nations. You haven't mentioned Britain. While it's not part of the eurozone. It certainly is affected by it. And the -- (clears throat) -- excuse me -- Cameron's austerity policies don't seem to be doing quite well.

MALLABY: Simeon, you want to have a crack at that? Austerity in Britain, good idea, bad idea?

DJANKOV: They've already gone through enough years of austerity so that the government on the one hand claims that it is starting to be seen as a -- as a success. This last quarter, as you know, they've had unexpectedly, even in their mind, good results, growth results. And the government hopes that this is the beginning of what they've been saying all along, particularly coming before their upcoming elections.

I think Britain has some of the same issues, however, that the rest of Europe. And we've already mentioned now currently there is a big discussion there on the cost of energy, something that in the U.S. we mentioned has been one of the reasons to expect higher growth; well, energy costs in both continental Europe but particularly Britain are very high relative to what it is here. So lately, if you -- if you talk to the policymakers, this is, I would say, their number one concern, that we are starting to lose some of the chemical industry, metal industry are starting to move from Britain to the extent that they still have them onto the United States or some other parts of the world.

So somehow, on the one hand, the government can say, we needed to do this with debt (overhang ?) that other countries have and have not done anything about it. We resolved it heads-on; it's cost us politically, but we have gone some of the way toward it. On the other hand, the long-term growth perspective of Britain, like most of the rest of Europe, doesn't seem very pretty. And it is somehow amplified by the current focus on (see the U.S. managed ?) to have shale gas revolution. We don't have that; we are only now starting it. Are we going to be successful? If not, what if our basic manufacturing is not competitive? And I think that's the focus.

In addition, we also have fairly high youth unemployment, we've already mentioned in other context. And not much that I can see -- policy to deal with it, unlike Europe, where at least vocational training -- some of the issues are starting to be addressed.

MALLABY: There was -- last year, the U.S. posted the biggest oil output in the world, I think. Vincent's had a mention of this energy equation. Do you -- do you see that as having implications beyond what we've discussed. Is it simply a marginal shift in manufacturing to the U.S., or is it bigger than that?

ALEXANDER: Look, it's a -- it's a very dramatic change in the outlook for U.S. energy production. I think it's important to remember a couple of things. One is, first of all, oil and gas extraction is a relatively small part of the economy, and so it's a kind of big deal within that -- within that space, but it can be overstated.

One of the things which has happened is, the natural gas part of it is -- it's hard to transport, and that generates big gaps in prices. So if you look at the price gap between natural gas in the United States and the marginal costs in, say, Europe or Japan, that gap is on the order of five times. That creates the comparative advantage that means industries that utilize natural gas have a comparative advantage here because of that price differential. I think, over time, that's likely to diminish as we produce the infrastructure that will allow us to export it and whatnot.

But it's a relatively big deal. If you look at the projections, you know, over the next two or three years, you're going to see further substantial increases in U.S. production of both natural gas and oil. That is going to have an impact on the balance of payments at least in the short run. I think some of the more extreme kind of -- there are -- there are some analyses out there that sort of would imply it's going to transform the U.S. economy; I think those are a bit overstated. But it's another in a set of positive trends that includes housing and includes, you know, as Vince said, the deleveraging in the household sector, the fact that the financial sector is largely through -- is a good way along in its adjustment that gives you this better outlook for the U.S.

MALLABY: There was a McKinsey study that pointed out that one of the features of energy-intensive manufacturing is that it's heavy and therefore traded a bit less than other things. And so therefore, the kind of export boost to the U.S. would be less than --

ALEXANDER: Right. I mean, it's -- look, it's part of a positive trend, but I think it's easy to overstate how big a deal it's going to be.

REINHART: I mean, those manufacturers are upstream, however, to the manufacturers who do (to ?) export. Bottom line is, it's one sector in an economy, and the economy is overall constrained by aggregate supply. We may grow our supply a little bit better -- more because of the capital spending in that industry. But it probably also means we have a more appreciated currency than we would have otherwise, and it gets crowded out somewhere else. Is it -- is it a positive for wealth creation and longer-term growth? Yes. Is it going to revolutionize U.S. manufacturing? No.

MALLABY: OK. Absence of a revolution -- I think we're going to stop it there. (Laughter.) It's 9:00. Thank you very much for coming -- and thanks for coming. (Applause.)

SEBASTIAN MALLABY: So welcome to the council. I am Sebastian Mallaby. I work here at CFR. We meet at an interesting time. I don't mean that in a nice way. (Laughter.) We have the taper upsetting markets. We have the prospect of a Chinese growth slowdown. We have the prospect that Japan is maybe not irrelevant to the global economy, and maybe even Europe is in a lull that will not prove permanent.

But -- we'll get to all those things, but I want to introduce people first. First here is Simeon Djankov, who was until recently the finance minister of Bulgaria, Bulgaria being in the EU but not in the eurozone. You've been on the inside of all the debates and decisions that the euro system has been making. For the most recent period before that, Simeon was a regulatory economist, a senior economist at the World Bank, creator of the well-known Doing Business indicators on business conditions around the world. Then we have Lewis Alexander, who is the chief economist for the U.S. at Nomura, and before that senior counselor at the Treasury. And Vincent Reinhart, who is the chief U.S. economist for Morgan Stanley and before that had a long career in senior positions at the Federal Reserve Board.

So Vincent, let's start with you. We'll start with the U.S. economy. I think you recently revised up your growth forecast both for this year and for next year. Talk a little bit about what's driving your optimism about the real economy while the financial economy is heading down a cliff.

VINCENT REINHART: Part of it is the calendar. Part of it is surprise. Calendar is the financial crisis is receding and that the drag on the level of activity associated with having to delever and derisk and reregulate finance is lifting. And so we would expect to see the expression of the resilience of a market economy once we get past the fiscal consolidation. Then comes the surprise. We have something like on the order of 1 3/4 percent swing in the structural budget deficit, mostly front-loaded in this year, and it looks like the U.S. economy is going to expand on the order of 2 percent in the first half. So that does suggest that there's some underlying momentum and that once we get past the full effect of the fiscal drag, growth can pick up, to the neighborhood of close to 3 percent by next year.

MALLABY: So you mentioned the fiscal drag as being less of a threat. Lewis, do you share that sense that -- first of all, do you share the sense that the growth forecast needs to be revised out and this fiscal drag a bit --

LEWIS ALEXANDER: Look, I think generally the Vince characterized it I very much agree with. I think there is a bit of a question in my mind about whether or not the fiscal drag we've actually experienced, or whether or not it's an issue of timing. So we have seen household savings rates fall quite sharply in the first quarter. There's a basic question as to whether or not that's sustainable.

But the overall picture I would very much agree with. And in some sense, when you think about the volatility that's been generated by the discussion over Fed policy, I think you have to remember that it comes in a context of it's an improving economy that's generating the whole discussion.

MALLABY: So let's get to the Fed and its meeting this week, and I'm going back to you two because you've both worked there -- Vincent most recently. Would you say that in some ways Bernanke's comments last meeting were a mistake, in the sense that he has managed to spook the market before he really seems to want to taper, and so he's brought forward the market reaction more than he needed to have done?

REINHART: So execution issues are always problematic in a big committee, a democratic committee where you have a lot of governors and bank presidents out expressing all sides of an -- of an issue. I think deep down your characterization of bringing forward -- volatility bringing forward is bringing forward some of the adjustment that ultimately has to be made.

If financial conditions otherwise remain supportive of spending as Treasury yields back up because their view of the economy is looking a little better and equity markets can support that, then the Federal Reserve is in fact getting some of the adjustment done before it actually touches the policy rate.

Now, were there execution problems? Did they talk too much about tapering and add an unnecessary element of volatility? That's probably the case. I think they talked so much about tapering because they wanted to convince us and themselves that it's actually a more flexibility instrument than it really is because therefore it wouldn't send a signal about their broader intentions to keep rates low for a very long time.

MALLABY: So given that, do you think that at this week's meeting the chairman will seek to adjust the impression he left last time, or will he kind of feel burned and not want to go back into that snake pit?

REINHART: So they really don't have to do a heck of a lot other than acknowledge a fact. And the fact is inflation has fallen. Inflation has fallen even further below their long-run goal of 2 percent and their interim threshold of 2 3/4 percent. If they say that inflation's fallen and they're worried about the anchoring of inflation, that'll send a signal that they're going to stay accommodating for a while. That'll get people to dial back tapering.

MALLABY: So, Lewis, just acknowledge inflation -- is that enough for the Fed or are going to --

ALEXANDER: Look, I think there are multiple ways they could do it. That's certainly one. What they say about the state of the labor market matters. What they say about the relatively slow growth in the second quarter and whether or not that's temporary or permanent will also kind of shape all of these things. What they say about financial conditions will matter.

I guess, you know, the fundamental question is the degree to which they really want to go forward at this point or not. I think in some sense if it was a mistake, they've had plenty of opportunities between now and then to correct that, and they haven't really done that. Obviously, this will be another opportunity to do that, but my sense is they're closer to this than you might think.

I would very much agree with Vince that tapering is not really a very flexible tool. I think there is this perception that they're trying to create in some ways that it's sort of just like the old Fed funds rate in the good old days when you could move it up or move it down. And I think that's a bit naive when it's pretty clear that the neutral rate of asset purchases is zero.

MALLABY: So let's come to other countries now, Simeon. This is not the first time the end of an easy-money cycle in the U.S., the prospect of tightening, has big effects on the rest of the world, whether it's the early 1980s and Latin American debt crisis comes to the fore or whether it's the '94 tightening cycle and you get Mexico defaulting at the end of the year -- or coming close to default.

In this particular instance, do you see a consequence for Europe that the whole lull that we've had in European markets in the last year may feel somewhat less resilient in the face of the end of quantitative easing in the U.S.?

SIMEON DJANKOV: Certainly that is the case. In Europe, especially over the last two or three months, there have been more and more voices that the European Central Bank's policy, essentially mimicking the quantitative easing here in the U.S., is actually legal under the treaty. And as you know, there is a constitutional case in front of the German court, very much argued by the opponents that since it's illegal, Germany shouldn't participate in it. The fact that tapering may take place here in the U.S. helps these opponents in Germany -- and not just in Germany; all of northern Europe strengthened their case. But really, what is happening now and will be happening until the mid-fall is German elections. Everybody is waiting to see what the results of German elections are. And as a result, we don't expect any activity, not that Europe is very active at any one time, but we don't expect much activity until about mid-October.

MALLABY: Is there any crisis in the markets that could happen between now and the September German election, which could force some policy action?

DJANKOV: A small crisis I think is very likely to happen, which is Slovenia. Slovenia is one of these smaller countries that not many people are following, but just like Cyprus exploded after a year of delaying and delaying, delaying until the presidential elections, they -- now everybody is hoping that Slovenia will manage to wait and go bankrupt after German election. (Laughter.)

But realistically -- but realistically, the situation there has worsened quite significantly over the last year or so. There is a relatively new government. They need help. And whether they may sustain this very bad situation until October and then get the help, I give it a 50-50 chance that there will actually be a problem during the summer.

Notice that every summer since 2008, there has been a problem in Europe when people are on vacation and least expect it. My guess is that there will be problem in Slovenia before the elections, and that will then unravel this comparable -- comparative lull that we've had since about April or so.

MALLABY: And if you think about this sort of -- you're know, there's a slight danger in everybody waiting and waiting for the German election and the expectation that after the German election, when -- very likely, the chancellor will be the same person, there will suddenly be this policy thaw, and grand new initiatives will be rolled out. Do you think, in fact -- well, I guess two things. What should Germany propose after the election, in your ideal world? And what will they?

DJANKOV: Germany over the last few months especially has been very hurt at telling everybody else that they should reform just the Germans have over the last decade or so in terms of labor market reform, pension reforms, in terms of export competitiveness. This is easier said than done because Germany is one large market with its specificities, and the rest of Europe is not that export-competitive, especially the southern part. But Angela Merkel has been pushing this to basically everybody who visits her or she visits in Europe, so far without great results. I think --

MALLABY: So to reform like we did.

DJANKOV: Reform like we did. But the issue is that it's one thing for Germany to do that; it's another thing to go to one of especially the smaller southern European countries, like, let's say Portugal, and say you become a great exporter, and you ask yourself the question, what products do we know that Portugal has export? Just name one product other than pork, let's say. (Laughter.) Well, they don't have -- don't have many such products, and it's very unlikely that in a short period of time they will manage to break through.

But I think the ultimate issue that nobody -- and in my four years as finance minister, participating in all of the decisions -- has brought to the fore is that unlike the U.S., Europe has rapidly aging population. Every country without exception last year was losing workers. The last incident, late last week the predictions for Germany came; it turned out that they have 2 million people less than they thought and that just in the -- in -- to the end of this decade, they'll lose about 7 million people working age, which is all of Bavaria, to give you an idea of how much workforce they'll lose. And this is an issue in every country, long-term competitiveness, long-term growth, that so far has not been addressed.

MALLABY: I feel a sort of Oscar Wilde moment there. You know, to lose 1 million people is careless -- to lose 1 million is unfortunate and 2 million is careless. (Laughter.)

So maybe we'll go to Vincent on that. I mean, starting with the same question I asked Simeon, I mean, is it possible that this lull in Europe, which was ascribed to OMT -- which always surprisingly struck me as surprisingly how well that thing worked, given the doubts about Europe's ability to execute on OMT, the fact that it was going to be conditional on country behavior, that they would -- but yet it worked its magic. Wasn't the magic really coming from the Fed, to some extent?

REINHART: No, I think it tells you the power of central banking and that it's very difficult to express an opinion contrary -- doubtful of a macro policy by shorting the security the central bank could buy. And if ultimately the ECB could step up and do it, then that would pose lots of difficulties to the enterprise.

I mean, basically the biggest lack, the -- you know, failure for the German leadership is telling us what Europe should look like. We need a vision of that shining house on the hill, right, and then, having done that, provide the bridge, finance, to get us from here to there and also recognize that not everybody's got -- can be the exporter. Somebody also has to purchase those goods, and that includes Germans. An export-led growth model doesn't work in a closed system.

MALLABY: I'm going to come to Lewis in a second, but I want to add a quick one for you, Simeon. So what Vincent just said was, we need leadership in Europe, we need the vision of where it's going. And I'm told that, you know, a big reason why we don't get it is essentially Germany, for historical reasons, hates to be a leader. If you say the word "leader" in German, it's "Fuehrer," and they don't like that. So there's this huge sort of embarrassment and reluctance to actually exert sort of enlightened leadership.

Is that sense in Germany something you observe, as a European, when you go there? Do you feel as though it comes partly from the views of other countries in Europe, which are telling the Germans, don't lead too strongly?

DJANKOV: No, it's certainly the case both Germans themselves feel that they don't yet have the historical right to lead Europe, and I've seen this many times, even on small decisions where Germany has clearly taken the decision but very informally asked the Finns or the Dutch -- you wonder why the Finns always say the most outrageous things in Europe over the last -- (laughter) -- it's because the Germans ask them to do it most of the time. (Laughter.)

So you certainly see this in a lot of the decision-making, but it also is the case that when Germany says, OK, now we are going to lead, that all of a sudden France, Italy, the southern part of Europe especially says, well, why are they going to lead? You know, we know what their leadership took us to in the -- in the past. So it's both ways, as you said.

But if I can return to one point that we've argued a lot in the last one or two years in the council of finance ministers, heads of state in Europe, which is this example. So Germany currently gives itself as the example and says, you all should be like us. But it's obvious that especially the small economies cannot be like Germany. Not everybody can be an expert.

But there is an issue of the example of the examples to follow, because prior to the crisis, if you asked people the question, what are the European examples, they were very clear. For small countries, it was Ireland, so a small out -- open-oriented, foreign direct investment-driven economy; a good labor force and so on. Midsize country, Spain -- this was given as an example. So it's reformed rapidly. It attracts a lot of new industries, growing real estate market and so on.

And now Ireland and Spain are gone, and for small and medium-sized countries, which is basically almost everybody in Europe other than Germany and France, you don't have a good example to follow. So if you ask, well, who should we be like, and there is silence in the room.

MALLABY: Let me ask just so -- yeah --

REINHART: There could -- I think you also want to remember the benefit Germany is getting from this enterprise, right? Because there's a euro, Germany's not Switzerland. It's got a weaker currency than it would have otherwise. The euro area, in some sense, is an elaborate subsidy mechanism to German manufacturers and their financial intermediaries to lend or finance. So there is an economic aspect to this as well.

MALLABY: Yeah, and ironically Switzerland is the country which maybe approximates Germany's vision of its own leadership potential. (Laughter.)

Lewis, do you -- if you had to predict, let's say, you know, on January the 1st of next year, will the European markets look calm, or we'll be back -- be back in another crisis phase?

ALEXANDER: Look, I think we -- I certainly have been surprised at the ability of Europe to manage through, you know, the crisis in the Italian elections, Cyprus and whatnot. And my -- I -- whereas I, you know, a year ago, I would have been much more pessimistic, the success of the OMT and whatnot, I think, suggests that we're in this for sort of a longer haul.

I think, having said that, the thing I worry about is in some sense the point Vince raised, is we don't have a vision of the long run, and I think that that, you know, is not just a German problem but it's frankly an inconsistency between the German vision and other visions within Europe. And in some sense, we haven't made enough progress collectively figuring out what that is.

I actually think the Germans have a vision, which is one that they're more inclined to give up sovereignty than, frankly, some of the other major countries. And they -- it would be in some sense easier for them to define that vision, where they have transferred more authority to some sort of European one-entity. I think it's others that have more problems with that.

And so we don't have that long-run vision, and we also don't have, I think, full confidence that there is a transition path from where we are today to that -- whatever that long run might be. And this is where, you know, continued slow growth, political consequences thereof, you know, can these countries really stick to it? I think we're clearly in a less acute phase now than we were before -- you know, last summer, before OMT was put in place. But there's still plenty of risk.

DJANKOV: If I can add something, one statistic that we didn't discuss here -- and perhaps in the United States it's not a big issue but in Europe it's becoming the number one issue -- which is youth unemployment. You by now have some countries where two thirds of the young people under the age of 35 or 40 actually don't have jobs. Spain is like that; Greece is like that; in Cyprus, it's very rapidly rising. Two thirds, so 60-some percent of young people in Spain and Greece do not have jobs.

Well, that tells you something about the long-term potential of this economy. But it also tells you something -- tells you something else: Well, if young people don't have jobs, what do they do? They go out to the streets and strike.

And this is why you see more and more every day strikes happening in countries on a number of issues, so no longer just the issues of unemployment and where this crisis is going, but on social issues and political representation issues, that basically, people are saying more and more around Europe, we don't like any of the parties. So we're not going to vote for any of you because we don't like what you've done, not just with this crisis, but in the last 10, 20, 30 years. And that becomes quite dangerous for the social model that Europe so far has managed to maintain somehow.

ALEXANDER: I just want to, you know, agree that it's not the same issue here as it is in Europe, but it's a big question mark. Because when you look at U.S. labor markets, what's striking is in some ways, the thing that it's done the best is the unemployment rate. You look at broader measures of the utilization employment, things like employment population ratios or whatnot, you look at simply gross labor, you get a very much worse picture of how we're doing.

And one of the fundamental uncertainties, when you look at the Fed right now, is they say that ultimately, what is driving this is the outlook for the labor market -- what exactly are they talking about? Because depending on what you look at, you're going to get a very different picture.

And so while I would agree that it's a different issue in Europe, it's -- that issue exists here as well. And I think part of the confusion over what the Fed is really doing came from the fact that I think a lot of us kind of looked at this broader picture in the labor markets and were surprised by the notion that the Fed seemed to be closer to making a decision to reduce the pace of its asset purchases than a broader take on the labor markets would have suggested.

MALLABY: And Vincent, yeah, you and your wife, Carmen, have written a lot about debt overhangs, and -- well, maybe not a lot, but with impact -- (laughter) -- (inaudible) -- it's the quality, not the quantity.

The -- so one crude characterization of Europe's struggling with its problems would be to say that on the -- in terms of southern country current account deficits and competitiveness, there has been progress, but in terms of debt burden relative to GDP, there has not, because GDP has basically shrunk for several quarters in a row.

Do you see the -- is there a way out of the -- of the debt, the level of debt that you've got in the crisis, or potentially crisis countries? Do they have -- does there have to be more restructuring in the future? How do we resolve that?

REINHART: So there's three ways out: One is restructuring. If you have a problem -- you could always work the numerator down by write-downs. The second is grow faster, but that doesn't seem to be in the cards anytime soon. And the third is financial repression, to use government policy to keep the cost of borrowing lower than it would be otherwise.

And that -- and that's actually part of the misunderstanding about the -- about the periphery, about the need for a fiscal consolidation. It isn't -- it isn't just what it does to the national income accounts, if you reduce government spending or raise taxes. The fact is, in many of these countries, they've -- the governments fund themselves by taking more and more space of banks, which are already undercapitalized and not serving those economies. So there's a very real crowding out of lending space associated with governments.

DJANKOV: The comment, excuse me, on restructuring -- restructuring is quite tricky in Europe, because a lot of the bad debt is actually in mostly French banks -- somewhat Italian banks. So any time that you start discussing restructuring, then the French immediately say, no, there must be another way, and then point to the other ways. (Laughter.)

But one needs to realize that French banks hold a lot of bad debts. At the moment, Greek debt, Portuguese debt, Spanish debt -- Italian banks also own a lot of bad Spanish and Portuguese debt. So if that starts going on, you quickly can get into a situation where you have two large countries that Europe as a whole cannot deal with. One is Italy and one is France.

There is no amount of -- currently, stability mechanisms and so on that either one of these countries can be saved, so to speak. Europe can possibly save Spain if things get worse, but not France or Italy. And that's why people are very cagey about touching the issue of bank restructuring or also debt -- government debt restructuring for that -- where would it go? And it would go mostly to France.

REINHART: You've got to remember that a financial crisis is essentially an enormous wealth loss. And then, governments then have to first admit the wealth loss. Then they have to allocate the wealth loss, and then they have to absorb the effects of the wealth loss on their economies through other policies. Europe's not even at the admitting part.

And there's different models of who gets to allocate the loss. The model for the periphery is just, all should be German taxpayers. The German model is that all -- it all should be the periphery. And in -- but until you admit the loss, you can't even begin to think how to allocate it intelligently. Which means you're not doing anything else on other policies to absorb the effect on the economy.

MALLABY: I want to bring in emerging markets before we go to the members for questions and comments.

Lewis, do you think -- is the reversal of emerging market currencies and markets recently just a phase that, you know, once you get through the tapering trauma, it'll sort of stabilize. Or was there something structural that's happened where emerging economies have run -- gotten used to running big current account deficits, financing them with portfolio in-flows, because money -- we're seeking yields somewhere. Is it a deeper thing?

ALEXANDER: Look, I think this is -- this is a bit of a turning point. I think we have gone through, with emerging markets, a very positive period for a number of years. And I think if we really are at the beginning of the turning of U.S. monetary policy, then ultimately, that is going to create a more difficult environment. And it's not just what's going on in the U.S. I think the other big thing is, if China is really ratcheting to a slower rate of growth, which is, I think inevitable, and one that is less driven by things like domestic investment, that has a broad range of implications that affect a number of countries.

And, you know, having sort of watched emerging markets for many years, it does feel like we are at a bit of a turning point in that sense. Having said that, the vulnerabilities are substantially less in some respects than they have been in the past. So there is less external financing, more internal financing. And that makes a huge difference. I think --

MALLABY: There you're talking about the currency composition, that emergency markets have got debt in their own currencies --

ALEXANDER: Right. So, for example, Brazil, a country I've followed for many years -- what's striking now is, they have more dollar-denominated assets than they have dollar-denominated liabilities. It used to be that one of the fundamental dynamics with respect to Brazil was, if you needed a currency to adjust to deal with a current account surplus, the problem is, it would deteriorate the fiscal accounts, because they were a net external debtor.

Now, it works the other way. And that is a hugely stabilizing relative to the past. Having said that, Brazil is -- continues to be very exposed to global terms of trade so that if China's going to slow down -- and that means iron ore prices are going to be lower -- then that's going to have sort of first order effects on places like Brazil. But it does feel -- I think there's -- an awful lot of policy progress has been made over the last decade or two. I think we are going to see some of the benefits of that, and that's in this cycle, but it does feel like we're at a bit of a turning point.

MALLABY: So I mean, you've followed, I think, Turkey for some time. That's an example of an emerging market that has been extraordinarily hard at some times -- now may be in trouble. What's your sense of the underlying dynamics there? I mean, is it the miracle place or the crisis place? What's -- if you looked at the basic drivers of growth, where will you come down?

DJANKOV: I think Turkey is one of these countries which is actually very exposed because it runs a large current account deficit; second, because it is mostly foreign currency denominated. Thirdly, we forget, but Turkey on the one hand exports to Europe, and Europe now has been for nearly two, in some cases three years in recession. It has depended very much on the Middle East to pick up the slack. The Middle East, the situation is not improving, either economically or politically, to say it mildly.

So Turkey is in a situation where the export markets don't work for it. It grew by about 8 1/2, 9 percent for a few years in a row. Last year it went below 2 percent. This year their own forecast is for about 3 percent. But you see in Turkey what I mentioned earlier, that with this growth, which is mostly driven by large infrastructure projects, Turkey actually has very high youth unemployment, something in the order of 38 percent, I think, even with this growth, mostly because the growth is focused in the few large cities and everybody else actually doesn't have -- doesn't have many growth and job opportunities.

And these protests that we are now seeing, they're partly political protest but I think they're partly what we've discussed for the rest of Europe, an issue that you don't -- the young people don't see prospects. The economy somehow doesn't work for a large part of the population in a country like Turkey as well. I think it's very exposed. And if Turkey goes that way, its not just a problem for Turkey, but is given as the only example to the Middle East of, if you like, a democratic Muslim country. And if Turkey doesn't do well exactly in this period, who do you point to?

MALLABY: Let me ask one more question before we open it up, for Vincent. I'll throw you a question about Japan. You know, is this mixture of quantitative easing and stimulus and so forth -- when you look at the prospects for that in Japan, how does it feel compared to the U.S.? I mean, would you expect it to work as well, less well?

REINHART: So it's an amazing experiment in monetary economics; that you have a central bank that for two decades said they wanted to generate inflation, now has a government that seems determined and willing to allow the currency depreciation necessary to generate that inflation.

That's a hard challenge because the Abe administration has to find G-7 counterparts willing to tolerate an appreciation of their currency. They got to keep a voter base that has actually been pretty comfortable with deflation, the oldest population, which (leads to ?) unfair intergenerational trade. And they have to do this through ultimately structural reforms so that it becomes output, not just prices. And I think more than anything, we're seeing execution issues. It's just slow-moving in policy, and markets are open 24/7 trying to move in anticipation of that.

Ten years ago wrote a paper with a guy named Bernanke, looked at a quantitative assessment of Bank of Japan policy. And we said, good news, Bank of Japan policy is now going to get traction: they set their zero interest rate policy to a conditional commitment; they said they'll keep at zero as long as there's effective deflation. And nine months after that paper was published, they embarked on the quickest shrinkage of a balance sheet in post-war central banking history, where they sold -- where they shrank their holdings in JGBs (ph) by 30 percent.

So more things are pointed in the right direction as a bank and a government. On the other hand, backsliding has been common.

MALLABY: OK. So at this time let's go to the members for questions. If anyone's got a question, please raise your hand. I can see one right over there. So please state your name and affiliation into the microphone.

QUESTIONER: Rachel Robbins, most recently with IFC. I'd be interested -- Hi, Simeon.

DJANKOV: Hi -- (inaudible).

QUESTIONER: I'd be interested in the panelists' views of China's urbanization plan to move hundreds of millions of people into cities. And what do you think that will do over the next decade or two to the growth in China?

MALLABY: Who wants to take a crack?

ALEXANDER: I'll take a crack at it.

Look, if you look at the -- you know, I haven't looked at these numbers in the last six months, but basically you still have a very large part of the Japanese (sic) population that lives rurally, something like 50 percent.

MR. : Chinese.

ALEXANDER: Chinese, sorry. And if you look simply at the pace of growth, if you look at the income levels and look at other emerging economies and where they have been in terms of urbanization given the -- some of their income levels, it would strongly suggest that a logical thing for them to do is to have an urbanization rate of not 50 percent but something like 70 percent within that two-decade horizon.

Now, you kind of work backwards from, OK, what does it take to actually move a quarter of, you know, over a billion people into cities, in terms of the infrastructure you have to build? It's really quite daunting. I know no country's every really sort of managed something quite that quick. And so if you look at things like how much steel they produce and all of that sort of stuff, it all kind of adds up to this big process.

Now, the problem is, you don't have to slow it down very much before a lot of things sort of move in the other direction. And I think one of the things that people underestimate is the degree of social unrest that this process in China, broadly defined, is generating. Urbanization is part of it. Part of the -- part of the way you see this comes from things like local governments using imminent domain to take over land to sort of do these big projects that will sort of make this all work.

It's -- I think in some sense it is -- I guess what I would say is, I think those objectives are consistent with, you know, their growth objectives. If you really think they're going to grow 5, 6, 7 percent on a continued basis for the next 20 years, it makes perfect sense to think that part of that process is going to be this rapid urbanization. But it's challenging in all sorts of ways. It has environmental implications. And whether or not they can manage, frankly, the social costs of this in their political system is the hardest thing, I think, to judge.

I'm never -- I've never covered China as my job, but I've -- you obviously have to observe it a lot. And the Chinese I talk to, the thing -- the biggest disconnect I see is over the notion of is the political process going to keep up with the pressures that this generates. It's -- you know, it's a very material question for the global outlook going forward in all sorts of ways.

REINHART: I mean, it is called a middle-income growth trap for a reason, and that is -- as you -- as you follow the biggest rural urban migration in Earth's history, you're creating a middle class, and the middle class has middle class values, including resentment toward corruption, resentment toward waste. It also relies more on market-like mechanisms, which are much harder to control. And there's always demographics as well. This is the -- this is going to be the oldest population, and it is one in which there is really very little social family network because of the one-child policy. This is -- this is challenging.

MALLABY: I wonder whether there's something also -- and maybe Simeon could comment on this -- about the extent to which infrastructure buildout, which you get with urbanization, is a good growth strategy or not.

DJANKOV: It certainly has been tried so far in China. First to mention, but over the last about 20, 22 years, China has moved about that number of people. SO in some sense, we are now seeing it now, (pre-announcing ?) it, but actually that's what they've done in the last two decades.

Also, a number of other countries have done it. Turkey's an example, and it's also an example of when you rapidly move a lot of people to the cities, urbanization, you politically get some surprises. Now, China and Turkey are somewhat different in terms of their political system, but perhaps not all that different.

And here you see a surprise in a matter of 10 years. One decade of this policy of Erdogan, of building large infrastructure, getting the people from the villages to first build that infrastructure, or building cheap housing for them so that they can move to the larger cities -- well, it takes a decade of these people who first are very happy and then increasingly become unhappy with some parts of the social policy. I think something like this very quickly can happen in China, especially if you are moving this large numbers of people.

And the issue then becomes its medium-term good growth policy to build a lot of things. It increases GDP while you're building them. But there is only so much that you can -- that you can build -- decreasing returns to scale.

And at least in Turkey, this is actually very obvious. If you look at the last decade of huge buildups, how over time, first the population's view on this becomes less and less positive, and also how GDP growth starts falling after the first five years; also, once you have covered the most important economical projects -- economically projects, and then you're building just to be able to move these large parts of the population to the cities.

MALLABY: OK, I see another question right here.

QUESTIONER: Thank you very much. (Inaudible.) The question of unemployment -- youth unemployment especially -- what is the way out? I mean, you talked about the problem. It's widespread, it's large and it's structural. So, what do you see as the evaluation of this, and what are the social and other consequences?

DJANKOV: Over the last couple of years, we've had a number of discussions in the context I mentioned of heads of state -- European heads of states, finance ministers, and, frankly, haven't come up with anything particularly bright as a solution.

One smaller solution has been to say, well, who in Europe has less youth unemployment other than Germany? There are a few other countries like Denmark, like the Netherlands -- that have one feature which the rest of Europe doesn't have, which is vocational training. So, basically, early on already in the last years of high school, you divide, if you like, the people who'd be going to industry from the people who go onto more advanced studies. And that system seems to produce a lot less unemployment basically because you get comparative advantage, let's say, early on.

So, now there are a number of countries in southern -- in Southern Europe -- Spain, in particular; Italy as well -- that last year have started very -- changing their educational system and having this vocational training of the 15-year-olds. So, rather than waiting to 23, 24 years of age after university, you start -- you start early on. That, to me, is a small answer. Over time, it will reduce youthful unemployment somewhat, but certainly it is not a big answer.

The biggest answer, I think, and something that we have spectacularly failed in Europe to address is the issue of in which countries can you -- which currently do not have much economic activity -- how can you spur this economic activity? And asking simple questions like which business would like to start operating in Greece? So, just think of -- I gave you the example of Portugal, but do you know any great brands that are export-driven other than feta cheese, yogurt and so on -- not that many.

But why is that the case? And you go back to look at the regulatory environment. Even the basic regulatory environment -- what does it take to start a business in Greece? And the numbers are just astounding. It's something like 30 times more expensive for a very basic business -- grocery store -- to start it in Athens than to start it in Berlin. Just the upfront costs are way, way higher for somebody who is young and says, OK, I want to be in business, to start operation.

These kind of issues which is ultimately a competitiveness -- a regulatory competitiveness issue has not been addressed in Europe at all. And when you try to address it, you know what the answer is? We don't have the right structure of the European Commission, so we don't actually have a commission of who's in charge of that. We have a commission that deal with finance issues. We have a commission that deals with internal market issue, but that's not an internal market issue. There's nobody to take charge. Seriously, you ultimately get to that discussion if you will be rejected

MALLABY: OK. A question right in the middle over there.

QUESTIONER: Steve Blank. Let me more from financial to material things.

The last couple decades, we've watched an expanding globalization of trade in the world -- obviously, much out of China's elaborate supply chains linking all parts of the world. Are we likely to see a contraction of this in the next few years -- more -- what -- (inaudible) -- might talk about -- perhaps the triad -- with less T-shirts, fewer T-shirts coming out of China and crossing the ocean -- or with more -- and with more localized, regionalized production. Is that -- is that a model that we're likely to see in the coming decade?

MALLABY: Vincent -- slow food, slow T-shirts, deglobalization.

REINHART: I think it's very tough to slow that process up. Poorly-performing economies are not good for national governments' attitudes for free trade. That, you know, that said, that's always a risk.

But specialization has some important benefits. That said, can easily see at least a little bit of re-shoring in the United States. In the middle portion of the country, we are good at extracting a form of energy. We don't like to shift Shell Oil and natural gas. That does give us a local comparative advantage to which we are taking advantage and in which we should see a buildup of manufacturing there. But it's going to be an interconnected world. It's -- and I think the process of globalization can be set back a little bit, but the level is still going to be quite interconnected.

Where I think we're seeing much more of a push-back is on financial deglobalization, that is, increasing reliance on national sources of funding for governments and increased barriers to international finance. That too is hard to go back to -- to push it back too far, but that process is -- has stopped and reversed some.

MALLABY: Lewis, you want to -- (inaudible) --

ALEXANDER: Yeah, no, I would -- I would just agree with Vincent, just make the observation that on the trade policy front, actually, against all the odds, in some sense you actually see a little bit of optimism. And I don't want to overstate this, but the fact that Japan has signed up for the TPP negotiations in Asia, I think, is important. I think the fact that the EU and the U.S. are actually talking about sort of getting serious about a trade agreement is notable, and in an environment where, frankly, for the last 10 years there's been very little to be optimistic about. And I think the basic point that Vince made, I would very much agree with, is it's -- that's not a tide which I think is likely to roll back.

MALLABY: Another question? Over there.

QUESTIONER: Thank you. Hi, Neely Gilbert (sp) from Ateran (ph) Capital Management. I wonder whether our panelists think that some of the fears around the beginning of tightening in monetary policy and the associated increase in long rates may be misplaced. When we look at periods of monetary history where we've seen the beginning of these cycles, they've actually tended to be associated with economic growth and rising markets because the markets are responding to good news, and the Fed is eventually reacting to it, or other central banks. So, you know, when you look at 1994, which you mention, Lewis, after a stumble in the bond markets and some trial and error, we know that that led -- that was a period of great expansion for the U.S. economy. Similarly, housing has always been important, as it will be for this expansion. So are some of the fears misplaced, or at least early, around the next stage for monetary policy and interest rates?

ALEXANDER: I guess I would make the observation that it really depends on whether or not we're right about the outlook for the U.S. I mean, in some sense, if you look at the last three years, we had "QE1," and that stopped, and then the Fed felt ultimately had to do "QE2." "QE2" stopped, and then ultimately they had to go back and do Operation Twist. We've had, over the last several years, several sort of stops and starts on all of this.

I think it's my view -- I think Vince would share it -- that we are looking at a better outlook going forward, and if that is the -- if that is the context for this, ultimately, then I think it'll prove -- the way you characterize it will prove correct. And you can think about the bond market as in fact anticipating a stronger economic outlook. But we have to be right about the -- about the underlying economy for that to work out that way.

REINHART: Yeah, we ask many different questions that all have the same answer: Can the Fed exit QE gracefully? Are equities fairly valued? Is the fiscal position of the U.S. sustainable? Well, actually, if we're picking up to a growth rate in the -- almost to 3 percent, the answer is yes, yes, yes. On the other hand, if we don't get the capital expenditure that amplifies the swing in spending and we muddle through at 2 percent, then those questions have much harder answers.

And I think to the basic point is over the last 30 years the -- when the Fed tightens, it does so because the economy is improving and the outlook looks sustainable. That is supported by otherwise easing financial conditions, i.e., equity markets going up. And the only problem is market participants tend to get ahead of themselves. At this stage of the cycle, they expect tightening sooner and by more than the Federal Reserve actually intends to deliver. And the communications challenge is to push back against that so as not to get an unnecessary tightening in financial conditions that snuff out what you want, a sustained economic expansion. That's the -- that's the balance that Fed officials are trying to strike.

MALLABY: But isn't there a point here that in a cycle involving conventional monetary tightening, the Fed is more able to do it when it feels confident it's the right time to do it? In the cycle involving quantitative easing, there is a danger that it's simply exhausted with the use of a politically controversial tool that it's not sure how it works, and there's debate as to whether, you know, it's a good idea or not. And so you might just give up, not because the economy really justified it but because you're just exhausted.

REINHART: So if there are so many different margins in terms of the costs, the benefits of each policy, then you are right in the sense that your decision on your balance sheet may also be influenced by the political economy or what you're doing to market mechanisms associated with -- you know, more than half the ownership of Treasury securities are in official hands. Those are margins the Fed's got to balance.

Actually, I think they mostly lost their faith in QE as an instrument given they've already pushed the term premium on 10-year Treasury securities deeply into negative territory. And more than anything, what they have to defend, what they have to protest, if markets get it wrong, is that they can actually delay tightening with their conventional policy instrument, that is, the funds rate, until well into 2015.

MALLABY: Another question. Yes, over there.

QUESTIONER: Elizabeth Bramwell.

Following up on the growth of the United States, you know, what are the assumptions behind the economic growth increasing? You know, I see "Obamacare" coming, and I think it's disruptive, especially for small business. And there are all these rules and regulations that are still coming. And if you knew that interest rates were artificially low now, you thought they were going to be 3 percent or something in two years, you know to take that into account. So, you know, what are the basic assumptions?

REINHART: So in our forecast, it's a combination of three things.

One is the lingering drag on growth associated with the financial crisis is lifting because financial intermediaries have deleveraged and derisked, and households have deleveraged some, and we've gotten through a good portion of the re-regulation envisioned in Dodd-Frank. So that drag on growth is lifting.

Second, the fiscal consolidation may have a little more of a (tail ?) to come, but mostly the hit to growth associated with the swing toward the increase in the structure adjusted surplus is mostly behind us and that we will therefore mean that as that drag is lifting, we will see sales and sales expectations.

And the third element is firms will start spending on capital goods. Once they do that, then that will amplify the swing associated with the lifting drag, and we will get to a sustained growth in the neighborhood to 2 3/4 to 3 percent. That requires capital spending to pick up. It is the case that regulatory environment is -- has changed, but indicators of economic policy on certainty have come down a lot just in the last six months. And firms have a lot of cash on their balance sheet, and historically, when they see sales, the expectation of more sales, they start spending. But that is the critical assumption of the forecast.

MALLABY: One more question.

If there's no question, I'm going to --

Ah, I can see a question right here. Wait for the microphone. One second.

QUESTIONER: Evelyn Leopold, a journalist at the United Nations. You haven't mentioned Britain. While it's not part of the eurozone. It certainly is affected by it. And the -- (clears throat) -- excuse me -- Cameron's austerity policies don't seem to be doing quite well.

MALLABY: Simeon, you want to have a crack at that? Austerity in Britain, good idea, bad idea?

DJANKOV: They've already gone through enough years of austerity so that the government on the one hand claims that it is starting to be seen as a -- as a success. This last quarter, as you know, they've had unexpectedly, even in their mind, good results, growth results. And the government hopes that this is the beginning of what they've been saying all along, particularly coming before their upcoming elections.

I think Britain has some of the same issues, however, that the rest of Europe. And we've already mentioned now currently there is a big discussion there on the cost of energy, something that in the U.S. we mentioned has been one of the reasons to expect higher growth; well, energy costs in both continental Europe but particularly Britain are very high relative to what it is here. So lately, if you -- if you talk to the policymakers, this is, I would say, their number one concern, that we are starting to lose some of the chemical industry, metal industry are starting to move from Britain to the extent that they still have them onto the United States or some other parts of the world.

So somehow, on the one hand, the government can say, we needed to do this with debt (overhang ?) that other countries have and have not done anything about it. We resolved it heads-on; it's cost us politically, but we have gone some of the way toward it. On the other hand, the long-term growth perspective of Britain, like most of the rest of Europe, doesn't seem very pretty. And it is somehow amplified by the current focus on (see the U.S. managed ?) to have shale gas revolution. We don't have that; we are only now starting it. Are we going to be successful? If not, what if our basic manufacturing is not competitive? And I think that's the focus.

In addition, we also have fairly high youth unemployment, we've already mentioned in other context. And not much that I can see -- policy to deal with it, unlike Europe, where at least vocational training -- some of the issues are starting to be addressed.

MALLABY: There was -- last year, the U.S. posted the biggest oil output in the world, I think. Vincent's had a mention of this energy equation. Do you -- do you see that as having implications beyond what we've discussed. Is it simply a marginal shift in manufacturing to the U.S., or is it bigger than that?

ALEXANDER: Look, it's a -- it's a very dramatic change in the outlook for U.S. energy production. I think it's important to remember a couple of things. One is, first of all, oil and gas extraction is a relatively small part of the economy, and so it's a kind of big deal within that -- within that space, but it can be overstated.

One of the things which has happened is, the natural gas part of it is -- it's hard to transport, and that generates big gaps in prices. So if you look at the price gap between natural gas in the United States and the marginal costs in, say, Europe or Japan, that gap is on the order of five times. That creates the comparative advantage that means industries that utilize natural gas have a comparative advantage here because of that price differential. I think, over time, that's likely to diminish as we produce the infrastructure that will allow us to export it and whatnot.

But it's a relatively big deal. If you look at the projections, you know, over the next two or three years, you're going to see further substantial increases in U.S. production of both natural gas and oil. That is going to have an impact on the balance of payments at least in the short run. I think some of the more extreme kind of -- there are -- there are some analyses out there that sort of would imply it's going to transform the U.S. economy; I think those are a bit overstated. But it's another in a set of positive trends that includes housing and includes, you know, as Vince said, the deleveraging in the household sector, the fact that the financial sector is largely through -- is a good way along in its adjustment that gives you this better outlook for the U.S.

MALLABY: There was a McKinsey study that pointed out that one of the features of energy-intensive manufacturing is that it's heavy and therefore traded a bit less than other things. And so therefore, the kind of export boost to the U.S. would be less than --

ALEXANDER: Right. I mean, it's -- look, it's part of a positive trend, but I think it's easy to overstate how big a deal it's going to be.

REINHART: I mean, those manufacturers are upstream, however, to the manufacturers who do (to ?) export. Bottom line is, it's one sector in an economy, and the economy is overall constrained by aggregate supply. We may grow our supply a little bit better -- more because of the capital spending in that industry. But it probably also means we have a more appreciated currency than we would have otherwise, and it gets crowded out somewhere else. Is it -- is it a positive for wealth creation and longer-term growth? Yes. Is it going to revolutionize U.S. manufacturing? No.

MALLABY: OK. Absence of a revolution -- I think we're going to stop it there. (Laughter.) It's 9:00. Thank you very much for coming -- and thanks for coming. (Applause.)

SEBASTIAN MALLABY: So welcome to the council. I am Sebastian Mallaby. I work here at CFR. We meet at an interesting time. I don't mean that in a nice way. (Laughter.) We have the taper upsetting markets. We have the prospect of a Chinese growth slowdown. We have the prospect that Japan is maybe not irrelevant to the global economy, and maybe even Europe is in a lull that will not prove permanent.

But -- we'll get to all those things, but I want to introduce people first. First here is Simeon Djankov, who was until recently the finance minister of Bulgaria, Bulgaria being in the EU but not in the eurozone. You've been on the inside of all the debates and decisions that the euro system has been making. For the most recent period before that, Simeon was a regulatory economist, a senior economist at the World Bank, creator of the well-known Doing Business indicators on business conditions around the world. Then we have Lewis Alexander, who is the chief economist for the U.S. at Nomura, and before that senior counselor at the Treasury. And Vincent Reinhart, who is the chief U.S. economist for Morgan Stanley and before that had a long career in senior positions at the Federal Reserve Board.

So Vincent, let's start with you. We'll start with the U.S. economy. I think you recently revised up your growth forecast both for this year and for next year. Talk a little bit about what's driving your optimism about the real economy while the financial economy is heading down a cliff.

VINCENT REINHART: Part of it is the calendar. Part of it is surprise. Calendar is the financial crisis is receding and that the drag on the level of activity associated with having to delever and derisk and reregulate finance is lifting. And so we would expect to see the expression of the resilience of a market economy once we get past the fiscal consolidation. Then comes the surprise. We have something like on the order of 1 3/4 percent swing in the structural budget deficit, mostly front-loaded in this year, and it looks like the U.S. economy is going to expand on the order of 2 percent in the first half. So that does suggest that there's some underlying momentum and that once we get past the full effect of the fiscal drag, growth can pick up, to the neighborhood of close to 3 percent by next year.

MALLABY: So you mentioned the fiscal drag as being less of a threat. Lewis, do you share that sense that -- first of all, do you share the sense that the growth forecast needs to be revised out and this fiscal drag a bit --

LEWIS ALEXANDER: Look, I think generally the Vince characterized it I very much agree with. I think there is a bit of a question in my mind about whether or not the fiscal drag we've actually experienced, or whether or not it's an issue of timing. So we have seen household savings rates fall quite sharply in the first quarter. There's a basic question as to whether or not that's sustainable.

But the overall picture I would very much agree with. And in some sense, when you think about the volatility that's been generated by the discussion over Fed policy, I think you have to remember that it comes in a context of it's an improving economy that's generating the whole discussion.

MALLABY: So let's get to the Fed and its meeting this week, and I'm going back to you two because you've both worked there -- Vincent most recently. Would you say that in some ways Bernanke's comments last meeting were a mistake, in the sense that he has managed to spook the market before he really seems to want to taper, and so he's brought forward the market reaction more than he needed to have done?

REINHART: So execution issues are always problematic in a big committee, a democratic committee where you have a lot of governors and bank presidents out expressing all sides of an -- of an issue. I think deep down your characterization of bringing forward -- volatility bringing forward is bringing forward some of the adjustment that ultimately has to be made.

If financial conditions otherwise remain supportive of spending as Treasury yields back up because their view of the economy is looking a little better and equity markets can support that, then the Federal Reserve is in fact getting some of the adjustment done before it actually touches the policy rate.

Now, were there execution problems? Did they talk too much about tapering and add an unnecessary element of volatility? That's probably the case. I think they talked so much about tapering because they wanted to convince us and themselves that it's actually a more flexibility instrument than it really is because therefore it wouldn't send a signal about their broader intentions to keep rates low for a very long time.

MALLABY: So given that, do you think that at this week's meeting the chairman will seek to adjust the impression he left last time, or will he kind of feel burned and not want to go back into that snake pit?

REINHART: So they really don't have to do a heck of a lot other than acknowledge a fact. And the fact is inflation has fallen. Inflation has fallen even further below their long-run goal of 2 percent and their interim threshold of 2 3/4 percent. If they say that inflation's fallen and they're worried about the anchoring of inflation, that'll send a signal that they're going to stay accommodating for a while. That'll get people to dial back tapering.

MALLABY: So, Lewis, just acknowledge inflation -- is that enough for the Fed or are going to --

ALEXANDER: Look, I think there are multiple ways they could do it. That's certainly one. What they say about the state of the labor market matters. What they say about the relatively slow growth in the second quarter and whether or not that's temporary or permanent will also kind of shape all of these things. What they say about financial conditions will matter.

I guess, you know, the fundamental question is the degree to which they really want to go forward at this point or not. I think in some sense if it was a mistake, they've had plenty of opportunities between now and then to correct that, and they haven't really done that. Obviously, this will be another opportunity to do that, but my sense is they're closer to this than you might think.

I would very much agree with Vince that tapering is not really a very flexible tool. I think there is this perception that they're trying to create in some ways that it's sort of just like the old Fed funds rate in the good old days when you could move it up or move it down. And I think that's a bit naive when it's pretty clear that the neutral rate of asset purchases is zero.

MALLABY: So let's come to other countries now, Simeon. This is not the first time the end of an easy-money cycle in the U.S., the prospect of tightening, has big effects on the rest of the world, whether it's the early 1980s and Latin American debt crisis comes to the fore or whether it's the '94 tightening cycle and you get Mexico defaulting at the end of the year -- or coming close to default.

In this particular instance, do you see a consequence for Europe that the whole lull that we've had in European markets in the last year may feel somewhat less resilient in the face of the end of quantitative easing in the U.S.?

SIMEON DJANKOV: Certainly that is the case. In Europe, especially over the last two or three months, there have been more and more voices that the European Central Bank's policy, essentially mimicking the quantitative easing here in the U.S., is actually legal under the treaty. And as you know, there is a constitutional case in front of the German court, very much argued by the opponents that since it's illegal, Germany shouldn't participate in it. The fact that tapering may take place here in the U.S. helps these opponents in Germany -- and not just in Germany; all of northern Europe strengthened their case. But really, what is happening now and will be happening until the mid-fall is German elections. Everybody is waiting to see what the results of German elections are. And as a result, we don't expect any activity, not that Europe is very active at any one time, but we don't expect much activity until about mid-October.

MALLABY: Is there any crisis in the markets that could happen between now and the September German election, which could force some policy action?

DJANKOV: A small crisis I think is very likely to happen, which is Slovenia. Slovenia is one of these smaller countries that not many people are following, but just like Cyprus exploded after a year of delaying and delaying, delaying until the presidential elections, they -- now everybody is hoping that Slovenia will manage to wait and go bankrupt after German election. (Laughter.)

But realistically -- but realistically, the situation there has worsened quite significantly over the last year or so. There is a relatively new government. They need help. And whether they may sustain this very bad situation until October and then get the help, I give it a 50-50 chance that there will actually be a problem during the summer.

Notice that every summer since 2008, there has been a problem in Europe when people are on vacation and least expect it. My guess is that there will be problem in Slovenia before the elections, and that will then unravel this comparable -- comparative lull that we've had since about April or so.

MALLABY: And if you think about this sort of -- you're know, there's a slight danger in everybody waiting and waiting for the German election and the expectation that after the German election, when -- very likely, the chancellor will be the same person, there will suddenly be this policy thaw, and grand new initiatives will be rolled out. Do you think, in fact -- well, I guess two things. What should Germany propose after the election, in your ideal world? And what will they?

DJANKOV: Germany over the last few months especially has been very hurt at telling everybody else that they should reform just the Germans have over the last decade or so in terms of labor market reform, pension reforms, in terms of export competitiveness. This is easier said than done because Germany is one large market with its specificities, and the rest of Europe is not that export-competitive, especially the southern part. But Angela Merkel has been pushing this to basically everybody who visits her or she visits in Europe, so far without great results. I think --

MALLABY: So to reform like we did.

DJANKOV: Reform like we did. But the issue is that it's one thing for Germany to do that; it's another thing to go to one of especially the smaller southern European countries, like, let's say Portugal, and say you become a great exporter, and you ask yourself the question, what products do we know that Portugal has export? Just name one product other than pork, let's say. (Laughter.) Well, they don't have -- don't have many such products, and it's very unlikely that in a short period of time they will manage to break through.

But I think the ultimate issue that nobody -- and in my four years as finance minister, participating in all of the decisions -- has brought to the fore is that unlike the U.S., Europe has rapidly aging population. Every country without exception last year was losing workers. The last incident, late last week the predictions for Germany came; it turned out that they have 2 million people less than they thought and that just in the -- in -- to the end of this decade, they'll lose about 7 million people working age, which is all of Bavaria, to give you an idea of how much workforce they'll lose. And this is an issue in every country, long-term competitiveness, long-term growth, that so far has not been addressed.

MALLABY: I feel a sort of Oscar Wilde moment there. You know, to lose 1 million people is careless -- to lose 1 million is unfortunate and 2 million is careless. (Laughter.)

So maybe we'll go to Vincent on that. I mean, starting with the same question I asked Simeon, I mean, is it possible that this lull in Europe, which was ascribed to OMT -- which always surprisingly struck me as surprisingly how well that thing worked, given the doubts about Europe's ability to execute on OMT, the fact that it was going to be conditional on country behavior, that they would -- but yet it worked its magic. Wasn't the magic really coming from the Fed, to some extent?

REINHART: No, I think it tells you the power of central banking and that it's very difficult to express an opinion contrary -- doubtful of a macro policy by shorting the security the central bank could buy. And if ultimately the ECB could step up and do it, then that would pose lots of difficulties to the enterprise.

I mean, basically the biggest lack, the -- you know, failure for the German leadership is telling us what Europe should look like. We need a vision of that shining house on the hill, right, and then, having done that, provide the bridge, finance, to get us from here to there and also recognize that not everybody's got -- can be the exporter. Somebody also has to purchase those goods, and that includes Germans. An export-led growth model doesn't work in a closed system.

MALLABY: I'm going to come to Lewis in a second, but I want to add a quick one for you, Simeon. So what Vincent just said was, we need leadership in Europe, we need the vision of where it's going. And I'm told that, you know, a big reason why we don't get it is essentially Germany, for historical reasons, hates to be a leader. If you say the word "leader" in German, it's "Fuehrer," and they don't like that. So there's this huge sort of embarrassment and reluctance to actually exert sort of enlightened leadership.

Is that sense in Germany something you observe, as a European, when you go there? Do you feel as though it comes partly from the views of other countries in Europe, which are telling the Germans, don't lead too strongly?

DJANKOV: No, it's certainly the case both Germans themselves feel that they don't yet have the historical right to lead Europe, and I've seen this many times, even on small decisions where Germany has clearly taken the decision but very informally asked the Finns or the Dutch -- you wonder why the Finns always say the most outrageous things in Europe over the last -- (laughter) -- it's because the Germans ask them to do it most of the time. (Laughter.)

So you certainly see this in a lot of the decision-making, but it also is the case that when Germany says, OK, now we are going to lead, that all of a sudden France, Italy, the southern part of Europe especially says, well, why are they going to lead? You know, we know what their leadership took us to in the -- in the past. So it's both ways, as you said.

But if I can return to one point that we've argued a lot in the last one or two years in the council of finance ministers, heads of state in Europe, which is this example. So Germany currently gives itself as the example and says, you all should be like us. But it's obvious that especially the small economies cannot be like Germany. Not everybody can be an expert.

But there is an issue of the example of the examples to follow, because prior to the crisis, if you asked people the question, what are the European examples, they were very clear. For small countries, it was Ireland, so a small out -- open-oriented, foreign direct investment-driven economy; a good labor force and so on. Midsize country, Spain -- this was given as an example. So it's reformed rapidly. It attracts a lot of new industries, growing real estate market and so on.

And now Ireland and Spain are gone, and for small and medium-sized countries, which is basically almost everybody in Europe other than Germany and France, you don't have a good example to follow. So if you ask, well, who should we be like, and there is silence in the room.

MALLABY: Let me ask just so -- yeah --

REINHART: There could -- I think you also want to remember the benefit Germany is getting from this enterprise, right? Because there's a euro, Germany's not Switzerland. It's got a weaker currency than it would have otherwise. The euro area, in some sense, is an elaborate subsidy mechanism to German manufacturers and their financial intermediaries to lend or finance. So there is an economic aspect to this as well.

MALLABY: Yeah, and ironically Switzerland is the country which maybe approximates Germany's vision of its own leadership potential. (Laughter.)

Lewis, do you -- if you had to predict, let's say, you know, on January the 1st of next year, will the European markets look calm, or we'll be back -- be back in another crisis phase?

ALEXANDER: Look, I think we -- I certainly have been surprised at the ability of Europe to manage through, you know, the crisis in the Italian elections, Cyprus and whatnot. And my -- I -- whereas I, you know, a year ago, I would have been much more pessimistic, the success of the OMT and whatnot, I think, suggests that we're in this for sort of a longer haul.

I think, having said that, the thing I worry about is in some sense the point Vince raised, is we don't have a vision of the long run, and I think that that, you know, is not just a German problem but it's frankly an inconsistency between the German vision and other visions within Europe. And in some sense, we haven't made enough progress collectively figuring out what that is.

I actually think the Germans have a vision, which is one that they're more inclined to give up sovereignty than, frankly, some of the other major countries. And they -- it would be in some sense easier for them to define that vision, where they have transferred more authority to some sort of European one-entity. I think it's others that have more problems with that.

And so we don't have that long-run vision, and we also don't have, I think, full confidence that there is a transition path from where we are today to that -- whatever that long run might be. And this is where, you know, continued slow growth, political consequences thereof, you know, can these countries really stick to it? I think we're clearly in a less acute phase now than we were before -- you know, last summer, before OMT was put in place. But there's still plenty of risk.

DJANKOV: If I can add something, one statistic that we didn't discuss here -- and perhaps in the United States it's not a big issue but in Europe it's becoming the number one issue -- which is youth unemployment. You by now have some countries where two thirds of the young people under the age of 35 or 40 actually don't have jobs. Spain is like that; Greece is like that; in Cyprus, it's very rapidly rising. Two thirds, so 60-some percent of young people in Spain and Greece do not have jobs.

Well, that tells you something about the long-term potential of this economy. But it also tells you something -- tells you something else: Well, if young people don't have jobs, what do they do? They go out to the streets and strike.

And this is why you see more and more every day strikes happening in countries on a number of issues, so no longer just the issues of unemployment and where this crisis is going, but on social issues and political representation issues, that basically, people are saying more and more around Europe, we don't like any of the parties. So we're not going to vote for any of you because we don't like what you've done, not just with this crisis, but in the last 10, 20, 30 years. And that becomes quite dangerous for the social model that Europe so far has managed to maintain somehow.

ALEXANDER: I just want to, you know, agree that it's not the same issue here as it is in Europe, but it's a big question mark. Because when you look at U.S. labor markets, what's striking is in some ways, the thing that it's done the best is the unemployment rate. You look at broader measures of the utilization employment, things like employment population ratios or whatnot, you look at simply gross labor, you get a very much worse picture of how we're doing.

And one of the fundamental uncertainties, when you look at the Fed right now, is they say that ultimately, what is driving this is the outlook for the labor market -- what exactly are they talking about? Because depending on what you look at, you're going to get a very different picture.

And so while I would agree that it's a different issue in Europe, it's -- that issue exists here as well. And I think part of the confusion over what the Fed is really doing came from the fact that I think a lot of us kind of looked at this broader picture in the labor markets and were surprised by the notion that the Fed seemed to be closer to making a decision to reduce the pace of its asset purchases than a broader take on the labor markets would have suggested.

MALLABY: And Vincent, yeah, you and your wife, Carmen, have written a lot about debt overhangs, and -- well, maybe not a lot, but with impact -- (laughter) -- (inaudible) -- it's the quality, not the quantity.

The -- so one crude characterization of Europe's struggling with its problems would be to say that on the -- in terms of southern country current account deficits and competitiveness, there has been progress, but in terms of debt burden relative to GDP, there has not, because GDP has basically shrunk for several quarters in a row.

Do you see the -- is there a way out of the -- of the debt, the level of debt that you've got in the crisis, or potentially crisis countries? Do they have -- does there have to be more restructuring in the future? How do we resolve that?

REINHART: So there's three ways out: One is restructuring. If you have a problem -- you could always work the numerator down by write-downs. The second is grow faster, but that doesn't seem to be in the cards anytime soon. And the third is financial repression, to use government policy to keep the cost of borrowing lower than it would be otherwise.

And that -- and that's actually part of the misunderstanding about the -- about the periphery, about the need for a fiscal consolidation. It isn't -- it isn't just what it does to the national income accounts, if you reduce government spending or raise taxes. The fact is, in many of these countries, they've -- the governments fund themselves by taking more and more space of banks, which are already undercapitalized and not serving those economies. So there's a very real crowding out of lending space associated with governments.

DJANKOV: The comment, excuse me, on restructuring -- restructuring is quite tricky in Europe, because a lot of the bad debt is actually in mostly French banks -- somewhat Italian banks. So any time that you start discussing restructuring, then the French immediately say, no, there must be another way, and then point to the other ways. (Laughter.)

But one needs to realize that French banks hold a lot of bad debts. At the moment, Greek debt, Portuguese debt, Spanish debt -- Italian banks also own a lot of bad Spanish and Portuguese debt. So if that starts going on, you quickly can get into a situation where you have two large countries that Europe as a whole cannot deal with. One is Italy and one is France.

There is no amount of -- currently, stability mechanisms and so on that either one of these countries can be saved, so to speak. Europe can possibly save Spain if things get worse, but not France or Italy. And that's why people are very cagey about touching the issue of bank restructuring or also debt -- government debt restructuring for that -- where would it go? And it would go mostly to France.

REINHART: You've got to remember that a financial crisis is essentially an enormous wealth loss. And then, governments then have to first admit the wealth loss. Then they have to allocate the wealth loss, and then they have to absorb the effects of the wealth loss on their economies through other policies. Europe's not even at the admitting part.

And there's different models of who gets to allocate the loss. The model for the periphery is just, all should be German taxpayers. The German model is that all -- it all should be the periphery. And in -- but until you admit the loss, you can't even begin to think how to allocate it intelligently. Which means you're not doing anything else on other policies to absorb the effect on the economy.

MALLABY: I want to bring in emerging markets before we go to the members for questions and comments.

Lewis, do you think -- is the reversal of emerging market currencies and markets recently just a phase that, you know, once you get through the tapering trauma, it'll sort of stabilize. Or was there something structural that's happened where emerging economies have run -- gotten used to running big current account deficits, financing them with portfolio in-flows, because money -- we're seeking yields somewhere. Is it a deeper thing?

ALEXANDER: Look, I think this is -- this is a bit of a turning point. I think we have gone through, with emerging markets, a very positive period for a number of years. And I think if we really are at the beginning of the turning of U.S. monetary policy, then ultimately, that is going to create a more difficult environment. And it's not just what's going on in the U.S. I think the other big thing is, if China is really ratcheting to a slower rate of growth, which is, I think inevitable, and one that is less driven by things like domestic investment, that has a broad range of implications that affect a number of countries.

And, you know, having sort of watched emerging markets for many years, it does feel like we are at a bit of a turning point in that sense. Having said that, the vulnerabilities are substantially less in some respects than they have been in the past. So there is less external financing, more internal financing. And that makes a huge difference. I think --

MALLABY: There you're talking about the currency composition, that emergency markets have got debt in their own currencies --

ALEXANDER: Right. So, for example, Brazil, a country I've followed for many years -- what's striking now is, they have more dollar-denominated assets than they have dollar-denominated liabilities. It used to be that one of the fundamental dynamics with respect to Brazil was, if you needed a currency to adjust to deal with a current account surplus, the problem is, it would deteriorate the fiscal accounts, because they were a net external debtor.

Now, it works the other way. And that is a hugely stabilizing relative to the past. Having said that, Brazil is -- continues to be very exposed to global terms of trade so that if China's going to slow down -- and that means iron ore prices are going to be lower -- then that's going to have sort of first order effects on places like Brazil. But it does feel -- I think there's -- an awful lot of policy progress has been made over the last decade or two. I think we are going to see some of the benefits of that, and that's in this cycle, but it does feel like we're at a bit of a turning point.

MALLABY: So I mean, you've followed, I think, Turkey for some time. That's an example of an emerging market that has been extraordinarily hard at some times -- now may be in trouble. What's your sense of the underlying dynamics there? I mean, is it the miracle place or the crisis place? What's -- if you looked at the basic drivers of growth, where will you come down?

DJANKOV: I think Turkey is one of these countries which is actually very exposed because it runs a large current account deficit; second, because it is mostly foreign currency denominated. Thirdly, we forget, but Turkey on the one hand exports to Europe, and Europe now has been for nearly two, in some cases three years in recession. It has depended very much on the Middle East to pick up the slack. The Middle East, the situation is not improving, either economically or politically, to say it mildly.

So Turkey is in a situation where the export markets don't work for it. It grew by about 8 1/2, 9 percent for a few years in a row. Last year it went below 2 percent. This year their own forecast is for about 3 percent. But you see in Turkey what I mentioned earlier, that with this growth, which is mostly driven by large infrastructure projects, Turkey actually has very high youth unemployment, something in the order of 38 percent, I think, even with this growth, mostly because the growth is focused in the few large cities and everybody else actually doesn't have -- doesn't have many growth and job opportunities.

And these protests that we are now seeing, they're partly political protest but I think they're partly what we've discussed for the rest of Europe, an issue that you don't -- the young people don't see prospects. The economy somehow doesn't work for a large part of the population in a country like Turkey as well. I think it's very exposed. And if Turkey goes that way, its not just a problem for Turkey, but is given as the only example to the Middle East of, if you like, a democratic Muslim country. And if Turkey doesn't do well exactly in this period, who do you point to?

MALLABY: Let me ask one more question before we open it up, for Vincent. I'll throw you a question about Japan. You know, is this mixture of quantitative easing and stimulus and so forth -- when you look at the prospects for that in Japan, how does it feel compared to the U.S.? I mean, would you expect it to work as well, less well?

REINHART: So it's an amazing experiment in monetary economics; that you have a central bank that for two decades said they wanted to generate inflation, now has a government that seems determined and willing to allow the currency depreciation necessary to generate that inflation.

That's a hard challenge because the Abe administration has to find G-7 counterparts willing to tolerate an appreciation of their currency. They got to keep a voter base that has actually been pretty comfortable with deflation, the oldest population, which (leads to ?) unfair intergenerational trade. And they have to do this through ultimately structural reforms so that it becomes output, not just prices. And I think more than anything, we're seeing execution issues. It's just slow-moving in policy, and markets are open 24/7 trying to move in anticipation of that.

Ten years ago wrote a paper with a guy named Bernanke, looked at a quantitative assessment of Bank of Japan policy. And we said, good news, Bank of Japan policy is now going to get traction: they set their zero interest rate policy to a conditional commitment; they said they'll keep at zero as long as there's effective deflation. And nine months after that paper was published, they embarked on the quickest shrinkage of a balance sheet in post-war central banking history, where they sold -- where they shrank their holdings in JGBs (ph) by 30 percent.

So more things are pointed in the right direction as a bank and a government. On the other hand, backsliding has been common.

MALLABY: OK. So at this time let's go to the members for questions. If anyone's got a question, please raise your hand. I can see one right over there. So please state your name and affiliation into the microphone.

QUESTIONER: Rachel Robbins, most recently with IFC. I'd be interested -- Hi, Simeon.

DJANKOV: Hi -- (inaudible).

QUESTIONER: I'd be interested in the panelists' views of China's urbanization plan to move hundreds of millions of people into cities. And what do you think that will do over the next decade or two to the growth in China?

MALLABY: Who wants to take a crack?

ALEXANDER: I'll take a crack at it.

Look, if you look at the -- you know, I haven't looked at these numbers in the last six months, but basically you still have a very large part of the Japanese (sic) population that lives rurally, something like 50 percent.

MR. : Chinese.

ALEXANDER: Chinese, sorry. And if you look simply at the pace of growth, if you look at the income levels and look at other emerging economies and where they have been in terms of urbanization given the -- some of their income levels, it would strongly suggest that a logical thing for them to do is to have an urbanization rate of not 50 percent but something like 70 percent within that two-decade horizon.

Now, you kind of work backwards from, OK, what does it take to actually move a quarter of, you know, over a billion people into cities, in terms of the infrastructure you have to build? It's really quite daunting. I know no country's every really sort of managed something quite that quick. And so if you look at things like how much steel they produce and all of that sort of stuff, it all kind of adds up to this big process.

Now, the problem is, you don't have to slow it down very much before a lot of things sort of move in the other direction. And I think one of the things that people underestimate is the degree of social unrest that this process in China, broadly defined, is generating. Urbanization is part of it. Part of the -- part of the way you see this comes from things like local governments using imminent domain to take over land to sort of do these big projects that will sort of make this all work.

It's -- I think in some sense it is -- I guess what I would say is, I think those objectives are consistent with, you know, their growth objectives. If you really think they're going to grow 5, 6, 7 percent on a continued basis for the next 20 years, it makes perfect sense to think that part of that process is going to be this rapid urbanization. But it's challenging in all sorts of ways. It has environmental implications. And whether or not they can manage, frankly, the social costs of this in their political system is the hardest thing, I think, to judge.

I'm never -- I've never covered China as my job, but I've -- you obviously have to observe it a lot. And the Chinese I talk to, the thing -- the biggest disconnect I see is over the notion of is the political process going to keep up with the pressures that this generates. It's -- you know, it's a very material question for the global outlook going forward in all sorts of ways.

REINHART: I mean, it is called a middle-income growth trap for a reason, and that is -- as you -- as you follow the biggest rural urban migration in Earth's history, you're creating a middle class, and the middle class has middle class values, including resentment toward corruption, resentment toward waste. It also relies more on market-like mechanisms, which are much harder to control. And there's always demographics as well. This is the -- this is going to be the oldest population, and it is one in which there is really very little social family network because of the one-child policy. This is -- this is challenging.

MALLABY: I wonder whether there's something also -- and maybe Simeon could comment on this -- about the extent to which infrastructure buildout, which you get with urbanization, is a good growth strategy or not.

DJANKOV: It certainly has been tried so far in China. First to mention, but over the last about 20, 22 years, China has moved about that number of people. SO in some sense, we are now seeing it now, (pre-announcing ?) it, but actually that's what they've done in the last two decades.

Also, a number of other countries have done it. Turkey's an example, and it's also an example of when you rapidly move a lot of people to the cities, urbanization, you politically get some surprises. Now, China and Turkey are somewhat different in terms of their political system, but perhaps not all that different.

And here you see a surprise in a matter of 10 years. One decade of this policy of Erdogan, of building large infrastructure, getting the people from the villages to first build that infrastructure, or building cheap housing for them so that they can move to the larger cities -- well, it takes a decade of these people who first are very happy and then increasingly become unhappy with some parts of the social policy. I think something like this very quickly can happen in China, especially if you are moving this large numbers of people.

And the issue then becomes its medium-term good growth policy to build a lot of things. It increases GDP while you're building them. But there is only so much that you can -- that you can build -- decreasing returns to scale.

And at least in Turkey, this is actually very obvious. If you look at the last decade of huge buildups, how over time, first the population's view on this becomes less and less positive, and also how GDP growth starts falling after the first five years; also, once you have covered the most important economical projects -- economically projects, and then you're building just to be able to move these large parts of the population to the cities.

MALLABY: OK, I see another question right here.

QUESTIONER: Thank you very much. (Inaudible.) The question of unemployment -- youth unemployment especially -- what is the way out? I mean, you talked about the problem. It's widespread, it's large and it's structural. So, what do you see as the evaluation of this, and what are the social and other consequences?

DJANKOV: Over the last couple of years, we've had a number of discussions in the context I mentioned of heads of state -- European heads of states, finance ministers, and, frankly, haven't come up with anything particularly bright as a solution.

One smaller solution has been to say, well, who in Europe has less youth unemployment other than Germany? There are a few other countries like Denmark, like the Netherlands -- that have one feature which the rest of Europe doesn't have, which is vocational training. So, basically, early on already in the last years of high school, you divide, if you like, the people who'd be going to industry from the people who go onto more advanced studies. And that system seems to produce a lot less unemployment basically because you get comparative advantage, let's say, early on.

So, now there are a number of countries in southern -- in Southern Europe -- Spain, in particular; Italy as well -- that last year have started very -- changing their educational system and having this vocational training of the 15-year-olds. So, rather than waiting to 23, 24 years of age after university, you start -- you start early on. That, to me, is a small answer. Over time, it will reduce youthful unemployment somewhat, but certainly it is not a big answer.

The biggest answer, I think, and something that we have spectacularly failed in Europe to address is the issue of in which countries can you -- which currently do not have much economic activity -- how can you spur this economic activity? And asking simple questions like which business would like to start operating in Greece? So, just think of -- I gave you the example of Portugal, but do you know any great brands that are export-driven other than feta cheese, yogurt and so on -- not that many.

But why is that the case? And you go back to look at the regulatory environment. Even the basic regulatory environment -- what does it take to start a business in Greece? And the numbers are just astounding. It's something like 30 times more expensive for a very basic business -- grocery store -- to start it in Athens than to start it in Berlin. Just the upfront costs are way, way higher for somebody who is young and says, OK, I want to be in business, to start operation.

These kind of issues which is ultimately a competitiveness -- a regulatory competitiveness issue has not been addressed in Europe at all. And when you try to address it, you know what the answer is? We don't have the right structure of the European Commission, so we don't actually have a commission of who's in charge of that. We have a commission that deal with finance issues. We have a commission that deals with internal market issue, but that's not an internal market issue. There's nobody to take charge. Seriously, you ultimately get to that discussion if you will be rejected

MALLABY: OK. A question right in the middle over there.

QUESTIONER: Steve Blank. Let me more from financial to material things.

The last couple decades, we've watched an expanding globalization of trade in the world -- obviously, much out of China's elaborate supply chains linking all parts of the world. Are we likely to see a contraction of this in the next few years -- more -- what -- (inaudible) -- might talk about -- perhaps the triad -- with less T-shirts, fewer T-shirts coming out of China and crossing the ocean -- or with more -- and with more localized, regionalized production. Is that -- is that a model that we're likely to see in the coming decade?

MALLABY: Vincent -- slow food, slow T-shirts, deglobalization.

REINHART: I think it's very tough to slow that process up. Poorly-performing economies are not good for national governments' attitudes for free trade. That, you know, that said, that's always a risk.

But specialization has some important benefits. That said, can easily see at least a little bit of re-shoring in the United States. In the middle portion of the country, we are good at extracting a form of energy. We don't like to shift Shell Oil and natural gas. That does give us a local comparative advantage to which we are taking advantage and in which we should see a buildup of manufacturing there. But it's going to be an interconnected world. It's -- and I think the process of globalization can be set back a little bit, but the level is still going to be quite interconnected.

Where I think we're seeing much more of a push-back is on financial deglobalization, that is, increasing reliance on national sources of funding for governments and increased barriers to international finance. That too is hard to go back to -- to push it back too far, but that process is -- has stopped and reversed some.

MALLABY: Lewis, you want to -- (inaudible) --

ALEXANDER: Yeah, no, I would -- I would just agree with Vincent, just make the observation that on the trade policy front, actually, against all the odds, in some sense you actually see a little bit of optimism. And I don't want to overstate this, but the fact that Japan has signed up for the TPP negotiations in Asia, I think, is important. I think the fact that the EU and the U.S. are actually talking about sort of getting serious about a trade agreement is notable, and in an environment where, frankly, for the last 10 years there's been very little to be optimistic about. And I think the basic point that Vince made, I would very much agree with, is it's -- that's not a tide which I think is likely to roll back.

MALLABY: Another question? Over there.

QUESTIONER: Thank you. Hi, Neely Gilbert (sp) from Ateran (ph) Capital Management. I wonder whether our panelists think that some of the fears around the beginning of tightening in monetary policy and the associated increase in long rates may be misplaced. When we look at periods of monetary history where we've seen the beginning of these cycles, they've actually tended to be associated with economic growth and rising markets because the markets are responding to good news, and the Fed is eventually reacting to it, or other central banks. So, you know, when you look at 1994, which you mention, Lewis, after a stumble in the bond markets and some trial and error, we know that that led -- that was a period of great expansion for the U.S. economy. Similarly, housing has always been important, as it will be for this expansion. So are some of the fears misplaced, or at least early, around the next stage for monetary policy and interest rates?

ALEXANDER: I guess I would make the observation that it really depends on whether or not we're right about the outlook for the U.S. I mean, in some sense, if you look at the last three years, we had "QE1," and that stopped, and then the Fed felt ultimately had to do "QE2." "QE2" stopped, and then ultimately they had to go back and do Operation Twist. We've had, over the last several years, several sort of stops and starts on all of this.

I think it's my view -- I think Vince would share it -- that we are looking at a better outlook going forward, and if that is the -- if that is the context for this, ultimately, then I think it'll prove -- the way you characterize it will prove correct. And you can think about the bond market as in fact anticipating a stronger economic outlook. But we have to be right about the -- about the underlying economy for that to work out that way.

REINHART: Yeah, we ask many different questions that all have the same answer: Can the Fed exit QE gracefully? Are equities fairly valued? Is the fiscal position of the U.S. sustainable? Well, actually, if we're picking up to a growth rate in the -- almost to 3 percent, the answer is yes, yes, yes. On the other hand, if we don't get the capital expenditure that amplifies the swing in spending and we muddle through at 2 percent, then those questions have much harder answers.

And I think to the basic point is over the last 30 years the -- when the Fed tightens, it does so because the economy is improving and the outlook looks sustainable. That is supported by otherwise easing financial conditions, i.e., equity markets going up. And the only problem is market participants tend to get ahead of themselves. At this stage of the cycle, they expect tightening sooner and by more than the Federal Reserve actually intends to deliver. And the communications challenge is to push back against that so as not to get an unnecessary tightening in financial conditions that snuff out what you want, a sustained economic expansion. That's the -- that's the balance that Fed officials are trying to strike.

MALLABY: But isn't there a point here that in a cycle involving conventional monetary tightening, the Fed is more able to do it when it feels confident it's the right time to do it? In the cycle involving quantitative easing, there is a danger that it's simply exhausted with the use of a politically controversial tool that it's not sure how it works, and there's debate as to whether, you know, it's a good idea or not. And so you might just give up, not because the economy really justified it but because you're just exhausted.

REINHART: So if there are so many different margins in terms of the costs, the benefits of each policy, then you are right in the sense that your decision on your balance sheet may also be influenced by the political economy or what you're doing to market mechanisms associated with -- you know, more than half the ownership of Treasury securities are in official hands. Those are margins the Fed's got to balance.

Actually, I think they mostly lost their faith in QE as an instrument given they've already pushed the term premium on 10-year Treasury securities deeply into negative territory. And more than anything, what they have to defend, what they have to protest, if markets get it wrong, is that they can actually delay tightening with their conventional policy instrument, that is, the funds rate, until well into 2015.

MALLABY: Another question. Yes, over there.

QUESTIONER: Elizabeth Bramwell.

Following up on the growth of the United States, you know, what are the assumptions behind the economic growth increasing? You know, I see "Obamacare" coming, and I think it's disruptive, especially for small business. And there are all these rules and regulations that are still coming. And if you knew that interest rates were artificially low now, you thought they were going to be 3 percent or something in two years, you know to take that into account. So, you know, what are the basic assumptions?

REINHART: So in our forecast, it's a combination of three things.

One is the lingering drag on growth associated with the financial crisis is lifting because financial intermediaries have deleveraged and derisked, and households have deleveraged some, and we've gotten through a good portion of the re-regulation envisioned in Dodd-Frank. So that drag on growth is lifting.

Second, the fiscal consolidation may have a little more of a (tail ?) to come, but mostly the hit to growth associated with the swing toward the increase in the structure adjusted surplus is mostly behind us and that we will therefore mean that as that drag is lifting, we will see sales and sales expectations.

And the third element is firms will start spending on capital goods. Once they do that, then that will amplify the swing associated with the lifting drag, and we will get to a sustained growth in the neighborhood to 2 3/4 to 3 percent. That requires capital spending to pick up. It is the case that regulatory environment is -- has changed, but indicators of economic policy on certainty have come down a lot just in the last six months. And firms have a lot of cash on their balance sheet, and historically, when they see sales, the expectation of more sales, they start spending. But that is the critical assumption of the forecast.

MALLABY: One more question.

If there's no question, I'm going to --

Ah, I can see a question right here. Wait for the microphone. One second.

QUESTIONER: Evelyn Leopold, a journalist at the United Nations. You haven't mentioned Britain. While it's not part of the eurozone. It certainly is affected by it. And the -- (clears throat) -- excuse me -- Cameron's austerity policies don't seem to be doing quite well.

MALLABY: Simeon, you want to have a crack at that? Austerity in Britain, good idea, bad idea?

DJANKOV: They've already gone through enough years of austerity so that the government on the one hand claims that it is starting to be seen as a -- as a success. This last quarter, as you know, they've had unexpectedly, even in their mind, good results, growth results. And the government hopes that this is the beginning of what they've been saying all along, particularly coming before their upcoming elections.

I think Britain has some of the same issues, however, that the rest of Europe. And we've already mentioned now currently there is a big discussion there on the cost of energy, something that in the U.S. we mentioned has been one of the reasons to expect higher growth; well, energy costs in both continental Europe but particularly Britain are very high relative to what it is here. So lately, if you -- if you talk to the policymakers, this is, I would say, their number one concern, that we are starting to lose some of the chemical industry, metal industry are starting to move from Britain to the extent that they still have them onto the United States or some other parts of the world.

So somehow, on the one hand, the government can say, we needed to do this with debt (overhang ?) that other countries have and have not done anything about it. We resolved it heads-on; it's cost us politically, but we have gone some of the way toward it. On the other hand, the long-term growth perspective of Britain, like most of the rest of Europe, doesn't seem very pretty. And it is somehow amplified by the current focus on (see the U.S. managed ?) to have shale gas revolution. We don't have that; we are only now starting it. Are we going to be successful? If not, what if our basic manufacturing is not competitive? And I think that's the focus.

In addition, we also have fairly high youth unemployment, we've already mentioned in other context. And not much that I can see -- policy to deal with it, unlike Europe, where at least vocational training -- some of the issues are starting to be addressed.

MALLABY: There was -- last year, the U.S. posted the biggest oil output in the world, I think. Vincent's had a mention of this energy equation. Do you -- do you see that as having implications beyond what we've discussed. Is it simply a marginal shift in manufacturing to the U.S., or is it bigger than that?

ALEXANDER: Look, it's a -- it's a very dramatic change in the outlook for U.S. energy production. I think it's important to remember a couple of things. One is, first of all, oil and gas extraction is a relatively small part of the economy, and so it's a kind of big deal within that -- within that space, but it can be overstated.

One of the things which has happened is, the natural gas part of it is -- it's hard to transport, and that generates big gaps in prices. So if you look at the price gap between natural gas in the United States and the marginal costs in, say, Europe or Japan, that gap is on the order of five times. That creates the comparative advantage that means industries that utilize natural gas have a comparative advantage here because of that price differential. I think, over time, that's likely to diminish as we produce the infrastructure that will allow us to export it and whatnot.

But it's a relatively big deal. If you look at the projections, you know, over the next two or three years, you're going to see further substantial increases in U.S. production of both natural gas and oil. That is going to have an impact on the balance of payments at least in the short run. I think some of the more extreme kind of -- there are -- there are some analyses out there that sort of would imply it's going to transform the U.S. economy; I think those are a bit overstated. But it's another in a set of positive trends that includes housing and includes, you know, as Vince said, the deleveraging in the household sector, the fact that the financial sector is largely through -- is a good way along in its adjustment that gives you this better outlook for the U.S.

MALLABY: There was a McKinsey study that pointed out that one of the features of energy-intensive manufacturing is that it's heavy and therefore traded a bit less than other things. And so therefore, the kind of export boost to the U.S. would be less than --

ALEXANDER: Right. I mean, it's -- look, it's part of a positive trend, but I think it's easy to overstate how big a deal it's going to be.

REINHART: I mean, those manufacturers are upstream, however, to the manufacturers who do (to ?) export. Bottom line is, it's one sector in an economy, and the economy is overall constrained by aggregate supply. We may grow our supply a little bit better -- more because of the capital spending in that industry. But it probably also means we have a more appreciated currency than we would have otherwise, and it gets crowded out somewhere else. Is it -- is it a positive for wealth creation and longer-term growth? Yes. Is it going to revolutionize U.S. manufacturing? No.

MALLABY: OK. Absence of a revolution -- I think we're going to stop it there. (Laughter.) It's 9:00. Thank you very much for coming -- and thanks for coming. (Applause.)