World Economic Update

Tuesday, October 29, 2013
Lewis S. Alexander

Managing Director and Chief U.S. Economist, Nomura Securities International Inc

Nemat Shafik

Deputy Managing Director, International Monetary Fund

Vincent Reinhart

Managing Director and Chief U.S. Economist, Morgan Stanley


Director, Maurice R. Greenberg Center for Geoeconomic Studies, and Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations

Leading experts analyze the world economy.

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


MALLABY: ... as to why communications surely shouldn't be overstressed, because you're communicating from a committee which includes some empty seats coming up, and so what are those empty seats going to say? Who's going to fill them? How do you get clarity and guidance when the guiders themselves are a shifting cast that can't speak for their successors?

ALEXANDER: Well, I agree that you have to think about that as a constraint about what you can reasonably expect to achieve (inaudible) or communication more broadly.

REINHART: Just for the record, you said empty seats, not empty suits, right?


Then, second, I think a really good example is the current path for interest rates, consistent with the central tendency of the Federal Reserve Summary of Economic Projections. It envisions a committee that starts tightening in May 2014 and tightens a quarter point every other meeting for a year-and-a-half and in 2016 has a federal funds rate below 2 percent, even as output is at goal and inflation's at target.

That is implausible in lots of reasons, including group dynamics. Committees follow Newtonian principles. A body at rest stays at rest; a body in motion stays in motion. The idea you'd go a quarter, stop, go a quarter, stop, just doesn't actually work. And then the—and also the idea that you'd be able to sit there with a funds rate that low, even as you're satisfying your goals, is difficult to think...


MALLABY: I want to—I want to move on to Europe, if that's OK. So, Minouche, you know, we've had some better news out of Europe. We've had—I guess, the IMF projection is that after shrinking last year, shrinking this year, there will be modest growth of about 0.5 percent next year. But are we really out of the woods?

SHAFIK: No, we're not out of the woods, but we are off the cliff.


Which is good. I often use the metaphor, you know, we're no longer on the cliff, but we're going into a swamp. So now it's really the hard slog ahead, the hard slog of—the asset quality (inaudible) and it's now being called the balance sheet assessment of the European banks to make sure that, you know, they're sound. There's the hard slog of completing the banking union, putting in place common bank supervision. And there's the hard slog of structural reforms in the key countries in Europe, as well as completing the programs in the crisis countries of Greece, Portugal, Spain, Ireland, and Cyprus.

So there's a lot of work to be done, but the sense of impending crisis, I think, is thankfully off the table.

MALLABY: But don't you worry that, you know, because there is less of a market crisis, thanks largely to central bank promises, not actions, the political leadership has fallen off, and both, in the center, the appetite for creating new institutions has gone down and, in the periphery, the patience for sticking with the programs may be tested?

SHAFIK: There's definitely a sense of fatigue in Europe, both, as you say, in the crisis countries, although in some of them, you know, Ireland is a good example where, you know, the program has been pretty successful, they're on the verge of exit, so that's a good story. But completing the European financial architecture is not—it's still an unfinished project. And the appetite for mutualization, of pooling and sharing obligations, has never been very high and seems to be diminishing, I guess I would say.

MALLABY: Right, right.

SHAFIK: So, you know, they've made—they've made good progress on banking supervision, and the ECB is busy hiring banking supervisors from all around the world to take over its responsibilities of supervising the major European banks. They have just issued a pretty good set of decisions about how they're going to run this portfolio, this balance sheet assessment for the banks. And, of course, the ECB has continued to say all the right things about monetary policy being very accommodating, so those are all the good things.

But there's one important gap at the moment, which is it's unclear where the money will come from to recapitalize these banks as a result of this process. It seems to be so far relying heavily on national—national budgets to take care of any inadequacies in the banks. And that will put pressure on national budgets, some of which are in pretty difficult circumstances at the moment.

MALLABY: If national budgets were strong enough, we wouldn't have had this discussion about banking union in the first place, so...

SHAFIK: Well, that is true. And, you know, it's—the biggest worry we have at the moment for Europe is this incredibly slow growth recovery. I mean, the—you know, we're looking at maybe 1 percent next year, which is a very slow recovery. And the biggest thing holding that back is the financial fragmentation, which we continue to see because of the lack of banking union. You know, a small firm that's quite—that's quite viable and successful will face an interest rate of 6 percent or 7 percent, if it is based in Portugal, but if it was based in Germany, it would be paying 3 percent. That's not a financial—that's not a monetary union.

And we will not get a robust recovery until that financial fragmentation is dealt with, and that won't happen unless resolution is—is financed, and preferably in a common way.

MALLABY: So, Lewis, I mean, part of this waxing and waning of the crisis in Europe has been to do with whether central institutions could really act forcefully. And so the big turning point came when the central bank was empowered to do that, because Mrs. Merkel appeared to be ready to allow them to issue the OMT promise. But now we're up against the second thing, which is this banking union question that Minouche raises. If you do an asset quality review and you find big holes in balance sheets, but you're not providing any money to plug them, there is no TARP equivalent, it raises the question about how serious is Germany about making the system work?

ALEXANDER: I think it's a real issue. And I was struck—I was in Germany right before the election, and I was struck how the—you were just going through a national campaign in the context of what's just happened in Europe, and to be perfectly honest, Europe really wasn't part of the campaign.


ALEXANDER: And I think we—it seems as though the support for mutualization, as you put it, is rolling back. And we—two years ago, we were all having discussions about what were the—sort of the necessary conditions for a successful sort of monetary union? And it was all about fiscal union and a lot of talk about Alexander Hamilton and whatnot. And I'm just struck by the degree to which kind of year—year and a bit's worth of calm bought by the OMT has sort of pushed this all back.

And I think you kind of have to ask the question, what sort of Europe do they really want? And in particular, what sort of Europe do the Germans really want? Because ultimately, this does come back to them. And, you know, I think if you look at Germany as of the time of the Maastricht Treaty, it was kind of a different world, in many ways. We were coming out of the division of Europe. Germany had just unified. In many ways, the commitment to European integration in the West had been very much about Germany's particular problem with being divided and all of that.

Twenty years on, with those issues fading more or less completely into the background, it sort of raises a different set of questions. And as somebody who's kind of long viewed Germany as being committed to this, I have to admit, I was—I'm a little surprised to find us where we are. And it doesn't feel like the path we're on is—for all the reasons you've just described, which is, if this is really going to work, you need to solve this financial stuff, to need—to solve the financial stuff, you've got holes in the system. Even like let alone the capitalization issue now, there's the ultimate backstop. It is—I find it amazing how successful the OMT has been. If you think about what ultimately backs up the ECB, well, it's sort of the—a joint fiscal commitment to the central bank's balance sheet, ultimately, and that that is all kind of implicit in a very kind of fuzzy way here.

So, you know, in some sense, markets have calmed down and growth is coming back, and that's all great, but are we really any closer to kind of a set of institutional arrangements that seem to make sense? It's not obvious.

MALLABY: (inaudible)

SHAFIK: Well, I—the polling numbers in Europe show that the European project is less popular everywhere in Europe, except Germany, which is interesting. I think the other thing is that the—that appetite for mutualization, of sharing and pooling risks across countries, in Germany is very low for legacy issues, but higher for the next crisis.

MALLABY: Uh-huh. Uh-huh (inaudible)

REINHART: So I would say, you have to do three hard—make three hard decisions after a financial crisis. You have to admit you had a wealth loss. You have to allocate the wealth loss among the membership, and then you have to use your other policies to offset some of the adverse effects on the economy of that wealth loss.

In terms of the admission of the wealth loss, until you really do sincere bank stress tests, you haven't got—done that, allocation, that's about mutualization, that's about the decision of whose taxpayers have to bear that burden, and—and having failed the first two—two hurdles, you're really not in a position to use policy to offset it. And that's where Europe is. That is a muddle-through scenario.

MALLABY: So you're giving them a flat zero out of three there?

REINHART: No, oh for two, and three is not prudent.


MALLABY: So—but come back on one of those things, because part of the question about the outlook for Europe does depend on this issue you've written a lot about yourself, which is debt overhang, both public debt overhang and private debt overhang. The U.S. is much further along in deleveraging. Where would you put—make a comparison between the U.S. and Europe on...

REINHART: So Europe is going to have to go through an enormous deleveraging of its financial intermediation sector. It's difficult to see how you do that with national balance sheets and national financial champions, so—and it's an economy with more a bank-centric role for finance, and that is going to be an impediment to growth for a while to come, if part of the solution does not include debt write-downs.

MALLABY: Let me—I want to go to the members for questions in a second, but let me just put one last question to Minouche about emerging markets, which went through a sort of stress test of their own during the taper talk. And I think that gave rise to debate at your meeting as to whether the Fed should conduct itself in any different way, taking more cognizance of the spillover effect to the rest of the world. How do you feel that debate is evolving?

SHAFIK: I mean, as you implied, we've downgraded our growth projections for the emerging markets this year, particularly because growth has slowed down considerably in countries like India, China, Brazil, Russia. The debate about spillovers from Fed tapering were quite lively, but I think—I think where they ended up was that it was very important for emerging markets that the Fed be very clear in its communications, and that's to mean for both U.S. domestic reasons, but also very much for the world, so that they could plan.

In some ways, what happened on May 22nd with tapering talk spilling over onto big hits for emerging markets was in many ways a useful stress test, because it—I mean, I think everyone was a bit surprised at how big the impact was on emerging markets. But it enabled them—you know, many of them have now recovered from those lows.

But it forced them to begin to prepare. And most of them allow their exchange rates to depreciate and absorb the initial shock, which was very sensible. And I think—I think it's important to remember that emerging markets are in a much better place than they were in '97, the last time we had an emerging market crisis. They have more flexible exchange rates. They have big reserves. And they have much lower debt.

So—so they've had a bit of practice with what it's like. And I think many of them are now putting place policies and beginning to do the things that they need to do, both structural and cyclical—macro-cyclical policies to cope with the future tapering, because it—you know, I think everybody knows it's coming.

MALLABY: Great. Let's go to the members for questions. Who's got a question? OK, I can see Byron Wien right in the front here.

QUESTION: I can't believe—Byron Wien, Blackstone—I can't believe you've left out the second- and third-largest economies in the world, so I wonder if you would comment specifically on what's going on in China, where there seems to be a slowdown coming, and Japan, whether Shinzo Abe's policies of monetary and fiscal expansion are going to work on a long-term basis.

MALLABY: Byron, we left those out because we knew that you would bring them up, so thank you very much. So who would like to have a crack first at China? Vincent, do you want to have...

REINHART: So it's a middle-income growth trap for a reason, and—and that is that if you grow rapidly for three decades, you create a middle class, and a middle class has middle-class expectations, i.e., less tolerant of corruption, more desirous of control over your own balance sheet. That's difficult for a corporate state to deliver and still retain control.

And so it seems like the regime is picking a different point in the tradeoff between growth and financial stability. An advantage of being—having so many different controls in that economy is you have many different levers of policy, and so you can achieve that—a different point on that tradeoff between financial stability and growth by a series of many small reforms, rather than a big bang. Big bang is—in the Chinese context—is nothing but risky. And so we think they will accomplish that. However, giving people more control of their balance sheet, dealing with credit, dealing with an asset bubble are very non-linear things, so there's lots of risks associated with that.

MALLABY: It seems as though—I mean, China has gone from steady-state growth of 10 percent a year down to a sort of new normal of 7.5 percent. It's done that because it's addressed one imbalance, namely the current account surplus, which has come down from 10 percent of GDP to about 2.5 percent.

So the other question is, it's got this second imbalance between investment and consumption. If it addresses that, does it knock another 2.5 percentage points off growth and come down to 5 percent? Minouche?

SHAFIK: I don't think necessarily. I mean, investment in China has been incredibly high. In 2012, it was 50 percent of GDP. I mean, I've never seen an economy that's investing 50 percent of GDP at—but I think the Chinese authorities are well aware that that's a risky proposition, because you start to invest in some very low-return things, you create bubbles, et cetera, et cetera.

So I think they know that they need to shift demand toward consumption. And that—you know, if they're successful at doing that, they could sustain these high growth rates. But in the end, China will evolve into a more like an advanced economy, but in the medium term, you should expect those growth rates to come down from these extraordinary...


QUESTION: But with—but with investment, you can push a command-and-control button and generate spending and growth. With consumption, it's kind of up to what consumers do, and you don't have that control.

REINHART: That's exactly what I meant by the tradeoff between growth and financial stability. If the model is, in a command-and-control economy, invest, then you'll make terrible decisions across a big continent. Once every 10 years or so, you make the decision to write down the nonperforming loans, close the factories that should never have been opened, and if you're completely unsentimental about it, you start over again the next day, you do that for another 10 years, repeat that process for three decades, and the material progress of your citizens is enormous.

However, once it becomes consumption, with households controlling their own balance sheet, you have to rely on more market mechanisms, because you can't control that process, and at that point, it is no longer your decision when to take the hit on nonperforming loans. It's no longer completely in your control.

QUESTION: Lewis, why don't you do Japan?


MALLABY: Abenomics, will it work?

ALEXANDER: I think the jury's still out. I think you have to—is the honest answer to that question. But I think if—first of all, degree of difficulty, very high, combination of, you know, legacy of deflation for many years, fiscal accounts that are sort of wildly unsustainable by normal measures, and big structural problems.

Starting with very high degree of difficulty, I think you would have to argue they've been successful in the way you would have hoped in the kind of best case. If you went back a year ago before the election and asked, what are the odds that we'd find ourselves where we are? I think very few people would have put very high odds on being where we are.

So you've had a fundamental transition of monetary policy that's arguably been successful in both shifting asset markets, and you're beginning to see real effects of that, certainly in inflation expectations, actual inflation. You're beginning to see investment pick up. So in the part of it that you could move first and most dramatically, it's hard for me to argue they haven't been successful. And for people that have, you know, argued for 20 years that the BOJ has underperformed, it's a very different environment.

I think with respect to fiscal, they have obvious challenges. They are confronting them. I think anybody who kind of lived through '97 and, like, the big consumption tax increase and the world that played at that era has to be a little worried about another big consumption—increase in consumption taxes. But I think they've got a plan to offset that with other spending, at least in the near term, and I think there's a plausible case that they can manage what is a kind of—ultimately a necessary adjustment.

On the structural side, it's very much a work in progress. I think they've laid out—I would—I think you have to think about two things. There's a kind of political policy process in place to do structural reform. And I think the most optimistic I would be is, given the politics, given the mandate that the Abe administration has, given the way they have set up mechanisms to try and take structural—the structural policy forward, I think that is a good way of making progress in those things in the Japanese context.

You look at kind of the details of what's actually on the table and the way it lays out, and there are more questions. First of all, an awful lot has been pinned to trade negotiations, in particular the TPP process that sort of links them with Asia and the U.S. And they've—there are an awful lot of things that in the Japanese context are tied to that. If that doesn't go forward on schedule—and lord knows there are plenty of reasons to be skeptical about that—that's going to create, you know, problems in terms of their ability to take that forward.

So, look, I—very much the jury is still out on this. But I think there are good reasons to be optimistic. Certainly on the monetary policy side, you know, they've done something which I think many of us thought was very unlikely.

MALLABY: From a global perspective, it seems to me that the central sort of scary question is, OK, so this economy has racked up this unbelievable public debt. It's only been sustainable because long-term interest rates have been super low. If you have a recovery in Japan, interest rates will presumably go up, at which point this public debt becomes unpayable. Is—I mean, and that has global repercussions. Is that—Minouche, Vincent, anyone?

REINHART: Can I modify that a little bit?

MALLABY: Yes, sure.

REINHART: I would add to that, it's financed domestically. So the reason the rates have been low is there's been a very large domestic pool of savings. Look, you kind of look at the fiscal problem, and you've got a bunch of obligations that are largely owed to domestic old people. You've got a fiscal problem that is associated with obligations to that same generation.

There's going to kind of have to be a realignment there. And the...


MALLABY: ... the realignment words, sounds like a nice word for something...


REINHART: But, I mean, the structural issue is, Japan is about unsustainable and unfair generational transfers. How do you address it either directly, which is extremely hard, or indirectly, through higher inflation? What I would say is, what's interesting about Japan, it's an amazing experiment in monetary economics, where you've had a central bank that's said it wanted to generate inflation for two decades, now has a government willing to tolerate the currency depreciation that potentially can get you there.

But I think the thing we've got to remember is, monetary policy can shift demand around. It can't create supply. It shifts demand intertemporally by keeping rates low, so you bring forward future output, or it shifts it internationally, by depreciating your currency and taking some of it from your trading partners. Right now, there is some resource slack in Japan, so if you create demand, it will produce extra output, but—like the IMF numbers, the slack is not enormous.

And so, therefore, to be successful, two things have to happen. The first is, the third arrow has to work, so that potential output increases, so there is something to pull forward. And, second, the Fed's got to be successful, because the tolerance of the U.S. Treasury for currency depreciation and politicians generally is going to be limited.

MALLABY: I saw a question in the front. Microphone's coming. Please stand (inaudible) here.

QUESTION: Thank you. I'm Vince Lauerman from Energy Intelligence. The IMF had long held a medium-term forecast for the global economy at 4.5 percent growth. And with the most recent World Economic Outlook, they dropped it down to 4.1 percent. At the same time, they had all sorts of conditions built into that, including the U.S. and Japan getting their fiscal houses in order, as well as, you know, things such as additional structural reforms in the emerging markets.

The question I had for the whole panel is, what do you think is a realistic medium-term outlook for the global economy?

MALLABY: Why don't we just make that real quick? And you guys can each give a global forecast. How about that?

SHAFIK: Well, I mean, I think—our central forecast remains in the World Economic Outlook at 4.5 percent because, as you say, we do assume that the U.S. comes to grips with the fiscal. We assume that the Fed keeps rates low until 2016. And we assume that the Europeans—that Japan delivers its three arrows and the Europeans—you know, we don't have a huge breakthrough, but at least they manage the remaining issues around banking union. That's our sort of central scenario, and that's where we get 4.5 percent.

But as you will have probably seen in the World Economic Outlook, we do a kind of—a low-case, which is grim, and—and a good scenario, we do a sort of high-case scenario which actually doesn't deliver a lot more growth than the 4.5 percent, but we argue, if the good scenario, you get more sustainable growth over the longer term.

ALEXANDER: Let me just say, like, in terms of the good scenario, you have—I think when you look at the industrial world, the only real place you can be optimistic is Japan, relative to kind of past norms, and I think there's a case to be made that Japan's going to outperform relative to where you would have expected five years ago.

I think with respect to both the U.S. and Europe, I think you have to look on a kind of medium-term sense that, for a variety of reasons, we're going to be less—we're sort of less optimistic. I think when you look at the emerging world, we had this incredible run, you know, over sort of 10 years, and you are getting to a point where you're seeing natural headwinds against that.

And while I'm optimistic about places like India, say, for example, whereas if you got things right would still have a long room to run, I think there's no question that China is transitioning to a slower place, other important countries like Brazil and Russia are kind of hitting headwinds after a good run that, you know, inevitably mean you're going to move into a slower zone. I think you—and so even in a kind of optimistic scenario, your optimistic scenario is less optimistic than it would have been a few years ago.

REINHART: I know we're supposed to judge things by degrees of difficulty, and you expect me to be the East German judge...


... but relative, I find the IMF forecast plausible. In our own forecast, we see the G4 countries accelerating, policy getting traction in Japan, to a lesser extent in the U.K., European officials muddling through, but we go from a small negative to growth to a small positive to growth, which is still an acceleration and a very modest cyclically tepid acceleration in the U.S.

And in the emerging market world, there's stabilization, as China figures out that different point on the growth and financial stability trajectory, and so it—you know, it is slower growth, but it's more shared.

MALLABY: Another question? Yes, there. The microphone's just coming around.

QUESTION: I'm Richard Weinart (ph). Would you discuss the taper, which I guess will eventually arrive, and the, I suppose, reduction of the Fed's balance sheet and the effect of that on growth and interest rates?

MALLABY: You mean the timing of the taper or whether it'll be...



ALEXANDER: Well, look, I'll start. And, look, I think to a certain extent we've had a lot of the adjustments that's associated with taper already. I mean, in some ways, the way I would look at it is, if you go back to 2011, and as we transition into Operation Twist and forward guidance, we had a collapse of term premium in interest rates of about 150 basis points. There was always a question that, as the Fed transitioned out of its current stance and policy, a good chunk of that was going to go away. Well, we've kind of done, you know, call it, you know, 70 to 100 basis points of that already. And to a certain extent, I think we've seen a lot of that.

So I think there will be—you know, rates are going to continue to rise as, you know, frankly, we get closer to the point when short rates are going to have to go up and the expected rate component of sort of long rates gets filtered in, but also there's some more term premium that has to come out, but it's going to come in a context of hopefully an economy that's doing better.

I would argue, you know, the—I agree with Vince's forecast of the U.S., in the sense of we think things are going to pick up and the rate adjustment will come in that environment. I think the broader context—I mean, you can tell our sort of scenarios for the global economy are the economy doing better. The tougher question, really, is, if you get into a scenario where the economy continues—the U.S. economy continues to grow at sort of 2 percent, the unemployment continues to come down, and you need to have a taper in that context, I think that's a more difficult environment.

REINHART: So the Fed has to ultimately re-normalize its position in financial markets and the economy. That will involve raising rates. That will involve stop making asset purchases. They'll stop making asset purchases sooner. That's the taper. And they'll do it, by and large, because they've lost confidence that it is—it's getting some sufficient marginal benefit, given they've already made their balance sheet so large.

But more likely, they—and the main channel of monetary policy influences is forward guidance, about keeping rates low for a very long time. And although we were surprised they didn't start to taper sooner, I think the evidence suggests they'll just keep rates lower for longer. And if they keep rates lower for longer, that does provide support to U.S. economic expansion and, therefore, to the rest of the world.

One part of the question, I think, I have an easy answer for, they're not going to shrink their balance sheet. They're not going to sell assets. The Federal Reserve is going to hold—hold those and, eventually in the fullness of time, allow some balance sheet shrinkage organically through redemptions and prepayments, but that's only in the fullness of time. And the fact is, historically, central banks that make their balance sheets big don't typically shrink them. What they do is let nominal activity expand to match that higher size.

MALLABY: Another question. I think we have one here in the front.

QUESTION: Nisab Waff (ph), Pace University. Would you please describe—discuss the outlook on inflation, generally speaking, the optimal level of inflation, 2 percent versus 4 percent, for example? And also the components of inflation, inflation in commodity prices, inflation in finished goods, and also inflation in nontradables? Thanks.

MALLABY: So this debate about whether 2 percent is the right target, who wants to have a shot? Minouche, do you want to talk about that?

SHAFIK: We like 2 percent.


REINHART: I think it's important to appreciate that, in the mid-'90s, central banks backed into an inflation goal of 2 percent, because inflation was in the neighborhood of 2 percent, and they were thinking about, how can they cement the legacy of their predecessors, importantly, including Paul Volcker, to prevent inflation from backing up from then? So this is a perfect example of framing. They had a discussion. It was around two and said, "Two looks pretty good to me." And now it's two.

So to understand the argument that two may be too low, because there are times in which you want policy to be more accommodative than a negative real interest of minus two, that is, if you can only drive your nominal funds rate to zero—nominal policy rate to zero, then the lowest you can get is minus two, that's where forward guidance comes in. Forward guidance is supposed to be in principle able to project that policy accommodation further into the future to help the economy today.

And there's two aspects, I think, why central bankers push back against anything different than two. One is, it's a slippery slope, is the argument. If you raise it from two then to four, then why wouldn't you raise it from four to six, opportunistically?

Second is, the reality is, in a lot of advanced economies, aggregate demand is just not that interest-sensitive. And to buy effective insurance against adverse demand shocks requires not 4, 6 or 8 or 10. And if you're talking 8 percent or 10 percent inflation, you're actually talking about something where the adverse effects of inflation that are harder to measure matter.

MALLABY: Also, I remember Alan Greenspan used to say that the point of 2 percent was a target that meant that people in the private sector didn't have to think about inflation in the way they made decisions.

REINHART: So that's the Volcker-Greenspan definition is—I don't know what the number is, but what you want is concerns about a changeable price level to influence materially the decision-making of households and firms.


ALEXANDER: Look, the big problem is if inflation expectations become unhinged. And that was in some sense what happened in the late '60s and early '70s that created the Great Inflation. And the problem is, we don't really know very much about what would actually generate that. We have kind of one kind of historical example that we kind of focus a lot of attention on.

And I think the fear—you know, the general argument that, gee, wouldn't a little inflation be good for all sorts of things? Of course. The sort of existential risk you face is, if by—if you could, in fact, generate that somehow, and it's not totally clear how you could, but imagine you could, I think the concern you face is you are running this sort of existential risk of unhinging what have been very stable inflation expectations.

And so, for example, if you look at the U.S. after World War II and ask—we came out of World War II with a debt-to-GDP ratio of 115 percent. How did we get it down in a relatively easy environment? And the answer is, incredibly stable inflation expectations. We had a kind of burst inflation that didn't get built into the structure of rates, and it was great. But, like, how do you kind of reproduce that?

MALLABY: Did you mention that argument when you were in Germany, by the way (inaudible)


ALEXANDER: Look, I—obviously, the other classic example of inflation expectations becoming unhinged is a certain—but it's the challenge of, how do you kind of do this that I think is the hard one. It's easy to build a case that, like, higher inflation would be better, right? But it's—it's ensuring that you do that in a way where it's just a little bit more. And that's the—that's the hard part.

MALLABY: Let's go over there in the middle, man in the blue tie.

QUESTION: Rob Spalding, CFR. Greenspan recently wrote an article kind of chiding economists for missing the financial crisis, in which he mentioned some heterodox economists like Thorstein Veblen. I'm just wondering if you've read the article and if you can comment on it, in terms of future crises.

MALLABY: I think he was chiding himself, as well as other economists, but his point was essentially that everybody failed to forecast 2008, September Lehman crash.

ALEXANDER: I have not read the article, but let me kind of comment generally. Reading economic history is a wonderful thing, and—and one of the things you—one of the things that jumps out at economic history is systemic crises are things that recur.

There were actually people who, I think, got this right. I give a lot of credit to the people of the BIS, who focused on credit cycles, and it's a little bit of revisionist history to look back and say, "Nobody saw it coming." There were people who did, and I—and I think having a somewhat more historical perspective would help.

I do think there are lots of ways in which, you know, the profession—like, and I was not one of them. I—like, let's be clear. I think there's a lot to be learned by thinking about the history in more serious and systematic ways in that sense, and I think it would be helpful. I haven't—I haven't read the article, but...

MALLABY: I mean, one of the—one of the things that it raises is this idea that, because of behavioral economic—the phenomena well recognized in behavioral economics since the late '70s turn out to be more important than Dr. Greenspan had factored into his view of the world before, and so that people are not merely irrational. They can be systematically irrational in a certain direction, and this will create recurring instability in market economies.

ALEXANDER: I—I'm sorry. I very much agree with that, in the sense that—that one of the standard results in behavioral economics is people extrapolate too quickly from small amounts of information. And so one of the things you see is things that tend to proceed crises are booms. They start off with some—often start off with some good innovation, and people project it forward too quickly based on too small amount of information.

And, again, when you look at kind of the history, this comes through. And I think that is very much part of how we all have to kind of think about the world.

SHAFIK: I think in addition to those aspects of behavioral economics is the fact that we grossly underestimated the spillover effects of the increasing degree of interconnectedness. And so, you know, the fact that failed mortgages in, you know, Arizona would spill over so quickly into Europe and Asia was just not on our radar screen. We hadn't thought about globally systemic spillovers in quite that way.

And that problem will only increase, the risks around—I mean, I think our assessment is that the risks around more systemic spillovers are actually going to be higher going forward, which means that it's even more important for us to have in place circuit breakers, ways to manage them, better policy coordination across countries, because this is going to be a permanent feature of the future, given globalization.

MALLABY: And that connects to the International Monetary Fund's reconsideration of capital controls, right?

SHAFIK: Yes. I mean, yes, in part. I mean, you know, we used to have a very liberal view on capital controls. We thought open capital markets were a good thing. But through a series of papers we've written over the last year or two, we've now—we've got a much more nuanced position, which is that in certain situations, it is legitimate for countries to impose capital controls, if they're temporary, if they're not substituting for a necessary macroeconomic adjustment, because capital flows are very, very volatile, as we saw on May 22nd (ph).

MALLABY: The spillovers are so enormous that you need more tools to deal with them, so (inaudible)

REINHART: So I would say two things. First is, this was a crisis in the financial markets and at institutions. It was also a crisis in economics and finance. Part of it is the frame of reference that most of the people building models and trading on those models and making monetary policy on these models had a domestic focus, post-World War II experience, in which case the Great Moderation was a considerable part of your sample and you thought—you thought the rules had changed.

Second thing about that, however, is, by and large, it's the same people making policy in the same models that didn't predict the onset severity or duration of the crisis are—are showing us optimal control solutions of that—of those models to guide—to do that forward guidance.

MALLABY: I understand, we've hit time, so last word to you, Lewis.

ALEXANDER: One very quick other thing. Part of the issue is, finance is growing more rapidly in the economies overall. Part of the challenge we all face is the sheer scale of financial intermediation is actually growing faster than the economies. And partly what makes—what made 2008, I think, such a big surprise is how quickly that activity had generally grown.

We've had some adjustment since the crisis, but, frankly, not much. And I think the ultimate factors that are driving that are just going to continue. And so I think we're going to have to continue to live in a world where financial activity is going to become more important, not less, and that means that sort of the financial volatility aspects of the macroeconomy are ones we're going to have to continue to focus on.

MALLABY: It's been a great conversation. Minouche, Lewis, Vincent, thank you very much.


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