World Economic Update

World Economic Update

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The World Economic Update highlights the quarter’s most important and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy. This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies.

MALLABY: Welcome to this morning’s Council on Foreign Relations “World Economic Update.”

With me to discuss the world economy, I’ve got Nouriel Roubini on my far left, chairman, I think it is, of Roubini Global Economics; Jan Hatzius in the middle, who is from Goldman Sachs Group; next to me, Lewis Alexander from Nomura. And I’m Sebastian Mallaby. I work here at the Council on Foreign Relations.

We’re going to start with the U.S. I’m in danger of being a little bit too obsessed with the U.S. because the growth experiment that seems to be underway with a combination of fiscal stimulus and still quite loose monetary policy strikes me as extremely interesting, but I promise we’ll get to—a little bit to the world in due course.

I guess the framing context for a meeting on the world economy right now is that we’ve had this tumult in markets in February, and yet the late January IMF forecast was that, you know, not only was the world economy in 2017 performing better than at any time since 2010 and more balanced growth performance, but 2018/2019 look to be, if anything, a tiny bit better. So you’ve got great news on the real economy, a little bit of tumult in markets. So I thought I’d go to Nouriel first, who’s been known as Dr. Doom sometimes, and ask whether the markets have now had their tantrum and that’s that, or are you expecting any more nasty animals to crawl out of dark corners?

ROUBINI: Well—(coughs)—sorry. Well, to answer that question one has to look at the economic outlook, what will be the policy reaction of the Fed, and what’s going to be, then, the impact on long-term interest rates and so on to think about further market volatility in the stock market.

I would say, if you put it in a historical perspective, you know, the recent correction is one of the many occurred since 2010. You have had at least 10 episode(s) of risk-off in the global economy since 2010. Six of them led to a correction. There was a 10 percent correction in U.S. and global equities. The last two episodes before this one were—it was in August and September of ’15, when there were worries about China landing. Then there was another episode in January and February of ’16, when there were worries about China, U.S., Fed, oil, dollar, Grexit, Brexit, and you name it—I mean, a perfect storm.

In each one of the previous episodes in the last, you know, eight years, markets corrected, then they reversed and went to higher highs. And my question is whether this time is similar—you should buy the dip—or whether this time around is going to be different. I would say there are arguments on both ways.

I would say on one side you could argue that in each one of the previous episodes the shocks that were hitting the global economy were I would call stagflationary, meaning the worries were about lower (risk and ?) inflation. This time is the first time since 2009 that we have seen worries about maybe rising inflation. And in each one of the previous episode(s), what happened was that the policy reaction—whether it was the Fed, ECB, BOJ, PBC, and so on—saved the day because they went into even more unconventional market policy, where in the last two episode(s) the Fed wanted to hike and did not hike, or delayed it, and so on. Well, maybe this time around one difference is that if—if, and there’s a debate on that—these inflation surprises were to be real as opposed to a fear, this time around the central banks would not be able to ease; actually, if anything, they’d have to hike more. So that’s one difference.

Secondly, I would say another difference is that this time around valuations, at least in the U.S., are much more stretched than in the past in terms of P/E ratios. And therefore, maybe this correction, that has been reversed only partially, is going to linger for longer.

Three, now we have this massive fiscal stimulus in a period of time of peacetime. Without recession, it probably is undesirable. It’s going to put pressure, potentially, on growth, potentially inflation, and force the Fed probably to hike more, faster, and sooner. How much this year as opposed to next year, to be debated. So those would be the reasons why maybe this correction could linger for longer, say in the 5 to 10 percent range.

On the other side, you know, growth is strong. Earnings are still doing well. The stimulus is going to have a positive impact on economic activity, at least this year and next year. The global economy is doing well. And therefore, the fundamentals are going to be justifying, probably, the fact that maybe some of this correction being driven by technical factors—you know, sudden rise in value that was not fully justified by fundamental(s) has been already reversed. So those better fundamentals might be a positive story.

But I would say valuations seem stretched. Some of this correction has been reversed. I don’t expect markets this year are going to be reaching new highs. Maybe moving sideways, all in all, depending, of course, on what happens in the economy, the Fed, and so on.

MALLABY: So, Jan, I think Nouriel’s saying that this is sort of an inflation shock, not a growth shock. If that’s the case—

ROUBINI: Or a fear of inflation. I didn’t say it’s going to happen. There’s a debate on that.

MALLABY: But if that’s the case, then the question is whether this growth can be delivered. Clearly, there’s enormous impetus from the demand side. And when an economy appears to be at somewhere approaching full employment, there’s always a question about whether the supply side will respond. So tell us about where you feel we are in the cycle, how much more scope there is to push unemployment down or generate more supply in other ways.

HATZIUS: I think the U.S. we’re at or maybe a touch beyond full employment if I take all of the different indicators together, I mean, putting some weight on the—on the wage and price numbers, which would say there is still some scope. But I think I would also put some weight on the labor market indicators—not just the unemployment rate but also other measures, which generally say that we’ve probably moved beyond what we can sustain—

MALLABY: Well, labor force participation, isn’t that down from the peak in 2007?

HATZIUS: It is, although you can basically explain all of that at this point with structural factors. I mean, there’s still some debate about it, but I don’t—I mean, at least the vast majority of the 3-percentage-point decline you can explain with structural changes. And there are also other things you can look at, like surveys of job availability, surveys of skill shortages, quit rates, job openings. I mean, they all tell you a slightly different story, but overall I would say they say we’re, you know, a little bit beyond full employment.

MALLABY: Just so we understand, because that thing comes—that point is made by the doves all the time, the structural factors you’re talking about, these are demographic structural factors? Or what kind of structural factors?

HATZIUS: The most important one is simply the aging of the population. So you can account for, you know, 2 ¼, 2 ½ percentage points of the 3-percentage-point decline just with the aging of the population; that, you know, we now have more 70-year-olds and fewer 45-year-olds.

And then the remainder is a little more up for grabs, I think. But we have seen—if you take male prime-age labor force participation, I mean, that’s down, but it’s been down for 60 years. So, you know, while it may be that some of this is still—is still cyclical, if you take a long-term perspective and you just look at what happened to male prime-age labor force participation over the last 60 years, it’s just a continuation of the—of the trend.

So I think it’s hard to be really certain with labor force participation. I mean, it’s just really difficult to distinguish between cyclical and structural factors. So I would—I prefer to kind of broaden the range of indicators that you look at to kind of triangulate between these different signals. And some of the what you see is what you get indicators, like quits or job-market perceptions among households, I mean, they should be relatively immune to these difficult decisions that you have to make between, you know, who is unemployed and who is out of the labor force. And that’s, obviously, just hard to do for BLS.

MALLABY: OK. So the labor market is pretty much at full employment.

HATZIUS: Right.

MALLABY: So what are the other prospects for delivering more supply in the face of this big demand stimulus?

HATZIUS: Well, there’s still, of course, trend—you know, trend employment; you know, maybe 100,000 per year or so. And then—but on top of that, what you would need for sustainable growth is productivity growth. I think there’s room for a pickup relative to the, you know, ½ percent pace that we saw for much of this recovery. I mean, that seemed really depressed, even if you take a, you know, fairly downbeat view of what the long-term trend might be. I mean, we’re still using about 1 ½ percent for the long-term trend in the nonfarm business sector, which gives you a little more than 1 percent in the—in the whole economy. And, you know, I think we can—we can get there, but that’s already built into a lot of the potential growth estimates that people have put out there.

So, if you take the Fed’s estimate, it’s a little under 2 percent. That builds in an acceleration in productivity growth. So, in order to get to something much higher than that, you’d need to see not just an acceleration of productivity, but a really big acceleration. And, you know, that’s a tough call to make, I think.

MALLABY: So I want to get Lewis’ view on this in just a second. But just to wrap up your view here, what you are saying, if I hear you right, is that you’ve got—you’ve got this big fiscal stimulus that’s just been baked in; you’ve got the Fed, which has a policy rate still substantially below the neutral rate—I guess it’s negative in real terms, the policy rate; and you’ve got quite a lot of quantitative easing still there in the sense that it’s a stock effect. And so people now talk about quantitative tightening. It’s kind of premature. So you’ve got both fiscal stimulus, monetary stimulus, and you’re saying the supply side hasn’t got a lot of room to respond to that. We’re going to overheat.

HATZIUS: Yeah. I think the biggest risk is an overheating, and I think monetary policy needs to lean against that. And that’s why we have a hawkish view on Fed policy, with four hikes this year and four hikes next year. So—

MALLABY: Four and four.

HATZIUS: Four and four. So, I mean, markets right now are priced for, you know, about half that, a little more than half that, with I think most of the gap coming in 2019. So I think we’ll see, under our forecast at least, more hikes in 2019 than the roughly 1 ½ that markets are now pricing. But, you know, even with these kind of, you know, still fairly gradual increases in the—in the funds rate—which are nevertheless above, perhaps, generally the expectation—even with that, I think there is a risk that you do get a more significant overheating.

MALLABY: Well, if there was four interest rate hikes this year and four next year, one wonders if the playing nice that one gets between the White House and the Fed would survive that.

But let’s go to Lewis. I think you have a slightly less aggressive estimate for the number of hikes in the next two years, four and two?

ALEXANDER: I have four and two. I suspect the difference between Jan and I is more about financial conditions than it is anything else. If I assumed financial conditions were essentially going to go on in a kind of relatively smooth way and not correct, I’d be at four next year too.

So the basic question is, what are the conditions that you need to slow the economy back down to a pace that’s more sustainable? The interaction between the Fed call and financial conditions is one of the hardest things to call. And so I think that’s really, frankly, where we would differ more than anything else.

MALLABY: So you would put more weight on the bond vigilante factor to restrain the economy from overheating and less on the Fed is what you—the markets lead.

ALEXANDER: Well, it’s not just bonds. It’s equities, all of the risks, in some ways, that Nouriel talked about. We are at, you know, levels of valuations in financial markets that are at the extremes in credit, in equity pricing. In spite of what’s happened over the last few weeks, we are still at those very extreme levels. If that persists for the next two years, I’ll be wrong on my Fed call next year because that—just raising the funds rate won’t be enough to slow the economy. It is very much about that interaction.

MALLABY: Right. And if we go to the—kind of the core real economy question, which it seems to me is that, you know, the last time you had a consensus in the economics profession—maybe not a consensus, but at least a strong view—that it was a good idea to run the economy hot, this is language from the 1970s, and we know where that ended up. We now have people arguing that, hey, it’s very good to have—you know, to try this stimulus, both monetary and fiscal, because perhaps we can squeeze more people back into the labor force, perhaps productivity is waiting to surge through some combination of rising CAPEX in the face of this large demand, diffusion of ideas that have been percolating in Silicon Valley for a while. Whatever it is, there’s a kind of bull story on the economy’s capacity to respond to all this stimulus. And you’re not—neither Jan nor you are really going for that.

ALEXANDER: Well, first of all, I agree with essentially everything Jan said on this, and all I’m going to say is sort of a nuance.

One thing I would stress is full employment is not a brick wall, right? I mean, in some ways the best analogy for where we are now is sort of the late ’90s, when, you know, we got an output—we got the economy well beyond conventional notions of full employment, and inflation expectations continued to come down and whatnot. And so you shouldn’t think of full employment as some point where, you know, you have to build some story about how you go beyond it.

Having said that, I think—the relatively pessimistic take on the supply side I think is very well founded. If I wanted to be optimistic on labor force participation, the only place I really see for making the argument is the potential for further convergence between men and women. So, as Jan laid out, prime-age men have been declining. With structural reasons you can—you know, I’m fully in agreement with that.

There is this interesting characteristic that participation rates among women basically from the 1960s up until around 2000 were converging. That convergence essentially stopped at around 2000. And since 2000 until relatively recently, you’ve seen prime-age female participation and male participation kind of basically be on the same track. Very recently you’ve seen some beginnings of signs that maybe that convergence will continue. But if I wanted to kind of be optimistic, I would—that’s the place I would look rather than the notion that you’re going to get a lot of prime-age men who are out of the labor force now to come back in.

MALLABY: OK.

ALEXANDER: On the productivity side, there are plenty of reasons to think that it’s possible that productivity could accelerate. And I think as an economist you kind of have to acknowledge we’re lousy at forecasting productivity growth. And so the people who want to be optimistic about that, there are plenty of good reasons to kind of make that case. I would stress the fact, however, that that is a forecast that is not really based on anything that’s happened. I think if you look at the data we have in hand, it’s very hard to make the case that there’s some evidence that it is, in fact, happening.

Investment, you do the math on sort of the contribution of capital to productivity, you’re talking very small numbers. It’s hard for that under any plausible scenario—even if you want to be optimistic about investment, that by itself doesn’t get you there. You have to believe the story that total-factor productivity is going to accelerate. And again, that could certainly happen, but I would argue there isn’t a lot of evidence that it is happening. And I think the prudent thing to do is to kind of wait and see.

MALLABY: Nouriel, let’s go to Europe. So 2.5 percent growth in the EU last year, best number since 2007, but an enormous amount of political uncertainty. And March the 4th will be a bit of a twofer on this: you’ve got not only the Italian election, but also the result of the SPD party member ballot on whether this grand coalition in Germany will be allowed to stand. So two major economies with that uncertainty. Meanwhile, you’ve got a pretty tired, weak-looking coalition in Spain. You’ve got, obviously, Brexit in the U.K. It feels as though, aside from Macron in France where there’s a lot of dynamism, where’s kind of a—a kind of creaky old feeling about Europe. Berlusconi is back in Italy. Rajoy has been in power now, or head of his party, I think for 14 years. How do you see this interaction of good growth news and kind of creaky politics playing out?

ROUBINI: Yeah, there is a little bit of a disconnect because from a(n) economic point of view, things have been much better than last few years, as you pointed out. Growth is stronger. The risk of deflation has been fading out. There is less fiscal austerity, even if there are still constraints. The ECB is still significantly accommodating. And in my view, the exit from unconventional monetary policy is going to be very gradual and sustaining of the economic growth. You know, the banks are—even in Italy have been sort of cleaned up and they’re in much, much better shape. So financial risk(s) are less. But the politics looks, you know, slightly more uncertain and volatile.

I mean, if you want to take a benign view, you would say the good news about Italy’s election is most likely the anti-Europe parties are not going to come to power. So, yeah, the center-right may be winning and Berlusconi may or may not be prime minister depending on legal constraints, but that would not be great. The best thing will be to have another grand coalition between center-right and center-left, with neither Berlusconi or Renzi in power, but Gentiloni, who has been quite a good prime minister, and Padoan, his finance minister. And then Italy for the next couple of years can at least do some reforms and so on, because if they don’t do reforms, with potential growth being low and debt ratios being high, once the ECB by the end of next year is going to finish QE and normalize policy rates, things could become much more bumpy. But, you know, Italy politically is not great, but maybe depending on the results of election, as I said, could be center-right, could be hung parliament, could be grand coalition. But maybe the more extreme scenario is less likely. It will muddle through.

In Germany, we don’t know yet but most likely this grand coalition is going to occur, even if most likely it may not last for four years. It’s pretty fragile for many reasons, and Merkel may not be chancellor. And there are lots of people within her party restless and want to become chancellor, and they’re going to undermine her in the next couple of years.

Macron is doing the right things. He’s going the right directions.

And Spain is noisy, but the Catalan issue has been somehow controlled.

So maybe the good news, if you want to take a political spin on what’s going on in Europe, is that the most extreme populist party, the extreme right and left, with very few exceptions are not in power, at least in the eurozone. In Eastern Europe, we see some of these populist trends in Hungary, Poland, and so on, but they don’t seem to have an economic impact and so on.

The problem is that the window for doing greater eurozone integration, it’s very narrow because you have to reach an agreement by June when there is the next European Council meeting. Because after that, in the fall you’re getting ready for the European Parliament elections.

MALLABY: Well, when you say—when you say more integration, you’re talking about banking union? What kind of integration are you—

ROUBINI: Well, there are many dimensions of greater risk-sharing and greater fiscal union. Could be on the banking side. Could be unemployment insurance. Could be some sharing of other aspects of fiscal policy. There’s a whole spectrum of proposal(s) on the table. The problem is the German(s) always say they’re worried that risk-sharing is risk-shifting to their taxpayer, that a fiscal union is a transfer union. Unless they believe that France is going to do as much as they claim they’re going to do, and unless Italy and Spain are fine enough, they’re going to say let’s wait and see. And if you wait and see—and there’s also uncertainties politically in Germany—the agreement they’re going to reach by June are going to be minor, cosmetic, nothing substantial. That means that you’re going to postpone any talk about real integration until 2020 at the earliest, because by ’19 we have the European parliamentary election, new president of the council, new president of the commission, new president of ECB, new president of European Parliament, this whole musical chairs all over Europe within the ECB, outside. Things are going to change. And then by 2020 you are closer to other elections. And therefore there is a narrow window.

Now, the optimists say this model has worked, we’re going to do limited reform, we can leave it even without further integration, and things are OK. Others say no, when the next time something bad is going to happen, if we don’t have as much risk-sharing then the institution(s) are going to be fragile. And there is an open discussion in Europe on whether it’s going to be one way or another.

MALLABY: So, I mean, Jan, you know, one question, I guess, that arises out of that is on this issue about if there was another downturn—there will be at some point another downturn in Europe, and how does it respond to that. It did muddle through last time, but it wasn’t obvious ex ante that that would work. And part of what made it work or the thing that made it work was really, you know, Mario Draghi’s policies. Draghi will be leaving. Will the next leader of the European Central Bank be so activist if he needed to be?

HATZIUS: I think it’s impossible to say. I mean, it wasn’t obvious that it was going to work, although it became a lot more clear very, very quickly once Draghi took over. I mean, things really changed dramatically. And it really showed how, you know, making forward-looking statements about your action as a central bank can be enormously powerful, even before the actions are actually carried out.

So, yeah, I mean, I think it’s an open question. If there is another bad crisis—and, you know, I don’t think a crisis like the one we saw is likely anytime soon, but of course there will be crises. And maybe they’re smaller crises, but perhaps still significant. How the ECB leadership would be prepared or able to respond, I think, is—it’s less clear.

You know, we’ll find out probably sometime this year, maybe early next year, who is going to be Draghi’s successor, and then we’ll see. It seems like there’s a higher probability of somebody from the north now that de Guindos is going to be the vice president—

MALLABY: So Spain has the vice presidency and—

HATZIUS: —and that might be a little more hawkish. But again it’s hard to know. I mean, even if you did get a—you know, somebody who has historically been more hawkish—if you had Jens Weidmann as the new ECB president, I think there’s still quite a lot of uncertainty around how—you know, how he would actually fill that role. But there is a number of candidates out there, and I just think it’s too early to tell.

The one thing I would say, you know, maybe a little bit more normatively on ECB policy is, you know, we talked about, in the context of the U.S., you know, giving growth a chance and, you know, should—is it a good risk/reward to deliver stimulus and easy policy in the U.S. And, you know, I think it’s not so clear. I agree with Lew on this.

But in Europe, I think it makes a ton of sense. The unemployment rate’s still 8.7 percent. And we’re still not seeing any signs of a pickup in core inflation. We’re still at basically 1 percent. Wage growth has picked up a little bit, but just all of the signs are saying there’s potentially still quite a lot of slack in the—in the economy. And unlike in the U.S., you don’t have to, you know, argue about trading off one indicator against another indicator. It’s a pretty clear picture. So there, I think it would make a lot of sense. And, you know, to what extent we see that beyond Draghi’s tenure I think is unclear. I mean, I agree that they’re going to be very slow in the—in the next year and a half in exiting. We have, as a positive forecast, the first hike in the deposit rate in the fourth quarter of 2019. But what happens beyond that is more uncertain.

MALLABY: So, Lew, it’s maybe a question on the dollar for you, then. I mean, you’ve got a situation where the Fed is forecast to hike a lot, needs to hike a lot. Europe, not the case. Much higher unemployment. A much stronger case for staying looser for longer. And yet, the euro is strong and the dollar is weak. What’s going on? And what does that mean for the rest of the world economy?

ALEXANDER: So, first thing I would say is the dollar weakness really goes back to the beginning of last year. So it’s not a recent phenomenon. Certainly, what I would have said before the fiscal impetus came, sort of late in—late last year and early this year, was that you can tell a story that was, importantly, about where the different countries were in their cycle. The very fact that the U.S. was further along, and that had implications for where policy was going to go, I think said a lot about what was driving the dollar at that point. And the sense that people were anticipating that Europe and Japan would ultimately catch up, and that that was—that meant in some sense more impetus for those currencies.

Since you’ve had the fiscal stimulus come in, you kind of have to tell a bit of a different story because that’s obviously changed the trajectory for the U.S. economy, it’s changed the trajectory for policy somewhat. And I think there the interesting question is the degree to which the quantities start to become an issue. Obviously bigger fiscal deficits mean bigger current account deficits. You’ve obviously got the fundamental question of how comfortable are people holding U.S. assets at these valuation levels. I think you’ve got a range of things that are sort of conspiring. And, you know, to a certain extent the dollar, let’s still remember relative to kind of where it was going back to early 2014, is still strong kind of relative to its historic norms. And so I think you are beginning to see some of the negative consequences of the inherent uncertainty around policy, the fact that this fiscal trajectory makes no sense whatsoever, I think are starting to weigh as well.

MALLABY: Nouriel, I mean, would you say—I mean, there’s been this—you talked about the risk on/risk off cycles at the beginning. And that has been a real dollar driver, right? And the risk on period—like in general we have now, the first couple weeks of February excepted—in a risk on period people fled to the dollar—I mean, fled away from the dollar. And so to the extent that people are feeling bullish about the world economy right now, you might find that the allure of the U.S. safe asset is diminished, and people look at their portfolios, they’re willing to rebalance away from the dollars that maybe they over-weighted in a time of fear about global economic performance.

ROUBINI: No, you’re correct. I mean, to explain what’s happening in the dollar, there are many factors at work. I mean, on one side you could argue with a large current account deficit while Europe and Japan has a surplus, that structure over the medium/long term should be great for the U.S. dollar, while in the short term, of course, capital account and balance of payment matter more and monetary policy matters more. But of course, you know, everything—a currency, about the price of two monies, also depends on relative monetary policies, relative growth, relative expectations about what’s happening in fiscal policy in different parts of the world.

And risk on or risk off, of course, matters. In a world in which for the last two years we have not had risk off actions, apart from these brief actions over this past month, and you have a pickup of global growth and things are improving more in the rest of the world, because U.S. improvement has been baked in at this until now. Then foreign assets, whether in Europe, Japan may be more appealing. So that part of the sentiment implies money moving into foreign markets, and then strengthening those currencies and weakening the dollar, especially when some of these positions are effects on hedges, that seem to be now more than in the past.

So, but you know, on whether the weakness of the dollar is going to continue or not, it depends, you know? There’s been a pickup in relative terms in global growth more than U.S. until recently. But now there is this stimulus. And the stimulus is going to strengthen U.S. economic growth. That might be—may be a positive for the U.S. dollar. If loan rates are going to go much higher, if the Fed is going to hike—I’m not convinced that the Fed is going to hike four times this year, four times next year, because I worry that if that happens the tightening of financial conditions between dollar, loan rates, the stock market, and credit spreads might actually weaken the economy in a way that doesn’t justify four and four. So I’m more like three and three. But, you know, it’s anybody’s guess. It depends very much on key—what happens to inflation—around inflation. We don’t know how much of that is actually going to occur.

But, you know, you could tell a story in which, like in the past, the fiscal stimulus has led—not in all episodes, but some of them—to a strengthening of the dollar until the current account becomes so bad it then has to reverse itself, like the cycles we’ve had twice in the last 20 years. So it’s a—movements of it are anybody’s guess. One thing that’s an important variable is that this administration is obviously, whether they say it public or not, in favor of a weak dollar. You know, the white, blue collar voted for them. Their jobs and incomes and wages depend on having a weak dollar, and a strengthening of the dollar, like during the early Reagan years, is going to crowd out, essentially, many of these jobs. And that fiscal stimulus is going to lead to some significant worsening of the current account. And while maybe jobs over all are not going to be weakened, there may be a trade and nontrade, that you could have upward pressure on the dollar that might actually weaken the competitiveness of trade of goods prices and therefore of jobs in the manufacturing sector, something the administration doesn’t want. So, so far, it’s been verbal intervention. But you never know, they might try to do something else to try to push down the dollar.

MALLABY: Did you want to say something?

ALEXANDER: Yeah, no, I was—I was just going to make a point that where the source of the sort of risk off—what’s driving that to some degree matters here. So I do worry about a context where it’s the overvaluing of U.S. assets in particular that are a part of the problem. And to a certain extent you’ve seen that recently, where you have a situation where it—you know, this correction was really something that was sort of related to the U.S. And I do wonder whether or not you’re going to see that same kind of same flight to the dollar in that context if ultimately that correction is really more about U.S. assets correcting, particularly if it becomes a sort of a broad-based equity correct.

MALLABY: I was going to ask about China, but I think it’s time to go to members and invite them to come in. Remember that this is on the record. If someone’s got a question, the microphone will come to you. I see one right over here. I see several, but let’s go here first.

Q: Thank you. Juan Ocampo, Trajectory Asset Management.

Sebastian, you’ve been holding these wonderful outlooks for years. And for most of those, there’s been very well-reasoned arguments for, you know, structural problems—fear, gloom. Sometimes you feel like you’re not going to make it out the door in time to sell your risk assets before it’s too late. (Laughter.) And once again, really cogent arguments. Here we are. You know, it’s almost—the news is a little bit too good. We might overheat. So what happened? Were we overstating the problems to begin with? Was the economy and the world more resilient in ways that were really fundamentally much stronger? Or are there still some lurking problems that is like the San Andreas fault? Well, we haven’t had a big one yet but, you know, it’s still there. It’s just a question of time. So that’s kind of three choices.

MALLABY: Well, since you’re looking at me, I’ll say something, but I’m glad to hear from the others too. I mean, I think what happened is that macro trumped micro in a big way. Central banks proved to be enormously powerful, as Jan was saying with respect to Europe. And the sheer force of macro policy, particularly from central banks, was able to paper over the fact that in many places there were not structural reform. Now, there were structural reforms in some places like, let’s say, Greece, Portugal, the sort of the—Spain, Spain is a good example. Some places when really pushed to the wall did respond with structural changes. But we had a conversation a bit like this at the Council yesterday, but in Washington. And Adam Posen, who was on the panel, went so far as to say, you know, forget micro. What we’ve learned is all this structural reform doesn’t really do much. He said, Washington consensus is rubbish. Of course, his think tank originated the Washington consensus. You know, and Adam went on to sort of—

ALEXANDER: Under previous management.

MALLABY: What?

ALEXANDER: Under previous management.

MALLABY: (Laughs.) Right. (Laughter.) But, I mean, I think he overstated it by some considerable amount, but, I mean, the broad point—I would say the answer is that central banks proved to be extremely effective. What do other people think?

HATZIUS: I mean, I would add that, you know, it took a long to kind of work your way through the headwinds from the crisis. I’m much more in the headwinds than in the secular stagnation camp. I think there were very long-lasting headwinds. And one of the headwinds was also, I think, getting over the hump of the first Fed rate hike. I mean, while it was only a 25-basis-point move, both the lead up to it and the aftermath, you know, had a big effect on global financial markets. A lot of worry about, you know, China deval, China crash, China hard landing, you know, in particular. And that’s, I think, why it took such a long time—you know, 2015—as you were going into 2015, the economies, you know, had—certainly in the U.S. had already made a lot of progress. But then you had the slowdown. But once you did get over that hump, you know, I think things have basically been improving ever since. And, I mean, if you want to date that it would be the middle of 2016, and over the period since then things have gotten a lot better.

MALLABY: Did you want to say something, Lewis?

ALEXANDER: Yeah. Look, I guess I’m not quite so optimistic. I mean, I think the general point that macro policy—and, let’s kind of distinguish what we’re talking about. I mean, there’s the obvious question of what the ECB and Draghi’s commitment did around the euro crisis, as well as sort of all the other things that are out there. I think it’s fair to say that was more fundamental than people would imagine, if you want to make the very strong case for, like, central bank policy really mattering. I think if you look at other areas, like Japan or the U.S., you know, central banks have pushed things in the right direction, but it’s hard to look at the recoveries in those two countries and argue that they were all that compelling. And, yes, they’ve ultimately worked. But I think it leads to sort of the basic questions of—the headwinds versus secular stagnation debate. I suspect I come down on a more pessimistic side than Jan does on that.

I’d look at the things we talked about that were important there, reasons why savings is high, reasons why investment is low. I think many of those things have persisted. And we are existing in a moment right now where Europe is kind of benefitting from what is a more conventional kind of cyclical recovery. I think the U.S. is, frankly, dealing with the sugar high of a significant fiscal stimulus. I think the question of where we—what this will all look like 12 months from now is going to sort of come back to that. You know, obviously, you know, there were points in time in 2011 and 2012, frankly, when the world felt pretty edgy. I remember that was—that was the first time in my professional career I have ever said the largest risk to the U.S. is actually coming from outside. And certainly, relative to that, we’re in a much better place. And I think it’s fair to say that the worst case that many of us thought about during that time didn’t come to pass. But the structural stuff, I think, is still out there. I think we—you know, I would caution against getting too optimistic about the particular moment we find ourselves in.

MALLABY: Right here.

Q: Bhakti Mirchandani, FCLT Global.

The world’s largest asset manager, BlackRock, has written increasingly suggestive letters from 2015 to 2018 out how companies should be more long-term oriented, have a social purpose. To what extent do you see that translating into the micro economy, i.e., companies’ decisions, and from there into the broader economy? Do you think that’ll be material?

ALEXANDER: You’re looking at me, so I will try and answer that. I don’t see a lot of evidence, frankly, that there’s been a big sort of change in corporate governance in that respect. I think one of the things that’s interesting about kind of where thinking is in the U.S. on those set of related issues is that there is a kind of recognition that concentration in particular is—has downsides that you see in investment, you see in labor market performance, you see in a variety of ways. I think there are some things that are sort of related to corporate governance around how corporations sort of respond to the market—to the incentives that markets are coming that are potentially dysfunctional. And so I think there is an interesting kind of debate going on about whether or not there is scope for making changes in those areas that might improve them.

I don’t think this is a political environment where I expect much progress on those things, to be perfectly honest. And so part of my pessimism about productivity is, in some sense, reflects that fact that I am not expecting those things to change all that much. So it’s not that I—it’s not that I don’t think there are ways that you could make changes in corporate governance that would potentially matter. It’s just, number one, I don’t see it happening. Number two, this doesn’t seem like an environment where I’m going to expect that to happen.

Q: Thank you. Joseph Cari.

What do you—do you anticipate that the capital controls in China will be lifted? And if so, what do you think would be the effect on the global economy?

MALLABY: Jan?

HATZIUS: I mean, it depends on the time horizon. I don’t expect it anytime soon. You know, if you had a, you know, 10-year time horizon, yeah, I think there will be significant liberalization of the Chinese capital account probably. But I think at the moment there is, you know, a lot of focus on still bringing down debt growth, and also keeping—you know, keeping the balance of payments stable, keeping the exchange rate managed. They’ve made progress in terms of the macro picture. The, you know, debt growth numbers were running near 20 percent, if you took a broad definition, a couple of years ago. We’re now down to 13 percent or so. So that’s quite a lot of progress in a decent growth environment. And, you know, I think that’s going to be encouraging.

Having said that, it may have been a little bit the low-hanging fruit that have been picked, and 13 percent is still a very rapid debt growth rate relative to the trend rate of nominal GDP growth. So I think this controlled slowdown in debt growth is probably something that they’re still going to be focused on. And capital controls have been have an important part of that policy package. And so I don’t think that’s going to go away any time soon.

MALLABY: We didn’t talk about China before, so let’s see if either Nouriel or Lewis, do you want to say something about China in regard to emerging markets?

ROUBINI: I’ll give you the end. The only comment I’ll make is that, you know, when there was worries about a hard landing and there were massive outflows, losing reserves, and with pressure downward on the currency, they really cracked down on capital outflows and the control became tighter. Now they have the dollar weakness and the currency in China has been actually spent, I mean, significantly. At the margin they might fine-tune and ease some of those outflow controls, just because if the pressure upward on the currency becomes excessive, they might do it. But, of course, I agree that phasing out the capital controls is going to be a long-term term kind of trend. It’s not a short-term kind of thing for them.

You know, on China, I would say this year was the year of the Party Congress. So growth and stability were trumping dealing with overleverage of the capacity, bad assets, bad debts, and so on. And they kept on kicking the can down the road and doing new rounds of credit fuel fixed investment, real estate, and you name it. And at this point, after the party’s over, he has control over the economy, over the politics, he has to start to deliver more on the structural reform and the rebalancing, reducing leverage and overcapacity.

I feel he’s going to do less than is optimal and desirable because he’s not a true reformer, the way Deng Xiaoping was, as led the neo-Maoist tendencies. And he believes actually in command and control more than any market-related activities of one sort or another. So reforms in China are going to be slower than desirable and optimal. That means that some of that buildup of excesses, imbalances, are going to continue. I don’t expect a hard landing, but I don’t expect a soft landing either. I think if they keep on kicking the can down the road, eventually you’ll have something bumpy. We’ve had already the two episodes in the last two years of risk off either from China. Unless they deliver seriously on the reform, eventually they’re going to have a risk off episode. People are going to start to worry about these people not doing what’s necessary.

ALEXANDER: I want to preface this by saying my day job is to focus on the U.S., and so I’m a bit of a tourist on this as a topic. But in previous careers I’ve focused on these issues. And in particular, you know, when I was working in Washington back during the Asian financial crisis, we were talking a lot about these things, when Washington consensus was formed. I think at that point we—kind of our view was the world was going to progress through a kind of form of convergence. And the kind of assumption was all the major economies in terms of the way the function, in particular anything that involved cross-border, was going to kind of evolve to some sort of common set of rules. I think the presumption that capital account restrictions were going to go away was very much a part of that sense of how that process was going to go.

I have to say, I look at where we are right now, and I look at what’s happened in China, particularly under Xi, and go: It’s not so obvious to me that that’s the right model for how the world is going to go, going forward. And it seems to me that China is struggling with the question of whether or not they have a different model for how to do this. And to a certain extent, I look at the very success they’ve had, frankly, with capital controls more recently—which, frankly, is almost—I know of few precedents for as successful a utilization of them in a practical sense—and wonder whether or not they’re really going to be sort of committed to that.

Look, as a—as a liberal, in the European sense, economist, my kind of natural view of what is the end point of China’s transition is a market-driven system which, almost by definition, means no capital controls. But I—like, it isn’t obvious to me how that process is going to go in China. And it certainly isn’t obvious to me that the Chinese thing that that’s the—think at this moment that that’s where they’re headed over some sort of reasonable time frame.

MALLABY: Let’s go in the back.

Q: Chris Brody.

You’ve used words like “surge,” “sugar high.” Could you talk about where we go from here? Does it trigger a virtuous cycle, where it does on forever? Do we get to a point where we have some sort of smooth migration back to normal, whatever it is? Or is this a boom-bust cycle? What triggers it? What does it look like? And where are we then?

MALLABY: So I guess the question is sort of, you know, can the Fed engineer a soft landing from this?

ALEXANDER: Well, the—let me talk about two different questions. First of all, if you just do the math on the fiscal stimulus, it suggests that it’s going to be a significant stimulus to growth this year, particularly the second half of this year. It will be a modest stimulus to growth for the first half of next year. But after that, it’s actually negative, right? So just the simple math of what the fiscal policy does has that characteristic. Sebastian’s question about can the Fed successfully kind of soft land this thing is a very important question.

If you certainly look at history, it’s hard to find examples of that. And frankly, even before the fiscal stimulus, if you looked at sort of where we were last summer—and you could have asked the same question: Was the Fed going to be able to successfully soft land the economy? And I would have said, look, history is not terribly optimistic about their ability to do that. The fiscal trajectory has only made that problem harder. Now, I’m a glass half-full kind of guy, and I don’t have a recession in my forecast, but I think the fiscal stimulus has made that problem harder, not easier.

MALLABY: Jan, do you want to comment on that? I mean, to add—just to sort of add to the question, in an environment where—so the history that Lew is referring to is generally, I think, a history in which structural price pressures in the economy were much stronger. And now, because of deregulation, because of trade, because of Amazon, whatever, you have less pressure on prices. So the soft landing should be easier in this context, shouldn’t it?

HATZIUS: Yeah, I mean, I agree with everything that Lew said. I think history would be against it. I think the point you’re making is that history might not be a great guide because there are—there are plausible stories that say, you know, maybe more anchored inflation expectations and some of the other factors, perhaps, that you talked about allow the Fed to sort of gently slow things down, when things really do need to slow down to a below trend growth pace, and then the increase in the unemployment rate that then needs to result can be perhaps very gradual and ultimately not turn into a recession. History would say, there’s never been an increase in the unemployment rate of more than 35 basis points that wasn’t associated with a recession. But of course, that’s not a—not a law of nature.

So I’m in the same boat. We don’t have a recession in the forecast. I mean, I think the recession in 2018, 2019 seems very unlikely—especially 2018. Beyond that, though, the risk goes up significantly, especially if we do get a big overheating. And we do have the unemployment rate falling below 3 ½ percent, which is, you know, obviously extraordinarily low.

MALLABY: In your forecast, Jan?

HATZIUS: I mean, that takes you to late ’60s levels.

ROUBINI: But, Jan, I mean, if I read correctly what you guys have written, you say you’re going to have four hikes this year, four hikes next year, and you don’t even rule out that you might have five hikes in this year under some scenarios. And suppose that you are right that, you know, the labor market is tighter, that all this globalization stuff doesn’t matter—especially for non-traded prices—and you have a significant acceleration of inflation, acceleration of growth, financial conditions are fraught, and the Fed does five/four. Then you could have a significant tightening of financial conditions, something like a rate tantrum as opposed to the taper tantrum of ’13. And then the economy could slow down. You have debt pick up and inflation. And even without the fiscal stimulus, as Lew pointed out, the economy might have been overheating. You have global factors. Commodity prices are rising. Now you upgrade the fiscal stimulus, 2 percent of GDP, that makes it even worse. And then it’s almost assured a hard landing, right? How are you thinking about—how do you get to a soft landing?

MALLABY: Now you’re going to start the risk assets.

HATZIUS: A few things—

ROUBINI: First financial and then economic, no? I mean, the best of our world becomes the worst, paradoxically, right? And now we’re worried about deflationary and recessionary pressures.

HATZIUS: Yeah. Although, I think five hikes this year, I think it’s a low probability.

MALLABY: Let’s try to get another question.

HATZIUS: The more plausible—I think the more plausible risk case is that next year you actually get significantly more hikes. I mean, if the unemployment rate’s down to 3 ½ percent or 3 ¼ percent, and inflation is at or above the target, you know, I think in that—in that environment, it might well do more than once per quarter. So I think there’s a, you know, distribution of risks around the sort of four hikes next year. Could we do it? I mean, if there is a big impact on financial conditions, definitely very possible. But I think it also could be—could be more than four.

MALLABY: Question in the aisle there, yeah.

Q: Thank you. Lyric Hughes Hale with Econvue in Chicago.

First, a quick comment on China. The sector to watch is, of course, real estate, where our prices began. And China’s instituting property taxes for the first time. And that experiment could be successful or unsuccessful, but I think it will have a great impact. My question is, though, something you touched on lightly at the beginning, Sebastian, about doing—goings-on in Silicon Valley. We have AI, quantum computing, cryptocurrencies. I know, Nouriel, you’ve been very negative about those. I think that that’s something that’s accelerating, and the impact is accelerating on all those levels—maybe not a 10- or 20-year horizon, but two or three years. Right now, one in three Koreans owns cryptocurrencies. I think—I’d love to hear comments from everyone on this issue. Thank you.

MALLABY: I guess there’s two questions. One is whether the innovations in Silicon Valley feed through to innovation. But we sort of talked about that. Cryptocurrencies, it’s gone from 17,000 for bitcoin to 11,000, which might be 11,000 too much. (Laughter.) But that’s my view. But maybe someone else. Nouriel’s negative. Anyone want to make a positive case for crypto?

ALEXANDER: So I would just make the argument that it’s very hard for me to see those things substituting in basic transactions in the way that conventional currencies out, if for no other reason than the very variance in their value, right? Part of—one of the obstacles, frankly, to it being a means of transaction in a normal sense is, like, if its value is going up and down as much as it is, it’s very hard to think of it that way. It’s a speculative asset at this point. And, you know, people can invest in it, and there are lots of people who are doing that. But the notion that that is somehow going to transform things in the ways that money works for transactions, I’m skeptical about.

Just on the AI and whatnot, the thing I would—the thing I would ask people to think about is it is amazing, all those things that are going on. But it doesn’t make everyone more productive. It makes a very sliver—thin sliver of the workforce more productive. And that means it is something that exacerbates income gaps, but it is not something, I would argue, that you should expect to generate broad-based productivity gains in the economy.

MALLABY: Jan?

HATZIUS: Well, on the—I mean, cryptocurrencies, I think one question is—I mean, I, again, I think we’re mostly in agreement here. One question is whether, you know, what we’re talking about is a future without central banks. But I think you’ll still have central banks or central bank-like institutions that are responsible for the stability of whatever currency, whether it’s digital or otherwise, gets used. So, I mean, a lot of the growth of cryptocurrencies was driven by deep skepticism about central banking. You know, I’m more positive on competent central banking. I think central banks can do a good job. And if they do do a good job, then I think they’re a force for stability. And I prefer that to the gold standard or something more akin to the gold standard.

MALLABY: Nouriel, do you want to say something about crypto?

ROUBINI: (Laughs.) I read a lot about it. I think the important point to make is the following one: I think not only there’s too much overhype about crypto or blockchain, but the real revolution in financial services is not driven by crypto or blockchain. It’s driven by machine learning, AI, Internet of Things, and big data. And that’s a fintech revolution. It has nothing to do with crypto. It has nothing to do with blockchain.

I mean, there’ll be revolution in payment system. We have already 1 billion-plus people who use Alipay, WeChat Pay, or Venmo, of PayPay, and a whole bunch of other things. There’ll be a revolution in credit allocation, decision made by credit office that can be done now using big data much more precisely. And maybe we’ll have less boom and bust of credit cycle. There’ll be a revolution in insurance. There’ll be a revolution in asset management. I don’t know how fast that revolution is going to occur, but these ongoing is going to change completely, you know, financial services over the next 10, 20 years. But that’s totally independent of crypto and blockchain.

MALLABY: Let me leave you with one observation about Silicon Valley and crypto, which is that in Silicon Valley, where I spend quite a bit of time now because of a book project, everybody talks about network effects nonstop. And so the notion is, you know, if Facebook has more users, then it’s more useful to other users. So one thing which has enormous network effects is the U.S. dollar. And I think people in Silicon Valley underweight the way that if everybody else is raising money, the markets are liquid, people are transacting in it, it makes it more attractive for people to stick with the U.S. dollar, which I predict will not be challenged by bitcoin in any significant fashion.

Thank you for coming. Thank you to the panelists. Have a good morning. (Applause.)

(END)

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