Meeting

World Economic Update

Tuesday, June 18, 2019
Toru Hanai/Reuters
Speakers
Lewis S. Alexander

Chief U.S. Economist and Head of Fixed Income Research in the Americas, Nomura Securities International, Inc.

Caroline Atkinson

Senior Adviser, Rock Creek Group; Member of the Board, Peterson Institute for International Economics

Jason Cummins

Head of Research, Brevan Howard Inc.

Steven A. Tananbaum Senior Fellow for International Economics, Council on Foreign Relations; @Brad_Setser

Presider

Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; @scmallaby

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: Well, good morning everyone. Welcome to this World Economic Update. I’m Sebastian Mallaby. I work here at the Council on Foreign Relations.

To discuss what’s going on in the world, we’ve got a star-studded team. Over there, Lewis Alexander, chief economist at Nomura Securities; Caroline Atkinson, who is these days at the Rock Creek Group, an investment group in Washington; Jason Cummins, head of research at Brevan Howard, a hedge fund; and Brad Setser, my colleague here at the Council.

So I’ve been chairing these World Economic Updates for several years now. And there have been times when, you know, the big issue is China’s financial fragility, the eurozone’s possibilities of cracking up, the Fed’s invention of new financial instruments. But at the moment, of course, the dominant thing, the dominant variable appears to be geopolitics and specifically trade policy.

You know, there was a long period after the WTO accession by China in the early 2000s when essentially trade policy was stable, it was dull. Now we are cursed to live in interesting times.

So we want to talk about first this trade tension and what that could do to the economy. And I want to start with Caroline because she’s just back from Asia.

This standoff between the U.S. and China, what were people saying when you were in Asia? And how big of a deal is it?

ATKINSON: Thanks, Sebastian. Well, I was at a meeting with a lot of defense ministers and officials, a little bit different from some of the—but I also spoke obviously to people in the markets. And my impression was that we are in a bubble, in a way, in the United States. We don’t realize just how huge a problem the rift is between the U.S. and China. This was on everybody’s minds in Singapore. And I also went to Tokyo.

And it’s not just about trade. It’s the big geopolitical rift. It’s the fear that the management of the rise of China and the relative decline of the United States will not be smooth.

And I would say that almost more concerning to people than the tariffs was the thought of technology barriers and technology sanctions. And I spoke to some people, including particularly the economists or the finance people, who were just puzzling about how to understand how bad and how feasible a technological rift would be.

The other thing I would say is that when you’re in Asia—and you all know this—China is just dominant. All of the countries around, they may be U.S. allies, they may be very strong U.S. allies like Japan, but China is their big trading partner and China is not growing as fast as it was, but it’s still growing a lot faster than the United States. And so they cannot conceive of separating themselves from China.

And also, China’s—a hit to Chinese growth, which most people think would come—will come from the tariffs and from the uncertainty around the tariffs, is a hit to all of them. So it’s a very big deal, I think.

MALLABY: Well, does this lead them to make any specific criticisms of the way the U.S. is running its policy? Does it—does it lead to a sort of—

ATKINSON: I think there’s—yeah—I think there’s more just sort of puzzlement. And a lot of people ask me, because I used to work in the Obama White House, that they had heard that Trump’s opposition and aggression towards China, if you like, was a bipartisan issue. So that was another concern. This is not something that, you know, if we just sort of hold on tight, maybe will end with a political cycle.

They wanted to know how bipartisan it was and whether this was something that would, in some way continue, this being the rift between the United States and China.

I think on the specifics, there was—there was the same kind of questioning and puzzlement that you get around the world about, you know, which way are you guys going and why is everything so uncertain and what is—what’s the underlying theory.

And, of course, again, with a lot of foreign observers and diplomats and policymakers and maybe, in particular, financial market people, they’re trying to figure out, where is the rationale for what’s going on? And that’s, of course, a little hard to describe with current policy.

MALLABY: Well, Lewis, that’s a good segue because I want to ask you, Lewis, about, you know, there was a kind of China trade tension, U.S.-China, where a lot of people would agree that certain Chinese commercial practices demanded a U.S. response, even if you questioned the nature of the response.

But then there’s a set of—a whole set of other trade tensions where there is much less of a consensus that it was broken, you needed to fix it. So if you’re thinking about the Trump administration’s position towards the WTO, towards Mexico, towards Europe, towards Japan, it feels as though there’s kind of the U.S.-China and then there’s Trump versus the global system. Do you think that’s right?

ALEXANDER: I do think it’s right. And I do think people think about it a little—in ways that are a little off. So there’s no question that U.S.-China is particularly important, as Caroline suggests. It has a breadth of dimensions to it that’s different from the other ones. But that tends to lead people to, I think, deemphasize the other issues. There is this sense that Trump will be more strategic with the other ones. And the cycle we went through with Mexico recently is a good example of that. And so I think certainly the people I talk to in markets tend to deemphasize the other issues from that perspective.

But, of course, what that misses is there is a systemic aspect to this. Even with respect to Mexico, while we’ve backed off the most confrontational aspect of this, there’s obviously an uncertainty that’s created by linking trade to immigration, which was certainly not something I was expecting, and the broader issues of undermining the system.

So you talk, you know, you can talk about the status of the WTO, its ability to be—serve as a dispute resolution mechanism, but you’ve also got issues that I think have gotten less attention, like the fact that the Trump administration has begun the process of starting to use, potentially, exchange rates as a rationale for putting on tariffs as a countervailing duty in effect, treating exchange rates potentially like an export subsidy. That’s obviously something that’s been around for a while as an idea, but would very much change the system in other dimensions.

So I think while, you know, China, U.S.-China, gets an awful lot of the oxygen in this debate, there are other important issues that I think are being under-considered.

MALLABY: Jason, from your perspective, when you think about global markets, macro trading, first of all, how do markets even price this kind of uncertainty?

CUMMINS: So this is—this is not a shock you can model. And what I mean by that is, if you’re thinking about how to kind of understand what’s going to happen in markets, you want to start out from first principles about macro, what’s going to happen to growth, inflation, the labor markets from a particular shock.

To give you an easy example of something economists understand, every time oil prices have doubled in the United States in the post-war period, we’ve had a recession. We kind of know what to do. There’s a tall goal, you click, look at the recessionary dynamics, kind of play it out. You won’t always get it right, but at least you can understand kind of the broad contours of what’s happening in a case like that.

There’s no trade-Trump-China-deglobalization, whatever you want to call this, amalgam of what we’re experiencing now, toggle to flip for us to understand. So as a consequence of that, it’s very difficult from first principles to figure out how this is going to affect the economy. We obviously have some ability to look at the data in real time and the data have, you know, weakened pretty quickly, even right on the bow wave of what we’re seeing in the latest trade tensions—some of the data, at least for me. We’ll get into some of the connections to the Fed and other bits of markets later on perhaps. But I find the effects on the economy so far pretty alarming.

And a thread I’ll pick up on that Lew just laid down is, you know, if you look in the models, trade is very hard to understand how it would have a big impact on the U.S. economy because, essentially, you’re taking a small number, which is the U.S. exposure to the outside world, multiplying it by another small number, the size of the tariffs—you know, even a tariff of 25 percent is pretty small, multiplying a small share of the overall economy—so small times small is smaller, and you wouldn’t think that that would have a huge impact. And yet, it’s clearly having some impact on the data. It’s having a huge impact on business sentiment.

And so my real-time barometer of that is the U.S. dollar. One of the remarkable things that’s happened quite quietly over the last let’s call it six weeks even is, as the entire front end of the U.S. rates curve is repriced to a baseline scenario of the Fed having to cut seventy-five to a hundred basis points as some version of risk management to deal with that amalgam of shocks I described, the dollar has done basically nothing. It’s come down a smidge.

But as the entire rates sector in the U.S. is repriced to something that’s in between a normal business cycle and recession, the dollar has stayed high. And so that, for me, is telling me that there is something very wrong with the global macro environment to see the dollar performing that way.

So although I don’t, as an economist, understand exactly how that model is, I look in real time at the data and the dollar and that’s telling me that something very important is happening to the economy presently.

MALLABY: And, Brad, somebody, I think Lewis, brought up the issue of the potential use of trade sanctions to punish perceived currency manipulators. You’ve just published a Council on Foreign Relations memo, policy innovation memorandum I think it’s officially called, on how the U.S. ought to be responding to currency manipulation. Tell us about that.

SETSER: Well, I guess there are several points. I think the first point is probably the one that frustrates President Trump the most, which is that if you use the traditional definition of currency manipulation, excessive, direct intervention in the foreign exchange market, you don’t find enough targets to satisfy the president. The euro area does not satisfy, by any measure, this criteria. Japan does not satisfy this criteria. The euro area doesn’t satisfy this criteria. Korea no longer satisfies this criteria.

So you’re essentially left with a subset of countries which might meet the traditional definition of manipulation that are small countries. The strongest cases are Vietnam and Thailand. It’s not earth-shattering.

The second observation is that if you think of it from a WTO legal point of view—and you can certainly say in this administration the WTO legal point of view is not all that important—the fit between countervailing undervaluation and the requirements of the WTO subsidies code is very difficult.

The key difficulty is that a subsidy to be countervailable is supposed to be specific to an industry. And a currency undervaluation is not specific to any given industry. And in order to make the case, then you really—in order to strengthen your position in the WTO, you kind of have to go through a series of individual cases showing individual sectors that have experienced injury, which is a pretty high threshold.

So my conclusion is that the most efficient way of countering true manipulation would be a fairly radical policy shift, one that Fred Bergsten has long advocated, namely, if after several warnings a country continues to intervene despite having a very large current account surplus, the U.S. would counter-intervene. You buy dollars, we sell dollars.

CUMMINS: Can I pick up on that point? So the currency analogue of freedom of navigation and movement in the South China Sea would be, for example, to buy one dollar of yuan in the ESF, the Exchange Stabilization Fund. That would have a much more profound effect on people’s psychology than the endless debate about whether you’re going to label China as a currency manipulator who just went out and said we’re able to do this and drew attention to the fact that they’re, you know, acting on the currency. They always say, of course, they’re acting in our favor, which, of course, is nonsense.

But they’re acting in a way that we now notice and counteract at least by laying down a marker. That’s the kind of thing I think we’re going to move to over the next five to ten years, whether it’s President Trump or President Warren. You may have noticed that, you know, regardless of whether you followed the president’s tweets this morning about the exchange value of the euro and how it’s being manipulated by Mario Draghi or whether you stand with Liz from last week when she wanted to manipulate the currency in order to promote, you know, factory jobs in the Midwest, this is a direction that populist politicians are going in. And I just think that the era, this kind of holdover, complacent holdover from the Bob Rubin days of, you know, benign neglect of the dollar, a strong dollar is in the U.S. interests, that’s something that is under review by both sides of the aisle, the far sides.

SETSER: Can I just chime—because we probably all want to chime in on this. I think it is a remarkable fact about the U.S. economy that, A, if you just look at manufacturing exports—so, admittedly, that’s a narrow subset—they are now about 5 percent of U.S. GDP, which is a very low level on a comparative basis.

And then if you look at all exports, excluding oil, there’s been essentially no growth. There’s actually been a slight fall relative to U.S. GDP over the last six years.

So the current level of the dollar, which isn’t necessarily a function of active intervention so much as a function of low interest rates all around the world, lower than in the U.S., is nonetheless a level of the dollar, which would reasonably be associated with bad outcomes for U.S. exports.

MALLABY: But, Lewis, it might also be reasonably associated with the fact that the dollar remains the reserve currency, people want to hold it. What do—what do you feel about this?

ALEXANDER: I think that’s exactly right. I think I’m, in some sense, quiet in this debate because I’ve never really understood exchange rates, in all honesty. (Laughter.)

CUMMINS: Work in the division that sets the exchange rate policy in the Fed. (Laughter.)

ALEXANDER: Exactly.

ATKINSON: He speaks with intention. (Laughter.)

ALEXANDER: It is remarkable in some ways how closed the U.S. economy remains. I very much agree with your comments that, you know, you do sort of the initial analysis on all this trade stuff and it’s remarkable how small it is.

I do think part of what’s interesting, Brad, about your comment about nobody is accumulating reserves at this point, we have gone past, you know—that period when you saw sort of massive accumulation of dollar assets abroad, that’s a decade ago, in many respects, and we’ve been dealing with sort of a different world for a while. Global trade stopped growing relative to global GDP a decade ago. So in some sense, we’ve kind of leveled off at a very different place than where we were a while ago. And to some extent, you’re seeing all of these things layered over a world that is—that is in a different place.

Look, there’s no question that the global influences are more important than anything else at this point. It’s hard to think about U.S. interest rates without them more broadly. And I continue to worry about the point when a bad day for risk or whatnot globally is not a good day for U.S. assets because that’s going to be the really bad day. Like, that hasn’t happened yet, but it’s still true.

And so partly the question of why is the dollar doing so well in an environment where U.S. rates have fallen, I think your basic point that that’s a warning sign for where we are in the global economy is absolutely right.

ATKINSON: And it’s also a continuation, I would say, of the fact that, despite sanctions and despite policy that is a little jangled up sometimes, the U.S. dollar is still the safe asset that people want to go to, maybe not quite as much as the Swiss currency, but the big, safe asset that people could go to.

I’d also say, Jason, that it’s not my—but I—maybe I’m being naïve, but I don’t think the Chinese have been trying—there was a huge problem with a Chinese current account surplus and with Chinese intervention to hold their currency down. But I think that’s also something that’s past.

Germany and the Netherlands and, therefore, the euro area is a different issue. But I’m not sure that you could sort of work up the political fervor against those countries that you could for the kind of switch that Brad is talking about.

On your point about it being a decade ago, I think that we’re dealing with the politics today of economics of a decade ago and it’s a real question of whether one can get into the political debate some of the issues of today’s economics as opposed to the economics of a decade ago. And I think that’s a really important issue.

You’re right, global trade hasn’t been growing for a long time, the inequality that people are fed up about, the lack of jobs, the economic insecurity, we have been moving out of that. But we could easily go back into it, I would argue, especially if we have more of this uncertainty from trade, you know, currently a rational trade policy.

MALLABY: I want to move the conversation to the Fed’s response to all of this. And in a way, that’s a point about whether you can get today’s circumstances into the debate is a good segue.

Because, Jason, you know, in the wake of 2008, which, of course, had followed a shallow recession following the 2000 Nasdaq crash, I thought we discussed this, I think you were sympathetic to the view—that’s probably soft, you were a proponent of the view that, you know, the Fed’s reaction function ought to include more in the way of financial instability, that monetary policy, if it’s simply targeted at consumer prices, was missing the danger in financial corrections and asset prices.

Now, as you’ve pointed out, the Fed is likely to be cutting in response partly to this trade uncertainty. And it feels as though we have a sort of regime shift going on where any concerns people might have had about finance are probably correctly taking a backseat to concerns about tepid wage recovery. And so kind of the politics of populism and concerns for inequality appear to be mirrored in the Fed’s changing stance, not just, like, where it is in the cycle, but where it is strategically.

CUMMINS: The Fed doesn’t get to pick its shocks, though in March of 1980 President Carter, much like President Trump, used executive authority to cut off credit to the consumer. The subsequent quarter, real GDP fell 8 percent at an annual rate. Interest rates went from 9 percent down to 4 percent essentially because of Gulf War I. There was 9/11, there was Gulf War II, which contributed to the second round of easing in that—in that era.

You know, if you’re sitting at the Fed, you can decide whether you like a shock or don’t like a shock, whether it’s from terrorism or a Democratic president or a Republican president, what have you, but you just don’t really ultimately have that much of a choice. And you don’t have that many tools either in trying to achieve two goals with essentially one plus some unconventional tools.

So the way we’re thinking about modeling this to try and bring some numbers to that high-level observation is, we think this is a negative fifty basis point shock to inflation that will persist for some time.

MALLABY: You mean specifically the trade tension?

CUMMINS: Yes, trade plus general slowdown, fiscal rolling off, kind of everything all at once, but certainly with the main impetus from trade, so a fifty basis point negative shock, not a positive shock, from this.

I would point out to you, for example, to help fix ideas, we had tariffs last year. We had tariffs last year and ex the financial services prices that Jay likes to mention occasionally, we never reached 2 percent. So it’s not like the tariffs last year got us 2 percent inflation. And inflation has only gone basically straight down since the start of the year, whether it’s actual price inflation, market-based inflation compensation, surveys from different methodologically designed surveys of consumer and also business expectations, and even wages have rolled over, for example. In the latest data, a three-month change of the broadest measure of average hourly earnings is growing at 2 ½ percent compared to 3.1 percent over the prior year. So pretty much every part of inflation in this economy has rolled out.

We think that whatever is going on—again, the thing I can’t figure out the name for—is minus-fifty basis points on inflation, that’s the way we’re modeling it at least, about minus three-quarters of a percent on growth persisting for a year or two. And if you put those things into the hopper, what you get is a baseline for the Fed to adjust just using some simple policy rules that would be quite common rules of thumb.

To bring the economy back into equilibrium from those shocks, you’re supposed to respond more than one for one, that’s the essence of these simple policy rules that Taylor developed in the early 1990s. You should be cutting rates—should be—according to these kinds of rules of thumb by about a hundred-and-twenty-five basis points. So the market is priced at about seventy-five to a hundred basis points.

We think the market probably has not caught up to what we’re at least modeling the shocks at. And as some of you may know and appreciate, the kind of modern macro implementation of these more simplistic policy rules is that you’re supposed to go much sooner and much more forcefully when you’re proximate to the zero lower bound because you don’t want to get stuck there. It’s a really bad state of affairs.

And to tie up my high-level comment to the data/modeling point to get you to where our Fed view is, with your last observation about potential consequences of this, the Fed’s in a really bad spot. It’s in a bad spot from the high level that I started at that they don’t get to pick their shocks. You know, this is very importantly caused by the president and whatever you want to describe what he’s doing and kind of his deglobalization shock. And what you’re ending with is the Fed using some of these traditional policy tools that are basically going to get rich people richer.

And so whether you’re the president or you stand with Liz, the Fed in a year or two on our baseline outlook is going to be in a pretty bad spot, even if they respond well, appropriately to the shocks that we’re seeing in the global economy. I think it would be quite unpleasant for the Fed later on because they’re going to come under further scrutiny for using these tools, which seem to exacerbate some of the kind of distribution of income, populism issues that are so tearing us apart.

MALLABY: Lewis, I read something you wrote recently to the effect that I think you were calling for two rate cuts this year. Jason is saying more, or at least more ultimately. I don’t know whether you mean two this year plus two next year or faster than that.

SETSER: He says is four fast, so I think he means more than that.

MALLABY: Four fast, OK, yes, that’s right. That’s right.

What do you think?

ALEXANDER: So, look, I don’t—I don’t see things as negatively as Jason does. I don’t think the shock to aggregate demand and prices are quite that large. But ultimately, that’s going to depend on how this filters back into business confidence and investment and all those things, which, as he suggests, it’s hard to model.

I’m not as pessimistic on inflation as he is. I would note that the tariffs that have been in place up until now have been quite small. The ones we’re facing going forward are substantially larger, so I’m not sure I’d take quite the degree of comfort that you do from that. But regardless, the tariff effects are temporary. It’s a one-off price level effect that’s not really the issue.

Look, the bottom line is the economy was weakening before the recent bout of trade stuff with China. Inflation has been underperforming. You’ve added on some negative shocks and we can argue about how big they are. I think that that is an environment that the Fed ultimately has to respond to. I think they are in the process of doing that.

I think the other thing which is underappreciated is I actually think their reaction function is changing. I think they are recognizing that in an environment of low neutral rates, even small downside misses on inflation are very problematic and they need to treat those very seriously.

In addition, I think they are approaching the employment side of the mandate differently than they have in the past.

I would push back a little bit on your characterization of the change in focus on employment as being populist. My first job out of college was as a research assistant at Brookings when Art Okun was still there.

MALLABY: I said mirrored the—but anyway, go on.

ALEXANDER: (Chuckles.) Fine.

MALLABY: I don’t mean it’s driven by populism.

ALEXANDER: But look, I think—I think there is a change in attitude about the employment side of the mandate that is underway. We all—we came out of the great inflation with this notion that, like, whatever you do, you can’t try and push employment past full employment. I think the argument for that was it created an inflationary bias to policy.

Well, we have an environment where we have a deflationary bias to policy. And to some extent, being more expansive on the employment side of the mandate is, in some sense, an anecdote to that. So you’re seeing things like the Fed talking about the benefits, particularly to vulnerable populations, of running a hot employment market. That’s exactly the argument that Art Okun and the policymakers of the ’60s and ’70s did that, in some sense, got us into trouble with inflation in a very different environment. I think that is something that is—that is underway.

So as you think about how the Fed is going to evolve, I think you have to think not only about the shocks, but the fact that I actually think the way they’re approaching this is changing.

ATKINSON: But does that leave you, for different reasons, agreeing with Jason? In other words, the shock might not be so large, but the importance of driving that hot employment market will lead them?

ALEXANDER: Yeah, I—look—

ATKINSON: And we know that they’re doing a rethink now of policy and should they be thinking about price level stability and modeling the price level rather than inflation rate and that sort of thing?

ALEXANDER: So I think all of those things are on the table. One of the things I would argue quite strongly is there’s this whole debate about their long-run strategy. And one version of this is, well, they’re going to think about it, they’ll make some decisions next year and it won’t really affect things now. I think that’s wrong. I think they can’t split their heads, the arguments for why you care about these things now affects the choices they’re going to have—they’re going to be making over the next two days, but also over a longer term.

Look, I think the difference between Jason and I is more about how we think about the size of the shock and the magnitude of the adjustment than it is the broader context for policy I suspect.

CUMMINS: We’re definitely not disagreeing on strategy, which would be, if we agreed on the impetus for the shock on inflation and on growth, we would probably get to the same spot roughly, roughly. I suspect that’s it.

MALLABY: Time flies when you’re discussing fun stuff like global trade wars and the Fed’s tight corner. But I want to invite members to weigh in with questions if you have some, so hands up if you do. Otherwise, we’re happy to—OK, I see, yes, right here.

The microphone is coming.

Q: Thanks. I wanted to get—Bob Hormats.

I wanted to get back to Caroline’s point about the meeting you just attended and the implications of this for the rest of the world, particularly East Asia, which I think is something we’ve just missed in the debate entirely. And we have in East Asia the politics now, internal politics are heating up. They have two elections, Korea and Taiwan, I think, next year or the end of this year.

Can you give a little sense of what this means both to the economics and to their political relationships with both China and the U.S.? Are they saying, look, the U.S. is putting too much pressure on China, the U.S. should relent? Or are they supportive? And what does this mean to the sense of populism or lack thereof in these countries if there is this kind of downturn? How does it relate to us or them?

ATKINSON: Thanks. The strong message that was being given out by all of the officials and others from the region that were gathered there was we hate having to choose and please don’t make us choose, we can’t choose. Even in Japan, there is a strong feeling that Japanese economy and Japanese business is very tied up with China. And I think that is more—has just become more true over recent years. And Japan’s obviously a high-tech economy as well.

Of course, there was one election—two big important elections in India and Indonesia. You can debate which way—they were in favor of continuity at any rate.

I think that the U.S. is seen as taking the action that has led to these concerns more than China is seen.

One interesting point that struck me in my time in government, it was always those on the economic side in the debates about China who were the stabilizing force. You know, the economists were saying, look, they’re big, we’re big, we’ve got to work together, it’s a positive-sum game, not a zero-sum game. Whereas the defense officials, the intelligence community in particular was like if they could squash China forever, that was their dream.

What’s happening now is that, first of all, in the United States, the economists have joined with the defense and intelligence community I think. But secondly, in the international context, we have these defense ministers suggesting, well, maybe we can be the stabilizing force, maybe our military-to-military can sort of talk and get along nicely whilst there are these economic fights. And I think that sort of shows how nervous people are about and how it just looks bad to have a split going forward.

Now, they were all very careful. Singapore—you may have read it, Bob—but the Singapore prime minister and the defense minister gave very carefully balanced messages about how countries in the region needed to be able to trust everybody—i.e., this is a message to China—and they needed to be able to, you know, continue to grow and in a peaceful way. And that was also a message to the United States.

So they all want to be balanced. And they basically want the United States and China to figure out how to work together.

Sorry, one last point. Everybody except the Chinese defense minister who spoke at this—over these couple of days referred with approbation to the rules-based order, the international rules-based order. The Chinese defense minister didn’t use that phrase once. I actually asked him in the questions, you know, what do you think about the rules-based order and he answered a lot of questions, he was asked about the Uighurs, he was—it was quite amazing—he was asked about the islands, he didn’t answer about the rules-based order.

So I think that they want to kind of cling to that notion of a rules-based order, but its great proponent, the United States, is no longer they’re backing it and that’s a real worry.

MALLABY: Over here.

Q: Arturo Porzecanski with American University.

I wonder if we can talk a little bit about the fiscal side of things. First of all, an economic growth deceleration, despite relentless increase in government spending and, you know, huge budget deficits and so on, if you have any thought about that.

Secondly, that we can have not just short rates, but long rates collapsing the way they have, despite the increase in debt to GDP and so on.

And in general, is there are role for fiscal policy over the next couple of years?

ALEXANDER: So first of all, yes, when we have a—when we have a recession, and it is only a matter of when, we’ll need to have—we’ll need to use fiscal policy to respond because, frankly, the tools of monetary policy we have will not be terribly effective, so we need to preserve that space.

But, listen, we’re living in a moment when the fiscal constraints look quite different than they have in the past and it is a function of all the various things that drive interest rates.

One point I would make is that when you’ve got sort of low neutral rates, in particular low interest rates relative to potential growth, that creates greater fiscal space. That is something which I think, you know, people are trying to adjust to. The problem, of course, is that does not mean there are no limits. And the debate has kind of gone to a world where, you know, the limits—the limits don’t seem to matter. And I think that is something that will come back at some point to be an issue.

But the economics of it, this interaction between where interest rates are relative to potential growth, means we’re operating in a world where those constraints are not as binding as they have been. And in some sense, we need a kind of a responsible political response to that, which I’m not confident that we’re going to get.

MALLABY: Jason, do you want to comment?

CUMMINS: I think the U.S. has two—unlike some other areas, but I totally agree with Lew—the U.S. has two kind of kinetic macro tools: fiscal and the exchange rate. So the exchange rate, by most models, is overvalued 10 to 20 percent. The IMF will soon be coming out with their latest estimates, but even last year before the dollar depreciated about 5 percent more on an exchange-weighted basis, they had kind of the midpoint of their models for how much the dollar was overvalued around 12, 13, 14 percent.

So if you think about the option value of what policymakers can do in the United States, there’s enormous fiscal space compared to other countries, given low rates. I kind of have this natural DNA that must be centered in the Petersen foundation of, like, being a responsible fiscal steward. But the fact of the matter is I once asked Bill Gale, who kind of co-heads the join tax center between Brookings and Urban, and I said, look, if you keep interest rates about where they are now and eventually in ten or twenty years do a VAT of about 10 percent, you run that through the models, it’s like you basically tidy up most of the U.S.’s fiscal problems. So it’s not like other countries, it’s not any kind of Italy situation. The U.S. has this enormous fiscal space and it’s got the enormous potential of getting rid of the exchange rate overvaluation, which essentially, the same side of—the other side of that coin is getting rid of the dollar as kind of the main instrument of kind of global trade, et cetera. That would be a much more mega-trendy thing to do.

But if you were able to manipulate the relative price of what we do in the U.S. versus the rest of the world, that would be something that other countries—two-handed interjection—(laughter)—that is something that I believe—that I believe other countries are doing, whether it’s this morning, Mario Draghi teasing further cuts in European interest rates, which of course will do nothing for the economy, but obviously are a pretty deliberate attempt to manipulate the currency, to the Japanese having had a pretty interventionist policy over the last call it five years, six years. The U.S. doesn’t do that.

I’m just saying—I’m not advocating it necessarily—

ATKINSON: We print money and people buy it. It’s fantastic.

CUMMINS: It’s a—it’s a good deal unless you stand with Liz. And then maybe not so good a deal. And so I’m not—I’m not—again, I’m not the stand with Liz—

MALLABY: You mean Elizabeth Warren, just to clarify?

CUMMINS: Yes, #standwithliz. She’s the one who’s doing the active exchange rate policy now. So it’s just an extraordinary thing I want to keep laying down a marker about, which is that the president’s doing it and Elizabeth Warren. They’re both saying that this is a problem for the economy. I’m not saying a “should” here, I’m just making the observation that there’s a big option there.

MALLABY: Lewis is sitting so far in his chair he’s practically falling out of it. (Laughter.)

ALEXANDER: So as a former member of the Division of International Finance at the Federal Reserve Board and—(laughter)—

CUMMINS: Which used to intervene a lot, by the way.

ALEXANDER: —and the U.S. Treasury—

ATKINSON: The U.S. Treasury did the intervention.

ALEXANDER: Well, actually, it was both, Caroline. (Laughter.)

So my—I would make simply two quick points. One is it’s all great to talk about exchange rate as a policy, but, like, how on earth are you going to do it in some way that is controllable. Frankly, I question our capacity to really do that, number one.

And number two, I would simply note we generate tremendous, tremendous benefits from the role of the dollar in the system. As someone who was at the treasury during the crisis in 2009 and had the job of, like, following financial markets, I talked earlier about, like, the day, you know, worrying about the day when we had a bad day for risk and it wasn’t a good day for U.S. Treasuries. That was from that time. And, like, we made during that period fiscal commitments of something like 50 percent of GDP to backstop the system. And there was never a point when markets every questioned that. That was a huge, huge benefit.

So I recognize that we had this—we had this period that really started with Rubin and went until Trump when you had—you called it benign neglect with respect to the dollar. But if you go back before that, we didn’t really have a dollar policy that was active in any sort of macroeconomic sense. We didn’t, you know, we didn’t have goals for the exchange rate the policymakers tried to drive. And absolutely things have changed, but the notion that you’re going to—that you would put on the list the dollar as an active tool for macro management, like, when we get to the next recession, I question whether or not we really have the capacity to do that.

CUMMINS: So I totally get at the CFR it’s heresy to say this stuff, I’m just telling you this is where some of the debate may be shaping up over time. So I’m trying to offer it up in that spirit. Like, this is not something that any of you would ever vote for.

Fiscal policy also isn’t a free lunch either. You have the potential that someday interest rates might go up as well. So if you have active exchange rate policy management—and I’d politely disagree with Lew. I mean, the Plaza Accord was obviously James Baker’s engineering of fiscal and monetary policy and activist international coordination to engineer a supreme devaluation of the dollar that had to be stopped, what, eighteen months later in the Louvre Accord. So it’s not as if we haven’t done these things in the past. President Carter issued bonds in foreign currency. So we’ve done all kinds of crazy things with the exchange rate in the past.

The markers are there. People are beginning to pick up on them. And it may be something that enters the debate later on.

MALLABY: So let’s test the theory that this is heresy at CFR by asking Brad what he thinks.

SETSER: I’m going to support the intermediate option—(laughter)—which hasn’t been put on the table, which is that you could probably weaken the dollar without destroying the dollar’s role in the system if some of our major trading partners had slightly less tight fiscal policies.

So the euro area is running an aggregate, despite weaker economic numbers than the U.S., a fiscal deficit of less than 1 percent of GDP. Germany, in a tiny little stimulus this year, but it’s still going to have a fiscal surplus of 1 percent of GDP. Korea has a fiscal surplus of 2 percent of GDP. Sweden has a fiscal surplus, Switzerland. Sum everybody up—the gap between U.S. fiscal policy and fiscal policy outside the U.S. is enormous. There’s even more fiscal space outside of the U.S. even in countries that aren’t classically reserve currencies than in the United States.

And if they use that, monetary policy differentials would fade and the dollar should return to a level—

ATKINSON: But in the real world, we know that the U.S. and many of us have tried very, very hard to persuade Europeans of how much good it would do to them as well to use up some of that fiscal space. But it’s typically, despite the concerns of deficit hawks and so on, the United States that does active policy, which I think would be absolutely the right thing to do, going back to Arturo’s point and Lew. Yes, there is fiscal space.

I think fiscal policy was actually cautious after the financial crisis. It initially looked very bold, but then it wasn’t enough. And the politically you couldn’t get more.

The question is—somebody said something about we’re spending a lot. It’s actually that taxes have been brought down a lot. And there is a lot of spending to be done, including on investment, which, after all, is a very—would be a very good use of government borrowing.

MALLABY: Let’s get another question. I just want to observe, though, that you’ve come here for insights on geo-economics, you didn’t expect linguistic innovation: mega-trendy. Right? Mega-trendy, it’s a great adjective.

Yes, a question here.

Q: Thank you. Grace Choi from the New York City government.

Following up on the point about Elizabeth Warren and knowing that we have 2020 to look forward to and the Democratic presidential debates start next week. So what advice would you give to current Democratic presidential candidates as it relates to economic policy?

MALLABY: I think you’re—

ATKINSON: OK. I would advise them to lead with the importance of righting the economy. And even though President Trump points to a strong economy, I think, as we’ve heard here, there are enough concerns about the economy and those will become greater.

And I think they should lead with specific policies that can be done to help the people that feel left behind: middle class as well as poorer people.

You know, obviously health care was very controversial, but once it was in place it was widely recognized, I think, to have been a big improvement. I mean, there’s still lots of things wrong with it. Other ways that one can promote the economic security of regular Americans.

I also think that climate change and the environment is a huge issue that the public is beginning to recognize as a problem. Again, maybe it’s important to look at some of the specifics. People are against regulation in general, but if you look at specific regulation, you’ve even got the automakers saying please leave us with the high emission standards rather than—rather than a mix-up. So I think those are two big points.

SETSER: Can I just chime in with one? And it’s a narrow thing, but it addresses concerns about inequality, concerns about trade, concerns about how you win the Midwest, and that is the Trump tax reform set very pro-offshoring provisions. I could go through the details, but basically you can lower your tax rate still by moving your intellectual property abroad and you can lower it even further by moving tangible assets, i.e. pharmaceutical plants, abroad. I think eliminating those provisions and taxing international profits at the same rate that small-business profits are taxed makes a lot of sense.

MALLABY: OK. Yes, there.

Q: In the next few years, the attacks on global economic institutions are likely to worsen. The institutions are seventy years old and creaky anyway. And even if Trump does not win reelection, those attacks will continue.

To avoid a beggar-thy-neighbor world emerging, what might a revision, a reconstruction of global economic institutions look like? Again, in just the sketchiest terms, crisis could mean opportunity. It’s time perhaps to rethink. So very roughly, if—what would—what would we want to do to recreate global economic institutions in the next—in the—for the next decades?

MALLABY: OK. So IMF, World Bank, WTO?

ALEXANDER: So I’ll offer—I’ll offer one response. One is there’s been a movement for a long time to revise the governance of these institutions in ways that moves away from their original legacy that was very focused on the U.S. and Europe. That agenda has lagged for a variety of reasons and it clearly has kind of made things worse. If nothing else, let’s just sort of go forward with that and try and realign that governance in a way that looks more reasonable. Number one.

Number two, to me, the big change is those of us—many of us here spent time in previous decades thinking about global architecture in a different world. Certainly, speaking for myself when I did this, I sort of assumed that the rest of the world would get rich by becoming more like us, that the process of development would lead to sort of systemic convergence, if you like. And therefore, you could—you could have a set of global rules that was sort of based on the idea that the constituent parts were more or less consistent. That was clearly wrong.

China has developed in a way that is very different from what we assumed. And to me, the big flaw in the—in the rules-based order is the fact that those rules are sort of based on the idea that everybody is more or less, you know, operating in a consistent way. You see this most acutely, I would argue, in foreign direct investment. And so CFIUS, for example, is having to deal with the fact that foreign direct investment into the United States, we’re dealing with major entities that are essentially state sponsored in some form or another. It’s not private entities that are doing the investing in the United States. And the whole framework for how you think about it has to be adjusted to that.

So I do think that, number one, you’ve got to address the governance. But number two, you’ve got to think about it differently in the sense of you’ve got to think about a rules-based order where there are some fairly major differences in the constituent parts of that. And to me, that’s the biggest issue.

ATKINSON: You need a kind of interoperability between systems that enables there to be, you know, interchange, but not based on the notion that every economy works the same.

Can I just offer up one other point from having just been in Asia? And you all know this, but the Belt and Road Initiative of China maybe has been overhyped by them, but it is very real and present and large in Asia, a lot of money. People mentioned several times, you know, the multiple that it—that the promised amounts are in relation to the Marshall Plan.

And the response from the West and from the existing institutions has tended to be, oh, it’s going to lead to over-indebtedness, has been critical. And those are not bad arguments and they may actually have led the Chinese to adjust a bit. But from the recipient point of view, it basically looks great to be having, you know, fast railways built, new highways, energy production, and so on. And we’ve somehow got to figure out a way to include these sorts of things in a notion of global institutions.

MALLABY: One of the ironies, it seems to me, is that, you know, in the sort of World Bank realm we’ve seen challenges, like the Asian Infrastructure Investment Bank, the Belt and Road Initiative, the BRICS bank, so these are challenges coming from the countries that feel left out by the failure to complete that governance reform that Lewis is referring to. So the U.S., kind of Washington consensus hegemony seems to be eroding.

But at the same time, in the world of IMF bailout thinking, the fact is that the ’08 crisis showed the centrality of the Fed’s swap lines. And so the U.S. is, if anything, more central to how you would imagine dealing with an enormous financial crisis next time. And that feels unstable. It feels unstable that the world’s crisis response strategy, if it really gets big, is so U.S.-centric when we have all these other indications that U.S. centricity is less acceptable.

I saw a question in the back. Yes, over there.

Q: Good morning. Rick Niu from C.V. Starr.

Could you each comment on the likely endgame for Brexit later on this year, if I could just switch to Europe? New deal? No deal? And also, its implication to the European and global economy? Thank you.

MALLABY: Want to do that? Or anyone else want to?

ATKINSON: Yes. (Laughter.)

ALEXANDER: You can start, yes.

MALLABY: I live in London, so I can’t help being immersed in this stuff constantly. And what’s going on is, as you probably know, is that the frontrunner by a mile to become the next prime minister is Boris Johnson, who will win the leadership contest in the conservative party barring some sort of extraordinary thing and that will make him prime minister.

And his position is that no deal is OK and that he’d prefer to try to renegotiate the deal with Europe, but if it comes to it no deal is OK.

Now, he’s not going to be able to renegotiate a deal with Europe because, A, the Europeans have negotiated for two years with Theresa May and see no good reason to redo that; and B, they can’t stand Boris Johnson, right? So it looks to me as if no deal, which felt like a small tail risk on the order of 10 percent six months ago, has now risen to kind of 30 percent, 40 percent.

Then it becomes then a question of, what does no deal mean? You can have chaotic no deal where you crash out on some sort of Lehman Brothers-style cliff edge or negotiating up to the—to the—to the very day before and it doesn’t work and then you leave in chaos. That would be very disastrous.

But I think it’s more likely that you get a recognition sort of some way before the October 31 deadline that this just isn’t going anywhere and you start to have sort of mini, you know, some mini negotiation which is designed to manage the fact that the U.K. will opt to leave without a—without the exit agreement that Theresa May negotiated.

I still don’t think it’s a—that’s still not the base case. I said it rose from 10 percent to 30 percent, 40 percent. I still think that the majority base case is that, because the economic consequences of leaving without a—without a deal and going back to World Trade Organization trading terms with the rest of Europe is not attractive economically that there will be some further iteration in this. You push the deadline back again beyond August the 31st. Maybe there’s a general election. Depending on the outcome of the general election, there could be a new constellation where something surprising happens.

So I think it’s incredibly murky. My friends and I joke that whenever you say anything about Brexit, the word “probably” should be assumed to be in the sentence twice. (Laughter.) But kind of that’s where we stand. That’s, I think—if no one else wants to comment on that, one more question and then—yes, Bhakti. Yes.

Q: Bhakti Mirchandani. I work for FCLT Global which is a think tank. This is my last World Economic Update as a—as a chair member, so thank you for a great five years of running these fantastic discussions.

My question is about sustainable finance. There’s a lot of momentum that globally Canada released its sustainable finance framework last week. This week, the EU is coming up with its—today it’s releasing its taxonomy on what is a sustainable investment. The Norwegian sovereign wealth fund is divesting fossil fuel. So what do you see in your worlds in terms of progress in this space? How real is it?

ALEXANDER: I’ve been impressed at some recent sort of events we’ve been involved in just as a firm at how serious it is on both sides. So you’ve got—this is—I see this more as a European kind of phenomenon than it is here, but the degree to which there’s real money that is being dedicated to this and it’s an important—it’s important criteria in people’s investment decisions on the one hand. On the other hand, I think people are trying to be creative about coming up with things that match those goals.

So, for example, you know, even some relatively banal organizations, like Fannie Mae and Freddie Mac, are, in some sense, responding to the incentives they’re seeing coming from the investor base that’s relevant to them to try and come up with projects that sort of match that. So I have to say, I’ve been surprised in some ways at the degree to which this does seem to be moving the needle both from a perspective of there’s real money behind it from the investor side, but also issuers are sort of responding to that. So I think it’s going to have an effect.

CUMMINS: Can I—one brief thing. So not in my role of what I do for my day job, but I’m a fiduciary for two investment committees, as I’m sure many people in the audience are, and so we’ve confronted these sorts of issues. And like Lew, I would say—I’ve kind of thought it started out as a bit of a fad, but it’s much more genuine and lasting than I had originally thought, but it’s also a much thornier problem than I could have ever imagined as a fiduciary.

So, for example, you want to put scrubbers on a coal plant: Is that green or not green? Some people would say yes, some people say enabling the coal-fired plant is a bad thing, you shouldn’t invest in that. Who’s the biggest polluter in the United States arguably outside of the energy sector? Amazon. Are you going to divest from Amazon? I just—I don’t know how to answer these questions and I think they’re going to bedevil folks like us on various investment committees for a long time to come. I don’t think there are any easy answers.

MALLABY: OK. Well, thank to those of you who—all of you who braved the rain to come here.

And thanks to the panel. It’s been a good discussion. (Applause.)

(END)

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