World Economic Update

Friday, April 25, 2008

DANIEL K. TARULLO: Welcome to the spring edition of the World Economic Update. As I think you all know by now, this session, unlike many, although a decreasing number at the Council, is on the record -- actually, I should have said an increasing number at the Council on the record.

When we get to the question-and-answer period, I'll ask -- when I recognize you, please stand and identify yourself before asking the questions. And finally, and most importantly, silence those BlackBerrys and cell phones, please.

So this morning we're pleased to have back with us Ethan Harris, whom many of you have seen here before. Joyce Chang from JPMorgan Chase has participated in the Washington version of the World Economic Update, but we're pleased that she's here in New York, where she actually lives and works, for the first appearance in this one. And down on the end you see old friend Nouriel Roubini from the Stern School at NYU, who's making his first appearance at the WEU.

What I thought we'd do this morning is truly to do a World Economic Update. I know everybody is focused, understandably, on the aftermath of the subprime and housing market crises, the continuing issues in the financial markets and all the rest, and we will talk about those.

But the world economy has perhaps gotten a bit of short shrift in our own press and our own discussions here in the U.S. precisely because everybody is so focused on what's going on at home. And I thought particularly we would try to ask the questions of decoupling or operating on a single engine in the world economy which, as those of you who have been coming for a number of years know, used to be a persistent theme here, where we would talk about how it was the U.S. economy that was driving global growth.

That so, let's start, though, with the domestic economy, with the state of financial markets and the real economy. It's -- believe me, I tried; I can't get an optimist for you. I can't get anybody who says it's all going to be okay. So what is clear that we're going to need to do this morning is try to identify the variables that will determine whether this is a relatively short and relatively shallow economic downturn or whether it is more prolonged and more severe.

And -- so I thought we'd start with that issue. And I'm going to start with Nouriel because, as many of you know from reading the papers, Nouriel has for some time been quite downbeat on the prospects for the U.S. economy. In testimony he gave in February -- very comprehensive testimony before the House Financial Services Committee -- he gave multiple reasons why things were going to be bad and multiple reasons why there was not much that could be done about it.

I wondered whether Nouriel's views had changed, but I've looked at the slides he had passed out, and I don't think so. (Laughter.) I think we're pretty much -- Nouriel's pretty much where he was in February.

So Nouriel, let me read the summary of your first answer and then ask you to elaborate on the why of this. "The U.S. will experience a hard landing that will be severe and protracted rather than mild. The U.S. economy is already in a recession -- it started in December '07 and it will last four to six quarters. Negative growth starts in the first quarter of 2008." The former -- the latter may, I guess, or may not end up being true, but surely it's going to be unimpressive.

So maybe you could start by saying why you think -- why you tend towards the hard, severe, protracted side of things.

NOURIEL ROUBINI: Yes. Well, my argument is as follows. At this point, as we -- I think we all mostly agree, the debate is not anymore on whether we're going to have a soft landing or a hard landing, but rather how hard the hard landing is going to be, meaning, is it going to be a short and shallow recession, V-shaped, lasting a couple of quarters, Q1 and Q2, we'll recover in the second half of the year?; or, as I do believe and argued, it's going to be U-shaped, a longer, more protracted, in my view, lasting for up to six quarters.

I thought I'd make the argument of why I think the consensus that says it's going to be short and shallow probably is going to be incorrect. If you look at the last two U.S. recessions, in 1991 and 2001, each lasted about eight months, so -- and they were short and shallow. So the consensus today is telling you that this is going to be even more short and shallow than the previous two.

But if I look at the macro and financial fundamentals, I believe that there are at least three important dimensions which -- things today are much worse than they were, say, 1991 or 2001. And that's why this is leading me to the conclusion this is going to be a longer recession than the last two that lasted only eight months.

The first I mention which things are worse is that this is really the worst U.S. housing recession since the Great Depression, and we are nowhere near the bottom. I mean, the numbers yesterday on new home sales, another 8.5 percent down, were a total disaster. And not only the production of new homes is falling, but the demand for new homes is falling even more, and therefore, the excess supply is becoming larger. Home prices have already fallen 10 percent since their peak based on the Case and Schiller number. They're going to fall another 10 percent this year. And I believe that by 2010, the cumulative fall is going to be about 30 percent.

Now, it's not just the wealth effect -- 20 percent is like $4 trillion of home values that are destroyed. But the most important part of it is that with a 20 percent fall in home prices, you're going to have about 16 million households out of the 51 (million) with a mortgage that are under water, with negative equity. The value of their home is going to be below the value of their mortgages.

And now the incentive, then, to walk away -- "jingle mail" -- put the keys in an envelope and send it to your bank -- is going to be huge. And I've estimated that approximately the total losses, just deriving from these phenomena of people walking away from their homes, might be something like as high as $1 trillion. It would wipe out essentially three-quarters of the capital of the U.S. financial system. So first observation, a severe housing recession.

Second observation is that, in 2001, the sector of the economy that was in trouble was the corporate sector, the boom-and-bust of the tech sector. But that was 10 percent of GDP, real investment spending. Today, the sector of the economy that's under stress is the housing sector. And as you know, private consumption is about 70 percent of GDP.

The U.S. consumers, they're shopped out, saving less, debt burdens, and now is buffeted by a series of negative shocks. Home values are falling, therefore, you cannot use your home as an ATM machine. Home equity withdrawal is falling. Credit crunch is driving up not only debt ratio but debt servicing ratios. Oil prices are now at 115 (dollars) and gasoline is going about 4 (dollars).

And people said all these negative shocks are there, but as long as there is job and income generation, people are going to keep on consuming. But guess what? Now for four months in a row, employment in the private sector has fallen, and even overall employment, including the government sector, has fallen for three months in a row. So once you have a contraction of consumption, the effects are more severe.

Third observation why this is going to be worse is that right now everybody speaks about the subprime disaster. But it's not anymore a subprime mortgage problem. The problem is spreading from subprime to near-prime to prime, spreading to -- the excess in commercial real estate is going to bust. Guess what? You're not going to build shops, offices, shopping centers in the ghost towns of the West.

Therefore, the housing slump has ridden into a real estate slump in commercial real estate. Real recession going to have a default -- (inaudible) -- for consumer credit, credit card, auto loans, student loans. You have the leveraged loans in the financial system that are sitting there at now worth 70 cents on the dollar. Even municipalities are going to default in the United States during a recession, as they did in 1991.

And finally, people say the corporate sector is lean and profitable. That's true for the average corporate sector. But it is a fact that a lot of corporations are actually distressed with high debt and low profitability. The last two years, corporate default rates were zero, essentially, 0.6. Well, in a normal year, they are 3.8 percent.

The last two recessions, default rates for corporations of their bonds peaked at 15 percent in a shallow recession. You're going to have a double-whammy. Not only default rates are going to go from 0 (percent) towards 10 (percent), 15 percent, but in a recession, recovery rates -- given default in the normal times are 70 cents on the dollar. In a recession, they are 30 cents on the dollar.

So across the financial system, you see losses mounting. So the combination of the most severe financial crisis since the Great Depression, the most severe housing recession since the Great Depression, and now the housing sector being on the ropes and stretched, implies this is not going to be just a six-month recession, in my view. It's going to last at least 12 (months) to 18 months.

TARULLO: Okay, thank you.

Now, for the pessimistic view, we're going to go to Ethan. (Laughter.)

One thing that I've -- one thing I think that's been apparent to all of us over the last several weeks is, notwithstanding all the factors that Nouriel has just mentioned -- and I know he summarized his analysis and could have mentioned a bunch more as well -- there are voices out there, voices who presumably know what they're talking about, who are suggesting that if the bottom hasn't been reached, at least there's not such a downward slope as we were experiencing just a couple of months ago.

And some of those voices, interestingly, are even coming from the financial community, which in general has been -- understandably, given the fact that people have to deal with their balance sheets every day -- quite gloomy.

So Ethan, maybe you could give us what you think are some of the reasons why at least some people are somewhat less pessimistic about duration and depth than Nouriel.

ETHAN S. HARRIS: Well, first of all, for legal reasons I have to give to an optimistic view, because if everyone commits suicide in the room there could be major lawsuits here.

And my biggest thoughts are always scribbled on a napkin as the other speaker's speaking.

I guess the -- first of all, I agree with the basic assessment that, you know, the fundamental problem in the U.S. economy is you've got 2 (million) to 3 million people who got a home and got a mortgage that probably shouldn't have. And the process of that playing out in terms of home prices, foreclosure rates and so on will take a long time -- and I know I'm not doing good job of getting people bulled up here -- so that it's likely to play out well into next year. So this isn't something that's going to go away quickly.

And of course, simultaneously we have to deal with a credit crunch, a big pulling back in the financial sector. And so even if it's true -- and I think it is that a lot of the -- at the major financial institutions, a lot of the losses have already been realized, because there's a fairly aggressive mark to market going on.

Even if that -- the financial sector maybe kind of already revealed a lot of the bad news. The economy now has to deal with the tightening of credit and their long and variable lags and how that impacts the economy. So you're going to have a lot of restraint coming out of the banking system and the credit markets as well.

I would -- but just to, again, to kind of put a little bit of a floor under the collapse that we're talking about here -- the one thing that is important here is that you're getting a very aggressive policy response out of the Fed and out of fiscal policy.

This is the best-timed tax cut in history. Normally it takes Congress and the president, you know, a year to figure out that there's a recession and the tax cut comes after the recession is over. This one is coming as the downturn is gathering momentum. One hundred billion in tax rebates is not chump change. Even if the people only spend, say, 40 percent of it -- which is what we're assuming -- it gives -- it's basically a double latte for the economy. It's a big shot of caffeine in the second half of the year.

Now, unfortunately, it doesn't solve the longer-run issues. It just kind of buys some time for the economy to kind of deal with these problems. And we're still going to have a very weak economy into '09. But that's good news that we're getting a strong fiscal response.

The other thing is the Fed, right? I mean, Bernanke's been roundly criticized on all sides. He's either too easy or too tight or too nice to the financial markets or not doing enough for the financial markets. The guy can't win.

I think he's done the right thing, essentially. He's had communications problems, but he's done the right thing. The Fed is being very aggressive in using their balance sheet to try and protect the system from a meltdown in terms of credit and they're going to continue to be very aggressive in using their balance sheet. And they're cutting interest rates and they'll continue to cut interest rates to deal with the scope of the downturn. Now, this doesn't solve things quickly, as I said, but it's a big offset.

So the bottom line from our forecast is that we get what we call a "W" shaped economy, in honor of our president -- (laughter)— so we're in a mild recession now. Actually, first quarter GDP is probably going to be positive. It's a bit of a fluke. I think we're in a recession. Very weak second quarter -- 1 percent or more drop. But then in the second half you will get the double latte kicking in and we'll get probably positive growth in the second half of the year.

Unfortunately, as we all know, after you're done with your coffee today, things -- you have a let down in the afternoon and that's going to happen in the beginning of next year. So we think it's going to be a very uneven, very weak picture -- not the worst recession we've had in the post-war period, but you know, very tough economic environment.

And just kind of bottom line here, we think the unemployment rate, for example, is going to go up to 6.5 percent. It's now roughly 5 percent. So you know, there's plenty of pain still ahead.

I hope that's cheered everyone up.

TARULLO: Well, if that's the optimistic view, then things really have moved.

Ethan, maybe you could just -- why is it then that one does hear from some people things like, "it's the beginning of the end" or "it's the seventh inning." Somebody on TV this morning said "it's the seventh inning" and everybody kind of looked at him. And he said, well, it might go into extra innings. So we're not really sure.

So why do you get -- not exactly isolated, but a few voices -- again, people who seem to know what they're talking or should know what they're about -- who are talking about the beginning of the end?

HARRIS: I think people are listening to Nouriel too much. I think that's the problem. (Laughter.)

No. I think that -- I mean, we're in a really a very tough environment. And there's no -- we're in the middle of a recession here. And you know, it's hard to see the good side over the valley of the shadow of death here.

So I mean, I think that the -- in commentary around the economy -- and this is just my own kind of deal with the way the news flow works in the economy -- when things are bad, there's a lot of -- you know, it's very easy to tell a story around the trends that are already happening. The tougher thing is to figure out, okay, you know, is there kind of a turning point up ahead there somewhere?

And as I said, I think that we will get through the flushing out of the bad mortgages. It's going to take time. And I do think people are underestimating the policy response that's going to happen.

I mean, for example, let's say that the real collapse scenario starts to play out here. We're going to get — you know, this may not be good news for a long-run taxpayer point of view, but we will get a big mortgage bailout if that happens. I just don't see how Washington can allow that to play out.

So we're going to continue to get -- the response to the weakness in the economy's going to be determined by -- it's going to be strong. And if the economy looks really horrible, we'll get a big response. That doesn't mean it isn't a tough outlook, but I think we'll get a response.

TARULLO: And Nouriel, one other question for you: Do you think that at least the prospects of a systemic crisis within the financial sector or the very negative reinforcement loop between the financial sector and the real economy has receded some?

In your February testimony you were quite concerned about that. And I wonder whether, in light of developments over the last couple of months, do you think at least that prospect is a little bit less daunting than it was before?

ROUBINI: I'm not fully convinced for a variety of reasons.

The first one is that financial institutions have written down a lot of assets, but most of them being these MBSs and CDOs, as I said, that leave mortgages.

What we're going to see in the next few months is that the real economy is contracting, then default rates really start going up and then you have to start to write down actual mortgages. And as I said, it's not going to be just subprime, you have prime and prime, but also commercial real estate, consumer credit, industrial and commercial loans, corporate bonds.

So, you know, two months ago when I came to an estimate that financial losses are going to be something like $1 trillion, people said, you're crazy. But since then, Goldman Sachs says their credit loss is going to be 1.1 trillion (dollars) and the IMF says it's going to be 945 (billion dollars). So they wind up being diplomatic around 230, 250. So I think that's one phenomenon that's going to actually put further pressure on the financial system.

The second thing that is a point and it actually was a very interesting one, that this morning Mohammed al-Arian did in his piece on FT, has been that until now, the Kalzad (sp) has been going from financial kind of crisis -- credit crunch, a liquidity crunch -- leading to an economic recession. I think the next loop, as he argues, is going to be one which the real economic contraction with falling consumption in demand, in supply, in employment is going to lead then to further financial losses for the financial system.

So you're going to get a feedback loop starting from the financial sector to the real economy, and then from the real economy contracting going back to the financial system. So I think that the risk is of this vicious circle in which the real economy contracts further, that leads to greater financial losses that leads to greater financial de-leveraging, greater credit contraction and further negative effects on the economic activity.

And for a variety of reasons, I don't believe that the policy response is going to be effective. But I could flesh out that point.

TARULLO: Well, let's move to that for a second, because Ethan already made reference to the anticipated effect of fiscal stimulus package.

Presumably, the Fed's actions -- at least the Fed's interest rate actions are still working their way through the pipelines of the economy.

But, I wonder, Ethan, whether the recent spate of readjustments of people's expectations, as to what the Fed's going to do in its next meeting, is a reflection less of a change in their assessment of the economy's performance than it is a increase in their concerns about inflation?

HARRIS: Well, I think that the -- right now the markets have given the Fed an opportunity to pause. And I think they're going to cut next week, but I think there's a good chance we will see them go on hold for a few meetings. And I think it's partly because there's the sense out there that we want to see how the rebates do; see if the lag effects of monetary policy work, and so people are not quite as nervous about the economic meltdown scenario.

I think the Fed's going to be back cutting rates again. I think that they -- you know, at the end of the year they're, they're going to find that they really haven't ignited the economy -- these rebates. It's helped. It's, again, given you -- bought some time to continue to work out the housing problem, but the Fed will be back cutting interest rates again.

On the inflation front, I think that people have forgotten something here, and that is that stagflation is normal at the peak of a business cycle. At the end of a long boom, you have a lot of momentum in inflation. You've got commodity -- tight commodity markets, tight labor markets. It takes awhile for the weak economy to kill inflation. But in every business cycle the recession kills inflation.

The best time for inflation, in terms of declining inflation, is in the first two years of economic recoveries. And the reason for that is that, you know, it takes some time to, kind of, pound inflation out of the system. But we just need to be a little patient here.

People, you know, kind of look at these commodities -- this commodity boom is kind of a -- it's never going to weaken. Well, I think there's the element of a bubble in the commodity markets. I think that, yes, there's an upward trend. We are -- you know, the Club of Rome got it right, there is a shortage developing there. Of course, the Club of Rome was 40 years early in predicting -- (laughter) -- the chronic shortage of commodities. But I think there's an upward trend in commodities, but I think we also, on top of that, have an overshooting, based on momentum trading.

The weakness in the U.S., which is going to -- we'll talk more in a minute -- obviously is going to transfer into weakness overseas -- should take the heat off the commodity markets. And so I think that the markets are wrong to be worried about U.S. inflation. I think that's -- you know, wait, we'll just wait six months and things will look a lot better.

TARULLO: Well, that -- so, on this point, let me quote from something else that Nouriel said in his slides, which is that existing inflationary pressures from oil energy commodities will be dampened once you have a severe U.S. recession and a global economic slowdown. True stagflation requires an exogenous -- and then, sort of, in brackets, "politically-driven negative supply shock to oil prices."

So, here's -- here's a question: Their kind of assessment, presumably, is based upon what's happened over the last 20, 30, 40 years. Are we in a -- are we at a stage now where demand from economies in the rest of the world -- particularly the fast-growing, developing economies -- in a sense, can provide that, sort of, continuing exogenous effect on U.S., on U.S. prices, so that even when we slow down here, prices are not responding as much as they have, say, 10 or 15 years ago?

And, Joyce, maybe I ask you to comment on that because a lot of this demand is coming from the developing world.

MS. CHANG: I think the key thing that makes this recession different than other recessions is how the global economy has changed. And I wanted to go back to your point about whether the global economy is a single production engine, or whether we -- we have seen emerging markets be coupled, because I get asked this question a lot.

And I don't believe in the decoupling argument. I think the global economy is a single production engine, but emerging markets' share of it has increased over time. So, if you look at the U.S. economy, the emerging markets economies are now 112 percent the size of the U.S. economy.

The trade -- if you look at world trade now, the growth of world trade, about 35 percent of that last year came from emerging markets. About 40 percent of that growth came from the G-7 countries. So, what -- we have really not changed the emerging markets forecast very much at all, even as the U.S. has slowed down. We see emerging markets growing 6 percent this year, and next year as well. And the demand for commodities, much of that has come from China and other emerging markets countries.

And I think you have to look at what's happened. You've had five or six years of the strongest growth in the last 150 years, so you are coming onto supply constraints; generalized shortages; you have the growth of the middle class. And I think the food prices shocks are just some of the first evidence of some more generalized inflationary pressure that are very clearly emerging around the world.

And you can see this most clearly in the emerging markets countries where many central banks are tightening. And we've seen that in Brazil, in Russia, in Peru; you're seeing more of that coming from countries like Poland and Hungary, as well. But I think the big difference for the world economy this year is just how much the emerging markets component has grown, and in many ways provided a cushion.

And if you look at the commodity story, I mean, commodity prices probably will moderate from here. But now, when everybody talks about low oil prices, they talk about $80 as low oil price. So, I think that you will see a moderation in commodity prices but, I mean, you're not going to continue to see -- you know, agricultural commodity prices up 20 percent just since the beginning of the year, 20 percent increase in oil in the last month.

But emerging markets have been beneficiaries of this. So if you look at emerging markets countries, 40 percent of them are oil exporters, another 25 percent of them export soft commodities -- you know, metals. So much of the emerging markets growth story has not been about the U.S. economy. It has been about China, and it's been about commodities.

And we've seen a shift in the direction of trade. For many of these countries, more of it directed towards China and away from the U.S. as well.

TARULLO: I was struck in looking at the IMF's projections for growth, global growth in the next -- this year and next year. While the advanced economies the IMF predicts will go from 2.7 percent in 2007, to 1.3 (percent) this year, and 1.3 (percent) next year, the emerging and developing economies -- similar to what Joyce just said, they predict going from 7.9 percent this year; to 6.7 percent next year -- this year; 6.6 percent in 2009.

And, actually, as I looked down the list of all their predictions, I was struck by the fact that the projection for growth in '08 is, in almost every case, between 1 and 2 percentage points lower than last year. The difference, of course, being the United States starts from 2.2 percent, and China starts from 11.4 percent. So, it's really, in percentage terms, quite a modest effect upon -- pardon me, upon China.

Joyce, to what -- to what degree does that happier story suggest one possible, if not route out, at least one possible mitigating effect on the U.S., which is to say, export growth?

MS. CHANG: Well, I think that if you look at emerging markets countries right now, the drivers of growth have been growing domestic demand and investment. Exports has been an important part of this but, you know, if you look at the current drivers -- take a look at China, for example. Last year was the first year where you had, you know, consumption growth stronger than other components of growth in the Chinese economy.

So, you know, exports are a bright spot in the U.S. economy. I mean, you see merchandise exports grow 15 percent because of the weaker dollar. I think the exports will add half a percent to 1 percent to GDP growth -- that's been the case over the last year -- and should continue this year. And, you know, it seems to me that that's one part of the story that is actually more optimistic in the U.S. economy.

So, we're seeing a slowdown in world trade growth, but I think if you look at the emerging markets story, it's about the creation of the middle class, domestic capital markets, you know, increased saving rates. The export story is an important part of it. And I wouldn't downplay it, but I think one reason why you have not seen emerging markets impacted so much is because that you are seeing that the drivers of growth this time around are very different.

And that's most apparent in Latin America where, typically, every time there has been a recession, Latin America has had a recession as well. This year, we think that Latin America can grow by more than 4 percent. And even in Mexico, the slowdown has not been as pronounced as it has been during past U.S. recessions. And that's because exports are an important component, but we've seen investment pick up; we've seen portfolio flows going into the region; we've also seen consumption -- domestic demand growing. And that's contributing to a lot of tightening pressures.

If you look at Latin American currencies, for example, since the beginning of the year many of them have appreciated double-digit levels. The inflows are that strong. In fact, if anything the risk on the emerging markets side is you're getting more controls, threats of controls, you know, taxation issues put in as countries, you know, really struggle -- policymakers struggle to manage these pressures.

TARULLO: So Nouriel, let me go back to you, at -- first with Joyce's observations about demand in the rest of the world, and thus the salutary effect on U.S. exports. But secondly -- this is a bit unfair since you're an economist, but I'm going to -- I want to do what I as a law professor always do with my classes, which is to force them to argue the other side of what they actually believe. (Laughter.)

So, if I said to you, Nouriel, make the best argument for a -- or best arguments -- for a relatively slow -- shallow, relatively short-lived recession, a couple of quarters rather than four to six, as you suggested. In addition to exports, what would those arguments be?

ROUBINI: If I had to start with the second part with what turns out to -- could turn out to be better than expected, certainly the story that, you know, Joyce and others have told about, you know, weakening dollar, and has strengthened as the rest of the world leading to net export to rise to be a significant source of growth is one of it.

The second one is that some believe -- I'm not convinced -- that the policy response, but in terms of monetary fiscal policy and possibly also a bail out of the mortgage market is going to be -- stimulate the economy, you know, more of the view that Ethan expressed -- that, you know, the "U" could become a "W" with a slight increase in consumption in Q3 because of the tax rebate, but we're going to then slump back again into a recession.

And thirdly, you know, the crucial thing is what's going to happen to the household sector. You know, they often say that U.S. houses have always been resilient in the last years with 9/11, corporate scandals and then the Iraq war and then all going higher and higher, and this and that. And the U.S. consumers were resilient. So this time around, they'll keep on being resilient. I don't believe it because now, the headwinds that are hitting the U.S. consumer are at least half a dozen, but I think those will be the key arguments for why things could turn out to be better.

On the issue of recoupling versus decoupling, my view of it is that if the U.S. had, had, you know, a soft landing or a short and shallow recession, I would agree that there is enough demand -- growth and dynamics on demand and growth in the rest of the world so that the rest of the world's going to slow down but in a small way.

But conditional on my argument this is going to be a more severe recession, say 12 to 18 months, I think that, for a moment, let's assume I'm right -- I might turn out to be wrong -- then I think when you look at that kind of severe U.S. recession in the trade channels, the financial channels, the spread of financial condition to the rest of the world, the effects of a weakening dollar in terms of transmission of deflationary forces to other countries' confidence effect, then I think that actually the growth slowdown in the rest of the world is going to be more severe. Of course, I'm not expecting a global recession, but I think that actually markets are pricing only a short slowdown of the global economy while I expect it to be more severe.

The reason why I think it's going to be severe is that we've been living for the last few years in a world that the U.S. has been the consumer of first and last resort, while China, Asia and most of the rest of the world has been the producer of first and last resort. We spend more than our income running current account debt just as the rest of the world were spending less that their income, running current account surpluses. And we look at the structure of demand, there was only one key driver of global demand. It might be -- you know, total U.S. consumption is about 9.5 trillion (dollars). The total consumption of 1.2 billion Chinese is 1 trillion (dollars) -- growing fast but from a very small base.

The total consumption of 900 billion Indian is 600 billion (dollars), and growth of consumption in places like Japan, Germany and Europe has been stagnant because of the stagnant growth of real income and real wages. So my concern is that if there is a fall in U.S. demand that's going to occur, then there is not enough domestic demand in the rest of the world to sustain global economic growth.

TARULLO: So, you're not disagreeing with the premise that significant parts of the fast growing development world have, in fact, created their own domestic demand base, but only that it's still way insufficient to offset the slowdowns in the much bigger developed economy?

ROUBINI: Yes. And I fear that actually, for example, excluded -- the country that's mostly decoupled from the United States in some sense is China because their growth is now maybe 10-and-a-half as opposed to 10-plus while the U.S. has gone into a recession. But I think that, until recently, the U.S. slowdown was driven by the non-credit factor, housing, while, if we're going to go into a consumer-led recession, then what do U.S. consumers buy? Mostly cheap goods from China. And if you're going to have a slowdown in U.S. imports from China, that slows down significantly export growth of China. And that's already happening in the export growth to the United States.

And you have a Chinese economy -- think about it -- in which the trade surplus that used to be 2 percent of GDP in 2002, now it's 12 percent. Exports are about 40 percent of GDP. Most of the growth has been driven by net exports. And even the rest of the economy, of that 50 percent of demand that is investment, living outside the non-traded part of it is housing, most of it is essentially production of new exportable goods. So you have essentially two key drivers of the Chinese economy are not consumption, but rather net exports and investment to produce exportables.

If you have a significant enough shock to the United States that slows down significantly China. And for China, by the way, hard landing is going from a growth of 11 (percent) towards 6 (percent) because China has to move, every year, 20 million poor farmers to the modern industrial manufacturing sector, so, for them, 6 percent growth will be hard landing. And if you have a severe slowdown of China, then East Asia, emerging market, the Colombia exporters also, have a significant slowdown. So I think the key is a severe U.S. recession would affect China, would affect, then, the rest of the world, the two main engines of growth in the world on the demand side the U.S. and on the production, China could be great.

TARULLO: He's in the same thing my students do, which is when I ask them to argue the other side, they do it, and then they go right back to where they were. (Laughter.)

HARRIS: Your question reminds me of the -- here's a cautionary note for you all. So the first time I was on this stage doing this panel, you had Steve Roach playing the pessimist --

TARULLO: Not playing. (Laughter)

HARRIS: It's was -- it's all an act. You had John Lipsky the optimist and Ethan Harris the sober middle view. (Laughter) And some, this was in the spring of 2003, the economy looked horrendous, business had frozen up in front of the war in Iraq, kind of looked terrible. And the forecast ranged from terrible to well pick up a little bit in the second half but it went -- it's not going to be very good.

So somebody in the back of the audience asked a question, said, "Can any of you see a scenario where we get really strong growth in the second half of the year?" So, I did what you did and I turned to Steve and I said, "I think this question's for you." And Steve puzzled for a minute, and he said, "No, I can't think of a scenario." (Laughter.) So I thought Nouriel did a good job --

TARULLO: Nouriel did a much better job.

HARRIS: -- but the point is, in fact growth was quite strong in the second half of 2003, so we were actually all wrong. So that's just a cautionary note on you all. Don't believe anything we're saying.

MS. CHANG: I actually think, Nouriel, that even if the U.S. has a hard landing it's going to be hard to get Chinese growth below 9 percent. I think 9 percent would even be hard for China to see. We think China will grow by more than 10 percent this year. But if you look at exports -- I mean exports to the U.S. are about 20 percent. Even if you look at the re-exports through Hong Kong, it's about 30 percent. And I think the question you have to ask about emerging markets is, "How coupled were some emerging markets to begin with? How much of the emerging market story is a story about low rates and very high commodity prices. Not great policies, not necessarily about coupling with the U.S. But, I would say that even under the U.S. hard landing scenario that you have, that Chinese growth of 6 percent, I don't see as likely to happen when you look at the components of growth.

TARULLO: But Joyce, suppose that -- I've lost my IMF sheet; here it is. Suppose the IMF is right about the Euro area and the Euro area goes down to 1.4 this year, 1.2 next year, Japan about the same in their view although many of the Japanese economists I talk with are more pessimistic. Won't the cumulative effects of recession in the U.S., significant slow downs in the Euro area -- or indeed all of Europe -- and Japan have an even greater impact on China?

MS. CHANG: I think when you look at the Chinese economy, 1.3 (trillion dollars) -- $1.5 trillion of reserves, it's hard to hard land in that much water -- 40 percent savings. So, you know I don't see the 6 percent scenario in China. I think they can do a lot of thing, and that they would -- fiscal stimulus, creating jobs, infrastructure, you know, social security, you know, housing solutions. I think that the Chinese, you know, are unlikely to see a scenario where it's 6 percent growth even under the recession scenarios that you lay out.

And if you take a look at the 2001 recession, where exports slowed to single-digit levels in China, we didn't see this disaster scenario occur in China, particularly in a year where you have the Olympics -- where I think you have the tremendous amount of space for expansion. What's the key risk in China? It's inflation. And that's really what is bothering policymakers in emerging markets at large. And what we do see for China is a lot more currency appreciation to come. We're looking at 15 percent for the full year.

TARULLO: So what do you think, by the way, from a Chinese policymaker's point of view the optimal growth rate would be this year? I was just going to ask you that before you mentioned inflation? Presumably they would not have wanted 11.4 percent growth again this year..

MS. CHANG: You know -- I mean, I think that, you know, you need to create jobs in China. When you look at what motivates the Chinese, though -- when you look at every crisis that has occurred in China or 1989, it's come off of inflation.

TARULLO: Mm-hmm.

MS. CHANG: So I think inflation is a big concern right now. But I don't see a slower growth, you know, scenario. What's optimal growth in China? I'd still say 9 (percent) to 10 percent. We're looking at 10.3 percent growth this year.

TARULLO: Mm-hmm.

Nouriel, did you want to say anything more about before I turn to Europe?

ROUBINI: No. I mean, I think the point you made before about -- it's not just the U.S. that's going to have a recession, but you're seeing pressures in Europe and in Japan. I mean, I would not exclude that Japan is going to go -- ease into a recession. If you look at the European economy, I think you're going to see a recession in the U.K., in Spain and in Ireland because of their bust of their housing bubbles. And you're going to also see a near recession condition in places like Italy and Portugal. And now with the euro being close to 160 rather than 150, even an expert superpower like Germany is suffering. That's why even somebody like Trichet is saying he's worried about too strong of a euro.

So you look at, for example, the European economy -- you know, the deflation of their housing bubbles, you know, the effects of the U.S. credit crunch on the European firms -- the European firms rely on back borrowing more than the U.S. firms. You look at oil prices at 115 that even converted where stronger euro are much higher in euro terms than a year ago, you see the shallow growth in real wage growth, you see the fact that demand growth was driven by net experts in countries like Germany -- you see all these factors happening and at least in the U.S., the Fed had cut rates by 300 basis points, while the ECB is on hold.

It's hard to argue that there's not going to be a severe slowdown of growth in Europe and recession in about half a dozen of the European economies. Same thing in Japan. And once you have U.S., half of Europe and Japan in a recession, I think you're going to see significant slowdown in the rest of the world. You know, emerging markets have been very well because of their long-term things and good policies, but also because of good luck. For the last few years, you had the highest global economic growth, you had high and rising commodity prices and you had searching for yield by investors or not having risk aversion.

Now everything's turning around. You know, growth is slowing down. I think there's going to be a significant downturn in commodity prices and you're seeing a rise in risk aversion. And -- you know, bear market's already an equity market across yen, with China down 50 percent. So these things are happening and they're going to happen. We'll lag, but I think actually that this slowdown in global economic growth is going to be quite significant.

TARULLO: Ethan, I wanted to get your views on Europe. And maybe you could address as you're talking about Europe the following issue, which is that while clearly the European financial system has been affected -- I mean, we've seen a lot of European-based banks taking big losses, having management shake-ups not unlike what happened a few miles from here -- less than a few miles from here -- that the story from European policy makers has been, "Yeah, we've had problems in the financial sector." And then they give you -- a dirty look to any American in the room because they're saying, "You sourced -- you were the source of our problems."

But they will then say, "We don't have the risks that you have because with the exception of Spain, there's not really a housing -- there's not the housing bubble here. With the exception of a couple of countries, there's not the consumer overextension that exists in the United States." So their story is basically one of yes, getting a bit of a chill from the United States but that they're really not at that great risk, which is what Trichet believes allows him to stay focused on inflation.

Do you -- well, let me just say -- go ahead.

HARRIS: Well, let me offer the sober middle view here. (Laughter.)

MS. CHANG: Mm-hmm.

HARRIS: I think -- you know, I think that Europe is clearly going to be weaker going forward. We have growth slowing from about 2-and-a-half percent to about 2-and-a-quarter over the next two years. It's not really different from what the IMF is talking about. And -- you know, they -- yes, the housing imbalances in Europe are more limited. They're more like a regional story, although originally that's what we were thinking was happening in the U.S. And so I think that the scope of the shock to those economies is much smaller.

But, you know, you're talking about a major strengthening of their currency. Exports have been a big source of growth for Europe and investment kind of derivative of the exports has been very important to Europe. And so -- you know, I think things are going to be weaker than the ECB thinks. I think that the -- once the -- if -- and we're assuming it does happen -- if oil cools off, then finally --

TARULLO: Cooling off being to --

HARRIS: Come down to $90 or something.

So we agree that they're not -- it's -- but remember, though --

TARULLO: No, I know. It is in the margin.

HARRIS: -- for right now -- what's happening right now is the ECB is frozen in place because headline inflation is so high -- 3 percent-plus inflation. If oil comes back to 90 (dollars), then by the end of the year inflation will come back into their comfort zone, and then they can kind of stop being Macho Man and start cutting interest rates. So I think by the end of the year, we will see a few rate cuts out of the ECB.


So I'm sure there are a lot of questions that you have, so I want to allow a little but more time than I normally do for questioning. But before I do that, I wanted to ask Joyce to address one other issue, which is the state of Asian economies other than Japan and China. We tend these days -- even when we focus on the rest of the world, we all tend to go right to China for understandable reasons. But to what degree are the rest of the Asian economies themselves dependent on some combination of the developed world and China itself, and to what degree do they have their own buffering capacity?

MS. CHANG: Well, we still see very strong growth in India. You know, given the stage that it's at in the cycle right now that Indian growth at, you know, 7-and-a-half to 8-and-half percent is still something that's very much in the cards. But when you look at just the stage they're at in investment, infrastructure development, domestic demand components as well, you've created a cyclical economy, more vulnerable to what happens in the G3 economies. But I would say the story in many of the ASEAN countries is still one where overall in emerging Asia, we see growth at around -- you know, around 7 percent this year.

TARULLO: And where's that coming from?

MS. CHANG: It's coming from -- well, part of it is off of China. I mean, China has been an engine for growth in Asia. You know, much of that is also coming off of -- you know, increased investment, increased infrastructure spending and, you know, increased consumption as well. So, you know, when you look at emerging markets across all regions, emerging Asia is still the fastest-growing region. If you take out China and India, you still have a growth rate that is higher than other emerging markets' regions -- higher that the growth you're going to see in Latin America at 4 percent, higher than emerging Europe, which is probably going to grow around 5-and-a half -- 5.8 percent this year.

So the Asia story -- much of it is about China, but it's also -- much of it is about just the stage where these countries are at at developing their domestic capital markets where domestic demand is at. And remember that you had -- you know, you really have quite a lot of capacity in Asia because the Asian banking crisis was so devastating, right? So you don't have sort of -- some of the excesses that haven't had the time to build up that you've seen in, you know, other parts of the world. But there's a lot of parallels that I would draw between what you see in emerging markets and what's happening in the U.S.

But I think the biggest difference for emerging markets is you don't have a lot of structured products, right? I mean, the U.S. crisis seems to me that -- one that started with the housing crisis, then you had leverage on top of that. But you had a parallel banking system of $6 trillion with structured products that was very dependent on short-term funding. And this parallel banking system was illiquid -- not regulated by the U.S. -- and once the short-term funding dried up -- and you had a lack of transparency, you had your classic bank run that you've seen time and time again in emerging markets countries. And in emerging markets, you know, you don't have the structured products. I mean, if you look at securitized instruments in emerging markets, it's maybe about 3 percent of the fixed income instruments that you see outstanding.

So, you know, there's a lot of lessons, I think, that can be applied from emerging markets to what's happened in the U.S. But it was this parallel $6 trillion banking system sort of facing a classic run, but -- you know, it has transformed monetary policy forever -- broker dealers using the window, securitized products in that window as well. So emerging market does have some bubbles, though, and what are those bubbles? I mean, we're worried about some of the banks. I mean, when you look at -- you know, Nouriel and I have a lot of -- been in Iceland together -- bank debt that's 1,011 percent of GDP -- you know, it's a lot of bank debt.

You know, Kazakhstan was able to borrow 53 percent of GDP in bank debt over about a two-and-a-half to three-year period. And many of the countries are the CIS countries -- the banking systems where they've had market access and they have borrowed tremendously.

It's not so much about the sovereign balance. It's corporates and banks over the last three or four years in emerging markets countries last year alone borrowed $600 billion. So you've got a corporate default rate in emerging markets that's less than 1 percent, which is not going to stay at less than 1 percent as you go forward a couple of years.

So there are bubbles in emerging markets countries, but it's not so much the weak balance sheet. A lot of the borrowing that was done in recent years was in the corporate and banking system.

TARULLO: Joyce's comments reminded me of one question I wanted to ask more explicitly.

Ethan, one of the possible reasons why some of those voices from the financial sector are slightly more optimistic than they were a couple of months ago would be a premonition that or some reason to believe that all this stuff sitting on their balance sheets, some of it at least, may actually be moved. Whereas for a long time, it was just sitting there, and people would tell you, well, we think this is pretty good quality. This isn't so good. We think it's pretty good quality, but nobody wants to buy it. And presumably, the reasons why nobody wanted to buy it were some combination of not being sure about whether the underlying assets, in the case of mortgages, were going to continue to deteriorate, not being really sure about the nature of the product. There are a lot of reasons.

Do you think that those markets are starting to thaw with some purchases by other financial institutions, the creation of a couple of funds that seem to be interested in buying semi-distressed assets? Or are those just little blips on page C-4 of The Wall Street Journal?

HARRIS: Well, I think that I don't know exactly where credit markets are going next, but I do think that, you know, markets don't just keep dropping. I mean, at some point the price and the bad quality of the underlying assets, I think that the fact that we've had, for a month now, a relatively consistent rally across a lot of the credit asset classes is a sign that, you know, people are kind of feeling like, you know, a lot of the losses have been revealed.

We are seeing, you know, as financial institutions record losses, we're seeing new money coming in, so there's a recapitalization, not a full recapitalization but a big chunk of it being recapitalized. And I think this is very different from some of the kind of historic crises in capital markets in that there is (mark to market ?). And so you can have a vicious circle or a virtuous circle. If people keep selling assets and spreads keep widening, then each time you mark the market you have to market --

TARULLO: That was what was happening early on, right?

HARRIS: That was what was happening. And now, even if just credit spreads remain at these very high levels and sit there, you don't have to do the same kind of mark to marketing. So for institutions that are heavily exposed to securities, you know, if we have hit the highs on the spread, even if they go back up to the levels we had in March, you don't need those big mark to market losses.

So I don't want to, you know, sound like I'm Pollyannaish about this. But I do think that, you know, there is some positive things going on there.

TARULLO: And it should be -- maybe I should have said this explicitly -- but there is a need, I think, for people to draw distinctions between problematic, even serious on the one hand and systemic and crisis oriented on the other. And that was part of what I was trying to do in a lot of these questions was you can have a pretty serious, prolonged recession without feeling that you're on the brink of a systemic problem. And of course, last summer we were on the brink of a systemic problem with no recession in the real economy. So that's just why I was trying to draw those distinctions.

Okay, now, really, back now to the audience.

Yes, sir, right in the middle. And please wait for the mike, stand and identify yourself.

QUESTIONER: Ed Cox with the McCain campaign.

There has been a linking of the drop in the dollar and the rise in oil prices and commodity prices. The panel seems to feel that commodity prices will drop. Does that mean that the dollar will get stronger? Is that the other side of what you're saying with respect to commodity prices?

HARRIS: Well, I think there's a connection there. So I think the weaker dollar, to some extent, drives the commodity prices because if you're a commodity seller and you're invoicing in dollars you need some compensation for the decline in the real purchasing power of your sales. But you know, I think that they're both going to happen. I think that as the Fed pauses, as they look at, you know, they wait to see how this rebate's going to play out, that will take some of the heat off of the weak dollar.

And simultaneously, I think, you know, later in the year as the ECB kind of comes around to their own rate cuts, that will also take some of the heat off of the dollar. So I think that, you know, we're probably going to see a more stable dollar picture going forward. It's not that I think it's a positive environment for the dollar in the long term. We've got a huge trade deficit. The U.S. economy does not look healthy. There's good reasons why the dollar's been weakening. But I think that with the pause from the Fed and with the ECB joining in the rate cuts later in the year, that will help, you know, stabilize and probably improve the dollar slightly.

TARULLO: Nouriel or Joyce on the dollar?

MS. CHANG: I mean, the dollar's dropped 8.5 percent in trade-weighted terms. And I think you've probably seen the bottom to the dollar, but I don't see a very rapid recovery for the dollar. I think it's not just about commodity prices. This is about, you know, more about structural changes and how we're financing the current account deficit and the trade deficit, as Ethan pointed out.

So I mean, we think that (EBIT ?) has a very modest recovery, you know, in Euro dollar, maybe to 152 by the end of the year. But I think high commodity prices, not necessarily at these elevated levels, but, you know, higher prices are here for quite a while. I mean, we think that oil prices are going to average, you know, around $98 this year.

TARULLO: Nouriel, anything on the dollar?

ROUBINI: Yeah. I mean, I think there are at least four bearish forces for the dollar. One is the still-large U.S. current account deficits. The second one is reactive policy rates with the Fed easing so far ECB and BOJ are on hold. The third one is a relative growth differential with U.S. going in recession and slowdown in Europe and Japan. And four, the perception that the U.S. assets are toxic. I think that, you know, over time -- (laughter) -- that's a reality.

Over time, however, I think that the point was made that what's going to happen is at some point the Fed might go on hold while ECB and BOJ might start easing. And the slowdown in Europe and Japan may become severe enough that then relative interest rate differential and relative growth differential growth differential that are now bearish for the dollar are going to stabilize and turn around. That means that probably there is a bottom to the dollar and some ceding to how strong the Euro and the yen can get.

TARULLO: Okay, next question. Yes, right here, sir -- right in the middle. It's coming from your left.

QUESTIONER: I'm Harish Kortesh (sp) of Structured Credit International, a bad name to have as a company, but maybe it will come back. (Laughs.)

My question is regarding the importance of emerging markets relative to the size of the U.S. I think you mentioned that emerging market weight, as it were, relative to the U.S. is around 113 percent. I believe that's purchasing power parry (ph), whereas Nouriel mentioned the nominal values which when you add up actually are not the same as purchasing power. Which one drives, in your view, the importance of the relative contribution of emerging markets? And do you think this is important in this coupling-decoupling debate?

MS. CHANG: Yeah, I mean, you know, look at -- for the global economy, you know, in PPP terms, EMs about 50 percent, but you're 30 percent, you know, otherwise. I think that, you know, it's not that I say that one is more important than the other. I would just say that the contribution that's coming from emerging markets and the growth that you're seeing coming in from this from emerging markets is one that I still think can progress, maybe at not quite the pace that you've seen over the last two to the three years. But that is providing some cushion as the rest of the global economy slows down. So it's less about decoupling than the global economy as a single production unit where emerging markets has perhaps provided a reason why the recession may not be quite the hard landing that Nouriel was pointing out and that it is providing more of a cushion.

You know, there's no way that you can say that emerging markets are dealing from what's happening in the developed world. But I think the growing share and the fact that growth drivers are in place remains, you know, a very powerful argument. So whether it is 35 percent of the world economy or 50 percent in PPP terms is less the issue than look at what the percent was at the last recession, you know, and look at how much it has changed over the last few years and that that momentum still, you know, in my opinion, remains intact.

TARULLO: Nouriel, you want to say anything?

ROUBINI: Yeah, I mean, the only caveat I would make is that some people suggest that, for example, that growth of trade within Asia and others have been using really in inter-Asian growth or southside trade implies that these countries are less dependent on U.S. economic growth than the past.

But actually, there have been studies done by the Asian Development Bank and others that suggest that actually, both on a cyclical basis and on a structural basis, Asia depends on the U.S. today as much, if not more, than five or 10 years ago. And the main reason is as follows.

It used to be a case that countries like Korea and Taiwan would have to directly produce goods for the U.S. market. And now with the rise of China with their cost and labor advantages, they cannot do it anymore. So what Korea and Taiwan are -- increasingly do is they produce components. Those are sent to China. China, because of low labor costs, assemble them and then send them to the United States.

So in spite of this very large growth of the inter-Asian trade, this study suggests that the cyclical and structural dependence of Asia on U.S. economic growth is as significant today as it was five, 10 years ago. And certainly on the financial side, we're not seeing any decoupling. Whenever U.S. stock market is sharply down a day, there's significant downturning in the Asian markets as well. So I think that's an important caveat to keep in mind.

TARULLO: Okay, Stanley -- coming right from behind you.

QUESTIONER: Stanley Arkin.

You've spoken about economic events and theories. What about a political event of some significance in the next two years? That could be, say, a revolution in Venezuela, a resolution in Iraq, some other kind of major, apocalyptic event. How would that factor in? Is that in your designs at all?

TARULLO: Anybody can answer. Anybody want to answer that and then I can give my standard answer. (Scattered laughter.)

ROUBINI: I mean, my concern, and that's something regarding oil and energy in general, is that rather than one apocalyptic event, one of the problems we're facing right now in the oil market is that demand growth is still significant. And even if we're going to have a U.S. recession, eventually U.S. and global economic growth is going to go back to potential and, therefore, demand is driven by the fast-growing countries' yen -- China, India and so on is going to be sustained. And the question is whether there's going to be increase in supply enough to satisfy demand.

And my concern is that increasing the large fraction of production of oil in the global economies in this very unstable petro-state. So one week you have trouble in Venezuela, the next week you have trouble in Nigeria, the next week things get worse in Iraq, and the next week we have another confrontation with Iran, in Russia -- you know, this creating nationalization of oil and energy is not beneficial. There is instability in the Gulf States.

So I see a situation in which a large fraction of the potential production of oil and energy is concentrated in countries that are geopolitically unstable where I don't see a huge amount of new investment in exploring capacity production coming up. So I think that's a significant worry from geostrategic point of view. So it's not the single event but rather the instability of a variety of petro-states that worries me.

TARULLO: I will just say the standard answer I find economists quite sensibly tend to give to questions about the impact of exogenous geopolitical events is they will say, you know, we're not the best at predicting the politics of it, but if you tell us what you're assuming, then we can give you an economic response as to what's likely to happen. The interesting thing about -- now I'm going to plug something else going on at the Council on Foreign Relations. Tell Richard I did this, whoever is here from the staff.

The geoeconomic center at the council is trying to the causality in reverse, which is something that is long needed to be done, which is to talk about how economic developments in turn feed back to affect geopolitical relationships and power allocation. And so it's really -- I mean, what this place, what the people in the rest of this building, I think, have long tried to do is predict the political or deal with the political and then start to ask what the affect on the economy is. These days, the causality may be running as much in the other direction, particularly when one's talking about China.

Okay, I want to ask somebody in the back of the room. Yes, way in the back. You don't have to stand up.


QUESTIONER: Yeah, Richard Katz, The Oriental Economist.

I'm a little -- I don't get it. I don't understand all the sermons wrong. I think our term "disaster" -- the numbers you're talking about, I haven't heard anybody say we're going to have a recession as bad as, say, '80 to '82 when unemployment went to 11 percent. We're talking something worse than 1991, which wasn't so bad, you know. The stock market drop was terrific. We hear talk about a credit crunch. And yes, certain markets have seized up. But overall, bank credit is still growing at a 10 percent year-on-year rate. So while asset-backed commercial paper is going down but non-asset-backed commercial paper is still rising. Consumer loans are rising. Commercial industrial loans are rising. Non-residential real estate assets are growing. And most of the foreclosures are really in the adjustable-rate side. The foreclosure rate on the fixed-rate prime mortgages which are about 65 percent of all mortgages, foreclosure rate's about 0.5 percent.

So that I don't -- maybe there'll be more of a -- and the IMF's latest report says even if there is a credit-growth stall, as it does in recessions, stalls at zero growth, that would only make the recession about 1.4 percent of GDP worse than it otherwise would be. So I guess what I'm saying is I don't see, either in the data or the projections of the data, events that I would characterize as the worst recession since the Depression, which I've heard from various people, or a disaster. It just seems like it's a recession, probably worse than we've had the last couple of times, but not as bad as '80, '82. What am I missing?

HARRIS: Let me say something and I think the other end of the panel may have an answer as well. First of all, on the credit side, remember that the first response of the economy to the tightening of supply of credit is to find ways to get around the restraint. So businesses run down their lines of credit, consumers who have been able to refinance from their mortgage and pay down their credit card debt start building up their credit card balances again. So I think a lot of what you're seeing, we just need to wait a little while and we'll see the impact of the pulling back of credit in actual flows in the marketplace.

I mean, if you talk to bankers, people in the commercial banking business, they're doing a triage, you know, their customers right now. They're saying, who's our valued customer that we want to keep open lines to, and who are we going to cut off? And so it takes time. And I think these restraints are kind of working their way into the system.

The other thing I would say that, you know, the problem for the housing market is that while the vast majority of mortgages are great, most people have been very responsible, the market's driven on the margin, right. And so you had home prices probably overshoot nationally by, we think, 20 percent. I'm sure other people have much bigger numbers. You've had on the margin a lot of the boom in the last three years of the housing boom was being driven by very easy credit. And now you're going back not only to the credit standards of, you know, a few years ago before the loose credit started to kick, you're going back to, you know, pre the days of before you had subprime mortgages. So you've got a massive tightening in credit.

Look at the house price statistics, right. So foreclosures, according to our data, won't peak until the middle of 2009. Even though foreclosures are still rising, home prices in the fourth quarter of last year fell at almost a 20 percent annualized rate from third quarter to fourth quarter. So they fell 5 percent in the quarter by the broader measures that include homes that are, you know, financed with subprime mortgages.

I mean, there is a lot of stress still ahead. And we need to think about the lags in the way this plays out. Again, my shtick on this is that the reason we don't get quite to the '82 recession, I think this is going to be worse than 1990, worse than 2000. It's not the '82 or '75 recession because of the dramatic policy response and the likelihood of more policy. If we didn't have the policy response, we would have the '82 recession.

TARULLO: If Bob Shiller is right, watch the Alt-A market, I think, my the end of this year.


ROUBINI: Yeah, I mean, I'm personally, of course, not predicting Armageddon, meaning Great Depression or not even an L-shaped recession like the one Japan had in the 1990s. What I'm just saying is the last two recessions were actually painful and lasted only eight months. The typical U.S. recession in the last 50 years has lasted 10 months. I believe, based on my analogy, it's going to be more like a 12 (months) to 18-month recession. And this is much more severe than we've seen before.

And I think that many elements make me worry about the financial system. We have never seen such a sharp fall since the Great Depression in home prices -- already 10 percent. I think everybody would agree this is going to be another 10 percent, and more likely, at the bottom, it's going to be something like 30 percent. And ask yourself the real and financial consequences of a falling home price of 30 percent. I think, you know, as I said, the losses could be $1 trillion just in mortgages.

Secondly, we've not seen a contraction of consumption since 1991. It didn't happen in 2001. We've never seen the U.S. consumer being so stretched, you know. The debt-to-income ratio of the U.S. consumer used to 70 percent, then went to 100 percent in 2000, now it's 136 (percent). I mean, we've had the years in which people spend more than their income because home prices were going up. They were using your home as an ATM machine. I think the contraction is going to be severe and painful.

And for the financial system, you know, the 1991 was just a bunch of S&Ls regional problems going belly-up. And in spite of that, we had the mass -- the credit crunch and a severe recession. This time around is much more systemic than just the subprime mortgages. I mean, we have Alt-A essentially going bankrupt. We see prime mortgages, jumbo loans being in trouble. We see commercial real estate. We haven't even seen the wave of consumer credit let alone corporate bonds or mini-bonds or leveraged bonds and so one.

We have -- you know, Alan Greenspan says this is the worst financial crisis since World War II. I say it's the worst financial crisis since the Great Depression. I think it's kind of a small nuanced difference at this point -- (laughter) -- I mean, really.

TARULLO: Okay, I'm sorry. It's quarter-past, and I want to let everybody get out of here on time. Thank you very much. And thank our panelists.









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