World Economic Update: Conference Edition

Friday, March 10, 2006
John Lipsky
Vice Chairman, J.P. Morgan Investment Bank
Stephen S. Roach
Chief Economist & Managing Director, Morgan Stanley & Co.
Peter Hooper
Partner & Chief U.S. Economist, Goldman, Sachs & Co.
Daniel K. Tarullo
Managing Director & Chief U.S. Economist, Deutsche Bank Securities

DANIEL K. TARULLO: Can I have your attention please, everyone? We’re ready to get started in an effort to get you all out in time. This is, as you know, the final session of this year’s conference, and we’re doing a special edition of the regular program we have here at the council, the World Economic Update, with many of our regular participants: Steve Roach, John Lipsky, and Peter Hooper.

I’ve been asked by the council staff to remind you that some of the sessions in the last two days have been off the record, and others, including this one, are on the record. So please, if you, during the question and answer period, are putting a question on something that builds on something you learned earlier in the conference, pay heed to whether you learned that in one of the off-the-record sessions, and if that’s where you learned it, please don’t quote anyone. (Laughter.)

Your conference this year has been structured around the question of various vulnerabilities, global and national, which the United States faces in its foreign policy. What we’re going to try to do at this wrap-up session with a focus on the economy is to explore some vulnerabilities to the economy that are sourced differently. So we’re going to begin by looking at the principal geopolitical source of potential vulnerability for the economy, which is to say the energy sector. And I know there was a session on that yesterday. Then we’re going to look at an economically sourced vulnerability to the economy, which is to say the current account and other imbalances that face us. And we will then alight into a potential political source of vulnerability for the economy, which is to say protectionism or measures to stop flows of trade and capital, some examples of which we have seen both here and abroad recently.

So let’s begin with energy. A couple of years ago, some of the members of this panel, and others whom we’ve had on the panel at different times, addressed what at that time was still the rising level of oil prices. And I recall the statement of one panelist who said, “You know, $45 or $40 a barrel, that we can sustain. But if we get up to around $60, that’s going to be a real problem.” Well, we’ve been up around $60 for some time now, and although a few tenths of a percentage point have been shaved off of GDP, and probably a few tenths of a percentage point added to the inflation rate, there surely has not been any wrenching dislocation in the performance of the economy.

So the first question I want to ask the panel is why that has been true, and answer that question as a prelude to what about something more abrupt, what kind of impact would we expect to have seen if we should have a supply cut-off, and why might that be different from what we’ve seen to date?

And a couple of pieces of information—many of you probably know it already. Even at $60 a barrel, in inflation-adjusted terms, we are well below historic highs. If you look at the prices in late ’79, early 1980, you would have to, with inflation adjustment, have today’s prices at about $95 a barrel to approximate that. And secondly, of course, this price rise has been relatively gradual; it hasn’t been overnight.

But having said that, we are at $60. We’ve been around there for a while and we don’t really show any signs of dipping significantly beneath that.

So, Peter, maybe you could start by addressing the question, why has it had such a modest effect?

PETER HOOPER: Well, I think there are two main reasons. One is, is that this shock has come on us a little more gradually than the ones we’ve had in the past. It’s occurred over a period of a couple of years, gone up not quite as suddenly as you did in the early ’70s and the late ’70s; I mean you had a doubling of oil prices within a matter of months, and on both those occasions you had military confrontations involved and a big hit to consumer confidence; the sustainability of existing oil supplies was very much in question then.

This is quite a different circumstance. It’s been gradual, it’s been a demand-determined development as much as supply. And I would have to add in this first general category also the fact that the economy is less energy-intensive, as you observed. You need to get to nearly $100 a barrel to equal the last shock, and you maybe need to go beyond that if you adjust for the fact that energy consumption is now 50, 60 percent below its level previously relative to GDP.

The second main reason I would throw in there is we have a very different set of expectations about monetary policy, about inflation. I think the Fed has done a very good job over the last several decades building credibility, reducing the kinds of expectations—reducing the opportunity for the kind of expectations that rose in the ’70s when you had oil price shock, inflation expectations rose, interest rates soared. This had as much a negative impact on the economy as the effect of cut-off in oil more directly.

This time around financial markets have taken it in step. You have not seen inflation expectations rise, certainly at the core, anywhere near as much as they did previously. And I think as a result, we’ve been able to get through this quite a bit more easily.

TARULLO: So, John, Peter gives us a nice succinct, coherent explanation ex post as to why there wasn’t that much of an effect. Try to go back a couple of years in time, though; why did so many people anticipate that $60 a barrel would have been a problem?

JOHN P. LIPSKY: Oh, I think, quite straightforwardly, I doubt that most of the folks who would have told you that—and maybe some of the folks sitting here today would have subscribed to that, and maybe even did—wouldn’t have expected that you would have seen such a rapid run-up in prices without supply disruption or threat of supply disruption. I doubt that most folks would have thought a market as well established and with a liquid forward market would have deviated so sharply from the forward. What I mean by that is the only thing I would add, maybe disagree a little bit with what Peter said—I don’t think—in 2004, energy prices—petroleum prices doubled, the average price has doubled. That was not expected, and I would consider that a pretty big deal. The consensus view for 2005 was prices stabler, lower, and we see what we got.

So to me, the surprise was, again, that relatively well-established liquid markets could deviate from the forwards so dramatically, not based on any kind of supply change, but simply on an underestimation of the strength in global growth and the strength of demand.

If I could ask just at a tiny bit for 2005 why did this happen, one thing is—one of the aspects that Peter pointed to was in contrast to the ’70s, the price system was allowed to work, at least here. There were no price controls. The impact flowed through directly, but not everywhere. And some of the emerging market countries—for example, China—the change in the world market price was not reflected in the price at the consumer level, and therefore you haven’t seen everywhere a slackening of demand that you might have expected if there was a full pass in price, and I think that was one explanation for how we got this new jump up to 60.

TARULLO: So, John, looking forward, even if prices continued to rise, but they continued to rise without supply disruptions and because of increased economic activity that produces more demand, would you expect to continue to see a relatively modest impact on the economy as a whole from the rising energy prices?

LIPSKY: Well, we could debate the issue of when something stopped being modest, but in broad terms, I think that’s right.

TARULLO: And is that because there’s a kind of self-equilibrating mechanism at work here, where people are changing utilization rates and the like?

LIPSKY: Yes. Again, with the market operating in a relatively smooth manner, then you wouldn’t expect to see the global economy, a broad macroeconomy fall over because of one increase in prices—

TARULLO: Okay, all right.

And now let’s change the scenario. Instead of demand-driven price increases that may be fairly rapid but are still gradual—they’re not overnight—let’s now contemplate one of the various scenarios that people talk about in the geopolitical realm.

So we have, because of insurgency or civil war, a cutoff in supplies from a major producer like Nigeria or Iran or Saudi Arabia. Or Iran or Venezuela or some other country for political reasons decides to cut off—and this is something that’s done overnight. Then let’s now say that the price goes up to about $100 a barrel quickly, which is to say it reaches the equivalent of our all-time inflation-adjusted high.

Under those circumstances, Steve, what kind of impact on the economy would you expect to see, at least in the near term?

STEPHEN ROACH: First of all—just a request—the guys at a table ate all the brownies, so if someone could save me a brownie. (Laughter.)

Look, what you’ve heard from Peter and John—I’m hungry, okay? (Laughter.)

TARULLO: The man—he flew overnight from London to get here, and I don’t think they feed you on planes anymore.

ROACH: No. (Laughter.)

HOOPER (?): This is dinner. He’s going to get another dinner.

ROACH: You ever had a sandwich on a British airline? (Laughter.)

What Peter and John are saying is it matters a lot if the price goes up because of supply or demand. Largely, we’ve added demand move, although I would note post-Katrina, there clearly was a supply disruption, and the economy did exactly what you would think, it responded very quickly and slowed to, you know, 1, 1 1/2 percent in the fourth quarter of last year, and that’s sort of the model of what you would expect. Of course, if you take it up to 100 on a supply disruption, then that would be a huge deal.

And, Dan, I want to call you on one thing—the relevant macro comparison is not the inflation-adjusted price today vis-a-vis some distant peak in 1979 in inflation-adjusted terms.

The way the macro works is preshock, you have some equilibrium level. Whether it’s above or below ’79 is irrelevant. And then where the shock takes you from there, that’s how you measure the macro impact. So I think it’s wrong to draw a false sense of security from the fact that while in inflation-adjusted terms we’re below ’79, we’re up a lot, as John said, from where we were three years ago largely because of demand. But if we grow up a lot further from here because of supply, I don’t care about the late ’79 levels. That would be a huge delta from—

TARULLO: It was a big blow in 1979.

ROACH: It was supply.


ROACH: And it was supply in ’73.


ROACH: And this is mainly demand with a little bit of post-Katrina supply. But you just asked a question on—

TARULLO: No, I’m hypothesizing.

ROACH:—hypothesizing on—if you take it up to 100 from here, I think that’s a recession, depending on how long it stays there. Now, if it just goes up, you know, for a nanosecond, it’s not a big deal. But if you take it up and it stays there for three or four months, that’ll be enough to really have a crushing blow on consumer confidence. And, you know, consumers at this point are so—and we can debate this, but—I think they’re so stretched and overextended that it’s not going to take much to break that camel’s back.

TARULLO: Would you agree, John? Say it’s a refresher?

LIPSKY: Well, for sure. I think—here’s one way to think about it. If we’re discussing vulnerabilities, I think the point here is just because we have come through this rather striking rise in energy prices, we shouldn’t be complacent that there’s no danger from this side.

Just to think back, in ’73, there really wasn’t a supply disruption. Actually, it was the fear of supply disruption that produced the effects. It was when you had hundreds of millions of car owners of vehicles where everybody decided they better fill up their gas tank because they might not—

TARULLO: (Was there ?) an oil embargo?

LIPSKY: But if you look at the supply—yes, there was talk of that, but when you look at the supply data, actually there was never any shortfall of supply. Again, I’m not trying to say nothing happened. Just the fear that supply was going to be disrupted produced reactions that drove up the price and created a recession. So for sure it could happen.

TARULLO: Peter, do you agree?

HOOPER: I would scale up. I’d say you need a little bit more than a hundred. And the reason I say that is it’s not just the real oil price, but the doubling of real oil prices. It’s also the fact that the economy is now a good deal less oil-energy-intensive than it was. So maybe 120 will do it. (Scattered laughter.)

TARULLO: But what about the shock to consumer and investor confidence that—

HOOPER: That’s critical. I mean, it’s got to be a supply shock. It’s got to be something that really gets consumers concerned are they going to be able to get gas at the pump, are they going to be able to get gas—you know, do we have a sustained cut-off in gas supplies here, or oil supplies.

ROACH: Hey, Dan, just one data point here. We’ve had sort of three oil shocks from the supply side—’73, ’79 and this brief one, I guess in ’90 after Saddam first marched into Kuwait. The personal savings rate, a number that everybody likes to diss, averaged 8 percent in those three shocks. The last time I checked, today it’s in negative territory for the first time since 1933. So consumers don’t exactly have a cushion. You know, maybe they’ll take out the fourth mortgage on their homes to pay higher oil prices. But there was a lot more cushion in the old savings rate in these earlier disruptions than there is today, and I think that’s a very important point in setting up the vulnerability or lack thereof of the American consumer.

TARULLO: Peter, and then—

HOOPER: I wonder if that cushion isn’t—or lack of cushion might be partly offset by the existence of these strategic petroleum reserves that we have that could cushion at least a three- to six-month shock in some of these supply regions.

TARULLO: What do you—do the petroleum—

MR. : But Dan—you can’t do that, Peter. That’s just not fair. Dan took the oil price up to a hundred.

HOOPER: Oh, okay. Fair enough.

TARULLO: Peter may be making—Peter may be alluding to the potential for the use of strategic reserve to restore—to stop confidence from going through the floor. I think that’s probably the purpose to which people would try to use it. Unfortunately, it now gets tried—people want to use it every time prices go up, even when it’s demand driven.

All right, let’s use Steve’s comment about consumer confidence and negative savings rate to move into the second area of vulnerability, and this is economically created vulnerability to economic problems. The U.S. current account deficit stands at about 6-1/2 percent right now, may well be on its way up to about 7 percent. This is not just high, but unprecedented by historic standards. There are a lot of other imbalances or disequilibria as well. Steve alluded to the savings rate. Compare that with the extremely high savings rate in China.

Despite all of this, although the trade-weighted value of the dollar is down about 15 percent since 2000, it’s actually up about 6 percent in the last year, so the dollar has not felt the brunt of downward pressures from a huge current account deficit. And interest rates have certainly not reflected an inability to finance the big budget deficit. We’re only getting now to the point at which they’re roughly neutral, non-stimulative to the economy. So everybody agrees that we’ve got these big disequilibria.

I think everybody agrees that this situation can’t go on forever, but the issue is, how long is forever, or how long is shorter forever, and more importantly than that, will the eventual changes be by their own terms gradual and steady or will there be something quite disruptive and wrenching that forces adjustments a lot more quickly. We’re going to want to focus in particular on some of the factors that may induce a wrenching change like that.

But first, John, you said to me the other day you think that this may be the make-or-break deal for figuring out which route we’re going to go on adjustment.

LIPSKY: Yeah, I think so.

TARULLO: Why do you think that?

LIPSKY: Well, I claim that this is a pretty profound turning point year for the global economy, in the following sense. Think of what happened. In the late ’90s—first of all, let me just start it with 1990 was a critical year—collapse of the Soviet Union, and—it’s simplifying, oversimplifying—that marks the emergence of a real global economy for the first time in a profound sense.

The number I use as an example—when the IMF was created in 1945, there were 40 member countries; today there are 184 member countries. We have a real global economy. But it really dates from 1990. And that economy, as contrasted to previously, was an economy marked by floating exchange rates and open capital markets. That version of globalization quickly ran into some—a series of shocks. You could start it in `94 with the Mexican peso crisis or `97-`98 with the Asian crisis. We could go on, the litany; you all know that.

What happened? Why didn’t those shocks even produce a global recession? The reason was, of course, because policymakers responded the opposite they did in the 1930s with the application of stimulus to support demand. The net result: the strongest stimulus was applied in the economy that was the most flexible, the biggest and—(inaudible)—to make use of it, the U.S. The result was what Ben Bernanke calls the global savings glut, but that’s really a cyclical issue that helped produce the U.S. current account deficit. That—this could go on because this is a—I think a very profound and important topic on discussing and understanding the U.S. current deficit, but suffice it to say that the growth of the U.S. deficit up to now has been a stabilizing force in the global economy and not the other way around. In other words, if the U.S. authorities—

TARULLO: Keeping demand up.

LIPSKY:—if the U.S. authorities had done whatever it would have taken to prevent that deficit from going up, that would have been destabilizing. Essentially, that was advocating the policies in the 1930s.

Now, this doesn’t mean bigger is better, and it doesn’t mean the deficit should just keep growing and growing and growing. There is a very clear path that has been laid out that—in broad terms and agreed by the G-8 as to how do you attain a smooth adjustment as the global economy renormalizes, and that three elements of that plan—there’s number one, increase savings in the U.S.; number two, stronger domestic demand growth in Japan and the Euro area; and third, greater flexibility in the emerging Asian economies.

In broad terms, there’s no disagreement about—if—certainly not among officials that that’s—that is a formula for producing it.

TARULLO: And that was just a key year, though.

LIPSKY: Now, why this is the key year is because at this time there’s little doubt that global growth has renormalized. We’re back at trend rates growth. Japan—our forecast is 3 percent growth for the Japanese economy with solid growth in domestic demand emerging. We think growth in the Euro area is going to be 2 percent plus, not wonderful but something close to trend. We think growth in the U.S. is going to be 3.5 percent or so, and it’s in a context of low inflation.

Now, what’s happening is the key authorities are withdrawing the stimulus that was applied in 2000-2001—why this is a turning point here; because by the end of this year, we’re going to have a pretty clear idea whether this is going to work. Can was sustain solid growth, low inflation and begin a path of also adjusting the so-called global imbalances in a way that looks stabilizing?

TARULLO: Okay. Now, Mr. Hoover down there at the end, where did—

MR. : Mr. Roach, anyway.


MR. : No, “Hoover” not “Hooper.”

MR. : Hoover, yes.

LIPSKY (?): I never realized, Peter, there’s only one letter between you and Herbert. (Laughter.)

TARULLO: You—Steve, you would not subscribe to the proposition that the—allowing the current account deficit to get to where it is has basically been stabilizing, right? You think that it’s—

ROACH: Not in the least, Dan. I think—and John, you know how much I love you, but I disagree with everything you just said. (Laughter.)

TARULLO: Including—seriously—

LIPSKY (?): Whew! That’s a relief. I was getting worried.

TARULLO: Including the proposition that this is a key year for knowing which way things—

ROACH: I don’t know—I don’t know if this is a key year. I do know that last year was an important year in sort of challenging the view that myself and others like Paul Volcker and Pete Peterson, to name a few, had over the global imbalance issue. And a lot of expectations have been set on the basis of the fact that rather than fall for a fourth year in a row last year, the dollar rose.

But look, here’s the point, and John actually laid—you know, set a trap for himself by talking about this world coming back. What’s it going to mean when Japan grows 3 to 3.5 percent? When Europe—what’s the number for Europe? You said two?

LIPSKY: Two plus.

ROACH: Two plus. And I think I would—I mean, our team would say that Germany will probably lead that.


ROACH: Both of those growth dynamics will be driven increasingly by internal demand, which will drawdown their surplus saving and leave less capital to send our way. The big issue going on in China, which is at the margin bin, are huge financiers, as Peter has pointed out in a lot of his work. They are focused like a laser on stimulating internal demand, and they too will drawdown their current account surplus. These are the three largest surplus nations in the world.

America needs $3 billion of capital inflows each business day of the year today, and if the world comes together in this synchronous way, the noose is going to tighten on us. And John also laid out the agenda that the world has got to sort of fix itself, and you know, the U.S. has been preaching this agenda for some time in terms of the—what it expects from the rest of the world, but we’re asleep at the switch in fixing our own saving problem.

So here we are preaching to the rest of the world what they’ve got to do to have a more synchronous and flexible global economy, and we continue to suck in $3 billion of foreign capital a day with no discipline on the budget deficit; personal savings rate in negative territory. You know, the best way to describe this from my point of view is, beggars can’t be choosers.

TARULLO: But, now, Steve, wait a second here. If one subscribes, as I guess we all do, to the Herbstein (sp) proposition—that it’s something that can’t go on forever won’t—you’re going to have an adjustment that is of some sort or another. One possible adjustment is a very unpleasant one. Something happens, people panic, people start to sell, you get a big decline in the dollar. You seem to me just to have described something which will not be pleasant for U.S. consumers but may well be better than the alternative, which is the growth of demand in the rest of the world, which provides some support to the global economy, which may put some downward pressure on the dollar, but in circumstances in which there is the opportunity to export a little bit more.

ROACH: Look. Our export capability is so hollow now I don’t think we’re going to benefit from that. Right now, I think, based on the trade data that just came out, goods imports in the United States are about 85 to 90 percent higher than goods exports. So the only way to really fix the trade current account issue is through a reduction in the growth rate of internal domestic demand in the U.S., which is an excess consumption story. The export fix through the currency is not there.

TARULLO (?): But one second, though. Wouldn’t what we just talked about—downward pressure on the dollar, some increase in interest rates in the United States—wouldn’t that itself necessarily suppress U.S. domestic demand?

ROACH: If you get a normalization of real rates at the long end of the curve, that would do much more to slow down the growth rate of internal demand in imports than a sharp currency adjustment.

But let me just say one thing, Dan. Everybody wants the smooth adjustment, the benign correction. We all do. But when you push an imbalance as far out as this has gone, there are no guarantees. We don’t know. We can hypothesize about, you know, the coming hard landing of this or that. We all hope for a gradual adjustment over a long period of time. The imbalance is so big now that the odds of a more disruptive adjustment are higher than would otherwise be the case, but that doesn’t make it a sure thing.

LIPSKY: Why is that, by the way? Why does bigger make it more likely that it’s going to be worse.

ROACH: We’re more dependent on the expectations game, and so if something happens in the U.S., whether it’s a post-housing bubble adjustment of the U.S. consumer, you know, an unwinding of some of these carry trades as the liquidity cycle turns, or the third piece of what we’re going to discuss today, the U.S. continues to sort of rattle the protectionist sword, then I think foreign investors and some of their policy surrogates who are buying dollars head for the hills, and the adjustment will be sharp.

This is not my best-case scenario, but I can’t dismiss this in any way whatsoever, given the magnitude of the imbalances.

TARULLO: Go ahead, Peter.

HOOPER: It’s taken us 14 years to get from zero to 7 percent deficit current account, about a half-percent of GDP per year. I think it will take 10, 14 years to go the other way, getting back to zero. I think it’s going to be a gradual process. But I think there is something to John’s notion that this could be a watershed year. It’s very important that the Bank of Japan feels that the Japanese economy is expanding strongly enough now to begin to shift—make a significant, a major shift in their monetary policy. By the end of the year we’ll start seeing interest rates rising there. Europe, too, starts to look a little better.

I think it’s going to take a good while, but the relative attractiveness of investing in the U.S.—which, after all, is what’s allowed us to run this ever-increasing deficit—is going to begin to shift, and I think it’s maybe beginning now. It’s going to take place slowly. China too, as Steve mentioned, is beginning to shift its investment policies toward investment for domestic—production for domestic consumption, not so much for export.

This is all in the direction of increasing global—increasing demand abroad, making investment elsewhere relatively more attractive. And I think as part of this adjustment process, you’re going to see over time a major drop in the dollar and further increase in U.S. interest rates. That’s what has to happen to get the U.S. saving rate up. I mean, with real interest rates as low as they are now, there’s no way you’re going to get saving up significantly. So we need a substantial move in prices, interest rates and exchange rates. And I think that process is now beginning with this shift in relative attractiveness.

TARULLO: Your expectation is for the more gradual rather than the more abrupt scenario.

HOOPER: Mm-hmm.

TARULLO: What factor or two or three might develop to catalyze an unpleasant abrupt adjustment which creates major problems rather than a gradual one?

HOOPER: Well, at the risk of slopping over into the next session—or next question—for example, legislation on the Hill now prohibiting non-U.S. residents from holding U.S. Treasury securities. (Laughter.) Given that more than half of the U.S. national debt is held abroad, that would give you a pretty abrupt adjustment. (Laughter.)

MR. : Could I—

TARULLO (?): Peter, who introduced that, by the way? Do you have the name?

HOOPER: I don’t have the name. It’s was a congressman. I don’t have it.

LIPSKY (?): Let’s talk about economic developments that could undercut this. And to be honest, I was with Peter all the way till he said “and for sure what we need are much higher real interest rates and a much lower dollar.” I mean, it’s possible. Never say never. Necessary? I don’t get it. I don’t see it. It’s going to depend on how things unfold. But in broad terms, better balanced global growth strikes me as good, not bad. That’s a positive environment for adjustment, not a negative environment for adjustment. The discontinuities that have been warned of from some folks just aren’t—haven’t appeared yet and don’t look like they’re appearing.

However, if you wanted to get economically sourced disruption in the U.S., you’d have to reverse the two things that have happened in the U.S. that have surprised the consensus and have led to the unexpectedly positive—(inaudible). First, the decline in inflation that was unexpected and the sustained low inflation in the face of both strong growth and, more recently, the rise in energy prices that have so far been contained mainly to the energy sector.

Secondly, the unexpected acceleration in productivity in the U.S. economy that changed from 1995-1996-1997. Lots of folks, experts would have told you the U.S. economy can’t grow faster than 2 to 2 1/4 percent per year, and now we all believe the U.S. economy can grow from 3 to 4 percent per year because trend productivity has accelerated.

Think back to what happened in the ’70s. How did we run into bad situations in the 1970s?

Number one, looking back in history, productivity suddenly slowed and folks were slow to recognize it, among others the Fed that kept trying to push the economy along, and all it produced was rise and accelerating inflation. You can’t rule that out. It could be happening, but it doesn’t look like that’s what’s going on now.

TARULLO: So, Steve, what—play out a little bit the discontinuity, the discontinuous adjustment rather than the smoother adjustment. What is it that puts together the factors you mentioned earlier—the under-the-carry trade, interest rates going up—

ROACH: I think we’ve touched on both of them, Dan. I mean, the turn in the global quiddity cycle as the three major central banks are now pretty much on the same page recognizing that the need for extraordinary accommodation is largely over; you know, the Fed’s far more advanced on this, the ECB has moved a couple of times, the BOJ is sort of holding its breath and starting to move.

But, you know, I think we’ve had very powerful global quiddity cycle now for a number of years, with each of these authorities moving for somewhat different reasons. And that has been a very important aspect of the cross-border arbitrage of saving that’s gone on to cushion some of these imbalances. And now we’re going to test that in a more normal policy environment, and the interesting thing will be, as we normalize rates at the short end of the yellow curve—I don’t want this to sound overly technical—will we now normalize the rates at the long end? We will have a more normal slope between the short- and the long-term interest rates? And if we do, you know, how do some of these cushions hold up in an unbalanced global economy? I don’t have the answer to that, but I think this is going to be a—and I would agree with John at this point—this will be a very important year to begin to test that thesis.

The American consumer has been the mainstay on the demand side of the global economy for a long time. I actually do agree with John that it’s good news for the world if we can get other consumers into play, but I think there’s a bit of a timing issue here. I think the other consumers are going to come on with sort of long tails, and the U.S. consumer may have more immediate risk post-housing bubble than sort of this smooth adjustment scenario would lead you to believe.

And then there’s, you know—

LIPSKY (?): What risk would that be?

ROACH: Well, I think—you know, consumers have spent freely out of their overvalued homes, gone deeply into debt to do it, and if the value of the collateral goes down at the same time their debt service obligations go up and their labor income remains subdued as it has over the past four years, they’re going to have to cut back in discretionary consumption, unless they, you know, happen to own, you know, fancy real estate like you do, John, in Manhattan. (Laughter.)

LIPSKY: Let’s clarify—I own no real estate in Manhattan. (Laughter.) Let’s just say, I’m proud to say I own real estate in Brooklyn.

ROACH: All right. (Laughter, applause.)

TARULLO: If we look at geopolitical problems that can induce—

ROACH (?): I apologize. (Laughter.)

TARULLO:—can induce economic problems, are there—how likely is it that, for example, a(n) energy price supply coming from a supply cutoff or a geopolitical crisis of some sort over Iran or some other hotspot is the catalyst for the wrenching adjustment, as everything—people try to adjust, people start selling, people say, “We got to reappraise the way things are”—there’s a story to be told that actually it would be dollar positive, that there may be a flight to quality or at least perceived quality during this period. But how might geopolitical disruptions feed into the general imbalance problem?


HOOPER: I think of all crises actually as being—yes, being quite dollar positive, in part because you need dollars to buy oil, and I mean, over the last year, the big increase in oil prices was part of the factor that drove things up.

So I don’t see a geopolitical oil energy-related crisis as being something that’s going to solve this problem. It’s more—

TARULLO: I’m not going to say things that might exacerbate—

HOOPER:—exacerbate—I mean, as you start to think about what is it that’s going to really come into international transactions, and for an economy that’s running a huge deficit, if we suddenly had to go to a balance, that would mean a huge movement in financial markets. Potentially a major avian flu crisis that really cut global transactions sharply; a—a—well, I don’t have a good—I don’t see anything in the energy area that’s going to do that.


ROACH: Dan, I mean, look, there’s an elephant in the room, and you call it protectionism.

TARULLO: All right, let’s turn to that.

ROACH: And that’s in the U.S. Congress led by a New York senior senator is—I think it risks of mixing bad macro with increasingly populist politics and on the brink of making a serious mistake in China-bashing, Dubai-bashing and this point that Peter made on—someone introduced an amendment to the debt ceiling bill to restrict foreign holdings of Treasury debt. Senator Shelby was on record in the FT recently talking about restricting cross-border activity into the U.S. from state-owned foreign enterprises.

You know, I realize we’re, you know, in a political season here. But we’re playing with fire here. For a country that is more dependent on foreign capital than any country’s ever been in the history of the world—for us to try to dictate the terms on which that capital is provided in telling Dubai, for example, you know, “You can’t buy our port facilities, but keep buying our treasuries,” and telling China basically the same thing, I really worry about the potentially dangerous path that our elected leaders are taking us down.

TARULLO: And why, Steve—but play that out, okay? So what—what is it that happens step by step which takes us from a lot of talk in the Congress and a bunch of bills introduced—and I should just say it is very easy to introduce a bill if you’re a member of Congress, okay? You just hit the button on the word processor, and the clerk assigns an enrolled bill number to it and that’s it. What takes us from that to major negative economic consequences in the world?

ROACH: Well, you know, the Schumer-Lindsey-Graham bill, through some deft maneuvering, was attached to the omnibus foreign aid bill last spring, and then—(inaudible)—


ROACH:—that day, and the vote to attach was 67 to 33. A lot of senators told me later, you know, it was a free vote. But there’s more sentiment for that today than I think there was back then.

So you asked me—the scenario is, just say we pass the bill, the president vetos it and it gets overridden and, you know, there’s a lot of appeal through WTO because some people think this bill is illegal. In the meantime, do the Chinese keep gobbling up our treasuries? Say they don’t. The dollar goes—interest rates go up—

TARULLO: But you’re saying they would stop gobbling up the treasuries as a political response to the passage of Schumer-Graham?

ROACH: I think there’s a—I won’t say there’s a solid chance of that, but the Chinese are proud people and they’re not going to sit back and have their major export market priced away from them. About 40 percent of all Chinese exports come to the United States directly; more than that indirectly, if you, you know, capture through greater China.

TARULLO: But you think it’s passage of the bill and not imposition of the tariffs? Because the bill does include waivers—

ROACH: Look, the bill, you know, it’s a crazy bill. You know, it should never have gotten this far. There’s certainly greater risk, if that bill works its way through Congress, of a retaliatory move from China than would otherwise be the case. I don’t know for certain if the Chinese are going to pull the trigger, depending upon the margin of the vote, but this type of legislation is terrible for what could well be America’s most important bilateral economic relationship of the next, you know, 25 years.

TARULLO: John, go ahead.

LIPSKY: Well, I wouldn’t disagree with anything Steve said. But it strikes me that these kind of highly dramatic outcomes are very unlikely. And I worry a little bit that we’re missing the big point, and that is that we have a global trade round, the Doha Round, before us, and it’s getting obscured by all this—these side issues. And I think that it strikes me that there is a chance that we are going to allow the Doha Round to fail and without noticing—

TARULLO: If the Doha Round fails, it’s not going to be because of the Dubai Ports.

LIPSKY: It will not be because of Dubai Ports. It’s going to be because of agricultural trade.

TARULLO: That’s correct.

LIPSKY: And everybody’s going to—the important players are going to have to get in the room and cut a deal. And it’s going to involve compromise. And there better be enough wisdom around places like this to understand how important it is that we not have failure of the Doha Round. If you want to see the momentum on globalization start to slip away, that would be the way to do it. I’m not trying to say there’s nothing bad could happen any other way. I don’t think these grandstanding things like let’s have a 27.5 percent tariff on everything from China, we go straight to the WTO and it’s illegal.

TARULLO: Except that—well, as long as people pay attention to what’s actually in these bills rather than just look at them symbolically. But maybe the world won’t.

ROACH: But, Dan, the interesting question, I think is, with the unemployment rate in the U.S. below 5 percent, why does protectionism in the Congress get such political traction on a bipartisan basis?

TARULLO: That is an interesting question. And you might hypothesize several things, right? One, you might say the objects of the protection or the protectionist impulse include not just economic considerations, but non-economic considerations. Certainly the terrorism fears have played a role in the Dubai thing, all the calls from constituents. And in the case of China, there is no question but that relative to thinking about Japan 15 years ago, there is a sense that China is—some people have the sense that China is a rival generally, rather than being just an economic challenger, which was the view of Japan. So there’s a different kind of atmosphere in which these views are developing—I think that is true.

The other thing, Steve, you might say is well, it’s not a 5 percent unemployment, it is something you’ve written about in different contexts, it’s wages and the perceived inability of people to make more money in middle and lower-middle income jobs, which is calling globalization into effect. So there are other things going on from what was happening 15 years ago.

The reason I’m asking you guys these questions, though, about the protectionism is, to be honest, I have trouble seeing how it unleashes some sort of uncontainable force, as opposed to creating a set of really difficult problems that, you know, Bob Zoellick probably will be the guy who has to end up managing for a while. It’s not to belittle them or to undermine them, but I do get—what all three of you seem to have said, you think the biggest risk to the economy is protectionism rather than one of the other things that’s going on. It does strike me, as a Washington person, a little bit wrong.

MR. : Well, the U.S. has been a relatively attractive place to invest because it has open, very liquid, fluid markets, because it’s easy to buy assets here. Now, if we’re going to make that more difficult, if Dubai Ports expands into a broad congressional review or administrative review of a wide range of types of purchases of assets in the U.S., suddenly this is not an attractive—anywhere near as attractive a place to be putting your—

TARULLO: How much effect after the Unocal merger was stopped last year?

MR. : It was a dip on the radar screen, but, I mean, things can accumulate. And if it happens at a time when central banks globally are beginning to tighten, and going back to—I guess the only point that John and I were disagreeing on—was the implications of a significant short—drop in foreign investment in the U.S. for U.S. interest rates. And we’ve done research; the Fed has done research suggesting something on the order of a hundred to two hundred basis points on interest rates being the impact. If you look at that kind of an increase in interest rates at a time when the housing market is cooling—and yes, there’s some vulnerabilities in parts of the household sector—you could create a scenario for a pretty sharp drop-off in domestic demand and possibly a recession.


MR. : But that’s—okay.

TARULLO: Okay. Now, let me—I want to get a question here because we cut short on my questions last time.

Okay. So we’ll take questions from the audience. We’ve got people with mikes I think, yes.

MR. : They’re all leaving, Dan.

TARULLO: They’re all leaving?

MR. : The people with mikes?

TARULLO: No, not the people with mikes.

Yes, sir? Right there.

QUESTIONER: Hi. Peter—(last name inaudible)—from Bank of America. A quick question regarding the leverage in the financial system under the environment that you lay out over the next year. Clearly, the advent of credit derivatives wasn’t around when we looked at the last recession back in the early `90s. Obviously, I’m not talking about GM default, but clearly, credit derivatives on GM debt, for instance, there’s probably six times the outstanding debt that’s out there.

So I want you to address in particular the leverage that’s in the financial system here, and two, the development of the yield curve. As you mentioned—Steve, you mentioned when we get back to normalcy, upward sloping. But given the fact that the Chinese really have no other place to invest in, maybe you could say the Euro, do we see a hump in the yield curve over the next year or two? And what does that basically mean for financial markets?

MR. : Go ahead.

ROACH (?): Look, I’ll take—well, just to comment on derivatives, I do believe that the advantage of derivatives in that it sort of—parts—distributes risk much more broadly and deals with the potentially serious problems in the past. It saw a concentration of risk in a certain segment of the investor base that unwound in a very nasty fashion. That’s the good news about derivatives. The bad news is that there’s no regulator that I know of that has a good set of metrics to measure the dispersion and the degree of exposure and the quality aspect of the embedded swaps, for example, that are out there in derivative (land ?). I’m not saying it’s—you know, that there is something terrible there, but the knowledge base in understanding this aspect of the problem is not as good as it should be, and I think most regulators would confide in you off the record that that is pretty much the case.

TARULLO: But the New York Fed’s trying to do something about it, though, right?

ROACH (?): Yeah, good luck. I think it’s going to be very difficult for them to assemble the data.

The second point is on—I don’t see a hump in the curve. I think the—you will—the mistake that a lot of people have made has been forecasting long-term interest rates on the basis of inflation risk, and as you come around to the view—and I’ve had this view for quite some time—that globalization and central bank credibility pins the inflationary premium down, then you could still have a back up in the real interest rate piece at the long end of the curve that would give you a more normal slope.


LIPSKY: Yeah, a couple things to add.

The—first of all, it strikes me that the—a lot of the assertions that there’s excess liquidity, generally that reasoning tends to be circular. It’s usually—we know there’s too much liquidity because asset prices are too high, and risk spreads are too low. And we know that asset prices are too high and risk spreads too low because there’s too much liquidity. The—and it’s—to be honest, it struck me that also the argument that says foreign official intervention is holding down interest rates in a meaningful way, most of those studies strike me as, like, wrong—ill-conceived, because basically what they’re doing is doing a supply-demand kind of analysis—that if you took that demand away, how—where would interest rates go. And it strikes me that that’s missing the point.

Foreign purchases—official foreign purchases of U.S. securities are in support of an exchange rate policy, and if they stop making those purchases, either it’s because somebody else is and they don’t have to, to attain their currency goals, and though they’ve changed their currency policy. So then the counterfactual, what’s the world look like with very different exchange rates? And frankly, I’m not smart enough to know the answer, but I’m smart enough to know that the studies that claim to tell you how much that intervention is worth in basis points isn’t reliable.

The—it strikes me on the issue of the yield curve, that there’s been a lot of discussion, especially in the U.S., in the context that—does the inversion of the yield curve of—this unusual shape of the U.S. yield curve, although, it’s not unique to the U.S.—imply something about the U.S. economy going forward? And you’ve had a lot of central bankers saying, “Well, you can’t really tell. It’s a very complicated question.” The question that they haven’t addressed, and hopefully they will, is, isn’t the inversion of the yield curve a sign that monetary policy is restrictive? In other words, the idea that there’s a lot more interest rate rises necessary in the U.S. strikes me as not at all obvious when you look at the—certainly at the financial markets.

TARULLO: But, John, just a question to you. Compared to, you know, previous periods of yield curve inversion, this is tiny, right? This is not a horrible—

LIPSKY: Well, that’s why I say I’m not so interested in the question of does it imply that the economy is about to fall over. The question that I ask is, what does it tell you about the stance of monetary policy, and why shouldn’t you interpret the current stance of the Fed’s policy as restrictive? And what I haven’t heard from the Fed is an explanation of either that restrictive policy is appropriate, and/or why you shouldn’t assume that this current yield curve shape implies restrictive policy.

TARULLO: But by saying—at least the former chairman speaking a lot about the conundrum, he is implicitly saying that the long-term interest rate should be higher, and relative to where it should be, he thinks the short end is probably okay.

LIPSKY: But I’m not sure about where this “should” comes from. It’s like the argument that there’s excessive leverage in the system. We know that there’s a lot of leverage in the system, but that’s different than saying there’s too much leverage in the system. When you look at debt service payments, they don’t look to be excessive either on the household side or on the business side. So one way of interpreting the leverage is people have begun to believe that inflation is going to stay low for a long period of time. In other words, they actually believe the Fed is going to do what it says it’s going to do. Why that is bad escapes me a bit. In fact, it strikes me that we’re creating a constituency for sustained low inflation.

But finally, to come to the point of vulnerability that was implied by the question, which I think is correct, think back to the LTCM incident in which the failure of a hedge fund in Greenwich caused the U.S. Treasury bond market to freeze, at least temporarily, until the Fed responded. And when you analyzed what happened then, how could that have happened, it turned out that basically—again, it’s a longer story, but the nutshell is there were some important players in the financial system who were taking risks that they didn’t know they were taking. It’s not that they were taking risks they didn’t understand in the sense that they were being fooled, it was there were interrelationships and—

TARULLO: Do you think that’s going on now?

LIPSKY: That’s the question that’s worth asking—could that be happening now?

TARULLO: With credit derivatives, emerging markets and—

LIPSKY: And that’s why it’s worthwhile asking that kind of a question, because you’d ask where has there been rapid growth in instruments, and the answer is in the credit default swap market, credit derivatives. But I can assure you that organizations—or institutions like my own, firms like my own that are major players there understand very well what’s at stake, and hopefully are paying adequate attention to the risks that are being taken.


Other questions? Yes, ma’am, right here.

QUESTIONER: Hi. My name is—(inaudible). I think this is the Bank of America contingent acting up. I’m also from Bank of America. My question is actually for John. I don’t know which of you made the statement, but someone said earlier that a falling dollar and rising interest rates might actually give—make the U.S. savings rate move in the direction that we want it to. Historically—and not having living in America for long—has the U.S. savings rate actually responded to those two factors, or is it really just market valuation and asset valuation and—(inaudible)—reached their value of their property makes them that actually is the main driver of the savings rate? I just don’t know, and I’m curious.

LIPSKY: Well, I guess that was directed to me.

There’s no simple answer as to what drives the savings rate in a lot of discussion. But it strikes me that the—of course we’ve seen a decline of the U.S. savings rate been’s going on. As Peter pointed out, this is not a new phenomenon, it’s been going on for 15 years. What has been happening over that 15-year period, by and large, has been a period of rapid growth in household net worth that I think’s easy to claim was unanticipated because it resulted from an unanticipated fall in inflation and, hence, interest rates, and an unanticipated acceleration in productivity. Households finding themselves getting richer faster than they had anticipated naturally felt they didn’t have to save as much as before. It strikes me that that has been a key driver of the decline in the savings rate.

At the same time, there’s a—it’s often claimed that that rise in household net worth is highly dependent on house valuations, and that stems from looking at house balance sheets, but only at the asset side, when you find that home equity constitutes about—or the value of residential real estate is about half the value of household assets. But, of course, for most households they have borrowed and the majority of the equity is not owned by the households. When you look at the growth in net worth—this may be a little technical—only about 20 percent of it derives directly real estate.

TARULLO: But, John, the interesting thing about this question, there are a lot of things which seem to make the savings rate go down. What is it—historically, do we have a strong correlation with—I know there are no policies which seem to work, but with some economic phenomenon or demographic phenomenon which drives the savings rate up?

MR. : Dan, the savings rate went up in the early ’90s when, you know, we actually had a budget surplus for a while under an administration that—

TARULLO: That was—yeah, that was the national savings rate.

MR. : Well, the national savings rate is what matters.

TARULLO: But what about the individual—

LIPSKY: Well, I think I described the circumstances that will produce, and I think in the next few years will produce a rise in the savings rate. Namely, the inflation rate is no longer falling, productivity is no longer—

TARULLO: I’m asking a different—I’m asking a different—I don’t have—(inaudible)—question, but I meant if you sort of did a—not a real regression but, you know, you really tried to isolate factors in the past, not just once but multiple times, have led to an increase in the personal savings rate, what would those be?

LIPSKY: Drop in household net worth.

TARULLO: Okay. Drop in—

LIPSKY (?): Exactly. And I think you get an increase in interest rates, you’re going to get a drop in the housing market, you’re going to get a drop in household net worth and household—instead of having asset markets do their saving for them, they have to start saving more out of their current earned income, the saving rate goes up. But if interest rates are just stable, if inflation stabilizes and interest rates are stable and productivity growth stabilizes so potential growth stabilizes, you’re going to find household net worth—I’m sorry—household savings rates are going to be rising persistently for the next number of years. And if you want it to happen in a real hurry, then the Fed should just crank up a lot of inflation and run a really rotten economy, and people would save a lot and we’d have a recession. (Laughter.)

TARULLO: Okay. We can take one more quick question.

MR. : Boy, John, that’s a horrible (view ?).

QUESTIONER: Peter, this is for you. If we thought that—this is Joe Schlosser (sp) from PriceWaterhouseCooper. If we thought lowering our dependence on oil would help the geopolitical situation, what policies would you recommend from an economic perspective to achieve that in the United States?

HOOPER: Lowering our dependence on oil. Well, number one, I’d start taxing oil at a significantly higher rate than we do now. I mean, every time the gasoline price moves for some reason, I would put a floor under it. And that, I think, would begin to have an impact. Other than that, I think we’d be pretty much shooting ourself in the foot to try to cut oil consumption. I mean, we do have long-standing gains in productivity—in oil usage conservation. It’s not something you implement overnight. So the tax wedge would be the first one I would go to.

TARULLO: Okay. So we’re going to draw the economic panel to a conclusion. But now the highlight of the conference, which is some words from the president of the council, Richard Haass.


RICHARD HAASS (CFR president): Hardly the highlight. First of all, thank these gentlemen. Economics is in danger of no longer being the dismal science.

Just very quickly to some thank-yous and one request. The thank-yous are to David Kellogg and Jackie Shine (sp) and the corporate team, to Nancy Bedirk (sp) and the meetings team, and to others who really made this possible. A lot goes into these 24 hours, and I want to thank them here publicly in front of everybody else.

Secondly, thank you to you all. My one request is, we will be getting in touch with you all to get some feedback. It’s been good. Things that are good can always get better. So if you have ideas about things you didn’t see that you’d like to, or things that you saw and you wish you hadn’t, it’s a chance for feedback.

Lastly, we know we compete for your time, and we appreciate you giving it to us. So thank you for yesterday and today, and more important, thank you for the other 363 days during the year when the corporate members of this council exercise their membership.

So with that, bon voyage, thank you, and travel home safely.









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