Assessing the State of the World Economy

Lewis Alexander, U.S. chief economist at Nomura Securities, Vincent Reinhart, visiting scholar at the American Enterprise Institute, and John P. Lipsky, senior fellow at Johns Hopkins University, join CFR's Sebastian Mallaby to discuss the state of the world economy. The panel considers the effect of the recent equity market volatility in China on global growth, the ongoing challenges for the Eurozone, and the U.S. Federal Reserve's trajectory on interest rates.

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

MALLABY: For those of you who don’t know me, I’m Sebastian Mallaby here at the Council. This is an experiment. This is the first edition of the World Economic Update here in Washington. It’s something we do quarterly, or thereabouts, in New York. So we’ll try it out here and see what you guys think.

We have some highly experienced World Economic Updaters. You know, I think you’ve all done it multiple times.

But over there is Lewis Alexander, who is the managing director, chief U.S. economist for Nomura.

In the middle, John Lipsky, who is at the SAIS, School of International Studies.

And next to me Vincent Reinhart, visiting scholar at the American Enterprise Institute.

So we start this discussion right after the IMF meetings in Lima, where the mood was gloomy. But I’d start with you, John, with a question on sort of defining this gloom. So on the one hand the IMF is projecting growth this year of 3.1 percent for global growth, not a recession. On the other hand, there is chatter about global recession. Can you explain why, with 3.1 percent projected, people even use that word?

LIPSKY: Well, a number of reasons. Of course, that, as you mention, is based on PPP GDP calculations. Back when the IMF said they—the Chinese currency was significantly undervalued, it was easy to understand why GDP at PPP prices might be quite different than market prices, but now that the IMF says that the RMB is fairly valued you are relying very heavily on some relative price statistics to decide just how strong PPP-measure growth is. At market rates, growth is quite a bit slower.

But I think most important the—for the advanced economies as a whole, as we know, many are just back—first of all, that is, for the advanced economies, below their medium- to long-term average growth rate. And in essence, the advanced economies as a whole have never filled in fully the growth hole of the recession of 2008-9. So this remains. Years later, we still haven’t, in many economies, made up lost ground.

And in the—in the emerging economies, that have been growing relatively rapidly, they have now settled back to their long-term averages. So this period of exceptionally strong emerging-market growth has also disappeared.

So it’s easy to understand why there would be such a concern.

REINHART: So, I mean, the annual meetings are always this echo chamber where everybody’s going to the same meetings, and by the time the week is over they’ve settled on a theme. This time round there was a little more diversity of views, that the IMF started with their WEO update that was marked down, that had an outright decline in output if you had it at market prices. But I think there was probably more pushback among the participants, saying that maybe China isn’t as bad as you thought, maybe there are—there are better growth prospects. Obviously, everybody’s worried about commodity prices. Everybody’s worried about the re-normalization of monetary policy. And everybody’s worried about those long-term averages because potential output growth is slowing in the advanced economies.

MALLABY: But this would be the first time in a while if the IMF was too pessimistic. I mean, normally the growth is serially revised down. You’re saying it could be the other way round this time.

REINHART: They were getting more pushback than they normally would, I would say that. I’m not the person to turn to to say what’s the reasons for optimism. (Laughter.)

MALLABY: (Chuckles.) All right.

So, Lewis, let’s think about—so the kind of pessimistic story, I think, runs as follows. It says, first of all, you had the Lehman shock and the financial crisis. Then you had the eurozone crisis. Now the third leg of that could be a(n) emerging-market crisis where excessive exposure to dollar debts, excessive exposure to commodities, excessive exposure to China, all of these things come together and you get a sort of third leg where it’s not just a slowdown to par but something worse than that. I mean, if you look at the emerging world, first of all, does that feel right? And second, where is it right?

ALEXANDER: Actually, I don’t sort of see it that way. I would stress more what’s interesting to me is the slowdown in potential that is a very broad thing. To a certain extent, it is related to, you know, recoveries that come after financial crises. But some of the more recent work has actually looked at recoveries generally and found that they tend to have been, you know, after deep recessions, regardless of whether or not it’s financial, has tended to pull down potential growth. And what you’re seeing—the breadth of that you’re seeing across the global economy is I think the thing that’s really interesting.

When I look at the emerging world, what I see is, frankly, flexible exchange rates working. So what—the pressures you’re seeing show up as terms of trade shocks for many countries. That shows up as weaker currencies. They are sort of reacting to that in the way that you would expect. Some countries are facing the challenge of do they have to do, effectively, pro-cyclical fiscal policy tightening, which is the sort of classic dilemma for emerging economies. But what I don’t see are the kind of crises we’ve seen in the past.

Now, that’s a—that’s a very bleak outlook in a lot of ways, but it is different in the sense it is more a protracted period of slow growth rather than we’re facing a bunch of crises. So I look at, you know, the places people worry about—Brazil, for example; Russia’s another one; Turkey—and what you see is a kind of response to particular circumstances, but it’s one in which the currencies are flexible and they have means of adjusting, and it doesn’t necessarily generate the same kind of crises.

Now, I do worry that you’ve had tremendous financial deepening across these countries over the last 10 or 15 years.

MALLABY: Financial deepening meaning they’ve all borrowed a lot. (Laughs.)

ALEXANDER: Yeah. I mean, you—well, but it’s—there is this question of, so, credit broadly defined in a country like Brazil has gone from very low by international standards to being still low by international standards, but it’s grown very rapidly, and that creates a certain set of risks. And you could see that, you know, manifest itself as sort of financial crises in many of these countries, and that’s the big risk, to me.

LIPSKY: Yeah, I was going to say, the—certainly the—in the past, emerging-market crises and debt crises were characterized by problems of excessive public borrowing in general. As we know, the Fund has been concerned about the potential implications for emerging markets of the rapid and significant growth of corporate debt, including debt denominated in foreign currency. It’s worth—it’s worth thinking about because it is an aspect that is new relative to the past. And we’re probably—there is the potential for increased strain at a moment in which many of these countries are having trouble with their policy adjustments to this world of flexible exchange rates and adverse terms of trade.

REINHART: I mean, a stress test is coming.

LIPSKY: You better believe it.

REINHART: And we’re—it’s a test of the resilience in a couple ways.

One is in terms of debt. A key feature of most market economies is that private-sector mistakes become public-sector obligations at a time of stress. And that’s why economies that had well-behaved—say, Ireland—suddenly have excessive federal government debt burdens.

Second point is that, in the EM world, most defaults—sovereign defaults come at levels of debt relative to GDP that would have satisfied the Maastricht Treaty, and so they’re just less resilient.

And then I think the third point is it’s going to be a test of political resilience. Politicians are going to have to explain that, having lived through a commodity price boom and a capital inflow bonanza, things will be less good on the other side, and you’re going to have to reset your expectations.

MALLABY: Which does raise, I think, a question about whether this is more than just a slowdown. If you’ve got the slowdown coupled with some sort of political paralysis—take Brazil, for example, where growth is projected to be negative 2 ½ (percent) this year. And on top of that, some of the policy tools that you might wish are not available because the president is under a corruption cloud and cannot get anything through Congress. Does that feel familiar here? Right, so do you think that there’s a danger of a sort of risk to the downside that, because you’ve got this policy paralysis on top of the economic trouble, it gets worse?

ALEXANDER: Yes, but. So look, you look at a country like Brazil that is facing both a kind of historic terms of trade shock, so we’re—it’s a country that has always been sort of very dependent on commodities as exports. In this environment, with weak commodity prices, that is a very significant real shock. On top of that, you’ve got—they’re coming after a period when, frankly, policies have not been strong. So to a certain extent the buildup to this has not been great. And plus, you now have these severe political constraints.

So you add those three things together and you have to say, you know, there’s a significant risk that this problem could get worse. On the other hand, as somebody who’s kind of studied Brazil’s problems over the years, one of the things that’s striking about it is, from the—from the federal government’s perspective, they have—they have actually positive exposure to foreign assets, so their foreign assets exceed their foreign liabilities.

We talk a lot about this surge in corporate borrowing. It’s been very rapid. But to be perfectly frank, the levels aren’t all that high. So, for example, if you take Brazil in 1999, when they had—you know, they had had a fixed exchange rate and they had to devalue, at that point they had many, many, many more foreign liabilities denominated in dollars than they had assets, so that when the exchange rate went their fiscal position actually deteriorated. They’re in the position now there it actually works the other way. When the exchange rate weakens, the value of their foreign assets go up relative to the domestic economy.

MALLABY: This is for Brazil the country, not the government. This is the entire—

ALEXANDER: So what I was mainly talking about is the government. But even if you assume that ultimately the corporate liabilities end up on the—on the public sector’s balance sheets, they’re not big enough to offset the value of the assets.

So the basic point is there’s a very different dynamic here. In the past, when things went bad, you had this sort of explosive characteristic that, when the exchange rate went, everything—all the—everything else got worse. That’s not true now. It’s actually stabilizing. And so that’s the sense in which, if you look at the emerging world today relative to, say, the late ’90s, the big difference is flexible exchange rates and very large amounts of foreign exchange reserves.

Now, that doesn’t forgive all sins. And you know, for all the reasons you laid out there are risks. But it is—it is a different environment, and I think it’s going to manifest itself differently.

MALLABY: John, Russia may be a test case, right? So there was—if we’d had this meeting several months ago, you know, Russia was in a position where it had enormous reserves, but it was burning through them at a remarkable rate. And there were people who kept on—you know, who projected that, you know, there wasn’t that much time to go, if you extrapolated. But in fact, although the macro is still very weak, the currency crisis aspect of it seems to have stabilized, right? So this is an example of how better macro management, more reserves, flexible currencies have—do seem to have prevented Russia from repeating 1998.

LIPSKY: Yes, but remember, at the same time this downdraft in the currency occurred in a moment of great uncertainty and some extremely negative views among some about the outlook for oil prices—remember, talk of $20 a barrel, et cetera. So I would say it’s—that potential (tale of ?) gloom that has gone away that has probably also helped stabilize.

But let me just come back a little bit to one aspect. Lou was talking about Brazil, and what he was saying is certainly right, but. And the “but” is that the bit that is a bit worrisome, the—you might want to take a look at the IMF’s Global Financial Stability Report and their discussion and study about their concerns about the potential problems arising from the growth of corporate debt in emerging markets, and that is that is appears that the performance of individual countries’ debt has been less dependent than in the past on that individual country’s performance and more generalized. In other words, it’s responded more—they have seemed to respond more to global issues.

So I would say you’re absolutely right the risks are going to be different and, e.g., in Brazil it’s less likely that you’re going to have a crisis of the—on the—on the fiscal accounts of the kind that you had in the past. But the risk is that the economic performance is going to continue to suffer, and it could be for—worse for a longer period of time than we might have hoped.

REINHART: I would keep—I would keep saying more flexible exchange rates because, as you know, countries have been burning through reserves. The exchange rate is not completely floating. It is, at the end of the day, a policy decision, and those policy decisions may not always be pleasant.

The second thing is, for some of these economies, we’re talking about pretty opaque systems—opaque central bank balance sheets, the ability to take positions in derivatives markets in ways that crises develop by those surprises.

And then the third part—related to John’s point about the—you know, the much deeper financial markets—deeper and wider financial markets are a source of contagion. And so that there is cross hedging, there’s—there is—you know, securities held in very large buckets tend to move together. And those are risks going forward.

EM is a source of fat tails. And we’ve benefited from the last five or six years on the—you know, the good side. That doesn’t mean the bad side’s not there.

MALLABY: Let’s get to the—talking about opaque, let’s get to the elephant in the room, which is obviously China. So, Lewis, I guess the question is partly, you know, if I put the negative case—which I think you’re doing this morning, and everyone else can be more optimistic than me—you know, is China in a sort of position a bit like, say, Japan in 1990, when a financial shock exposes a sort of structural problem and you can stimulate a bit but, you know, after not too many more years you’re in a—you’re in a position where you get into a much different growth path? So you’ve got negative demography in China, like in Japan. You’ve got a difficulty of exiting an investment-led growth strategy. You’ve got an immature financial system, and a huge buildup in debt which went with that. And you’ve got a loss of confidence, arguably, in the competence of an opaque group of political leaders. I’m sure there are lots of differences that you’re going to wheel out, but how do you see China?

ALEXANDER: So I think it would be extraordinary if China could get from where it is today to being a kind of normal middle-income country without having some significant thing that feels like a recession and that ultimately is a global event. The natural process of what’s going on in China involves the—essentially the private part of the economy growing faster than the rest of it, as well as the government gradually giving up tools of control. I think inevitably that is going to mean that at some point they’re going to face a set of problems that they can’t manage. I think the question right now is, are we at that moment?

There certainly is big imbalances in the property markets that are in the process of correcting. You had the equity markets. I think, frankly, that’s less significant to me than what you saw going on in housing. You’ve kind of got a local debt problem. You’ve clearly got overcapacity problems in a variety of industries that have built up over this period of very—extraordinarily rapid investment growth, that it must have created bad assets in the banking system that will ultimately have to be dealt with.

I think the question you have to ask yourself, though, is: Is this the moment where the problems overwhelm the capacity of the government to manage them? I don’t—it doesn’t seem to me that we’re at that point. You kind of do the math on fiscal capacity and plausible estimates of the—you know, the contingent liabilities, and I’m reasonably convinced that it’s not obvious that, like, that’s going to be the thing that constrains them.

I think it is the—one of the things I would stress, though, is the degree of difficulty for the Chinese authority in managing these problems is just getting—is going up. You saw that in what happened with the equity market. They had a particular view of how that was going to contribute to growth going forward, how it was going to help them restructure their state-owned enterprises. It kind of got out of control and they had a bunch of moments where, gee, we weren’t able to manage this quite as well. You saw it with the exchange rate, where they did what was a seemingly modest change in their exchange-rate regime. I think they thought they understood how it was going to play out. It didn’t seem to work quite the way they thought. And it just highlights the fact that as they continue to evolve in a way that’s closer to being more like a normal market-driven economy, the challenges just become greater.

So I’m fully convinced that at some point in my professional career—what little of it is left—that I will have to deal with a global recession driven by China. I don’t think this is the moment, but as you say, it’s a very opaque system. It’s hard to know.

MALLABY: John, you were just there.

LIPSKY: I was just there. They still have—can do things on a scale that no one else can. I just visited the Pearl River Delta and saw some—one project that’s particularly impressive, essentially Canary Wharf on steroids. (Laughter.) And it’s—and it’s all happening.

But let me come back to—

MALLABY: Canary Wharf did go bust, actually, along the way. (Laughter.) The Reichmann brothers, if you remember, went bankrupt.

LIPSKY: It did, but—and you’ll remember it because they built this wonderful office complex with no transport access. The Chinese have high-speed rail going in this. (Laughter.) But the—

MALLABY: Elon Musk is going to build pods. (Laughter.)

LIPSKY: (Laughs.) Exactly.

Look, the point is, it’s kind of—at a certain level it’s simple. China invests an incredible amount and doesn’t get much growth out of it. So their big problem is it’s very inefficient. They’re making very inefficient use of capital. And guess what, they got that.

If you say, do they have a plan to correct it? The answer is, absolutely. Look at the twelfth five-year plan. And you go down. The tenets of the twelfth five-year plan, it’s complete, it’s coherent, in every single element probably most people here say, yeah, that’s the way—that’s what to do. Do they have a big concept of what they’re doing? Yes, we’re moving away from export-led, investment-led toward services-dominated, consumer-dominated. It’s all there.

Cautionary tale: a lot of that great stuff was in the eleventh five-year plan and didn’t happen. So obviously, you know, we have this image of a command economy—the guys on top decide and it just happens. And you realize it’s not that simple in a country of 1.X billion people, and there are some big vested interests that are perfectly happy with the things the way they are.

So this is going to be—so my concept is they have a clear view of where they need to go. They have a plan of how to do it. It’s just going to be not simple to get it done because it’s not in everybody’s interest, and those who it’s not in their interest are going to—are going to resist. So to my mind, it’s can they—are they—I guess it’s really consistent with what Lou said.

Are they likely to be facing a severe downturn now? I don’t think so. I think they’ve got the tools to stop it if that were happening. But those tools are all anti-reform tools. The tools are stimulate credit growth and stimulate construction and send more money to the municipalities to do more infrastructure spending—i.e., just—you do that, you may stop the slowdown, but now you create doubts about the seriousness of the reform effort.

Interestingly, I also had the good fortune of attending President Xi’s welcome dinner in Seattle and listened to his speech. And he said, don’t worry about market perturbations; we’re dedicated to the process of economic reform because we understand that’s the only way forward. Let’s see if they can do it.

MALLABY: So, Vincent, I think you’re going to be somewhat optimistic, so before you—

REINHART: Uncharacteristically.

MALLABY: Before you do that, I’m going to put the negative case again—(laughter)—and hold your—you know, and invite you to contradict it.

So I guess there’s a kind of feedback loop story. There’s maybe two of them going on in China. One is simply that, when you’ve got growth which has come down from 10 (percent) to 6 ½, 7 (percent), to be a bit optimistic, that’s not enough to sustain a huge investment rate that you’ve had up to now. So investment has got to come down because demand is growing more slowly. Once investment comes down, that obviously—because investment’s such a big proportion of demand, that drives growth down further, and then that drives investment down further.

So one investment—one feedback loop is kind of growth to investment to growth. The other one is lower growth, you know, more NPLs on the debt, as more financial problems arise, lower growth, and so on. The response is policy stimulus, but the stimulus means more debt—more of the problems that China faces in the first place. So why is this not a sort of—you know, something that in the next year or two is going to bite very hard?

REINHART: Not willing to say the next year or two. I will agree the growth model doesn’t work.

But step back for the big picture: this is the biggest rural to urban migration in Earth’s history. When you move a worker from a rural area to an urban area, you give them productivity, you create so much extra income. You can tell that person half of it is saving, and you use that saving to allocate investment across a big continent. In doing so, you make an enormous number of mistakes and you facilitate corruption. That’s a downside of that model, but you do get enough capital investment you can bring the next worker from the fields to the city, and they will be productive. And you can do that and do that and accumulate mistakes, and then once every 10 years or so you acknowledge the NPLs, the factories you shouldn’t have built, the see-through buildings. And if you’re completely unsentimental about the process, you write them down, you start over the next day. And if you do it for three times, that’s 30 years of progress that has really improved the lot of your citizens.

The fundamental problem is, in doing so, you create a middle class. And a middle class is restive toward corruption and desirous of having some control of the balance sheet, and that is at variance with the growth model. And the problem with giving them market-like phenomena is it’s messy. You don’t—it is no longer a decision.

And you know, I think the near-term forecast is policymakers still have a lot of levers of policy. They have a record of pulling the right levers. I think John is right to emphasize we talk about the policymaker, but it’s a group of people with different interests, and it could go wrong for that reason. It could go wrong in terms of a middle class that has—is desirous of controlling their own balance sheet. So there’s lots of risks associated with it.

And the phenomenon you’re talking about is not just unique to China. Growth is slowing around the world. In six out of seven of the G-7 economies the IMF has marked down the estimate of potential output growth. Potential output growth, it determines the slope of your expected future income. And if growth slows, the whole trajectory rotates downward and you have less debt-bearing capacity. And the standard story is you think for a while you can take on more debt, that’s self-fulfilling because that creates the extra demand that allows you to grow faster.

And then at some point you appreciate that supply hasn’t caught up, and there are three things that can happen. One is a crisis. That’s the debt event. The other is you figure out ways to grow faster. Economies are really—if there were ways to just pick growth off the shelf, we would have done it a long time ago. That’s the least likely, but it’s always why an IMF program has all those pages on structural reform. And then the third is just a slow slog, where you grow slowly and you hope the political system is resilient to that. The most resilient political system of all is Europe, where—(chuckles)—with operating a democracy deficit you could have such a long stretch of poorly performing economies. You know, tell me which of those three doors China’s going to knock on.

ALEXANDER: Just two points.

One is, in response to your feedback loop, that kind of presumes a set of market processes. And like one of the fundamental questions is the degree to which China is really operating in that world versus one where they have enough means to essentially break what are the normal feedback mechanisms that you see in a market economy. And when China has a recession, it will be through some mechanism like the one you described. It’s just not clear whether or not that’s really the way China functions right now.

I think the point John raised is very important in terms of the opacity of governance. You know, one of the things that’s just so darn hard to evaluate China is not understanding how this process really works. And I think that’s a very important point, is just it’s very hard for, I think, those of us on the—on the outside to really understand how this process works, what are the internal political feedback loops, what are the real constraints. And I think that’s one of the big challenges.

I think on the—on the question of at what point does the debt become binding, if you—if you look at nominal rates of growth that China has relative to interest rates that are very low in nominal terms, it’s kind of hard to get all that excited about this, even with the slowdown. So I’ve kind of done this kind of—those calculations at various points in time.

And if we’re coming back to a country like Brazil, China’s just in a very different place. Even if you kind of assume 6 percent growth instead of 10 (percent), right, it’s still the—just the dynamics of that, it’s not obvious that they’re facing a crisis at this moment. At some point those dynamics will probably come to bear. It’s just not clear when that’s going to happen.

MALLABY: One more word on China and then we’ll go to—did you have one more?

LIPSKY: Well, again, I’m just going to repeat myself that, number one, the big challenge is they’re investing a huge amount and not getting very much growth out of it. So they’re not—the model—the preexisting model is not sustainable. It’s being—and even that slow growth is being accompanied by a very large run-up in private-sector or corporate debt—not private, but corporate debt.

A big element of the inefficiency of the state-owned enterprises is why market—it’s not exactly a market system. They have—they have a plan that they would say we have to change the model, so they understand that—they have a clear view what they’ve got to do. The problems are obvious. They had—the old system did produce a lot of corruption. They’ve got to get rid of that to create believable market mechanisms. And we could go, you know, long list of all the things they need to do to get it all right, but the biggest ones are pretty clear. They’ve got to be able to reduce the investment in the state-owned enterprises that are basically Rust Belt kind of industries and move to a different model, and that’s going to be a challenge for a while.

MALLABY: Well, so we haven’t yet got to—we normally do the opposite, we start with the developed world and we talk a lot about the U.S., and this time we’ve done the other way around. So I’m going to rely on clever questions from the members to get us to the next Fed decision, relatively better growth—

REINHART: Take your time. It’ll be fine. (Laughter.)

MALLABY: —relatively better growth in Europe, Abenomics running out of steam, three arrows relaunched and ineffective. But anyway, who has a question? I see—OK, let’s go to Paula and—yeah.

Q: Thank you very much. Good morning. Paula Stern.

Thank you for mentioning Japan. You really got it in there at the last minute, Sebastian, because it’s the third-largest economy in the world. I am interesting in hearing what y’all think about this crazy notion I came up with yesterday, listening to a discussion on U.S., Japan, and TPP. And it is, is it possible to see the incorporation of women into the Japanese economy as a significant source of growth? I mean, Japan has been suicidal for quite a long time, but it’s really affecting the rest of the world now that China is no longer growing like it used to. So where are we going to get, if not from Japan, the kind of help that the U.S. needs to keep the global economy pumping along? Is it women? Is there—has there been studies on this?

MALLABY: You mean Japanese women sort of boosting Japanese labor force participation? Yeah.

Q: Japanese women—exactly. Has there been studies on this in terms of increasing their growth rate, their productivity rates, structural change? But it’s stunningly important, it seems to me, for the whole world, not just for Japan.

ALEXANDER: So just on the simple math, I think it’s unrealistic to think that anything that Japan could plausibly do is going to replace the slowdown in China, in terms of you just—

MALLABY: The slowdown in China?

ALEXANDER: Yes, in terms of the contribution to global growth. The most optimistic scenarios you could make about—the way I think about Japan, in some ways Japan has this horrible fiscal problem and it is facing this problem of can it get growth and avoid a kind of long run fiscal crisis and whatnot. And the upside for the global economy for Japan, it seems to me, is it manages that process effectively, that it gets growth up enough so that its own internal dynamics don’t end up being a problem at some point down the road. But I don’t think you should think of it as Japan has the potential in some ways to replace what has happened in terms of the slowdown in potential growth you’re seeing in the rest of the world.

Having said that, I think the story of women in Japan is actually one of the places where they’re actually making a difference. So you have seen a notable increase in participation among women in Japan. It’s actually one of the success stories of what is going on over the last several years. Look, it is totally about what your frame of reference is, right? If you judge it by what it might be, it looks terrible. If you judge it where they were and, you know, the negative expectations we all had before Prime Minister Abe came into office, I think it’s much more of a success.

But on Japan more broadly, Abenomics has clearly not delivered what it was hoped for initially, right, the notion that you would have this combination of monetary stimulus, get asset prices moving, combined with big structural change that would generate potential growth. You’ve seen obviously the monetary policy and the asset markets worked pretty well initially. That’s waning a bit. That hasn’t translated into as much aggregate demand as people had hoped. And the structural side has in many respects not delivered what had hoped.

I would stress a couple things about that, though. One is, it’s very hard to judge what’s going on there because this isn’t one of those things where you pass a bunch of big laws. This is really about how the bureaucracy implements things. And I think when you look at it in that way, the news is somewhat better than what it would be—what it would seem, if you’re judging it by what’s moved through the Diet. I think it’s also important that in some ways the importance of TPP at this moment for Japan is after having the prime minister shifted his attention to what was in effect foreign policy for Japan.

So you had kind of initial Abenomics. A lot of it was kind of monetary and asset prices and a lot of good news and let’s through the first election. There was a shift in his attention to national security and foreign policy issues. With TPP back on the table, there is an opportunity to kind of refocus on the economic issues. And again, I would stress it’s the hard, dirty work of getting the bureaucracy to actually behave differently. And that’s just a harder thing to judge.

So I am—I’m not sure I would describe myself as optimistic about Japan, but it is—it’s easy to be very pessimistic. And I think that’s not quite right. But if you frame it as, can Japan substitute for the slowdown of China, that’s not going to work.

MALLABY: Paula, I saw that on the relaunch of the three arrows just recently one of the promises that Abe made, as I read it in the press, was to arrest the decline in Japan’s population, to which my response was, wow, he’s really abrogating unto himself some magic powers that I didn’t know he had. (Laughter.) But perhaps, you know, your idea is part of that.

LIPSKY: Sebastian, actually when—in that speech of sort of his new arrows, what you found previously, it was easy to define—monetary stimulus, fiscal measures, structural reforms. Now it’s local Abenomics. It’s still development. It’s increased productivity. It’s become stuff that sounds political and fluffy rather than something very specific. So it makes you a little concerned that the focus may be back on economics, but with good intentions, but not specifics.

MALLABY: It seems like the biggest and least-satisfactory QE experiment, surely. I mean, absolutely massive QE, and inflation still, I think, around zero.

ALEXANDER: Look, they are—that’s a whole nother subject, right, which is the broad question of how do we think about inflation in this world, how do we think about extremely aggressive monetary policy in many places and what it can and cannot do. That is certainly not something that’s unique in Japan. Look, I share all of the questions and doubts. And the one thing I would just caution people about is judging the success of small reforms like that is just—it’s harder to do from a distance. And I believe there is evidence—to me, the most compelling one is the fact that you have actually seen an increase in participation among women, that we can make some positive change. And people should keep that in mind.

REINHART: I mean, the good news is TPP is a lever to make more structural reform, and to say here is a deliverable. We have to legislate for all these reasons. While we’re doing it, let’s do some more. And you know, a fundamental issue is Japan’s a nation of unfair intergenerational trades—i.e., the elderly are wealthy, it’s not an accident that they tolerated deflation for so long, because that’s what kept real JTB yields high in the presence of such low nominal rate. At some point, they have to correct that unfair intergenerational trade, which besides deflation is associated with over-subsidizing agriculture, misrepresentation in the Diet, over-subsidizing construction. Got to make that shift. That’s hard to do. And the good news is they may be trying to do it through monetary policy if they can generate inflation.

MALLABY: Mitzi.

Q: Thank you very much. I’m Mitzi Wertheim with the Naval Postgraduate School. And I never studied economics, so I’m a little lost. (Laughter.) I start—

ALEXANDER (?): So are we. (Laughs.)

Q: Well, no, I—Sir Adair Turner spoke at Hopkins a few years ago. And he’d been appointed, my understanding was, eight days before our financial collapse occurred. He was given an enormous responsibility to understand the financial circumstances. Anyway, he started out by saying he created a committee that spent six months trying to understand the details about how we collapsed. What strikes me is, academic do not write—they write in code and they don’t write for the general public to understand. And this continues. And yet, when you say the public needs to be a part of this story, they have no idea how to think about it. I’m just going to pass on something rather quickly, which is Alan Alda had figured out if you want the public to understand, you write for 11-year olds. And he’s created—oh, he’s created these competitions that started out—the first one was how do you explain—

MALLABY: So really we need the question there. What’s the question?

Q: Well, I want to ask how you get academics to write for 11-year olds, as well as for each other, because if you just write for each other you do not have an informed public.

MALLABY: Well, Vincent.

REINHART: So I don’t—I don’t think this is a modern phenomenon. If you ask me, what’s the biggest cost of a financial crisis? It’s the lessons you learn from that experience. And quite often, you don’t learn the right lessons. For instance, coming out of the Great Depression we had the completely wrong diagnosis in terms of the sense that it was in fact the result of an excess of competition, that it told you you needed fixed exchange rates, that monetary policy was ineffective and it’s only fiscal policy that worked. It took—and that was reflected in legislation. That was reflected in lots of controls. That was reflected in the Bretton Woods system.

It wasn’t until 1963 that Milton Friedman started pushing back on that wrong diagnosis. And it took another 15 or 20 years to change the legislative edifice. Now, we probably didn’t get that right. I’m not—I’m willing to accept that. But we typically—it takes time to learn lessons when you have an event as complicated in such an opaque system.

MALLABY: I think there’s a question there. Karen.

Q: Thank you. Karen Johnson. I’m a consultant, but I’m ex-Fed, so I will ask Sebastian’s Fed question, OK?

You’ve painted a picture of the EM world that is, shall we say, disappointing, but it’s not a calamity. My question is, to what extent does that depend on when the Fed in fact acts? And vice versa, to what extent does the Fed’s—do you think, the Fed’s decisions on when to act depends on the outlook for the global economy and on the EM world in particular?

MALLABY: Vincent, go ahead.

REINHART: So I don’t think it is as much a question when the Fed acts, as how it acts when it does. The disconnect that it’s not so much whether they go in October, December, or March, it’s that if you look at the Federal Reserve’s interest rate guidance in terms of the summary of economic projections, their forecast for the path of the appropriate policy rates lies everywhere above the euro Eurodollar futures curve, i.e., the Fed is much—or, the other way—the market is much more dovish in its pricing of what the Fed is going to do than what the Fed does.

And when that first tightening comes, if market participants come to believe that the Fed is on a fixed march along the path to a 3 ½ percent nominal funds rate, which is what the terminal point of the summary of economic projections is, that’s going to be an enormous tightening in financial conditions. And that will be a stress test of all markets. So I think the important thing is for the FOMC to convey that it really—all decisions are data-dependent and made meeting-by-meeting.

As for how much—so EM will, importantly, depend on what the Fed does and how the Fed explains what it does. Will the Fed care about EM in determining its policy decision? Not really. It’s a bunch of domestic monetary policymakers that have always followed the syllogism that you care about a market X if that affects your forecast for output and inflation, i.e., the pursuit of your goals. They tend to underweight the consequences of policy for the rest of the world. And they’ll probably do it again. They say more about the rest of the world now because the rest of the world is bigger, not because they’ve increased their concern—their marginal concern for the rest of the world.

ALEXANDER: Can I?

MALLABY: Yeah.

ALEXANDER: I think you’ve heard up here, in terms of emerging markets, a range of views. There is a—this isn’t totally fair to Sebastian—but a kind of more apocalyptic view of what we’re facing—(laughter)—and then a kind of moderate slowdown view.

MALLABY: I’m provocalyptic. I’m not apocalyptic. (Laughter.)

ALEXANDER: But, look, it’s reasonable—the question is totally reasonable. And to sum, the way I would characterize it, to me, for the Fed, is when will it become clear which side of those two things is correct? I think as long as there is a realistic prospect that you’re facing something much more severe, I think they’re rightful to be mindful of that as a risk. And there is a sort of question of how quickly will you know that we’re facing kind of moderate slowdown versus something worse. And so to my mind, that’s the kind of near-term timing question.

I very much agree with Vince that the—I find it a little odd that there are people out there arguing that, oh, if they would just hike it would reduce uncertainty. Like, that’s only true if they hike and then promise never to go again for a while, which is what markets want, right? The point Vince made I think is exactly right. The problem is, once you lift off, you then look at these dots that the market is ignoring, these interest rate forecasts that the market’s ignoring, and they’re going to look at them differently. And that is a real risk, so.

MALLABY: It’s an extraordinary thing. In this realm of, you know, central bank communication being a new thing, that you’ve had all this communication which is just being ignored by the Eurodollar futures rate.

REINHART: So I would put it—or—

LIPSKY: Go ahead, you’re the expert on that. You both are.

REINHART: I would put it differently. And that is the dots and the Eurodollar curve have this undiscovered territory in between, right? And that’s the place Janet Yellen can hide. Because if you’re the chair of the Federal Reserve, it is an easy problem to live with markets being more dovish than you think is necessary to sustain economic expansion. If you’re not particularly worried about financial stability issues or resource allocation—and I don’t think they by and large do so—because that’s a much easier problem than if markets ever got more hawkish than you thought was necessary for sustaining economic expansion. So you live with the easy problems because you know if you needed to you could fix it in two sentences, and because you don’t want to risk creating the hard problem.

Well, what does that mean? You don’t have to define yourself. You can let your colleagues yap and yap about what they think is right for policy path. You can give the shortest semiannual testimonies on record. You just don’t have to tell people what you’re going to do. You just tell a framework. And so I don’t know—I don’t know what kind of chair Janet Yellen’s going to be, because she’s in that undiscovered territory.

MALLABY: You’re saying that she can say, hey, I’m not the super dovish. Those guys at Morgan Stanley, those are the real crazies on the far left. John.

LIPSKY: Yeah, I got to get this in. I feel very honored to be up here with two very distinguished and talented former Fed staffers.

REINHART: Who both worked for Karen. (Laughter.)

LIPSKY: I frankly don’t quite get this obsession with the Fed at this point. It’s been obviously from a long way away that the Fed is not going to be proactive in this context, that if anything they’re going to be biased towards being late to the party. And the notion that this—that the Fed’s actions are going to depend—they’re going to determine the course of the economy and the world economy and markets, et cetera, I just don’t—I don’t buy it, frankly. I just don’t think the Fed is going to be that important in what’s—looking forward.

To me, the issue that I worry about and wonder about is how—so how did we get to this sluggish growth? And particularly, how come we are having a shortfall in business investment virtually in all the industrial economies, despite a whole round of effects that should have done the opposite? We have super low interest rates. We have low real interest rates. We just had a big decline in commodity prices, especially energy prices. If you look at the U.S. corporate sector, debt—leverage is very low, cash reserves are at all-time highs. And the stock market is telling corporate managers that what they should do is take that cash and buy back shares. But if you go and invest in real stuff, we’re going to punish you.

And that’s why—slow investment is why we have slow growth. It’s why we have sluggish growth in potential. It’s why we have slow growth in productivity. It’s why we have slower growth in—slow growth in income. But I don’t—what I don’t get exactly, and we can talk about it, is why hasn’t there been more response.

MALLABY: We’re going to go back to the floor in one second, but I can’t resist. This—I mean, it seems to me that one answer to your mystery—you know, you’ve got this low interest rate structure, apparent encouragement to invest, and yet in the developed world not much investment. Isn’t part of the answer is that the investment has been going on, but in the emerging world. And there’s been a huge amount of dollar borrowing based on low dollar interest rates and plenty of investment, it’s just that it’s in Asia?

ALEXANDER: So that’s true, but only to a degree. But the fundamental—one of the fundamental puzzles of the last 20 years is why this surge in growth in the emerging world has actually led to more global savings, not less. One would have thought—and like we thought when the Berlin Wall came down and emerging world—that the logical thing was these are capital-poor areas. Surely, this will mean higher real interest rates, not lower. One of the puzzles is, it’s been the opposite. And that’s sort of part of the answer.

I think John’s question is a very important one. It’s a complicated—there are a complicated set of answers to it. I would push back a little bit on, like, productivity is low because investment’s low. That’s part of the answer to why productivity is low, but TFP is down pretty much everywhere. And that’s its own puzzle that is sort of independent of what’s going on with investment. Part of it is demographics. So one of the—one of the global things you’re seeing is population growth, labor force growth slowing virtually everywhere. That has a direct impact back on growth prospects, which has its own affect back on investment.

I think there are a host of interesting questions about technology and what that means for this. One of the things that’s happening is the price of capital growth is falling relative to everything else because it’s so much dominated by tech. So partly there’s a difference between the nominal and the real that’s complicated. And then you get to the fact that—think about the fact that our most innovative companies, what is their fundamental problem? How to spend the money.

So you look at a Google, their problem is they’ve got more money than they know what to do with. That is telling you something about the investment opportunities that they see. They see things like Uber, right, which frankly is created a business model that generates a lot of revenue and certainly a lot of market value. But it requires virtually no real investment. It’s essentially—we all got smartphones already. And there is—we are living in a world where I think the, in some sense, need for physical investment is different than it’s been. And there—but these are—it’s a whole nother world into itself, but.

LIPSKY: That’s right, but an implication—and a clear implication of what you’re saying—one potential implication is you could say, well, maybe it’s not a measurement problem but it’s a horizon problem, that if what you’ve said is true, there ought to be an acceleration in productivity coming, right?

REINHART: I would just point out—

MALLABY: Or maybe—just on this—maybe the productivity acceleration is also in leisure. We are much more productive about how we spend our non-measured, non-GDP leisure time because cellphones are helping you to—

LIPSKY: I wish. I wish.

REINHART: I mean, GDP is not a measure of wealth, right? But I would point out that 10 years after the 15 worst financial crisis in the second half of the 20^th century, real GDP per capital was 15 percent below the trend of the 10 years prior to the crisis. And that is in the 20^th century. So some of this is financial crises are incredibly costly. We don’t respond to them correctly. As Lou pointed out, recessions generally are costly, and deep recessions are more costly. This is a public policy challenge.

MALLABY: I want to hear from the floor. Yes, over here.

Q: Hi. Hani Findakly, Clinton Group. Hi, John.

Question back about China that you raised before, and that is that I just also came back from China. And I wonder about the policy options and the tools that the Chinese have that you’ve spoken about. And one missing ingredient of that is one that’s not talked about a lot, which is a foreign exchange issue. The money devaluation experiment that the Chinese went through sent shocks through the market. And the Chinese are watching—and they told me that in no uncertain terms—that they watched the Japanese yen decline by almost 50 percent over the last two or three years, same thing with the euro.

And against the experience of a very large hemorrhage of foreign exchange reserves—they lost several hundred billion dollars, including 250 billion (dollars) in the last quarter alone—would they be sitting pat against a growth which is now talked about in the 3 to 5 percent range, as compared to the 7 percent rage? Would they be sitting idle here against that loss of competitiveness and against a loss of foreign exchange reserves? And if they are not, what are the likely actions and steps they take? And what are the consequences for emerging markets in that case?

MALLABY: So you’re really—

ALEXANDER: I think I’ve got this one.

MALLABY: Sorry.

ALEXANDER: I have to admit, I have a strange—perhaps a strange perspective on this. During the ’97 crisis, I was working in IF for Karen. And we spent a lot of time thinking about reserves. So frankly, in those circumstances you got to the point where reserves were effectively zero. That was true in Thailand. That was true in Indonesia. That was essentially close to true in Korea. The response then is to build up a tremendous number of reserves. China’s reserves numbers are 3.6 trillion (dollars). Yeah, a couple hundred billion in losses over a couple of months is a non-trivial number, but the notion that it’s large relative to their capacity I find odd to characterize it that way.

It gets back to the question of, you’ve had this tremendous build-up of reserves and there’s a kind of fundamental question of, like, what was it for? What do you use them for if they’re not prepared in an environment where, yeah, capital flows can be volatile? The policy change that they introduced was at one level a kind of minor adjustment, on the other hand it was a fairly kind of significant signal about where they were going. I don’t think if it as, you know, the expenditure of reserves was all that large relative to their capacity. If you weren’t going to use them in circumstances like this, what kind of was the point?

And I think that—for me, that applies across the emerging world, right? People talk about the potential claims on Russia’s reserves. I think you dig into that and they still—they’ve got lots, relative to sort of previous crisis where we were. So, look, I think the question for China is one where, in part, do they want to go back and use exports as a way of offsetting their growth shortfall? But that’s, in some sense, the argument for, well, gee, we need a big deval because we’ve got a competitiveness problem. That raises all the sorts of problems about the growth strategy that we’ve already talked about.

I think that more on the question of they’re on a path towards liberalizing their capital account. They’re also—that is also on a path towards, frankly, having a more market-driven financial system, which is ultimately one of the solutions to this problem of investment allocation which they have. And that’s a tricky road. The history of it is, you know, those kinds of liberalizations are points when financial crises happen. I think they are right to be reluctant about it. But my—forgive my strong reaction, it’s just I—when a country that has 3.7 trillion (dollars) in reserves spends a couple hundred billion and people act like, oh my god, they’re at their limit of what they can do on reserve usage, I find that odd.

MALLABY: OK, right here. In the last row. The mic is coming.

Q: I mean, we’re all fans of the floating exchange rate system, but you can see that the dollar’s getting strong and stronger. It is causing big—Dick McCormack, CSIS. The dollar’s getting stronger and stronger. If the emerging markets aren’t able to other structural changes, this process is going to continue. It’s already causing huge problems on the Hill for trade policy. Treasury is beginning to talk about the possibility of some kind of a modified and expanded Plaza Agreement ultimately to begin to address this issue. Is this—is that a realistic prospect, or is that just a pipedream?

MALLABY: An agreement to address the issue of currency—

Q: Currency and the macro policy coming together, the way the Plaza Agreement originally did.

MALLABY: The Plaza Agreement, yeah, OK. Anyone believe in a second Plaza?

LIPSKY: No. (Laughter) But I would say the principal institutional response to the global financial crisis was the creation of the G-20 process at the leaders’ level. And the principle response in this context was the creation of the so-called Framework for Strong, Sustainable, and Balance Growth that was exactly to intended to address these kind of issues in a cooperative, coherent way, that would give confidence that these kind of—that policies would lead to these kinds of threats of currency-led imbalances, et cetera.

And I think it’s quite disappointing how little political capital has been spent on making that effort real to the degree that hardly anybody even thinks about, even though there’s a big bureaucratic effort to keep it going. And the way to deal with these kind of problems is not these kind of—the kind of measures that you talk about up on the Hill and elsewhere, in other countries, but a more coherent approach to macro policy. And it’s—as you say, it’s been very—I think of the big disappointments is the lack of political capital that has been invested in that process, even after that was—as I said, that was the principal response—institutional response to the crisis.

REINHART: I mean, what we’ve seen over the last year tells us the challenge going forward. The Federal Reserve is the first of the advanced central banks heading for the exit. We know that the BOJ and the ECB will keep monetary policy accommodative for as far as the eye can see. That is going to put pressure on bilateral exchange rates. And EM economies are going to have to make a decision about how much do they want to limit the fluctuations of their currency vis-à-vis the dollar. And how much do they want to lose competitiveness to third parties?

That is going to test their—test lots of frameworks. And it will become a political issue because the secretary of the treasury, with a straight face, can say at the G-7 level, those changes in the exchange rate are the outcomes of monetary and fiscal policy decisions. It gets harder when it’s at the G-20 level. So it’s going to be a political challenge, as well as an economic challenge.

MALLABY: Lewis, do you want to add anything?

ALEXANDER: No. (Laughter.)

MALLABY: Wow. I think actually we’re running up against the clock. I’m just going to say one last thing about Dick’s question, which is that if Congress expects anything other than, you know, an unpleasant sort of exchange rate conundrum in the context of global growth, which is slowing down, of course they’re going to be disappointed. It might be useful if they thought about stuff like, you know, a more intelligent regime for investing in infrastructure so that we can put money in and not see it wasted, would be my personal two cents.

But the main point is to say thank you to all three of you for a great show. I hope you enjoyed it. And thanks for coming out this morning. (Applause.)

(END)

This is an uncorrected transcript.