World Economic Update

In conversation with Sebastian Mallaby, CFR Paul A. Volcker Senior Fellow for International Economics, Lewis Alexander, Managing Director and U.S. Chief Economist at Nomura Securities International, Inc., Emma Dinsmore, Cofounder and CEO of r-squared macro, and James Grant, Owner and Editor of Grant’s Interest Rate Observer, discuss Brexit’s potential short-term and long-term impact on the U.K. and European economy, the economic challenges facing China, and the Fed’s current position on economic growth. They also consider current monetary policy and global productivity trends.  

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: OK, I think we can get started. For those of you who don’t know me, I’m Sebastian Mallaby. And I work here at the Council. Welcome to today’s meeting on the World Economic Update. This will be on the record. And it’s presented by the Maurice Greenberg Center for Geoeconomic Studies. We’re going to get going with a panel of three speakers.

On the far—my far left, your far right, as he ruefully noted earlier, is James Grant, founder and editor of Grant’s Interest Rate Observer. Emma Dinsmore in the middle, cofounder and chief executive of R-Squared Macro, which is the hedge fund in Alabama, or a hedge fund?

DINSMORE: The?

MALLABY: It could be the.

DINSMORE: The.

MALLABY: The hedge fund in Alabama, OK. (Laughter.) And next to me, Lewis Alexander, managing director and chief—sorry—a managing director and chief U.S. economist for Nomura Securities International.

So I think it’s hard to not start with Brexit, which was roiling the markets, especially yesterday. And maybe, Jim, I’ll start with you. There have been a whole queue of sort of blue chip economists forecasting how much growth Britain would forego if indeed the country voted to leave the European Union. The latest person to intervene is George Soros, who predicts that you’d have a currency fall bigger than in 1992 when he made all that money by shorting sterling. How do you see the—I mean, clearly there’s a negative effect from leaving Europe. How big do you think it would be? Would it be in the currency? What do you think?

GRANT: Good morning, Sebastian. Good morning ladies and gentlemen. I would say, in the first place, that of all the prognosticators on the future of this British referendum, I dare say that George Soros speaks with unique authority, certainly with respect to the pound, and even more with respect to the downside of the pound sterling.

But, Sebastian, with respect to the myriad forecasts having to do with the imminent loss of this and that in Britain, in the event that leave should win, I would say that—I would ask of those people who have made these predictions, including the British Treasury, the governor of the Bank of England, and on and on, how many of them were on the right side of the events of 2007 and ’(0)8? (Laughter.) I would say the future is a closed book. And if all the economists think one thing, one is at least advised to imagine the alternative outcome.

It seems to me that fundamentally the question is not one of finance or of the future of growth in Britain, but rather of a philosophical nature. When Margaret Thatcher was dealing with the events of the late ’70s and early ’80s, she was accosted by the members of her party about the incomes policies that she had reviled. And they said: Margaret, you cannot do without them. If the government does not lead industrialists and unions in the direction—and you indicate a proper direction for growth, we will be in a very bad way. And she said, in effect, my platform is freedom. My platform is supply and demand and the individuals making choices in markets.

So between the economists predicting disaster on the occasion of a leave vote on the one hand, and as the alternative of perhaps a greater increment of freedom, a greater increment of opportunity—entrepreneurial opportunity, I would say, it’s at least appealing to give some thought to that latter.

MALLABY: So Margaret Thatcher was also, of course, a supporter of EU membership, although under terms which were tough that she negotiated. Maybe, Emma, so, you know, I guess Soros makes three comparisons with 1992. He says that when sterling came out of the exchange rate system then, at least when it fell it boosted exports. In this case, if it falls the export boost will be muted, to say the least, by the fact that you’re leaving a trade agreement, or you may be leaving that trade agreement at the same time. There’s a bigger current account deficit now in Britain so more of a reliance on foreign capital. And monetary policy is more constrained because interest rates are already so low. As somebody who trades macro how do you—do you think that’s right? Do you think that the risks of a downside shoot in sterling that could really be a Lehman moment for Europe are there?

DINSMORE: I think it’s really important to put it in context of what’s going on. In terms of the depreciation of the pound, I think certainly a Brexit is a huge headwind to the pound. Soros is estimating maybe 15 to 20 percent decline in the pound. I think maybe 10 to 15 seems reasonable. You’ve seen that across the board with economists. Mark Carney at the BOE has said that the pound would be very vulnerable in that sort of scenario. In terms of the trade implications, I think they’re somewhat muted by the fact that the euro is likely to get hit as well, and any kind of cross border trade there, there might be a little bit of a wash, although I assume that the pound will get hit greater than the euro. And that creates tremendous uncertainty.

I think beyond that, if Brexit passes, we’re looking at three years of negotiation for the U.K. to come up with its own trade agreements, which the U.K. has not unilaterally negotiated a trade agreement since the 1970s when it joined the EU. It doesn’t even have those infrastructures in place to do that. So I think that that—the uncertainty on that outlook alone, what that means truly for the U.K. economy, what the dynamics of the new trade agreements will be, how it will affect exports in an environment where global trade is already dampened, really certainly present headwinds for the pound. I expect credit spreads would likely blow out. But I don’t know if you would see a Lehman size event. I think more likely you’d see something more akin to what we saw with the European financial crisis.

And really, the response is going to depend on how credible central banks handle it. I think that they’re well-prepared. I think that there’s been a lot of cooperation among central banks. I believe that the Fed’s decision to delay rate normalization clearly influenced by Brexit. There’s clearly a lot of preparation on that front. So the extent there’s some credibility in there and a swift policy response, you might need some of that. But definitely short term volatility.

MALLABY: And, Lewis, the idea of a central bank policy response does run up against the issue of two things. First of all, the zero lower bound is not that far off, so how much can you really cut? And particularly how much can you cut without hurting U.K. banks? And secondly, you know, in an environment where you have an enormous current account deficit, you need to attract capital, cutting rates is obviously a problematic strategy. So do you—I mean, the Lehman idea, I guess, is that you have this shock. People are not expecting it. And that’s true. After yesterday, they’re not expecting it because of a few polls. If it’s unexpected and the policy response I complicated, could this spiral out of control.

ALEXANDER: I have a hard time getting to that, in part because while it—you know, we’re talking about very short timeframes. I mean, in some sense the two weeks before Friday was the period when markets were, in some sense, getting used to the notion. Second of all, I would argue the banking systems is substantially better capitalized than it was in 2007, 2008. So I think the inherent vulnerabilities around that are less. I would stress the fact that nothing really happens immediately with this vote. It’s just a recommendation. As was noted, it’s going to take a long time to figure out what it actually means.

And so I have no doubt markets are going to react, including foreign exchange markets, but I think—look, I would never say never, but I don’t think the right first-case assumption should be some sort of systemic issue. Look, I would sort of agree with the first set of comments, that it’s, you know, hard to know what this means in the long run. But I think it means some obvious things in the short run. One is a lot of uncertainty. And uncertainty is generally not good for economic activity. It’s particularly not good for economic activity in an environment where macro policy responses are constrained. So for just the issues of monetary policy, doesn’t have a lot of options; fiscal, doesn’t seem to be an option. So just the near-term dynamics of a significant increase in uncertainty without a policy response is problematic.

I would also note that structural reform, whatever its benefits in the long run, tends to be negative in the short run. It’s often hard to, I think, generate big changes in structure, even if they are ultimately positive, and orchestrate it in a way that generates a positive effect in the short run. And so the kind of near-term dynamics around whatever you think the benefits or costs are going to be in the long run, it’s hard for me not to see it as being a challenge in the short run. I do think the biggest issue outside of the U.K. is going to be the financial spillovers. And that’s the thing which I think is sort of hard to predict. But that’ll be the biggest issue outside of the U.K.

MALLABY: Jim, this issue of policy constraints—so, if we think about not just the U.K. but more about the euro zone, you’ve got not only monetary policy which is already very active—hard to see how it could be a lot more active. But also, even if you could theoretically imagine more activism, Germany is reluctant to let the European Central Bank go any further. So if there was—if there was a shock, and the shock might be Brexit or it might be something in the Spanish election this Sunday where the Marxist left is expected to get about a quarter of the vote—in the event of that kind of shock, the central bank is a bit constrained, fiscal policy is constrained by EU politics as well. You’ve been associated, I think it’s fair, with a view that policy is often too activist and you should let things adjust. Do you feel comfortable with that in this case in Europe? I mean, is the right thing to admit that we don’t have policy tools all the time? And would Europe be better off if it took the hit and?

GRANT: Well, I think Europe would be better off if the, as they are called, the authorities did less rather than more. I have in mind particularly the hyper-innovationism of the European Central Bank. You know, my business, my publication is called Grant’s Interest Rate Observer. So I speak with an interest, there are no more interest rates to observe. I’m a little bit sore about this. (Laughter.) But interest rates are prices. They are arguably the most sensitive and important prices in capitalism. They define internal rates of investment. They help us think about risk. They discount future cash flows for the benefit of investors and business people.

And I think the way to think about this word we use, this kind of surgically clean phrase, policy choices or policy tools—one way to think about this is the—is the government systematically administering prices which arguably ought better to be discovered in the marketplace. So you ask, Sebastian, about policy response to these prospective events. And I think it would be blessing indeed if some way or other, the European Central Bank decided it would not impose its will on interest rates in the euro zone. As it is now, the European Central Bank has gone beyond buying sovereign debt hand over fist to buying corporate bonds, such that we see securities issued by fallible, mortal corporations priced to yield less than nothing, meaning you pay them for the privilege of giving them your cash.

Certainly very little is ever new under the sun of finance. This is new.

MALLABY: This is Unilever you’re talking about?

GRANT: Well, there are 50-odd billion (dollars) of security, short-dated to be sure, that are being priced. I mean, as in Japan, value is no longer a consideration in fixed—well, I was about to say fixed income. That too is a misnomer. (Laughter.)

MALLABY: Fixed donation. Fixed donation securities have become the new—

GRANT: Yeah. So I think there’s—I think there’s a great deformation—deforming of markets. And the owner of that problem, I think, or the cause of that problem is principally the European Central Bank.

MALLABY: But just to press you, so the answer to this deformation is a reformation where the European Central Bank quits buying securities, therefore interest rates zoom up—

GRANT: Well, therefore interest rates are—interest rates are allowed to go where they might go, the better to discount future cash flows and to reflect risk. As it is, with sovereigns of no particular distinction yielding about nothing before tax, and corporations are the same, how are we to think about risk in any sensible way? And what lies beyond is massive interventions. How do we—how do we refinance these debts when they come due and need to be either paid or refinanced? So I think what you’re talking about, Sebastian, is the putting off of some—not necessarily an evil day, but it’s certainly a day of clarification.

MALLABY: Well, maybe we should switch on that, so we can segue to the U.S., where the Fed last week indicated that it would be looser for longer than expected some months ago.

GRANT: Expected some days before. (Laughter.)

DINSMORE: Well, the call from Carney came through.

MALLABY: Emma, one thing that Yellen cited in her press conference was actually foreign risk, which seems to mean Brexit risk. If we get through this referendum on Thursday and that risk is off the table, should Yellen go back to the tighter forward path? You’ve got—I mean, talk about where we are. We’re at full employment. Is inflation heading back to trend in a way that feels comfortable? Or is there still a case for keeping rates super low for a long time?

DINSMORE: So I think the challenge is you can’t look at the U.S. economy in a vacuum. So obviously the Fed’s mandate has to do with full employment and inflation, but in the context of today’s global economy, with declining GDP output across the globe and China exporting disinflation everywhere, the Fed has to be inherently concerned about what’s going on abroad. The Brexit obviously provided an acute risk for the Fed. The implied volatility of that if Brexit passes could be tremendously unsettling for the U.S. economy. So it certainly makes sense that Yellen would have taken a pause.

In terms of going forward domestically, I think the U.S. economy as a whole looks fairly decent. We’ve had a very long and somewhat lackluster—it’s not been a really exciting recovery, but we’ve certainly had a recovery. And I would say, if I’m looking at his from the Fed’s perspective, I think that the U.S. economic recovery is a bit long in the tooth, in terms of just a short-term cyclical recovery. And so if I’m in the Fed’s position I’m a little bit concerned about a potential downturn in the U.S. and sitting at such low rates.

MALLABY: But you could just trigger the downturn if you tighten prematurely.

DINSMORE: Right. Right. So that’s the conundrum that the Fed sits in. So I think that short term financial volatility caused by external factors obviously creates a situation where you do not want to be tightening because you add to that uncertainty, you add to the financial instability. But I think the Fed is clearly looking for opportunities to tighten. I think that—I expect them to raise rates maybe one or two more times by early next year, just to give themselves some policy room.

And I think if you look at the language that Yellen used in her latest statement, much less emphasis this time on inflation than on employment. So in the past, Yellen has been tremendously concerned about the headwinds to U.S. inflation—so low oil and the strong dollar. But as the base effects of those roll off the calendar, you’re now starting to really believe that inflation—disinflation in the U.S. is probably transitory. And so the outlook for inflation I think, from the Fed’s perspective, is likely stabilizing. Obviously it has a way to go, but still stabilizing. So that front is a little more comforting for the Fed.

And I think that on the labor market side, the labor market as a whole has been doing fairly well. Obviously the NFP print was a shock. I think there’s debate within the Fed about whether or not that’s statistically significant or if it’s noise. Obviously—as the economy reaches full employment, I think there’s some debate about whether or not we’re there, there will be some decline in job gains. It’s just natural sort of course of things. So I think the Fed is willing to look past that.

My base case scenario is that once the Brexit risks pass, the Fed’s going to look for opportunities to raise rates. If you see any decent type of employment numbers coming out, nothing suggesting that last month’s NFP was a new trend, then you should probably see the Fed beginning to raise rates again, maybe in September.

MALLABY: So, Lewis, this idea that, you know, the recovery is long in the tooth feels a bit, well, this person is old so we should sort of finish them off. You know, so long as it’s healthy—and healthy could be defined as stable on a medium-term view because inflation is 1.7 (percent), core inflation, and it’s not—it’s still below target. And as Emma pointed out, there’s lots of disinflationary force coming from outside, notably China. Why not just let it continue? What’s the cost of just letting growth grow?

ALEXANDER: I think the thing the Fed is concerned about is letting the economy get too far past what you might think of as full employment or whatnot. So the unemployment rate is currently 4.7, which is actually the low end of the range of the forecast for the long-term unemployment rate. If you, in some sense, just let the economy run and let that continue to fall, the Fed’s own interpretation of what drives inflation is going to put themselves in a position where they’re going to have to raise the unemployment rate at some point down the line to keep the economy from, in some sense, overheating down the road. And that’s problematic. And I think that’s the tradeoff they’re facing right now.

So I think we’re—if you look at the latest Fed forecast, it’s sort of interesting. They have growth at potential. So they’re—literally their forecast for growth over the next three years are exactly at where their long-run forecasts are. They’ve essentially got the unemployment rate going down a little bit from here, but not very much. And in some sense, they’re predicting an economy that is essentially moving along the full employment path. And you can think about the interest rates that they’ve written down as this is their judgement of what is the path of interest rates that’s consistent with that outcome.

Now, if the economy were to, in some sense, accelerate, I think you’d see them raise rates more. If the economy does not continue to generate pressures that have the unemployment rate falling, then I think they’ll sort of hold pat. But I think that’s the sort of logic of where they are. I totally agree that there’s no real urgency here. And in the wake of volatility and risk, they are going to be pretty conservative in terms of how they transition. But I would totally agree that if you get some better economic data they are on a trajectory where they believe they need somewhat higher rates ultimately to keep them on that path.

MALLABY: Jim, there’s been a couple of times I guess in the last couple of decades where the Fed has confronted a situation where price inflation seemed to be under control, and yet there were big imbalances building up in financial markets and probably, in my view, not tightening at those points was a mistake. So I’m thinking of 1999 where the tech bubble was inflating and the Fed was very slow to act because it thought price inflation ain’t there, so why should we? And kind of the same in 2004, 2005 with real estate. Do you see anything like that now? Is there a cost to sitting there with low rates because imbalances may be building up someplace in finance that could bite us later?

GRANT: Without a doubt. Certainly they’re—I mean, the Fed, since 2008, has been implementing a policy that might be likened to putting the cart of speculation in front of the horse of enterprise. Kind of the three-dollar phrase was portfolio balance channel. What the Fed intended was that a rise in the value of various financial assets, real estate, equities and the like would induce greater spending by the owners of assets. And this spending would, as it were, trickle down—that phrase, I think, was not used—but it would trickle down into other segments of the community. And we would be seeing the fruit of—well, the outcome would be greater aggregate demand. That was the idea.

And what we have achieved collectively is much higher asset prices. Commercial real estate, so-called cap rates, are very near the old highs. Interest rates you know about. Bond prices you know about. Equity is not quite sky-high, but certainly treetop level. And I think the Fed is in a bit of a bind with respect to the divergence between activity on the one hand and asset prices on the other. And so the industrial economy, it seems to me, is very near recession. Other portions of the economy, not so much.

But if you are in the business of engineering a rise in assets prices, and if the earning basis of those assets, as to say the real economy, is slipping away, what do you do? And by keeping interest rates low, and by encouraging further speculation in assets with borrowed money you are building yourself the next crisis, which will entail still a greater dose of radical monetary intervention. So yes, Sebastian, it seems to me that there are terrific risks associated with these policies. Not just last FOMC meeting, but the string of interventions going back even before the crisis of 2007 and ’(0)8.

 MALLABY: And we can maybe come back to that when we go to questions, which I want to do in a minute. But I want to get to China before we open it up. So, Emma, the concern amongst outside observers of China used to be you guys manage your currency and you’re exporting low prices, deflation, through that route. Now it is you guys have got massive overcapacity in steel and so forth, and you are exporting deflation through a new route.

From China’s point of view, the first strategy worked quite well, managing the currency for a long time. But the overcapacity is going to be more painful to work out. How do you think, both in the near-term and in sort of—on a five-year view, how does China work its way through this problem of enormous amounts of industrial capacity, with lots of debt associated with that, and no clear markets for the steel they’re producing?

DINSMORE: Right. Yeah, so I think China has two choices. One is to swallow the pill and make the reforms that it needs to do to modernize its economy and continue down that path. And the other is to kick the can down the road and to continue to refinance this and continue to go back to old ways of infrastructure investing and doing that. And so I think the better outcome for China is to move down this path of building a consumption-oriented economy, and accepting the slower growth in the short term that will come with that because ultimately the only way to work out this excess capacity is to grow a consumer base to use it and to accept the lower growth in the short term.

Obviously China—moving down that course is very challenging for China. I think that there are a lot of economic and political risks to them doing that, to having such a massive slowdown so quickly, and also globally challenging. So you’re seeing them defray to kicking the can down the road and continuing more of the same. But ultimately, I think China needs to start reforming—pushing through more structural reforms to create broader safety nets, social safety nets, to encourage more saving—or, I’m sorry—more consumption, and let that gradually work through the economy.

Either way, China’s going to export disinflation, whether it was through their low currency or through excess capacity. It’s going to be a fact of the global economy. There’s not much they can do about that. And really, China’s best outcome longer term is to tap into this potential—this really large potential consumer base. Over the long run that’s a much more sustainable economy for them. It’s much more stable and much more attractive, although short run a little painful.

ALEXANDER: Yeah, just to build on that a little bit, I think there’s a little bit of a kind of glass half full, glass half empty. China is slowing. They are doing this transition. It’s sort of a question of how quickly. I think we’ve seen over the last year that they have gone through cycles where it felt like growth was at risk, they provided some stimulus, but at the same time not full, you know, foot to the accelerator, in the way they did in, say, 2008 and 2009. They are clearly accepting a slower path to growth. And there’s sort of a question of does the transition path work?

Look, I think the domestic financial problem, which is essentially the financial counterpart to the sectors that have this excess capacity is going to be a challenge to manage domestically. I worry about it in a context where China is opening up in certain ways financially, which is making themselves more vulnerable to market dynamics and finance. And that’s an inherently challenging thing. I think they have the fiscal capacity to manage it. Essentially the financial system is fully backed. But it is—it is going to be a tricky thing. And they’ve got a large asset quality problem in their banking system, which is going to take them many years to sort of work through. But you know, I don’t think it’s obvious that it isn’t manageable.

I do think the overcapacity, what it implies for trade going forward, is something that we’re going to hear more about and have to worry about. Just anybody who’s looked at the history of the steel industry is the history of the steel industry globally is global excess capacity leading to trade problems, right? In the sort of ’60s it was excess capacity in Europe. In the ’70s and ’80s it was excess capacity in Japan. And now—and both of those problems are dwarfed by the situation in China. And so that is going to be something that we are all going to have to manage. And in an environment where, frankly, I think trade is going to be a bigger part of the agenda going forward, it is going to be—you know, it’s something we’re going to have to be dealing with.

MALLABY: Right. The politics of the West are not such that absorbing a surge in cheap manufactures is politically easy.

ALEXANDER: Yeah.

MALLABY: At this point, let’s invite members to join the conversation. Remember, this is on the record. So if you have a question wait for the microphone and I will call on you. One right here, yes. Coming up.

Q: Yeah, thank you. Juan Ocampo with—(comes on mic)—Can you hear me?—Trajectory Asset Management.

Jim, I got a question for you about an interest rate that cannot be observed, the so-called natural rate that John Williams of the Fed has written about for a long time, et cetera. As you know, 30 years ago that rate, as they calculate it, was 500 basis points, and now it’s—they tend to calculate it around zero. And it’s being used as something that interventionists, as you would say, for very loose monetary policy say, well, we have to keep it very low because the natural rate is low. The question for you is, do you think the rate—the natural rate is so low because of this ongoing intervention that’s been going on for so many years that the patient, essentially, is showing a different symptom profile?

GRANT: Well, I do. One shouldn’t dogmatize about an interest rate that exists only in the imagination of the mandarins of monetary policy. Actually, there is an extensive literature on the natural rate that antedates Knut Wicksell, who died in, I think, 1926. The so-called Austrian school, now mostly associated with Hayek and Ludwig von Mises, talked about a natural rate at which the demand for savings was equal to the supply force savings, not bank credit force-fed into the system through unique and heretofore unimaginable central bank actions, but rather savings—deferred consumption.

So I think that the notion of the—of this invisible friend to the central banks called the natural rate, this secret, invisible friend. This is a kind of a contrivance. I think it is an intellectual contrivance that is used in argument to justify these increasingly grotesque interventions. And The Wall Street Journal reported on the so-called natural rate. And somebody was, you know, it’s—you can’t see it, but you can infer its existence. It’s like the planet Pluto. (Laughter.) And I was thinking, no. They have not discovered Pluto. Rather, they have blundered onto Goofy. (Laughter.)

ALEXANDER: Can I jump in here?

MALLABY: Sure.

ALEXANDER: Look, you can make this concept very artificial and whatnot, but ultimately it comes back to a very simple question, which is: What is the relationship basically between growth and interest rates? This whole debate about the natural rate and how you measure it is really just looking at that. Let’s look at the last six months. The last six months, the U.S. economy has grown at about 1.1, 1.2 percent, with real rates that are essentially zero. I would argue that 1.1 is almost certainly below anybody’s estimate of what potential is. So the normal definition of the neutral or natural rate that is commonly used in the monetary policy debate is what is the level of interest rates that gets the economy to grow at potential? It’s a very simple observation to say that whatever that rate is, it’s in some sense lower than where rates are now.

And when the Fed talks about that, that’s ultimately the issue they’re talking about. And I think when you—when you seriously try and look at how the economy’s behaved over the last five years, it’s hard not to draw the conclusion that that relationship between interest rates and growth is very different from what we had before. Now, I think what you’re seeing in the discussion around these issues within the Fed is struggling to understand why that’s the case and to try to project forward, you know, how is that going to happen going forward? I would argue part of the problem with the Fed over the last five years has been they have been too optimistic about the recovery. What you’ve seen consistently is them overestimating growth and overestimating the path of rates that the economy could accommodate. Ultimately, that is about the path of this very simple concept.

Going forward, what’s going to matter? I think the simple way to think about the way the Fed is going to behave is they’re going to see how the economy responds. If the economy picks up, that implies that in some sense it can handle higher rates and they can raise rates. If it does not, they won’t. It’s really that simple. And in some sense, you can—you can make this a bigger deal than it is. But ultimately it’s about the very simple relationship between growth and the level of rates.

DINSMORE: And I think on that point, in terms of the Fed overestimating growth, I think at the end of the day economic growth as a whole boils down to confidence. And if people are confident enough to invest, if businesses are confident to invest, then you start seeing that. And I think that a lot of the Fed’s—I would agree the Fed has been overly optimistic. But I imagine the counterfactual, in which Janet Yellen says that she was tremendously concerned about the outlook for the U.S. economy and they didn’t have this level of optimism baked in, I think that would be disastrous for confidence. And I think that that also goes back to the question about exceptional monetary policy, and we talked about that in the ECB and the euro. I wonder in the absence of the ECBs intervention, which I agree has been quite unprecedented and exceptional, what really would the European economy look like?

GRANT: Yeah. Well, we talked about growth, which is an income statement concept. But we also ought to talk about leverage, which is a balance sheet concept. And if the Fed insists on pressing down rates, or at least not lifting up rates, or doing what it’s doing, I guess, is the way to think about its policy—if the Fed insists on persisting, it seems to me we will see a great deal more of what we are currently witnessing, namely the incurring of debt to generate income that is not there in the natural level, or the observed level of interest rates, the nominal rates.

What you don’t see is what is going on with the balance sheet side of things. You can observe it at intervals, but I think there is a preoccupation on growth to the detriment of our awareness of the dangers that heightened leverage to induce—or produce income artificially, what that goes to finance, and the kind of crises it introduces and the kind of responses to those crises.

MALLABY: Another question? Otherwise I’ve got a question. Oh, I see one over here, OK. Here, and then you.

Q: One of you observed that—

MALLABY: Could you just identify—

Q: I’m sorry. Arthur Rubin with SMBC Nikko.

One of you observed that if Brexit were to occur, that only would the pound head down, but it would probably have a negative impact against the euro. There’s a finite number of things that they can go down against, which implies an even stronger dollar. The Fed—various members of the Fed have been vociferous in saying that they’re not going to make their decisions based on what’s happening to the dollar in the rest of the world, yet it’s hard not to believe that at some level there’s kind of a veto over what the Fed does by where the dollar is. Do you think that a Brexit should occur, and if it did have this knock-on effect on both the euro and the pound, what does that mean for the Fed’s decision making policy and the impact of the dollar rates? For anybody.

DINSMORE: Well, I think if that happens you’re going to see easier monetary policy across the board. No country is supposed to—no central bank is supposed to explicitly target their currency as a policy lever, but obviously currencies influence inflation. And so it can’t be ignored. A stronger dollar is one of the biggest headwinds, I think—or potential upside risks—or downside risks of inflation in the U.S. And you would most certainly see concerns—or, renewed concerns about the inflation outlook for the U.S. if the dollar breaks much higher from here. And really, I think, as you look at the Fed’s concerns about inflation—so their two concerns about inflation had been low oil prices and a strong dollar. And the base effects of those on a calendar year basis are scheduled to roll off, and so you actually should see some inflationary pressures. But if you see the dollar spike again, that’s going to renew this disinflationary concern, and certainly I think would prompt Fed members to be hesitant to raise rates.

MALLABY: Teresa.

Q: Teresa Barger from Cartica Capital, visiting from Washington, D.C.

I would just love it if you could talk about two things. One is productivity. Pre-GFC, it was growing for 50 years at 2.5 percent, and since at 0.5 percent. That’s a U.S. number. I don’t—but similar in Europe and similar in the emerging markets. We’ve had a real stepdown in productivity. And where do you see we might get out of that? And the related question is with margins. Corporate margins have come down. I, of course, only know the emerging markets, but it’s also true in the U.S. And are we seeing any green shoots of an uptick? And where will that come from?

MALLABY: Go ahead then.

ALEXANDER: I’m happy to talk about productivity. First of all, I would question a little bit the way you characterize it. When you said 2.5 percent before the global financial crisis, it’s—

Q: Over 50 years too.

ALEXANDER: Well, but what you, in fact, had was relatively high productivity growth until around the mid-’70s. It then fell quite dramatically. We had a little bit of a recovery starting in the mid-’90s that lasted for a decade or less. And that’s kind of where you get that average, but in fact it’s not literally constant. In some ways what’s happened is we’ve come back to those lower levels we saw in the ’70s and, frankly, lower levels that we saw before the 1920s. This is—there’s a lot of interesting work that’s going on on this subject at this time. There’s a book by Bob Gordon, who I—it’s a little too long. It could have used an editor. But it’s actually a very good book.

I think there are good reasons to expect low productivity growth as something where it’s here to stay. It’s not that there aren’t positive things going on, but I think they’re less broad than they used to be. One of the simple ways to think about it is as wonderful as IT is, and lord knows that is the thing that we’re living with, how many people are actually—how many workers are made better by IT, versus how many workers are effectively substitutes to IT? When you think about the technologies that drove those previous waves of innovation—things like electricity and the internal combustion engine—one of the characteristics of those things was they made everybody. And I think we’re living in a world where that’s much less true. And so I think it’s reason to be less optimistic.

As I look at the data, I think there’s very little evidence to expect an uptick. And so my expectations are built on the judgment that I’m not expecting productivity to accelerate. That’s not to say that it couldn’t happen. Frankly, economists are lousy at predicting productivity. So we should say that very clearly. But I do think a low productivity world is part of what we’re living with. When you look around the world, at emerging markets and others, what you generally see is slowing productivity everywhere. It’s a little bit of a different story. The stories you would tell for the U.S., which we think of as being kind of at the frontier, is a little bit different than what you would think of as an emerging economy that presumably is not at the frontier and ought to be able to, in some sense, generate stronger productivity growth by moving towards the frontier.

I think you have to tell kind of different stories. But it is certainly true that the data would suggest that this slowdown in productivity is a near universal phenomenon. And that is part of the problem of the world we live in. I think we are living in a world where growth is slow. And I think I would—I certainly feel like monetary policy is, like, not the best too—and I would argue it’s the worst tool to address that. It may, of course, be the only one we can use at the moment, which is kind of a different problem. But there’s no question that there are other things that we ought to be doing to try to and address this. And the frustration is it’s just pick your country, you tell a different story for why that’s not happening.

 MALLABY: And maybe, Emma, we could pursue this a bit with you. Because I think, I mean, Teresa had two questions. And the other one was about corporate margins. And maybe they’re actually linked, in the sense that some of what’s going on with new technology is stuff gets produced which is valuable to consumers, the apps on my iPhone and so forth, for which the price—the explicit price is zero. So it doesn’t show up in a productivity gain from the company that makes it, nor does it produce a profit. It may produce a welfare gain, but we’re not measuring it. And maybe that’s the linking factor in these two questions.

DINSMORE: Well, I think it does. I think in the global economy, technology has really thrown a wrench into how we calculate productivity and how we think about it. And I’m not sure to the extent that technology accounts for what percentage of the decrease in productivity growth that technology accounts for, but it certainly has to account for some of it just because we simply don’t understand the true monetary value of data. And data flows are skyrocketing globally. And companies don’t necessarily know what they can monetize off of data. Governments don’t necessarily know what value they’re getting from it. And it’s hard to really derive any kind of productivity or economic value to data other than to see that data flows are tremendously higher.

And I think the question for economists over the next few years is how do we quantify that, and what does that mean for global productivity and how we think about growth, and what’s kind of the next wave? I think it opens a lot of potential doors, particularly in the realm of structural reforms and innovations for economies, because in some ways data is the great equalizer. You know, if I have a smartphone I can do things that I could never do with ten other devices. So I think that’s going to open a lot of doors for technological advancements and machination across a lot of emerging markets, which could be a really hopeful prospect for the global economy.

But in the short term, really, there has to be a lot of cohesion about what to do. And as we mentioned right now, the main policy response has been monetary policy. And there has been a real disappointing lack of anything else on the front of structural reforms or fiscal policy to really push that through.

MALLABY: But let me just suggest one analogy, and see if any of you want to pick up on it. So maybe this is sort of a Japan 1980s type of thing, where, you know, the Japanese were both—you know, the kind of—the stereotype about Japanese business was it goes for market share, it’s great at getting market share, it doesn’t have enormous margins, super competitive. And in some sense, technological shifts has driven a lot of businesses, it seems to me, into a mind frame where they want to get a lot of eyeballs, they know that technology creates lots of network effects if you’re the first mover, you have to create these platforms. You monetize down the road, a long time down the road. And in the meantime, you’re accepting thing margins, and you’re not—you know, you’re not making consumers pay for what you’re doing, and you’re willing to create both the effects that you’re talking about, both low corporate margins and low measured productivity. Does that—

GRANT: Yeah, they’re not only low margins, but nonexistent margins in the case—famously in the case of the many unicorns in Silicon Valley. Notice that zero percent interest rates allow the suspension, as it were, of disbelief about future earnings. And with respect to the measurement of productivity, one is reminded of the difficulties of measuring many economic phenomena. There was a wonderful book published about—I guess more than 50 years ago, Oskar Morgenstern, on the accuracy of economic observations. And he absolutely rips into the newspapers of the day with their credulous reporting of these data from the Commerce Department to the right of the decimal place. Can you?

And here we are talking about whether the rate the inflation that the Fed is targeting is 1.7 or 1.8, bearing in mind, for example, that YouTube is for free. I mean, how exactly—what precision do we expect of these measurements? And are we quite right in being, as Janet Yellen is wont to say, data dependent? I think the thing to know about Ms. Yellen, among other things, is that she gets to the airport three hours early for a flight. (Laughter.) She is not an impulsive person. And perhaps she is right to be data dependent. But one must think a little bit about the accuracy of the data on which one depends.

MALLABY: Lewis.

ALEXANDER: So let me—let me kind of say a couple things. First of all, corporate profits are at record highs. All right, so if you look at the corporate profit share, it’s come down a little bit over the last year, but the basic story of the last 20 years has been rising corporate profit shares. So, yes, there are issues in the tech sector, but it is not a generic problem for the economy overall—number one. Number two, one of the things to just be aware of—and, look, I spent three years working for the Department of Commerce. So I was the chief economist at the Department of Commerce, and sat over all these things. And trust me, I understand full well the difficulties in doing this.

GDP is not reality. It’s just a concept and it’s an estimate. We put way too much emphasis on it. However, there are certain things that all these numbers are benchmarked to. And for example, all of our basically aggregate measures are benchmarked to tax returns. So if the question is, are we mis-measuring productivity because we’re not capturing income, you have to believe—and if that’s going to explain the slowdown in productivity growth, you have to believe that tax evasion has gone up. Now, I’m prepared to accept that it’s gone up some, but the notion that it’s gone up dramatically is kind of hard for me to get my head around.

Alternatively, we know that our concepts of output in big parts of the economy are just very, very weak. So a big part of our economy is services. To be perfectly frankly, it’s a lot easier to measure physical stuff, right? When the economy was dominated by manufacturing, it was a lot easier to measure because you measure how much steel comes out of steel plants, you can measure, you know, how man locomotives come out of the factories. When you start talking about the output of, say, the health care sector of the financial sector, our concepts are a lot harder.

And so in some aggregate sense there’s a huge amount of uncertainty and mis-measurement around these numbers. But that’s not really the question. The question is what we are seeing is a notable slowdown in productivity. And to, in some sense, believe that that is because of mis-measurement, you have to believe that all of those problems have gotten materially worse. And I would argue the serious people who have gone out and asked that question come and say: You can explain some of it, but not most of it. Most of what we’re dealing with in the global economy is a weak growth in nominal income. And that’s—you know, that is something where the measurement issues are just much, much, much smaller. Most of this measurement stuff comes down to the distinction between nominal and real. Our ability to measure nominal incomes are a lot better. And what—the problem, I would argue, that we’re all struggling with is a nominal income problem.

MALLABY: Another question? Yes, right here.

Q: I’m Kenneth Bialkin with Skadden Arps.

When we hear your discussion, it’s clearly premised on a collective objective of improving our economy, our employment, and the condition of the American people, consumers and workers. What I’m confused about is when we talk about China, which you’ve talked about a little bit, when China’s rulers, who are not necessarily responsible to their voters, look at what to do with the U.S. economy in terms of their activity—selling, buying, moving, not moving—they don’t care about American productivity. They care about the interests that are interesting to them.

My question to you is, on the decisions made by the rulers of China as to how to act with relationship to the American economy, are they favoring, are they interested, let’s stay, in the employment rate of the Chinese worker? Are they interested in the welfare of the Chinese consumer? Or are they focused more primarily on political or other interests having to do with their longer-range prospects? In other words, a difference between China and America in this conversation that we’re having, how do you evaluate that?

MALLABY: Well, OK, maybe let’s go to Jim first. I mean, I think what strikes me about the question is that it is true that in a non-market economy with a lot of state direction the objection of certain patterns of trading and so forth may be political. So when you see a wave of Chinese external investment buying up German robotics companies or American hotel chains, is this purely a market transaction, they want to make a profit, or is there some political agenda?

GRANT: Yeah. Well, with all the humility of someone who lives not in China, but rather in Brooklyn, let me propose a couple of thoughts. One is there appears to be a rather urgent movement of funds out of China. My second observation is that I propose to you that China might be fairly regarded as a kind of financial dystopia, in which the state sets the rules principally for the benefit of those already in power, namely the Communist Party and the friends of the Communist Party. And I think that China is—financially speaking—is the world’s biggest problem.

And I suggest to you that one day we will wake up and hear or read that there has been a collapse in the wealth management products of the Chinese shadow banking and banking systems. These wealth management products are closed and, indeed, blind pools. One doesn’t know what’s in them. They principally invest in credit instruments—bonds and the like. Three-point-six trillion (dollars’) worth. In a $10 ½ trillion economy these things are growing $4(00) or $500 billion a year.

The principal technique for the redemption of wealth management products is the issuance of new wealth management products. And the word Ponzi was in fact applied to this phenomenon by a leading Chinese banker a couple of years ago. A couple of years ago means that it has been going on, and kept going on, and defying the bears who see in it—as do I. I certainly am bearish on this. I see the world’s greatest financial risk.

So, sir, you asked what the Chinese want. I think they want to remain in power. The rulers want to remain in power. They are interested in the manipulation of information to that end. They are interested in the manipulation of markets to that end. And I think that what is going on within China financially is very, very worrying.

DINSMORE: I think I would add onto that, if you look at the history of China since 1979, the rise in Chinese soft power globally has been economically driven. And for the Chinese government, the economy is one of its most powerful tools. No one would be talking about China if China didn’t have the extraordinary growth rate that it has had over the last few years. And so I believe that it is in the interest of the Chinese party to stay in power. And to stay in power, it is in their interest to keep their economy growing, at least at some rate that doesn’t cause social unrest, which is why I think that they end up kicking the can down the road and they don’t want to agitate anything in the economy, and try to be so cautious in that.

I think politically that creates a—starting to get out of my realm of expertise as an economist—but politically it creates an interesting backdrop for the Communist Party, where as the economy slows, there are increasing calls for more representation from the people. And I think that you’re starting to see some concerns among the Party members about their own hold on power as the economy slows. So you’ve seen a lot of finger pointing, a lot of dissension within the Party. And so, for me, I think if you’re looking at the outlook for China, there’s an inextricable link between economic stability and the ability for them to continue under the one party system.

MALLABY: Yeah. And last word for Lewis.

ALEXANDER: Just three quick things very quickly. First of all, I total agree that the biggest risk we face in the globe the Chinese financial system, and the risk of a problem there. That’s number one. Number two, the material improvement in the lives of the Chinese people over the last 30 years is probably the single greatest improvement like that we’ve—in human history. So whatever else you think about what the Chinese are doing, I think you kind of have to acknowledge that this is the greatest economic success story for the broadest number of people we’ve ever experienced.

The third thing I would just say is, it seems to me it’s on us to manage our relationship with China in way that’s good for us. And that I don’t know. You know, one of the problems, frankly, with China, one of the things I worry about, is we do not understand how they make decisions. So it’s hard—it’s hard to answer your question directly. But ultimately, it’s on us to make sure that our economic relationship with China is one that’s productive for us.

MALLABY: OK. So from Brexit to China, it’s been a great sprint around the world. Thank you to all panelists and thank you for coming out. (Applause.)

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