World Economic Update

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

MALLABY: Good morning and welcome to today’s World Economic Update. We have Jens Nordvig immediately to my left, the founder and chief executive officer of exante data, Rebecca Patterson, managing director and chief investment officer of Bessemer Trust, and the empty chair over there is Lewis Alexander of Nomura. The Japanese are famous for just-in-time production, so he will be here in just a minute. (Laughter.)

I’m Sebastian Mallaby here at CFR.

We’re going to talk about the world economy. I think it’s fair to say that the big picture is that the world economy is strong. Growth this year, the IMF forecasts 3.9 percent, above trend, above last year. But at the same time, the number of concerns and worries has been mounting. And one could list a trade war, U.S. rate hikes stressing credit in emerging markets, other credit markets—you could call Italy another emerging market perhaps—but sovereign debt in Italy, maybe U.S. corporate paper. We’re in the homestretch now of the Brexit negotiations, so all those of you who have understandably been snoozing through this incredibly tedious negotiation may be forced to wake up in the next few months before the March 29 deadline.

And I think there’s a sense beyond all this that the good news on the world economy is being propped up by an enormous fiscal boost in the U.S., which is not going to be sustained unless there’s yet another major tax cut. So in 2020 it dries up and then it’s a whole different ballgame.

But we’re going to start with the trade tensions, I think, and maybe with Rebecca.

You know, until this latest news on China, which we’ll get to in a second, if we just look at the European part of the trade relationship and then NAFTA, there’s been a sense that, you know, we’ve had peak trade. In other words, the concern has now gone to it got very high, then there was a bit of a détente with the Europeans, and now the Canadians are almost certain to cave and join the Mexico—

ALEXANDER: You’re very optimistic. (Laughter.)

MALLABY: What do you think? I mean, do you—leaving China out of it just for a second—

PATTERSON: Right.

MALLABY: —how do you feel about the other two parts of the trade picture?

PATTERSON: So my sense is that there’s a lot of political calculus underlying all the different trade negotiations going on around the world. And as we head into the midterm elections, which are going to be hotly contested, that the administration is thinking, where are we going to get the most bang for our buck? Where are we going to have the less risk of blowback to U.S. companies that could hurt U.S. workers or the economy? And so my sense is that there is a decision that China is probably the fight worth continuing to fight so to speak, and that’s not to say that there aren’t real issues here that need to be addressed.

I think, you know, NAFTA was written in a very different world. And reviewing and updating trade pacts makes a lot of intuitive sense to me, but how we’re going about it all at once with kind of arbitrary, seemingly, deadlines in some cases has created some difficulties between the U.S. and a lot of our allies. So my sense is that the administration is trying to come to some sort of resolution on pretty much anything and everything and really hone in on China. And again, it’s not to say that this is all political. There’s absolutely real issues that do need to be addressed.

MALLABY: And you were saying that you were in China in the summer, so what’s your read on that part of it?

PATTERSON: So it was interesting. I went over by myself just to meet with lots of different businesses, some informal advisers to the government, some government entities for a week, visiting a number of different cities, both first tier, but then also smaller cities, and went out to see some high-tech manufacturing plants as well in the middle of nowhere.

And even in July, I was hearing from companies that they were already receiving subsidies of some sort from the Chinese government to help ease the strain of the trade tensions. And I think that’s an important kind of bigger-picture issue that we need to keep in mind, that just because of the different nature of the government in China, they can take different types of action, sometimes in much more efficient ways, to try to offset the hit from trade.

So is there pressure on China to do something? Absolutely. I mean, they don’t like—their stock market is down this much, they don’t like the economy slowing. But do they have the ability to weather this storm for a period of time? I think they do.

And I would also just remind people that when the stock market in China is down significantly this year and growth is slowing, it’s not only the trade issue. Back in April this year, China took an important and positive step to try to reduce leverage in its system and try to get more structure around some of its financial products and processes. And that deleveraging effort has been a major contributor to tightening financial conditions in China and that has also weighed on the stock market and growth. So that is totally separate from trade and something America and other countries actually want China to do and now they may have to ease off that and postpone that because they need that support for growth for the moment.

MALLABY: Yeah, right.

So, Jens, I mean, it seems like the picture here is that if the Chinese cannot rely so much on external demand, they’re going to have to generate more internal demand, and so the effort post those two sort of not quite crises, but shocks from the Chinese financial system, which we had a couple of years back, the effort to make the system more resilient by deleveraging may now be put on ice. How do you see that playing out?

NORDVIG: Yeah. I think—I think that’s the very tricky bit, that they kind of have conflicting goals, right? On the one hand, they want to maintain a decent growth momentum, on the other hand, they don’t want to commit the sort of—make the mistakes that they did right after the crisis where they just had too much credit growth and again in 2015, 2016, that stimulus that was put in there was sort of, in hindsight, deemed to probably have been excessive and created financial stability issues. So they have to balance their growth goal with sort of a long-term financial stability.

And on top of that, there’s the sort of long-term strategy on the currency. Like, the long-term strategy on the currency is that we want to have an opening of the capital account and really since 2015 we’ve made very little progress on that front. We have a very closed capital account as it pertains to the rest of their ability to take capital out of the country. And the only thing that’s really been opened is foreigners’ ability to buy Chinese government bonds. So there’s some progress there, but it’s sort of a very micro part of the picture. So a lot of conflicting goals.

And I think we’re seeing it actually play out in the sense that, OK, many in the market are waiting for this big announcement that’s going to turn the sentiment, but because they have so many conflicting goals, the steps are kind of tentative steps and they don’t generate much of a market reaction. So from that perspective, it feels very different from the previous bottoms where there was sort of a decisive move that really turned things around. And it doesn’t feel like we’re quite going to get the same thing this time.

MALLABY: So you mean people are waiting for a turn of sentiment towards bullishness to lift the market up out of its fall.

NORDVIG: Yes.

MALLABY: Hypothetically, what would that be? Just a clear indicator on credit creation or—

NORDVIG: Well, yeah. Well, so the one indicator that a lot of people look at and I think is a very important indicator is the fixed asset investment, right? That has been the sort of vehicle that has been used repeatedly, effectively. And now, if you look at that time series, it’s a pretty scary picture compared to where we used to be, there’s just very little growth in that space and they’re reluctant to use it because they have that deleveraging issue in mind.

If you don’t mind, I think it’s worth taking a bit of a step back on the trade issue. So the market tends to get hyper, hyper focused on these specific announcements and the market is very, very good at sort of calibrating what specifically is the news. And in relation to the announcement we had yesterday, there was a ton of focus on whether is it going to be ten percent or twenty-five percent, and because the headline said ten percent it was perceived to be perhaps better than expected. Right?

If we take a step back and look at what it is we’re facing, a couple of months ahead the ten percent will become twenty-five percent, it’s already planned, so we will have twenty-five percent tariff on half of Chinese exports to the U.S. If you had asked anybody, like, a year ago or two years ago, what’s the worst it could get in terms of U.S.-China tension, they would have said something like that, that’s the worst we can get. And that’s exactly where we are.

And then what is in store in coming weeks is that China’s going to formally retaliate. We already had the commerce ministry indicate overnight that the retaliation is coming, it’s just a matter of time, they just want to have the details right, so that retaliation is going to come. And then my concern is that Trump is kind of hoping that his strategy has been now to be forceful and they’re not going to retaliate—he’s going to see retaliation come and then he’s going to start to think about the remaining half. So then we’re really going beyond what people thought was the worst case just a year ago.

So that’s the big picture. So I think from that perspective, this sort of micro evaluation of the specific headline kind of misses the big picture. This is, like, a very dramatic escalation and there is no negotiation. We’ve had an invite sent out, so a negotiation, it’s from the Treasury Department. And I think we know that the people who have been closest to these negotiations are not in the—in the Treasury Department.

We also heard Kudlow at the—at the New York Economic Club yesterday saying, OK, China needs to come to the table with something serious before this negotiation is really starting. So from my perspective, it feels like there is no negotiation, so it’s hard to see the end of this. So that’s the big picture.

MALLABY: Right.

Rebecca, so one of the problems, it seems to me, is that the demands set out at the beginning by the Trump administration, which were essentially that China should back off its ambitions on high tech, whether expressed through the theft of IP or whether expressed through enormous government subsidies to strategic high-tech sectors which are going to rival the U.S., that China should somehow give up on that industrial policy vision.

They’re not going to do that, right? So in that sense, how does one ever deescalate? If that’s—if that’s what the U.S. is asking for and if that’s what China will never give, how does this end?

PATTERSON: So I think a lot of us who do this for a living spend an inordinate amount time thinking about when and how do we get to a resolution. And I think there are ways to get there. I mean, China can certainly say it’s going to buy X-billion-dollars’ worth of U.S. goods, that’s fairly easy for them to do.

MALLABY: But they’ve sort of offered that already, right?

PATTERSON: Right, and it was rejected—

MALLABY: Right.

PATTERSON: —back in the spring, but they could try that again. I think they could offer more access of foreign firms to Chinese markets and new sectors. And that has happened to a degree, but even though on paper the sectors have been open, the reality for firms is that there’s still a lot of hoops to jump through, it can be very onerous to actually get inside.

And I was talking to a CEO of a large financial firm that’s now setting up shop in China and they were saying, yeah, we’re there, but to get from A to B to C can take months. But they could further that.

And I think it’s interesting at the end of this year we’ll have the fortieth anniversary of Deng Xiaoping’s opening up and reform and President Xi may want to use that as an opportunity to make a big bang about further opening up to foreign governments. So that could—that could be step two.

But to your point on Made in China 2025, their industrial policy or one of their industrial policies, they need this. So you have to remember, put on your domestic hat, and if you’re President Xi, you’re saying, OK, how do I continue Deng Xiaoping’s trajectory for China from forty years ago to now? How do I—how do I take that twenty years from now and remain in charge, keep my party strong, keep social stability? I have to have economic growth. You can’t get economic growth the same way Deng Xiaoping did because you have demographics that are becoming a greater headwind to GDP growth. You probably aren’t going to have the same amount of government spending given the debt buildup, so you’re going to have to rely increasingly on productivity, which is technology, which is where this industrial policy comes in.

So I can see what they’re trying to do. They’re trying to become a value-added economy, similar to Germany or perhaps South Korea in a sense, a push up per capita GDP that way. Can they find a way to do it where they’re competing with the West and the rest of the world, but not in the same way that’s happening now, which is technology transfer or licenses that, again, are a way to transfer technology? I think there has to be a coming of the minds that we can compete, we can both be global leaders, but we both have to agree to a certain set of guidelines/rules, and then abide by them. And if that conversation can happen and there can be some compromise there, I think we can get to a resolution.

But for America or any other country to tell another country you can’t have an industrial policy, to me, is a little ridiculous. I mean, Germany has Industry 4.0 right now. They have an industrial policy. America in 1983 had Project Socrates, we had an industrial policy. So every country will do what it needs to do to grow and political leaders will do what they need to do to stay in power.

MALLABY: Yeah. So to that extent, the opening demands that the Trump administration made to China have to be dropped for there to be a resolution and this administration is not likely to want to drop something which is so much in the public eye and is so much a part of the identity of, you know, populist economic nationalism.

PATTERSON: It’s also how it’s going about. I mean, publicly bullying a country like China, given its culture, given the goal for the Chinese leadership of saving face and looking strong to their own population, is not likely to be a successful approach.

MALLABY: Right.

PATTERSON: You know, if you read some of the works Kissinger has written on China, including On China, you know, there’s a lot of discussion in there about past decades where the most productive negotiations were ones that happened behind the scenes at a table saying we understand what you’re trying to do, you need to understand where we’re coming from, let’s figure something out. And that approach where it’s not losing face in a public way seems to be a lot more effective for that particular country.

MALLABY: And in a second we’re going to segue to emerging markets—other emerging markets—but I want to just ask one quick comment.

Jens made a remark in passing that the strategic goal for China is capital account liberalization. I just wonder whether you—when you were there in the summer, is that really still their goal? Because I associate that with the technocrats of the people’s—of the central bank. Xi Jinping is not a technocrat of the central bank.

PATTERSON: No.

MALLABY: And he—so do you think they really do want to liberalize the capital account?

PATTERSON: I think there are factions within the administration that do. And I think longer term, if they want to be a global player, that that’s probably something that will need to occur. But in the short term, I agree right now, you know, the renminbi is down about five, six percent against the dollar so far this year. It had strengthened a lot last year against the dollar, so it’s sort of just roundtripped and we’re in a backdrop of a stronger dollar. So the renminbi weakness so far this year, to me, isn’t particularly striking, but if they have more renminbi weakness and you start seeing those reserves go down as we did in the beginning of 2016, that can create a bit of a self-fulfilling panic. And I think they’re trying to avoid that.

So for now, given what’s going on with the trade, I think they’re probably battening down the hatches on the capital account as much as they possibly can. So if they have this longer-term goal, I think it’s definitely been put on pause. Maybe it’s still there longer term, but right now it’s not a conversation.

MALLABY: So my plan, Lewis—welcome—was to get trade and China out of the way before you arrived. And now we’re going to do emerging markets, other emerging markets.

ALEXANDER: Excellent, avoid all the hard ones.

MALLABY: But if—I thought it was hard for you to come in and then comment on people’s previous comments that you hadn’t heard. OK, so right.

PATTERSON: That’s what we said.

MALLABY: We have a rate cycle in the U.S., which is pressuring emerging markets that have large dollar exposures.

Jens, the two obvious problems thus far are Turkey and Argentina. Do you see them in a similar way, or do you think one is clearly more vulnerable than the other?

NORDVIG: Well, I think there’s one big difference, that is that Turkey has some very serious political tensions globally to a degree where they probably can’t get an IMF program. So it’s a very unusual situation that you have an emerging market country that has some very significant financing difficulties.

And they’ve had some very serious issues with their monetary policy, independence being in question, but there’s no backstop from the—

MALLABY: Central bank independence—yeah, yeah.

NORDVIG: Yeah. But that’s really very unusual, right? And if you sort of go through the last 20 years every time we’ve had an emerging market situation like this, it’s been always controversial to get the IMF program. But if the country wanted it, they could simply get it and that’s what’s different now.

MALLABY: Well, isn’t Malaysia in 1997 a country example? Mahathir said to the outside community get lost, we don’t like you.

NORDVIG: Yeah, they didn’t—they didn’t want it. But I think the difference here is that even if they want it they couldn’t get it.

MALLABY: I see. Yeah.

PATTERSON: I think Turkey, to me, I mean, both situations are unfortunate and tragic for the people living in those countries who are affected. I think Turkey has another element to it, which makes it, to me, much more relevant, which is just it’s more geostrategic than economic. Yes, it’s material that you have Spanish banks that own large amounts of Turkish debt, for example, but that, to me, almost pales in comparison to what could be longer-term issues tied to Turkey.

So Turkey has an agreement with the European Union that it’ll receive six billion euros in return for not allowing immigrants from North Africa and the Middle East through Turkey into Europe. And according to Turkey, it’s only received part of that payment and it desperately needs more sources of financing right now. So Turkey actually has an interesting degree of leverage in all this with the rest of Europe.

If Europe doesn’t give them financial aid to get them through this crisis, one lever it can pull is opening the doors, so to speak, and letting more immigrants into Europe. And now we’re at a point in time very different than 2015-16 where a lot of these European countries that initially opened their arms to these immigrants today politically can no longer do so. And we’ve seen that in Germany and Italy and Sweden and in others.

So if you’re Angela Merkel—and let’s just face it, that’s the country that has the money to kind of move the needle here—if you give a bailout to Turkey, you’re going to have a part of your populous that’s angry that you’re supporting an autocratic person who doesn’t believe in human rights. If you don’t bail out Turkey, then the immigrants, there’s a greater risk that they come back in again, which is hurting you politically. And you have a risk that Turkey then says, fine, you’re not going to give me money, I’ll get it from Russia and Iran. So geopolitically, it puts Europe in a very delicate situation.

And in the U.S., there are still levers there as well. We have military bases in Turkey that are absolutely critical for us, NATO bases there as well; we need those bases to stay. So it’s—to me, Turkey is very important not just as an emerging market that’s pushing investors out of emerging markets broadly, but also from these kind of longer-term geopolitical issues that I don’t necessarily see how they’re easily resolve.

MALLABY: Lewis, on Argentina, the government’s raised the interest rate to 60 percent. A, can they sustain that domestically? And, you know, B, even if they did, are the markets going to carry on financing the country?

ALEXANDER: I think for a time the answer is yes. That country has obviously had its ups and downs over many—(off mic)—they have, I think, the scope to get through this with the support of the IMF. So I’m, you know, cautiously optimistic about Argentina.

I think the other thing I would stress about this is each of these cycles are similar in many ways and different in important ways. One of the things that is different is the swing in monetary policy is much less severe than it was in the past. If you think about what led up to sort of the crisis in Asia—first in Mexico and then in Asia in the ’90s, the Fed moved rates three hundred basis points in twelve months. It was a more severe shock. And if you go back to the one before that, which was Volcker, it’s even more severe.

Yes, there are dollar-debt issues in many of these countries. But to be perfectly frank, they are lower and less severe than you had in Asia where you had had fixed exchange rate regimes and had balance sheets that had FX exposure.

Sorry. You had balance sheets that had FX exposure that were a much bigger problem. So, yes, it rhymes in many ways with this, but I would stress the differences as well.

Jens’s point about Turkey is an interesting one. The one that occurs to me in the ’90s was Taiwan, actually. So if you thought about the Asian countries that were under pressure at that period that could not count on international support, the interesting one was Taiwan. Now, in that case, I think they had in fact been quite prudent about that. They had a more flexible exchange rate regime than others. They had more reserves than others. So they were in a position to weather it.

I would agree, Turkey has not—does not benefit from those advantages. And it is—I think it is an interesting case. But I would sort of come back to the notion that the swing in external circumstances, which is driving this, is just not as severe as the ones we’ve had in the past. And yes, stress is coming as it inevitably does, but I think it’s not a completely direct analogy.

PATTERSON: Maybe one quick point just to add to that. If you think about 2008 and the crisis then, remember the years preceding had been the era of the BRICS. And every investor in the world wanted to have emerging markets, and so you had a lot of capital that had moved into these economies and these markets and all of it rushed out a door very quickly when the crisis hit. We have seen net capital inflows into emerging markets against over the last few years in part for a search for yield. We saw that with the Argentine hundred-year bond just a year ago. But the amount of capital in these markets today, relatively speaking, is smaller.

So, yes, you could get more capital outflows that continue to drag on the currency, which then, in turn, can create inflation. But I think the degree of the potential pain, at least relatively speaking, is smaller than it was ahead of the run above the last recession.

MALLABY: Jens?

NORDVIG: I think—I think I’m a little bit less chilled out about this dynamic.

PATTERSON: You look pretty chilled out. (Laughter.)

NORDVIG: Yeah. Well, so—

MALLABY: I’m very worried indeed. (Laughter.)

NORDVIG: I think the issue is that, obviously, Lew is right, that on interest rates, sort of the range of interest rate movements is clearly much lower in this cycle. But there’s other types of sort of liquidity provisions that we’ve just never seen before and we don’t have any template for really thinking about how important they are.

So, like, one of the things that I’ve spent a lot of time looking at in the last couple of years is really to think about, if we really dissect the flows to emerging markets, it seems to me that, especially in terms of debt flows, it hasn’t really been the U.S. that’s been so important, it’s actually the Europeans that have done just a huge kind of portfolio of substitution trade where the ECB took out the bunds and the OITs (ph) from the market, right? And all the investment managers that held those assets, they went on a massive scramble for any kind of yield around the world, and you can see it very clearly in the—in the data.

If you look at all the aggregate flow that has come into EM debt essentially since the ECB QE started in 2015, it’s almost entirely accounted for by European flows. Like, the Japanese flow is borderline irrelevant. The U.S. flow in that space is almost irrelevant. So I worry that even if we don’t have much sort of variation on interest rates—and obviously, the ECB has not hiked rates yet—there is this liquidity provision that was just really supportive in ’15 and ’16 and ’17 and now the ECB’s tapering this year and will fully taper in Q4 and in January. And I think that’s a big drag. So it’s just one of those things, we don’t have a historical comparison how important that is.

And then on top of that, like, there’s also something going on with the interest rate variation in emerging markets. So we have massive currency moves this year, right? It’s not just Turkey and Argentina. We’ve had a really big one in Brazil. We had a really big one in South Africa. And guess what their interest rate variability is? Zero. There’s been no rate hikes in those countries. That’s also something that’s really unusual.

So that makes me think—obviously, in a way you can say that’s a sort of resilience that they haven’t been forced to do that yet. But on the other hand, if you trade the currencies, if you own those currencies, that’s going to make you more worried I think.

MALLABY: On the other hand, Russia has moved in response to exchange rate pressure, so it’s a mixed picture, right?

NORDVIG: Yeah, a mixed one, yeah.

MALLABY: You want to add?

ALEXANDER: Yeah, I just—relative to periods in the past when you had obvious sort of break points, I’m thinking about the pegged exchange regimes in the ’90s, clear fiscal sustainability problems like in various points and various countries. When I look at it today and I look at those reactions, you don’t see quite the same, OK, if it gets to here, that’s obviously kind of a breaking point. And it frankly feels like a more normal response.

The point about flows, I think, is the—is the hard one, right, in that we’ve—obviously, what central banks in the major countries have done is very different from anything else we’ve kind of been through. We’re obviously at a point in transition. I think it’s fair to say at this point that what the Fed has done has left pretty minimal imprint on markets so far. That in and of itself is a bit of a question given what’s going on on the fiscal side.

But I think that is—I would agree with you, Jens, that, like, to me, that’s the big thing I don’t—but it’s different. I’m not sure I fully understand.

MALLABY: Is this a segue here? I want to come to the members in a second. But we’ve been talking about the headline preoccupations, trade war, especially China and Turkey and Argentina.

There’s one sort of structural thing which I’d like to ask you, Lewis, quickly about, which is the whole global picture is underpinned, to some extent, by a strong U.S. economy driven by a big fiscal impetus. That, I think, peters out in 2020. Do you see a big recession risk in 2020?

ALEXANDER: I would say I see a growing risk. I would actually say it starts next year. Look, you know, our estimates suggest that the peak benefit to U.S. growth from fiscal policy is right now and that—and that I think of ’19 as very much as the transition year. As you essentially come off the peak, it will still be supporting growth. And as you make that transition and add into it whatever drag you get from other things like trade, right, the risks of a recession goes up. Now, it’s not—I don’t have one in my forecast. I don’t think it’s, like, part of the modal forecast. But I think you have to look at it as the further out you go, the higher that risk becomes.

To me, there’s this—there are kind of two big questions about the U.S. outlook. One is, have we gauged correctly what the aggregate demand effects of fiscal policy is? I view myself as sort of being on the pessimistic side in the sense of I have it tailing off more quickly than some other analysis. There’s other analysis that is more credible that would have the aggregate demand effects lasting longer.

Now, if it’s just that, it then becomes a question of the mixture of demand and interest rate. Because if you’re not doing anything on the supply side, you’re already past full employment and I tell you you’re going to get more aggregate demand, you’re just going to get higher interest rates.

So there’s a crucial second question, which is, is there anything going on in productivity? Do you buy a kind of supply side story from fiscal or anything else is a crucial judgment? I don’t see it. Could it happen? Yes. I’m not convinced that fiscal policy is going to drive it. I think if we’re going to have that surprise, it’s going to be more because of the way information technology is being incorporated and we get some sort of boost to—you can—there are plausible cases you can make for that.

I don’t see it in the numbers yet. But that is the thing that is the other piece of this story. But I do think you have to think of ’19 as the transition year from where we are right now to something that’s more pessimistic.

MALLABY: OK. Let’s go to members who’ve got questions.

Let’s go to Jeff first of all.

Q: Jeff Shafer, J.R. Shafer Insight.

You have, more or less, minimized the risks that Sebastian has presented you with. Could each of you say over the next two years what is the single thing that could happen—maybe not high probability, but could happen—that would lead to a serious global disruption?

MALLABY: Good question. OK.

Should we just have two sentences from each person? What’s the one thing?

Lewis first.

ALEXANDER: Look, a financial disruption in China, as hard as that is to imagine, is just so big that it’s hard not to put that at the top of the list. The second one I would say is U.S. corporate debt, which is—we’re in a sort of cycle. I think as the economy slows, we should expect defaults to go up. That’s another thing that I would put on that list.

PATTERSON: I’d say a capital war replacing the trade war between the U.S. and China. You know, we’re hearing that China’s already talking about qualitative measures it can take to hurt the U.S. in retaliation for trade. Could that ratchet up? I’m not talking about renminbi devaluation necessarily, but other forms of—and we’re seeing it with an expanded CFIUS. Could that ratchet up to a much, much greater degree? That would be one.

Two, for me, would be a renewed European crisis once the ECB backs off buying assets. If the Italian government decides to embrace fiscal largesse and we have another wave of immigrants and Europe no longer wants them, what’s the policy response, what’s the market response?

I worry that next year, which is the twentieth anniversary of the euro, incidentally, could be the most challenging year they’ve faced so far, especially if the markets are starting to anticipate a U.S. recession.

MALLABY: Jens?

NORDVIG: Yeah, so now a lot of—a lot of—

PATTERSON: We took the good ones.

NORDVIG: —a lot of things are taken. (Laughter.) So I would—I would probably emphasize the Italy thing. It’s a—it’s like a very important next few months where we find out whether the populist government that they have is going to essentially give up on their campaigning rhetoric. So we’ll figure that out. Right now it’s not clear if the technocratic people they have in the finance ministry and even the prime minister sort of get to set the tone, then I think it will be OK. But if not, then we could have a major situation there that really is much more serious than anything we’ve seen because Italy is so big.

MALLABY: OK, yes. Let’s go over there.

Q: Robyn Meredith, the author of The Elephant and the Dragon.

It seems to me that so far much of the talk about China has focused on the market reaction to the trade war and that tends to understate the potential effects. And so, Sebastian, I wonder if you could talk about what you’re hearing from sort of real world versus financial world, like, from actual companies operating there. Because knowing a bit about China, I suspect that China is already substituting U.S. made, you know, U.S. companies’ components and any U.S.-made components, substituting Japanese, Korean, Taiwanese, et cetera, in all of the many, many things that they make in the global economy.

MALLABY: I’m not the best person to ask about substitution by Chinese companies. Maybe I’ll ask Rebecca on your specific question.

But since you point to me, the thing which we didn’t raise today, which I think is important, is it’s not merely the level of tariffs that drives trade, it’s also the certainty or uncertainty around tariffs. And that’s something where the, you know, the fabric of certainty around a kind of rules-based trading system has been smashed up. And it’s hard to put the pieces back together again.

And so it seems to me that there’s a lasting cost in terms of companies trying to think about, you know, far-flung global supply chains, are they really resilient, can you rely on them? I think there’s going to be a recalibration and a sort of bias, a stronger home bias to how you organize your supply chains in the future because of that uncertainty.

I also think that, you know, there are consequences for the relationship between the two most powerful countries in the world, which go well beyond trade. The estimates I see on the GDP effects of even a major trade war—I mean, first of all, it’s hard to model this stuff. But second, you know, when you do, you get effects like ten basis points in the U.S., twenty basis points in China. Maybe you guys have seen or done much higher results.

But it’s not—you know, ten basis points off U.S. growth when you’re already growing way above trend is not—that’s not the point. The point is more a longer-term hit to confidence in the rules, stability in the biggest geopolitical relationship in the world.

PATTERSON: I’ll just add quickly to that.

MALLABY: Yeah.

PATTERSON: So again, this was July, it’s now September, so things may and probably have changed, at least marginally, but when I was there, I probably spoke with a dozen companies from very different sectors—personal care products, after-school tutoring, local banks, you know, real estate firms. Everyone was very much aware of the trade issues and nervous about it.

There were at that time already a few, in major cities, campaigns to buy domestic. And we’ve seen that before when China and South Korea have had some issues. So, for example, in a couple of the larger tier-one cities I was in, there is a local Chinese coffee shop now and it had signs in the widows “drink us, not Starbucks.” So things like that are starting—forgive the pun—to percolate. And I would expect that probably can continue directionally.

But to echo your point, Sebastian, when I speak to American companies, most of them—and I think this is true in China to a degree as well—to change your whole supply chain is incredibly disruptive and costly and time consuming. And it’s not clear, I think, to either side how long this lasts. If we get to 2020 and we have a different administration that has a very different view on trade, why would you spend the next eighteen months starting to make this change when you could just reverse it or just bide your time? I’m getting the impression from companies I speak with that a lot of people are trying to find the lowest-cost denominator fix to get through this and then hoping that it reverts to some more traditional relationship after.

MALLABY: Another question? Yeah, let’s go here. Yeah.

By the way, I should have mentioned that this is on the record, just to remind you all.

Q: Bhakti Mirchandani, FCLT Global. Thank you for an interesting overview of the world economy.

I’d like to pick up tangentially on Rebecca’s point about a potential capital war. What are your thoughts on the implications of falling FDI into the United States? How much of a—of a problem is it?

PATTERSON: So I’ve been—

Q: Could you repeat the question?

PATTERSON: Yeah. Yeah.

MALLABY: The falling FDI to the United States, how much of a problem is it?

PATTERSON: Yeah, I think it’s becoming a global problem, not just U.S. So, you know—and I should have earlier, you know, part of this Made in China 2025 initiative that makes the United States anxious isn’t just economic power and technological prowess, it’s also military. A lot of this technology can be used in a military function that also creates some anxiety in the U.S., reasonably so.

So strengthening the CFIUS, the Committee on Foreign Investment in the U.S.—I think, if I’m getting it right—and there was law passed as part of a defense bill in August to broaden the definitions of what can be reviewed by this committee and potentially stopped. Even in anticipation of this legislation, FDI from China to the U.S. so far in 2018 is down something like ninety percent from levels last year. So you’re already seeing incoming FDI basically come to a sudden halt.

And it’s expanded to secondary and tertiary issues. So, for example, if there is a German company that wants to make a strategic acquisition in the United States and they have a Chinese subsidiary and they worry about those links, they may block the transaction even with a German company, as a hypothetical example to explain this. It also goes into real estate.

So FDI is absolutely important. It’s an important part of the capital flow that supports the dollar. You’ve now seen Germany enact similar legislation, you see the U.K. discussing similar legislation, Australia has similar legislation, China—

MALLABY: You mean legislation on inward investment for national security?

PATTERSON: On reviewing M&A and FDI flows and possible announcements that could hurt national security or, frankly, just hurt national champions.

And so if you have global trade slowing and you have global FDI slowing, I think that absolutely would have—albeit a longer term, kind of the frog boiling slowly—market implications.

MALLABY: Yeah.

ALEXANDER: I’d just like to make the observation that I think you have to think about that whole question in a context of significant structural change in a variety of dimensions, one of which is actual physical investment is less important, much less important than it used to be. It’s much more about technology and intellectual property, number one.

Number two, we’re operating in a world where globally there are more very large firms that are operating in this. And you have to think about this in a context of it’s really about technology, how it’s evolving, who controls it, and whatnot.

I think there’s a fundamental question as to whether or not the old regime was really adequate for those structural changes, quite independent of anything that comes from Trump or whatnot.

I would add to that—I think showing my age—but when I go back to the ’90s when we were—I was in Washington and thinking about the global architecture, we had this vision that the world was going to—the rest of the world was going to get rich by becoming more like us. And so you had this system—you had this notion in your head of a system where the component pieces of it had systems that were basically compatible.

I think what we’re seeing with China is that that doesn’t have to be the case and that China’s approach to this is quite different. And I think you have to start thinking about a global regime for these things where you don’t have the same degree of consistency and the component parts that we had sort of long assumed.

MALLABY: Meaning that you can’t assume that China is evolving towards a sort of friendly, open system?

ALEXANDER: Exactly.

MALLABY: Yeah.

ALEXANDER: And to the extent that we are used to thinking about the rules as being ones where the individual countries basically had a consistent approach—and frankly, that’s what was embedded in the WTO agreement for China in 2000 was the notion that that was the track that they were on. And so quite independent of kind of Trump, I think this combination of the rising importance of intellectual property, generally, the rise of very large firms, and the degree to which sort of international investment is being driven by those factors in this environment where you’ve got at least one big player that really has a very different view of this, like, those facts by themselves kind of require you to think about this differently.

MALLABY: Yeah. I mean, just let me add one thing and then we’ll go to another question. But I do think that the moment when Google decided to not roll over that defense contract because it didn’t want to do AI work for the U.S. military, which might be used for lethal purposes, was a very interesting and related point where, because Google’s scientific faculty includes a lot of people from Iran or China or wherever, you know, the staff doesn’t feel happy contributing intellectual property to the U.S. defense effort.

So in other words, you’ve got this shift in the system, as you say, where you can’t assume that we’re evolving towards a kind of happy comity. But the unit parts, the corporations, have been built on the assumption that we are, that you can have a multinational faculty of research scientists, right, but then at the same time Google is an American company, so it’s split down the middle.

Another question? Yeah, let’s go here.

The microphone is right there, yeah.

Q: Byron Wien, Blackstone.

Two of the issues that you’ve raised in terms of threatening the world order are corporate debt and Chinese debt. But U.S. debt, the federal debt, is now twenty-one trillion (dollars) and it’s going up a trillion—or the deficit is a trillion (dollars) a year. And yet, even though there’s been an escalation of debt around the world, interest rates and inflation have stayed low. What’s going to change this? Isn’t this something that is looming, that is going to change the economic outlook for the world? Haven’t we accumulated too much debt? And in the U.S. particularly, aren’t we unilaterally accumulating more debt than we can really handle?

MALLABY: OK, who wants to take that? What’s the problem with more federal debt? What’s the downside? You have the reserve currency.

PATTERSON: Yeah.

ALEXANDER: So let me—let me react to that a little bit. First of all, I would distinguish private and public. I did talk about corporate; one of the things I didn’t talk about was households where I think the situation is better. I think corporate, it’s a cyclical issue and whatnot.

I do think there are good areas why structurally over time you can sustain higher debt levels. Frankly on the consumer side, I would make the argument that what credit bureaus can do today has a better understanding of the fundamentals of individuals that all you to sustain higher debt levels. So I’m not—I’m not in the camp that says debt, like, can’t go up.

With respect to the federal side, you know, I can give you a long economic explanation for why I think the supply effects have not manifested themselves and why they will going forward. But frankly, I’ve been worried about that my, you know, my entire professional career. And I have, like, the CBO long-run projections in my (‘dex ?). And I’m not sure I totally understand, like, what’s going to be the thing that sort of pushes you over.

I do think that as we transition back to a more normal monetary policy environment, so as we bet away from the zero lower bound, as the Fed balance sheet shrinks, the risks that the supply effects will start to manifest themselves in U.S. interest rates go up. And so I do think it is something that will be a—is more likely to be a problem going forward as we go down that.

But fundamentally for my professional career, we’ve been in a world where globalization of capital flows has meant the rest of the world’s demand for the assets we produce has been greater than our ability to produce them. Now, that can’t go on forever, but I don’t see a lot of evidence of that being something that’s going to be an acute issue soon.

PATTERSON: There’s just no options, right? So if there are other countries around the world that, for economic, because of our debt levels, or political reasons wanted to not own U.S. debt, where do they go? You know, until you harmonize European bond markets, which politically doesn’t look likely anytime in the foreseeable future, they don’t have the same depth, liquidity that the U.S. market has. It doesn’t look like that’s going to improve or change. China perhaps someday—well, it is on track, I mean, it is deepening its debt markets, but it’s in early, early stages of that. Maybe in our lifetime you’d also need an open capital account.

If you had a harmonized European bond market, that could change the equation overnight, in my view. If China continues down a path of deepening its bond market and opening up its capital account, that could change the equation. But until then, you have this one behemoth debt market that can absorb a lot of capital and no one else has a rival to that.

And so I think you could see interest rates rise. You’re certainly going to see tension as interest expenses for the government rise and that takes more resources away from other programs. Especially as we have aging demographics or entitlement costs keep going up, that’s going to be a stress point. But in terms of people suddenly fleeing the U.S. debt market because our debt GDP break a hundred percent, which it’s on track to do over the coming decade, where do they go?

MALLABY: Yeah. And by the way, the earlier tenor of our discussion was what these potential rivals to the U.S. debt market as a creator of assets that people can hold, they’re not accelerating towards rivalry, right? I mean, the Chinese are going to put on hold their move towards capital account openness because they’ve got other things they’re more concerned about. And, you know, Europe has Italy to worry about. And Macron’s grand speech for, you know, creating greater deepening and fiscal transfers in Europe, you know, dissolved on contact with German intransigence. And that’s not changing.

ALEXANDER: Did I—and did I miss the discussion on Brexit?

PATTERSON: No, we saved it for you. (Laughter.)

MALLABY: We haven’t—

NORDVIG: Can I make a quick comment on this?

MALLABY: Yeah.

NORDVIG: I would just make one quick observation really. Like, so we’re in a super interesting part of the cycle, right, where we’re seeing some growth and we have to figure out where it’s coming from. Some people, maybe determined by their sort of political views, will think, OK, there’s some underlying improvement in the potential. If you have that interpretation, you can extrapolate a bit into the future. Some people will think, OK, this is purely, like, a temporary demand stimulus and it’s going to go away very soon. So how you view the debt is going to be very much a function of whether you’re sort of hopeful that there’s this potential growth effect in the equation or whether it’s not there, you can’t see it very clearly in the data, right, time will tell.

But I think also, because people have political views and maybe sort of different weight on parts of academic literature, this is just a big debate that is not going to be resolved on this panel. And from a market perspective, it’s crucial, right, because the answer to that question is going to be very important as to whether this debt buildup is ultimately really unsustainable and is going to cause a big recession.

So I think from an investment perspective, like, this is one of the most important questions. And it’s just so crucial to how you position yourself into this recession or not recession that people are talking about.

MALLABY: OK. Another question? Yeah. Let’s go over there. Yeah.

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

The world today seems to be dominated by bilateral issues. What do you see would be a change in role for the World Trade Organization, TPP 11, or maybe China and Japan’s support at regional, comprehensive, economic, big partnership in Asia? Thank you.

MALLABY: How does multilateralism come back?

PATTERSON: I was thrilled to see that there are a group of countries reportedly led by Canada looking at the WTO. And I feel like WTO is ripe for a brand refresh and maybe a modernization. And I think if you had a trade dispute mechanism that was more efficient, that would certainly help.

You know, TPP, I think it’s really a shame that it didn’t get enacted more broadly because it was really a modern trade agreement and I think really addressed a lot of the issues that are there on both sides of the U.S. parties and on the political spectrum, and in other countries it probably would have been a positive thing. And maybe it’ll come back.

You know, I guess my gut is that countries tend to come together most when they have to. And whether the recession is 2019, ’20, ’21, et cetera, when there is a global challenge and you need each other to get out of it as quickly as possible for your populations, you’re more likely to work together. Maybe that’ll become an inflection point that we look back at as a good thing. I mean, we’ve seen it before. 2008 and ’(0)9, there was a tremendous amount of global cooperation.

I don’t have as much confidence it’ll happen again given the world we’re in right now, but I’m hopeful that when push comes to shove and you need your neighbor to get out of the muck quickly, maybe we will.

MALLABY: But surely, the crude answer is that the entire post-1945 collaborative architecture was predicated on the role of the U.S. as the dominant player that could corral others and sort of, you know, quarterback the global system. And if the U.S. doesn’t want to play that role because the Trump administration has a view that actually bilateral trade balances matter, it would rather deal bilaterally—almost not even bilaterally, just actually personally leader to leader—you know, Trump said in a recent thing about China, you know, President Xi and I, for whom I have great respect and affection and we know we’re going to work it out, it’s this personalization. If the U.S. is in that frame of mind, you’re not going to get multilateral cooperation. I mean, show me the example—maybe I’m missing something—of a—of a proper multilateral collaboration that didn’t have a dominant power that essentially led it.

ALEXANDER: So I’m going to agree in some ways and disagree in others. Look, there’s no question, if Washington remains the way it is that, yes, those challenges are huge and it’s hard to see much progress. I think the real question is, what happens after Trump and how permanent is that aspect of what Trump has represented? I think the jury is still out on that. I’m a little more optimistic about the fundamental economics of globalization as driving you towards these things.

My basic answer is there’s no real practical alternative to multilateralism in terms of dealing with an economy where transportation costs are low, information is much more important and it’s, like, essentially costless to have that across borders. Like, I just—I think about the problems we all deal with, like that’s going to drive you to some sort of multilateral solution if you want to be practical. But, like, it’s the—it is this question of sort of, what happens after Trump?

I think there’s also—there’s a slightly different question which I think is interesting right now, which is, in many ways I view Europe as the, like, the leading edge of globalization. Right? It’s further along in trying to do what I just described than anybody else. But you’re seeing the tensions, right?

MALLABY: That’s an understatement.

ALEXANDER: And I think the logic—the logic of it is you’ve got to find the right balance of what is effectively federalism. There are some things that you have to do at effectively a global level, but there are others that you don’t. And if you try and do everything at that level—if the European integration means integrating everything, it’s probably going to fail. That’s probably not the right way to think about it. But how do you strike that right balance? Where do you put Hungary? Where do you put the U.K, right?

But the fundamental notion that on, you know, trade in goods and most of the economics, you know, how you deal with the regulations, kind of get the treaty right, but you’ve got to find that right balance. But I don’t think Trump has a practical alternative for how to manage these problems in this world; and therefore, I think, like, once he’s no longer—the relevant question is, what is it going to look like once he’s gone? Who’s going to be in that seat? And I guess I’m a little more optimistic about what that outcome’s going to be.

MALLABY: Let’s get one more question in right over here and then we’ll wrap up. Yeah.

Q: I’m Chris Brody, Vantage Partners.

Rebecca, you just sort of threw out when we get a recession in 2021. I wondered if you could elaborate what you think the likelihood is, what the causes might be, and what’s it going to look like?

PATTERSON: Sure. Thank you. I have no idea what day or year the recession occurs. I wish I did, that would make my life so much easier.

You know, at the end of the day, most recessions, not that it’s on purpose, but most recessions are caused by rising interest rates, tightening monetary conditions, and that lifts those areas of vulnerability, like nonfinancial corporate debt, to the surface and suddenly you get a default cycle. And you have stress from the credit market quickly infecting the equity market and we spin from there.

So I think about, what is the pace of growth next year? Does the fiscal stimulus last through 2019, or does it start fading sooner? And how quickly does the Fed raise rates? And it is—every cycle is different and this one’s really tricky because maybe that tipping point on interest rates isn’t as high as it was in past cycles. How do you factor in the balance sheet reduction? You know, there’s lots of wonderful Federal Reserve papers that try to quantify how much that matters, but the honest answer is we don’t know for sure, we’ll know in hindsight.

So we have a recession model. Most academic and financial institutions do now that they use as one of many inputs. Ours would suggest that, looking over the next 18 months, 60 percent probability of a recession. It’s one input. I wouldn’t put anyone’s capital to work on the back of that. And what we’ve found historically is that equity markets don’t start to roll over until that probability gets closer to 75 or 80 percent. Those probabilities can change depending on incoming data day to day, so it could go from 60 to 50 (percent) or 60 to 80 (percent) in a month.

But at the end of the day, I watch the Fed, how quickly they’re tightening, and when do we see that stress start to show up in profit margins, and when do we see it in corporate credit markets? Right now we’re fine. For the moment, we enjoy the party knowing that the party is going to end relatively soon.

MALLABY: Jens, are you also dancing (from there ?)?

NORDVIG: I guess the one other thing to watch is what’s going on with the upcoming election in this country, right? So the ability to do anything on infrastructure or a second round of tax reform and these type of things is going to be impacted by what outcome we have there, not to mention any kind of more severe political risks. But I think that’s something that will also determine what the rail risk is in terms of how bad the economic outcome can get. So that—I will just add that, too.

MALLABY: You mean because the answer to the rolling off the fiscal stimulus might be a second fiscal stimulus?

NORDVIG: Yeah. And if we have another round of deadlock, as we’ve been used to for many years, then that gets kind of curtailed, right?

MALLABY: Yeah.

Lewis, last word.

ALEXANDER: Yeah. I’m a little more optimistic than Rebecca is just in the sense of, like, sixty percent over eighteen months, that seems like a very high number to me. But the general drift I agree with.

But to follow up on aspect of what Jens said, the thing I worry about in terms of the election, the upcoming midterm election outcome, is not really that it’s going to, frankly, have much effect on macroeconomic policy in a positive sense because, frankly, I think it’s—I can’t imagine a scenario where we’re going to have a positive policy environment after the midterm elections no matter what the outcome is. Right?

Republicans retain control of the House; if they do so, it’s going to be a smaller majority, the Tea Party is going to have a bigger role. The Senate is going to be a couple of seats either way. It’s, like, that’s just not an environment where you’re going to get much positive done. If the Democrats take control of the House, they will spend the next two years investigating the Trump administration. I think the inclination to vote for impeachment will be hard to resist. But frankly, if we don’t have a recession and the economy is kind of chugging along, I don’t think any of that matters all that much.

The one thing I do worry about is, if we go into a recession, we actually need the government to do something between 2018 and 2020. Like, it’s not going to be a good environment.

NORDVIG: That’s right.

ALEXANDER: And so I do worry that if something bad happens, the potential downsides are worse. We haven’t talked about the financial side, but—and I’m not particular worried about—but God forbid we face that, the restrictions that have been put in place on the—on what the financial policymakers can do are immaterial. And if you face, you know, any kind of pressure where you needed to use that authority, like, it would be dicey.

So I do think, like, the downside risks and a negative scenario when you’ve got the second two years of the Trump administration with a Democratic House. Like, that’s not pretty.

MALLABY: OK.

PATTERSON: That’s a happy note to end on, isn’t it? (Laughter.)

MALLABY: A happy note to end on.

Jens, Rebecca, Lewis, thank you very much.

And thank you all.

(END)