World Economic Update

SEBASTIAN MALLABY: I think we can get going.

For those of you who don't know me, I am Sebastian Mallaby. I work here at the council. I direct the Greenberg Center for Geoeconomic Studies.

I think we've been doing these -- this version, this iteration of the World Economic Update -- I've been chairing it for a bit over two years. Every time I do it, somebody comes up to me afterwards and says: Why do you depress me so much? This economic news is terrible. And I say: I'm just a messenger.

I was hoping to be a better messenger this time, with a pretty nice first quarter, that overnight the markets have sold off. It's just my luck.

I'm hoping that the rest of this panel is going to be more optimistic than I just was. It's a very -- I think veterans, all of you, on this stage -- Lew Alexander over there, United States chief economist at Nomura; next to me here, Joyce Chang, global head of emerging markets at J.P. Morgan; and here Vincent Reinhart, chief U.S. economist and co-head of global research at Morgan Stanley.

Last time Vince came to speak here, he managed to invoke "Rebel Without a Cause." In the recent Morgan Stanley video, he invoked the Lincoln assassination. So I'm waiting, Vince, and you better not let us down. We want the follow-up. We need culture -- we need culture; we need history. (Laughter.)

Just a couple of housekeeping points: Remember to turn those things out that go bleep -- off, completely off. They mess up the sound system. I think we have C-SPAN here, so we care a lot about the sound system today. And secondly, this is on the record. So keep that in mind.

Let's start, Joyce, with the eurozone, still the most turbulent part, I think, of the global economy. We had the LTROs in December and February. They seemed to stabilize things. We've just had the announcement of a big new -- or (it's a ?) new -- whether it's big or not, a question -- fire wall agreement. Joyce, are we out of the acute phase of this crisis in Europe?

JOYCE CHANG: The acute phase of the crisis, which I would define as liquidity, I think we're out of right now. But the chronic phase of the crisis, which is the economic adjustment and the pain of that economic adjustment -- I mean, we're embarking on that for a very, very long road. We're forecasting a recession of 1 1/2 percent contraction in the economy this quarter. If you look at the fire wall, that's not what's going to move the market. It's LTRO that moved the market. That really led to the risk rally. And if you look at where the European Central Bank balance sheet now as a percentage of GDP, I mean, it's in line with Bank of Japan, 30 percent of GDP expansion.

So acute, meaning that the systemic liquidity issues have been addressed through LTRO, not necessarily through the fire wall or other actions -- I think that's over. But the chronic economic painful adjustment -- take a look at Spain, I mean, 23 percent unemployment, a fiscal deficit that was 8 1/2 percent of GDP, well above what their target was, and a recession. So that chronic phase is going to extend for, you know, a long time.

And I think that's not just the European story. If you look at developed countries at large, the debt burden -- the public sector debt burden increased by almost 23 percentage points since the onset of the global financial crisis.

MALLABY: So Vincent, we've had three countries in Europe so far that have had formal support programs: Portugal, Greece and Ireland. How long before Spain gets one too?

VINCENT REINHART: That importantly depends on the willingness of the leaders of the rich countries to continue to send resources to keep the enterprise ongoing. I worry, as Joyce has explained, about the chronic aspect. We have a continent in which a large number of countries will be shrinking as part of fiscal consolidation, and the poor rich countries expect to have export-led growth. Not exactly obvious to me who they'll be selling to. And particularly if we get past the funding stage, could believe that the euro would appreciate, and they won't be selling to the rest of the world either. And so the chronic aspect of it is going to be when do people see the benefits of keeping the exercise ongoing.

Now, back to the immediate question, Spain is the first tranche, the funding, which is essentially a programming exercise the IMF used to do in the 1960s: What's the official resources; what do they have to roll over; how much can they contract? And the answer is it's going to be (close to what I'm saying ?) and importantly depends on the market aspect, how wide are the spreads?

MALLABY: But aren't they in this kind of debt-deflation cycle where they're crunching down the fiscal deficit; every time they do that, they drive more people out of work; demand falls, so then they have a worse deficit, and I mean --

REINHART: Right, yeah, think about the debt sustainability condition. It's a ratio. It's the current stock of debt, expected future debt. On the bottom is the real cost of borrowing and real growth. When you try to consolidate, you don't do anything good to real growth. And therefore, you make your -- often you make the sustainability probably even worse. The only moving part there is the real cost of borrowing. And so what we're seeing is increasingly they'll use their domestic financial institutions as the repository of the debt they can't otherwise sell.

So in some sense the answer to your question is, how much more room is there to impose on the European financial system the forced -- semi-forced ownership of debt in periphery countries?

MALLABY: Right. But even that would not solve the the growth problem.

REINHART: No.

MALLABY: So Lewis, Greece, on the other hand, is a great story. It's completely in compliance with its program. That is because the program's only been there for 10 minutes, but how do you -- (laughter).

LEWIS ALEXANDER: I agree. No, no, I think you raise -- you sort of highlight the important question. I very much agree with the way both Joyce and Vincent have characterized this in terms of the LTROs made a huge difference. The fact that the ECB has been willing to use its balance sheet that way has been very important. But ultimately this does still depend on Greece, in particular, being in agreement with the Europeans for continued funding.

And there is this fundamental issue of the Greeks have to make commitments that the rest of Europe is willing to fund. They do not have a primary surplus at this point. And as long as that's the case, you run the risk that if that basic political equation breaks down, then we're sort of going to be back in a more acute phase.

And we've got a Greek election coming up and that is going to be very difficult, and so while we're definitely in a different phase than we were in December, there is the risk that we go back to a world where you see the potential of a breakdown of what has supported the funding for Greece and then Greece's ability to stay in the eurozone becomes an issue.

So, you know, I very much agree we're kind of in a different world and the long-run growth issues are sort of the predominant ones, but the tail risks associated with that are very much there. And we still have, how, exactly, are we going to deal with Portugal? The official policy is no PSI for Portugal, but you kind of look at the numbers on that and raise -- one can easily raise questions about that. And then all of the broader financial consequences of that are still on the table.

MALLABY: In the case of Spain, the Portuguese-Spanish integration is quite disturbing.

ALEXANDER: Those are all -- those are all sort of complicating factors. And those things can just make the ECB's problem worse. And I think we're in a different phase, things are going better, but there are those risks. Those tail risks are definitely out there.

MALLABY: Vincent, would you say that the fundamental theme in all these debates about Europe ends up being that you have one camp that sort of has doom and gloom and breakup, and another camp, the optimistic camp, whose thesis is muddle through? And the question is, if you only can put muddle through as your optimistic scenario, well, if you muddle and muddle and muddle along a tightrope, if the tightrope is infinitely long, you will wind up falling off.

REINHART: I think it's also it's -- I mean, it's inherently a risky path, and so while one can imagine it working in some sense, it doesn't take large deviations to sort of put you over the edge. And I think that is the problem that sort of people and markets have to face.

Now, the Europeans have successfully managed to walk that so far, and each time, we have come close to the edge. Say, for example -- at the Cannes summit or when the Greeks proposed a referendum, you know, we came, arguably, very close to a disruptive breakup and people kind of pulled back. And I think there are some very strong incentives for the system to continue to manage in that way. But it is difficult. It's dangerous for the system to be kind of constantly on edge. I think it is a drag on global growth to the extent that everyone, I think, looks at downside risk in Europe as something you have to filter in to how you think about the outlook, and that affects your decisions.

Now, I think at the moment one of the reasons things are looking a little better in the U.S. is that big downside risk that we were facing last fall with respect to an imminent crisis in Europe has faded a bit, and that's part of what has gotten, I think, people more optimistic. But it's not hard to imagine that that comes back into people's radar, and I think that's an important aspect of how you think about the outlook going forward.

MALLABY: I want to put all of you on the spot. Three years from now will there be 17 members of the euro, 16 or fewer?

REINHART (?): I think fewer.

MALLABY: Fewer. Joyce?

CHANG: I think it will be the same. There will just be more debt restructuring and deeper haircuts. I don't think it's so much about exiting the euro as restructuring the debt.

MALLABY: OK. So fewer, 17 and -- ?

ALEXANDER (?): Fewer.

MALLABY: Fewer. OK. All right. We have a sort of prioritization here. (No one's on the ?) 16, Greece-only camp.

Let's talk a bit about the U.S. And maybe I should start with you, Vincent. We had the Fed minutes out yesterday. And you had been arguing in the month or two before that the chances of QE3 were rather high. Have you changed your mind?

REINHART: Certainly. You have to respond to what they say. It's an open and transparent Fed, and they're telling you something that matters.

We'd been thinking there would be about a 2-in-3 chance of some form of balance sheet operation in the first half, and that had three parts. We have a forecast where the economy grows essentially at trend but that we had been above trend and we come back to trend; that's the second part. In the third part, there's an election coming, and the Fed would be reluctant to want to step -- act during the campaign season. But if you logically see the window close at the end of the first half, you are more likely to want to act in the first half.

What the Fed told us was that it was data-dependent, that it -- policymakers would be willing to act if there was evidence of a cooling in economic growth. So they're not in the mode to buy insurance in advance of that. Their forecast of 2-out-of-3 chance was essentially 1-out-of-3 chance they'd want to buy insurance; 1-out-of-3 chance that given our forecast of a cooling in growth, they'd have enough reason to act; so we're down to 1-in-3 now.

MALLABY: So you changed your view because of the -- what the minutes tell us. But are they making a mistake? I mean, they're still -- we still have an economy operating way below capacity. Your projection, and I think most people's, is that inflation is leveling off, if anything, for (the scope ?) to put that insurance in place. You're below capacity. You've got space to try to buy more insurance. Why -- is it just politics, I guess is the question?

REINHART: So you don't have to put it in terms of the Morgan Stanley forecast. It's the FOMC's own forecast. They admit there is a lot of resource slack, and they assert that the temporary increase of inflation is -- that, rather, the increase in inflation now is only temporary and that inflation expectations are well-anchored. So they are short of both of their goals.

And so the real risk is that 2-out-of-3 chance they don't act. And in that case, it's possible it was just a growth spurt, we'll see the economy come back to trend, and it will be June, July, August when they come to appreciate that but then be hesitant to act immediately in the heat of the election season.

So I think that timidity could prove to be a mistake. In the same way, in 2010 they waited probably too long to nurture the green shoots. They only marked on "QE2" in November as evidence that the economy was softening started to accumulate as early as the spring. I think we could be in a replay of that.

MALLABY: I want to come to Joyce in a second for the international aspect of this monetary stance in the U.S., but maybe Lewis first. You know, part of this is what's -- is the kind of discrepancy between the employment data, which have been fairly strong, and the GDP data, which have been less strong. How do you see that conundrum?

ALEXANDER: Yeah, that's a -- that's an important aspect of how you see the outlook. The chairman has obviously stressed this in his statements and in -- and that is very much, I think, part of the what the Fed is struggling with.

I think when you look at it, basically, over the last four quarters, you've had GDP growing only about 1 1/2 percent, while you had the unemployment rate coming down a full percentage point. That's a very unusually positive performance, and the Fed has been pretty clear that they don't expect that to continue.

What's driven that performance is primarily two things. It's a combination of relatively weak productivity growth and very weak labor force participation. So you've seen people exit the labor force, and you've seen low productivity.

Now, I think the Fed has argued, and I think we would agree with them, that those trends are not likely to continue. And consequently, I think that the pace of improvement in the labor market is likely to slow. And I think that's part of what creates the argument for them doing more.

If I could just add kind of one aspect to the way Vince just -- the way that Vince talked about the near-term issue, I think the other problem they have is financial conditions. And I think -- I'm -- you saw in the way the market reacted to the minutes yesterday -- essentially their conundrum, if you like -- that if they make it clear that they're not going to do QE, there is the chance that rates will rise, that equity prices will fall and credit spreads will widen. And they will, in some sense, engender a tightening of financial conditions that they do not want.

I think one of the things that all the policymakers have been pretty clear on is that they believe at this moment we need to have continued very accommodative policy. And the market's own reaction to what they do can sort of create -- can create a situation that they don't want.

And so I think that one aspect, in addition to the way Vince characterized it, and I would say that would push them in that direction, is if you actually get into one of these feedbacks where, in anticipation of them not going, markets start to sell of, and then you get an effective tightening of financial conditions, which then undermines things, I think that is one of the trickiest challenges they face.

Be prepared, because of that, for confused communication because right now they've embarked on two sets of unconventional policy. One is the ongoing balance sheet operation, but the second is managing interest rate expectations by offering the assurance that rates would stay low till late 2014. If you look at money market futures, markets are contesting that view. They have priced in a tightening before late 2014. Fed Reserve officials are going to have to protest that, but -- and how do you protest that? You emphasize how much slack there is; you emphasize how much room there is for the economy to expand, how well inflation is contained. When you hear that, don't assume that they're signalling that they'll do QE. They're actually defending what they've already done.

MALLABY: It's an interesting conundrum about the way that central banks function in the sense that the theory has been, you know, if we communicate more clearly, more extensively and more openly, then the markets would get exactly what we want to do, and so there'll be none of these miscommunications. But lo and behold, they do that, and we're still talking about potential miscommunications.

But I want to come to Joyce and ask, you know, if there is a sustained recovery that the Fed appears to be more willing to believe in now, what does that mean for emerging markets, emerging market currencies and the global outlook?

CHANG: Well, for emerging markets' currencies, much of the story has been a dollar-weakening story. So you've seen in recent weeks a pull-back in a lot of the EM currencies, because there is a question: Are we at a turning point right now? It's a dollar-weakening story, you know, at a turning point, particularly when you look at the growth prospects, you know, for Europe.

I would, you know, just, you know, add to Vincent and to Lew's points, when the message has been no further asset purchases by the Fed, but we want zero interest rate policy to continue to 2014, and the G4 central banks, you know, at large have signalled that -- so that's still made emerging markets a pretty attractive place to be just given how low yields are.

So, you know, peripheral Europe at the beginning of the year was, like, at 7 percent. It's now down at 5 percent. You know, emerging markets is at 6 percent. You have four times the growth. You have China alone as 50 percent of the contribution to global growth.

So I don't -- I think that for capital flows into emerging markets, it's still a fairly robust picture just given where interest rates are likely to stay for the foreseeable future. The question, though, for the currencies, though, is are you through with this -- (inaudible) -- currency appreciation trend? And particularly in Asia, where rates are very low, are you looking at a scenario where rates have to go up?

But overall, when you just look at what G4 central banks have done, I mean, like, $6 trillion of, you know, balance sheet, you have to be looking at a period where we're heading into higher rates and higher volatility, particularly after the first quarter that we've had, where, you know, asset classes -- the risk rally has been very strong risk on. So you've had a market that's been very range-bound over the last few weeks. But emerging markets looks like an attractive place to be on the growth differential, which is only widening. The yield differential -- you're getting paid more for being in emerging markets.

Now, for the currency slope, can you still have the currencies appreciate? That's more of a question mark at this point in time, particularly given the appreciation we've had over the last few years for some of the currencies.

MALLABY: Do you think that in terms of the way the global system is perceived to operate, the wave of dissatisfaction that we've heard out of emerging markets are going to continue? I mean, just to recap, I'd say that, you know, the first shock comes in 2008 when China particularly holds vast amounts of dollar assets and suddenly realizes, gee, the U.S. capital markets aren't that safe, and they talk about dollar hegemony, and they want to change that. Then you get the kind of currency war rhetoric more recently, with the Brazilians leading that. Do you think that as -- you know, as things go forward, we're going to hear more of that dissatisfaction about the way the global monetary system works coming out of the BRICS and other emerging market economy?

CHANG: Well, I think you are hearing that dissatisfaction. But until you see, you know, countries like China really make deeper progress on currency convertibility, interest rate liberalization, where else can they go, right? I mean, so it's one thing to talk about the opportunity in emerging markets, but you have a lot of distortions as far as, you know, macroprudential controls and what is investable, the size and the liquidity of these markets.

So there is, I think, growing dissatisfaction, but emerging markets are still in many ways going to proceed very slowly on how they manage the capital inflows that are coming in given some of the risk associated with that. So we're still in an environment where, you know, there are not that many investable assets for just the size of the reserves that we're talking about. I mean, emerging markets now have 80 percent, more than 8 trillion (dollars), of the global foreign exchange reserves, and where can you invest most of that, just given the size of the emerging markets?

MALLABY: Vincent, I think you've argued that the kind of level of distortions around capital controls in emerging markets are converging, in a way.

REINHART: Mmm hmm. So it's a couple things. The first is, expect more capital controls, on average. Why? Because in 2009 half the economies in the world were in recession, but if it was an advanced economy, it was because they had a financial crisis. If it was an emerging market, it was because they had a demand shock. You snap back from demand shocks. You grow more slowly as a consequence of having a financial shock.

So that growth differential that we had going into the financial crisis, where EM was growing at a lot faster than advanced economies, is only going to widen. That implies that emerging market economies are going to be dissatisfied with the very, very accommodative monetary policies in the advanced economies and therefore going to want to reclaim a measure of independence. The way you do that is put on capital controls.

But they're starting from a very uneven base, and what -- and that gives China the opportunity to liberalize at its own pace but the Brazils and more globalized economies to tighten at their own pace, and they'll sort of converge in the middle. On average, (there/they ?) will be more.

MALLABY: Lewis, let's ask another question here about kind of global governance. You've got, on the one hand, the U.S. proposing a new president of the World Bank and some commentators observing that the Nigerian candidate seems to be much better qualified. You've got a fight going on about IMF resources, with the Europeans hoping that the emerging markets will kick more money in to match what they've promised.

How do you see that part of the governance of the global economic system evolving?

ALEXANDER: Well, in some ways, if you look back over the last several years, I would argue the G-20's been a success, if you look at the role they played in 2008 and whatnot, and the evolution that we've seen from the G-7 back in the '90s up until where we are now. I think there's some real momentum. And say, for example, the commitment that was made in Seoul on the G-20 summit to sort of change IMF governance I think is a very positive thing.

But I think if you look at kind of what's happened with Europe and what's going on here, it's taken a bit of the steam out of that momentum, and I think that is something to be concerned about.

I think about the situation of the U.S., and one of the things that's interesting is -- I've been doing a lot of looking at sort of polling data on what sort of priorities voters have in the context of the fiscal challenges we face. One of the few areas of consensus is less money for foreign aid.

Now if you translate that into what's on the agenda for the fund, that's a material issue.

MALLABY: For the IMF, you mean.

ALEXANDER: Yes.

MALLABY: Yeah.

ALEXANDER: The G-20 essentially made a commitment to try and complete the changing governance of the fund by September of this year, and frankly the chances of getting that through the U.S. political system this year is slim to none. And frankly if you were to try and do it, it would fail and you would be -- you would have to take a step back.

I think about the risk, in some sense, and when I look at all those things, and the U.S. taking a step back, frankly, from sort of being part of sort of global governance with being a real risk and this -- the -- in some sense the debate over the World Bank, I think, raises some real issues there. I -- you know, I have personally felt for a long time that we ought to open these things up. But I think there is a bit of a risk, just from the U.S. perspective, that if we kind of take less of a leading role in those things, that our overall commitment to the process is going to wane.

At the same time, you see what's going on in Europe, where they are, in some sense understandably, obsessed with their own problems. And that, in and of itself, has also taken some of the impetus away from the sort of the global governance side of things.

And you know, at the same time, there's obviously, you know, a bit of a reticence on the part of the Chinese to sort of step into the breach. And it feels in contrast to what it felt like in 2008, where I think there was sort of legitimate -- there was a real commitment to this, and it actually added to the policy response.

You get a bit of a sense of things kind of pulling apart, in a way, that I think is problematic. And I think it -- you know, I mean, the realities of an election year in the United States are what they are, and I think it would be a mistake to try and push this agenda now, because you'd get the answer -- you'd get an answer you don't want. But it does raise risks about where we're going.

MALLABY: I want to open it up to the audience, to members in a second. Because of the talent in the room, I want to get questions. But let me just put one last thing to all of you, maybe starting with Joyce. Is there a crisis sort of over the horizon that we haven't talked about, that we haven't focused on? Is it Turkey or some other economy that's running a massive current account deficit that's going to be in trouble? Is there anything you worry about? Is it oil prices spiking with Iran? What's in your kind of risk set looking out six months or 12 months?

CHANG: Looking out six months or 12 months, I don't think it's an emerging markets crisis, because even though you have a country like Turkey that is more vulnerable to higher commodity prices, that has a current account deficit -- doesn't have a funding problem, and it has a pretty deep domestic investor base. And I think that situation is manageable.

And you know, frankly, the higher commodity prices on the whole, that actually benefits emerging markets a bit more. So I don't think the crisis is actually one that would be forthcoming from emerging markets.

I think near term, it still comes back to Europe. It still comes back to Europe that -- you know, have we graduated from acute to chronic, but is it really that Greece was a kicking-the-can-down-the-road restructuring; that an exit from the eurozone is something that gets, you know, more debate, you know, over the next six to 12 months; and it comes, you know, back to Europe?

You know, the big surprise last year wasn't Europe; it was the U.S. ratings downgrade. That's what sort of started the whole sell-off last year. So we're getting into a U.S. cycle again -- you know, another debate about the debt ceiling.

So I don't think it's in emerging markets. I think medium term the markets will continue to focus on China, just because there isn't as much information available, you know, and because there are more question marks about how we're finally seeing that shift in growth in China, you know, from 11 1/2 percent to 8 1/2 percent, which in my opinion is not a hard landing. They've talked about that for a long time; now it's actually happening, but everybody's worried about that. I mean, that does pose some uncertainty over the medium term.

MALLABY: Any over-the-horizon shock you want to predict?

REINHART: December 31st, because --

MALLABY: (First of all ?)?

REINHART: -- because on December 31st, an unstoppable force meets an immovable object. We have adverse debt dynamics, and we have a legislative sudden stop on the equivalent of 4 1/2 percent contraction of GDP, around the same time we're talking about the debt ceiling.

MALLABY: And the ability of the U.S. political class to reach sensible compromise is not as robust as --

REINHART: Not proven. Yeah.

MALLABY: Yeah, OK. (Laughter.)

ALEXANDER: I very much agree with Vince that that's like the pre-eminent risk.

I just want to put something on the other side, which is I think there is an upside to the U.S. as well, which is if you get an electoral outcome that actually allows you to do things, I think we're lining up to do some fairly major things that are positive, in addition to some sort of long-run fiscal deal.

I would -- I would point out that, you know, just in the last couple of weeks, there have been a bunch of plans that have been put out on the fiscal side. The differences in those plans isn't really about stabilizing debt; they all do that. The difference is in -- is in the vision of government that you have.

And so I think if you get a clear outcome from the election on one side or the other, there's the potential for both doing a big fiscal deal, but that would include things like we're getting ready to do a major tax reform, which is, I think, potentially a very positive thing for the economy. I think we are lining up to do mortgage finance reform. So I think if you get an outcome of the election that essentially puts gridlock to the side, there are -- there are very positive outcomes that come of that.

Now, you look at the polls and ask yourself the question: How likely is that political outcome? And it is clearly not the most likely outcome.

So I -- you know, partly, and as I think about how we think about the second half of the year, it's just going to be very complicated, because there are -- is -- there are very negative outcomes that are possible, and I would argue there are actually positive outcomes that are positive -- possible, and it is going to depend on the complicated interactions of how -- what we get out of the election.

REINHART: So in some sense, the good news is we are so inefficient in the delivery of fiscal policy that there is no one direction we have to go -- that is, it's about taxes, it's about appropriations process, it's about entitlements, it's about the way we budget, it's the lack of rules. So you could actually contest the election on two different views of what -- how big the government should be, opportunity versus safety, marginal structure of tax rates -- two different views contest the election, and whoever wins puts it in place.

The problem is, if we don't contest the election on those issues, then it's very difficult to put it in place after the fact.

ALEXANDER: And I agree with that, but I think what --

MALLABY: It sounds like you want a parliamentary system. That's dangerous when --

(Laughter.)

ALEXANDER: Well, but one of the things that we are shaping up for -- I think those choices are going to be much clearer this time than they are normally. The Republicans, to their credit, have put on the table a credible budget plan that is in full detail and is very severe. It's not the plan I would choose, but it is a very clear vision for how you get fiscal consolidation. I think the Democrats have a very different vision of how you approach that same problem, and in some sense I think you are going to have very clear choices presented to the electorate.

Now, it's an election. It's complicated. These are -- these are not issues that are easy for people to understand. One of the things that jumps out of the polling results on this is it's interesting that there is consensus in the electorate across the political spectrum in some areas that is encouraging.

For example, you ask people, both Republicans and Democrats, would you be willing to raise taxes -- do you think it's a good idea to raise taxes on people who make more than $250,000, and the answer is yes. And you get majorities even among Republicans for that. I think that's encouraging. You look at some categories of spending and say, should we -- is this an area we should cut? And you see some areas where there's consensus. Unfortunately, on the spending side, that tends to be in relatively narrow areas. It tends to be, like, getting out of Afghanistan, farm subsidies, foreign aid. And unfortunately, that's not going to do it.

One of the -- you know, one of the places a little more troubling when you look at this is when you ask them about Medicare and Social Security, you tend to get majorities on both sides not for less, but for more. The Republican numbers on Medicare are fascinating. Twenty-one percent of Republican voters would support cutting Medicare, 24 percent would support spending more, which puts the -- sort of the Republican plan in a sort of an interesting context.

So I -- look, when you look at those numbers and ask the question, if the election were held today, would you get a sensible response from the electorate on the fiscal challenges we face, I think the answer is probably no.

CHANG: And both of you seem to be saying the chances of a bipartisan solution look incredibly slim; the electorate may not force this issue. So we are still at a phase where it is really kicking the can down the road. There isn't necessarily a drop-dead date that's 2013, because if it can be postponed, will it be postponed?

ALEXANDER: Well, I think the odds of a -- you know, a bipartisan solution of the sort we had in, say, 1983 on Social Security, unfortunately, given the political alignment, is low. To me the good outcome for policy is a sweep either way. It's all Republican, all Democrat. That's the clearest way, in my mind, for where you're going to get progress on all of these things.

If we get the most likely outcome, which seems today to be the president gets re-elected, the Republicans take control of the Senate and retain control of the House, that is problematic. And that is the outcome where I am much less confident that we get, you know, progress on all the long-run issues.

I personally think the problem of the beginning of the year will be handled in some way, but it's likely to be messy and noisy and have adverse effects from our vantage point. S&P downgrade seems possible, another one, Fitch downgrade. Sorry.

REINHART: (Inaudible) -- you'll be happy to know that this reminds me of my second-favorite quote from Kafka, which is from the "Country Doctor," which is, writing prescriptions is easy, dealing with people is hard. (Laughter.)

MALLABY: OK, let's go to members. Who's got a question? I see one right in the aisle there. Please identify. Hi.

QUESTIONER: Ken Brody?

MALLABY: Microphone there, Ken.

QUESTIONER: Ken Brody from Taconic Capital. A little twist on the question that you asked, Sebastian. There's some discussion among economic Democratic elites that's a sort of hopeful discussion on our economy, and I'm interested in the reaction of the panelists to it. For one, as you discussed, GDP growth has been inconsistent with the employment numbers. And typically, the GDP numbers are less reliable than the employment numbers. We've had a lot of revisions there, admittedly on the downside, since 2008. But national income accounts, which should be about where GDP is, are a good bit higher than GDP.

And putting these facts together, the hopeful Democrats say this is probably a pretty good indication that GDP growth has been stronger than we have seen reported and that we believe. And I'd like some reaction.

MALLABY: So, Vincent, are we richer than we thought?

REINHART: So that if you look at gross domestic income, it's increased faster than gross domestic product over the last year. We've seen some revisions.

Problem is that the spread between the two does vary a lot over time and can reverse itself. So it's tough to know. It's true, for instance, we got more household employment in the last month than payroll gains. However, when you look at it from the trough, we got more employment than household -- these are erratic readings on the economy.

There is clearly the -- a possibility of a breakout on the high side. We had an inventory bulge in the end of last year. That led to hiring. Hiring leads to income. Income leads to sales. Sales leads to sales expectations. And then all that cash that is on nonfinancial firms might start getting to be employed.

But I work backwards for, you know -- and you know -- and hope is a strategy. Hope is a thing with feathers. (Laughter.)

But when my optimism flutters upward, I think that the world's a risky place. We have an ongoing sovereign crisis and banking crisis in Europe, we have the possibility of elevated energy prices, and we have a fiscal cliff coming. Those are not the baseline outcomes, but the presence, the tail -- those tails to potential outcomes are reasons investors shouldn't have conviction. And if investors don't have conviction, you don't get the wealth creation that pulls an economy up relative to trend.

MALLABY: Byron Wien. There's a microphone right here.

QUESTIONER: Byron Wien, Blackstone. I think you're all too complacent about Europe. It seems to me that the European Central Bank --

MALLABY: They're supposed to be the optimists, Byron. Come on.

QUESTIONER: Oh, yeah.

MALLABY: (Chuckles.)

QUESTIONER: I'm trying to be -- get to their side.

The European Central Bank has changed its spots totally from focusing on inflation to focusing on shoring up the banking system and keeping the economy afloat. That's likely to continue for three years or so. But three years from now, isn't there a very strong possibility of a breakup? Because none of these countries are really going to be able to make the fiscal changes that are necessary. They're going to -- growth is going to be slow or negative. You're not going to be able to implement the austerity with the work rules that exist there. So consequently, three years from now, the ECB will have run out of money, and Europe's structural problems will still endure. Am I too pessimistic?

MALLABY: (Do you want to take ?) that?

CHANG: Well, even the next three years, I think, are pretty difficult. I mean, you'll -- not just after three years. I mean, if you look at just Spain and Italy between now and the end of 2014, they have 800 billion of gross sovereign funding needs. So the next three years are hard.

I'm -- it could be about a breakup of Europe, or it could be that you have weaker Europe and stronger Europe, which is the equivalent of a breakup. That -- it is just very clear that the fiscal pact, you know, cannot be held amongst all of the countries.

And I think the -- you know, the focus will be, you know, less on the Greece-Portugal than on the Italy and Spain, and what happens with those two, because that's 800 billion of sovereign gross funding needs, not even counting the bank recapitalization needs that they're going to have.

MALLABY: But Lewis, maybe just for me to follow up on that -- I mean, in some sense, what Byron is asking about is, is this sort of superman central bank thing an act that's going to be revealed to be a cartoon? I mean, otherwise, you know, you have a long debate in Europe about the EFSF bailout fund. It's supposed to have 440 billion euros of bailout capacity. And then one fine day in December the central bank says, you know what? Four-forty (billion euros) -- nah, we'll just print half a trillion (euros) in one day, and then we'll do it again in February. I mean, so there's this kind of macho central banking, and Byron is saying it's going to end in tears.

ALEXANDER: I would distinguish -- I would respond to that in the following way. The central bank can provide liquidity, and liquidity is very important in a funding situation, and that is the contribution they have made.

That was obviously an issue in terms of the response to -- I mean, if you go back to where we were a year ago, there was this perception that sovereign risk within the eurozone was a limited thing and very concentrated. Essentially what we went through in the fall was an adjustment to a new world where there's serious sovereign risk within the eurozone, and that generated pressures that the ECB could respond to.

What the ECB cannot respond to is this fundamental question that there are fiscal imbalances that need to be funded and are not going to be funded by the private markets. And it fundamentally depends on the political relationship between the countries that need the funding and essentially the European institutions' willingness to provide it.

There is a set of -- a political set of challenges, if you can think about it, between Greece and Germany. The Greeks have to commit to doing certain things -- right? -- in order to make it politically feasible for the Germans to fund them. And as long as they can find a balance between the Greeks' willingness to make commitments and to some degree actually deliver on them, in a way that is consistent with the political constraints on Germany on providing the funding, this thing can go on.

And, you know, as somebody who's watched European integration from this side of the Atlantic for decades, I'm always struck by we tend to underestimate sort of the commitment of the Europeans to that process. I fully agree with you that there are risks and there are parts of this that are likely to continue. My response to Sebastian's question was fewer than 16 down the road. And, you know, is that too optimistic? I don't know. But, look, there are very big challenges. I think there are -- there are risks of accidents along the way.

I don't think the ECB -- I mean, I think the ECB has done what it can do, and I don't think it ultimately faces a problem, in the same way that I tend to think the Fed is perfectly able to exit from its current situation and that will all be manageable in a reasonable way. I don't see that as the core problem. There's a different problem that is very tough to manage.

REINHART: I mean, monetary policy can be a bridge, but it has to be a bridge to somewhere. And so if there isn't a fiscal consolidation -- (inaudible) -- then there's nowhere to go to.

And before we give the ECB high marks on everything, their attitude towards public -- private-sector involvement has been unhelpful, because they have put -- essentially what they said is they don't participate in the haircuts in the Greek arrangement. But what that means is, when the ECB buys sovereign debt, it actually places itself senior to everyone else, and so it doesn't remove sovereign credit risk in its open market operations. That then raises the question, in a sovereign crisis in the future, what exactly will the ECB do?

MALLABY: Another question. Right over here.

QUESTIONER: I'm Chris Harkin McDonough (ph) from Jiff (ph) Brothers Investments. I have a question for Joyce.

I was struck by your response on what the EM countries are willing or not willing to do on exchange rate appreciation. Having traveled through Asia, I guess I share a lot of that, that they seem very unwilling to allow further appreciation. But I guess the question I have is, what would you look at -- other than seeing prices move -- what would you look at as a signal that the EMs are actually allowing, you know, the euro -- the dollar to depreciate more substantially to allow both regions to grow their way out of their problems through exports, which is kind of what both need and can help in rebalancing the global economy? But given their unwillingness, there's got to be something that you might be looking for as some sort of policy change or some sort of economic change that would signal a greater willingness.

CHANG: Yeah, I don't see the greater willingness right now. In fact, if anything, I think that there are emerging markets that are willing to look at more unorthodox policy mixes, because, you know, they have their own domestic agenda. And I think, going back to just the point --

MALLABY: You mean unorthodox mixes in order to prevent depreciation of their currency.

CHANG: Yes.

MALLABY: Yeah.

CHANG: Yeah, more -- and we've seen that across the board in a number of countries, particularly in some of the commodity exporting countries, that they've had appreciation pressures.

But, you know, I go back to the point that Lew made about, you know, the G-20; how are you going to get this kind of coordination with emerging-markets countries and with developed countries? I mean, for emerging-markets countries, you still have such a big income differential that to try to convince emerging-markets countries, where you have, you know, a standard of living which is -- the key objective they're looking at, that they're still thing to bring up to, you know, provide resources for a bigger firewall for countries that have a, you know, 35,000 (dollar), $40,000-per-capita income.

I mean, I think that for emerging-markets countries, you know, now it is more about what are their own domestic self-interests. You know, they have a deeper domestic investor base that's also increasing in size as well. So I'm not so sure that you get a (catalyst ?) that comes on some global policy coordination that's going to result in an agreement that will work, because, I would agree with Lew, it seems to me that you had a moment in 2008 and 2009 that looked more effective than it's become now. I think the European crisis has made that harder, because convincing poorer countries to bail out richer countries is just something that's politically very difficult. And we go back to the politics in all of these countries, when we talk about Europe and when we talk about the U.S. I mean, emerging markets has its own set of politics as well.

MALLABY: It sounds like the climate change debate a bit, where, you know, the rich countries say, you guys are growing emissions faster, and the emerging markets say, yeah, but you still emit more, and so why should we take -- I see questions; let's go right there in the back, and we'll come here in a second.

QUESTIONER: Hi. David Malthus (ph), with Enseema (ph). I wonder if you could comment on China. There is, you know, two schools of thought. One is that they're in trouble, so that's showing up in the currency not strengthening. China has recently raised its quota on bank lending and yesterday raised its quota on foreign investment into China. Is it headed in the right direction or is it still headed for a harder landing? Thanks.

MALLABY: You want to try that?

REINHART: China is a very opaque economy, and the line between the public and the private sector is extremely indistinct. What that means, however, is officials have lots of levers of policy to keep demand growing quickly. And our own forecast is they'll succeed in that; that they can shift, essentially, credit and capital and get some infrastructure building out of the private sector, they can support credit; and so that, if anything, growth is going to be very well-maintained in China.

MALLABY: OK. Did you have a question here? There's a microphone coming.

QUESTIONER: Betty Masham (ph), Gerholding (ph). If Sarkozy is not re-elected, will there be a spillover to the rest of Europe?

MALLABY: That's actually a great question, because it relates also, I think, to the German political situation, where there is also pressure from the opposition on Merkel to change her stance towards austerity versus growth. So this -- it seems like both in France and in Germany, the two core economies, you could get political shifts that made more space for pro-growth policies.

Lewis.

ALEXANDER: I'm not going to pretend to be an expert on French politics. I do --

MALLABY: I didn't ask you about the Andalusia election in Spain. Come on.

ALEXANDER: Fine. (Laughter.) Look, I do think the German -- the German situation is sort of a very complicated one in the sense that I think there is actually more support for Europe outside of the government than sort of within the government. And there is this problem within the German government that it's a relatively narrow base that is taking the most hawkish positions.

I think Merkel unfortunately is in the position of trying to sort of lead a coalition that has that at the base, and it's a tough challenge for her to walk that line. I think having a partner in France who she could work with was very important, and my guess is they will continue to find a way to do that. But it will make things harder, I think, for them to sort of manage going forward.

I'm -- you know, my impression is that, you know, the French is -- the French is -- the way they see these problems is ultimately consistent with sort of resolving the issues in Europe sort of regardless of which side wins on the election, so I'm not sure it's a -- it's a long-term issue. But it's going to make what is already a difficult process harder, at least for a while.

MALLABY: Joyce, one thing that could come out of these political shifts in Europe could be a transactions tax, right, because the German opposition is saying that's their condition to supporting what Merkel wants on the fiscal pact. Is that something your clients worry about?

CHANG: I -- and I think that most clients still feel that that's something that they probably will avoid at the last moment, or that for one country to do that unilaterally is probably unlikely to happen, that we've seen on a lot of these regulatory and risk issues is that that's where -- there wasn't been more coordination. I mean, all sides are, you know, actually worried about the amount of regulatory arbitrage that could occur. So, you know, there has been, you know, questions about the pace at which, you know, the U.S. is moving versus Europe. But I think -- and that's where we've seen more delays and more, you know, postponement, even though these become, you know, political issues. So I don't think that's come up, you know, as a burning issue, you know, more immediately.

But I would say that just on this political question -- (inaudible) -- all of the peripheral governments have been overthrown, and Belgium as well. So it's -- if you look at the trend in Europe -- I mean, look at all of the periphery, and, you know, your question on France, you know, it is -- it is -- I think the risk still does come back to, you know, politically, how can this hold together, given the kind of adjustment, you know, that needs to occur in Europe for them to make --

MALLABY: Of course, a key debate is, you know, is France periphery or is France core?

Let's go to a question right here. Lady in the aisle.

QUESTIONER: Yes, Carole Brookins, former USED at the World Bank. What oil price or energy price over what period of time becomes a real game changer in your models?

MALLABY: Game changer for U.S. growth or -- (inaudible) --

QUESTIONER: Well, for U.S. growth and world growth.

REINHART: I'll speak for myself. I think -- in general, I think these things are not cliffs; they're not sort of -- generally, they're not -- there's no question that higher oil prices are a -- generally a drag.

We did see in this first half of 2008 when gasoline prices hit $4 a gallon, you saw very discrete kind of changes in consumer behavior. Having been to $4 a gallon before, I don't think we're going to -- we're going to see that again. I think if we're talking about normal supply and demand in the context of coming into a driving season, when things are going to go up probably until June, I don't see that as a big issue. If we get a supply disruption out of the Middle East -- there are obvious scenarios under which that could happen -- that is a different kettle of fish. I don't think that's the most likely thing to happen, but it is certainly one of the things that would be on my list of risks.

CHANG: Yeah, and you know, I'd also look at whether it's a supply shock or a demand shock that's causing the change in oil prices. So, you know, the first half of last year you had a 33 percent move in oil prices that was largely off of a supply shock with Libya. And if you look at where we're at currently, you know, sort of the 120 (dollar), 125 (dollar) range, I mean, we estimate that that's the same -- maybe it takes .25 percent off of growth -- I mean, not a huge move off of growth. So whether it is a supply rather than demand shock, you know, I think, you know, makes a big difference. I'd also put the risk of -- it seems like sanctions is the path they're going. I would put the risk of military conflict as an unlikely scenario at this stage in the game.

But you know, there isn't necessarily a price, but what we look at, at least in emerging markets, is, you know, what is the break-even price for these countries where they're budgeting the price of oil and whether they're saving the windfall or spending it. And I'd say in emerging markets, most countries have been really pretty conservative. They have budgeted oil, you know, conservatively, maybe a good, you know -- you know, $30 below, you know, where it's at right now. So I'm -- it's more of a problem for the developed, you know, markets -- countries. And right now the current trend seems to me in some ways less worrisome than what we saw a year ago given the move we had in the first half of the year.

MALLABY: Vincent has been sneaking a peek at the chartbook he's concealed in his lap. (Laughter.) (Inaudible.)

REINHART (?): So I think from the U.S. perspective, it's all about gasoline prices. And the evidence suggests that households basically pay for higher prices at the pump by cutting back on other parts of consumption as long as gasoline prices are within prevailing norms. Once they break out more significantly from prevailing norms, then they cut back in total. If we remain around where we are, then that means it's a problem for lodging -- you know, lodging or food away from the home or components of consumption, but not for overall consumption. It's a modest drag for economic activity because we are a net oil importer. Our chief risk is we've now essentially rolled back the earlier decline, so we're at the high end of prevailing norms. And so any increase from here on would more likely be associated with more restraint.

MALLABY: One last question. I saw the one in the aisle there first.

QUESTIONER: (Inaudible.) Where do you all think the Dow will be in the first week of November? And do you --

MALLABY: (Inaudible) -- specify which day in November, just so -- (laughter) --

QUESTIONER: And do you think that any industries or countries such as Iran will make any unusual attempts to influence the outcome of the election, say by constricting oil supplies?

MALLABY: OK, so there's two parts of that: foreign meddling and where will the Dow be on election day.

ALEXANDER: I thankfully am an economist and not an equity strategist, so I feel it's acceptable -- (laughter) -- for me to not give you a straight answer to that question. Having said that, one of the things we are thinking about is how the uncertainty around the election will actually sort of affect markets. There's the economics of the fiscal cliff and whatnot, but there's also how are markets going to react in anticipation.

If you actually look at what happened last year around the debt ceiling and whatnot, the interesting picture you get is that the primary effect of the uncertainty that was created by that showed up in weaker equity prices, as opposed to higher interest rates. And so there's a sort of an interesting question, if you're facing, you know, fiscal chaos, how do markets respond to that? And I think the -- certainly the experience last year would suggest that that will show up as uncertainty about the economic outlook, uncertainty about earnings that translates into weaker equity prices, as opposed to people decide they want to sell Treasurys. And I would suspect that that will -- would be the pattern.

So to the extent that you come into the election with one of these uncertain outcomes that we kind of talked about earlier, my guess is you're not going to get the reaction of, oh, my god, people are going to look up and decide they don't want to hold Treasurys. It's going to be, there's more uncertainty, the economic outlook is likely to be weaker, and that will mean weaker equity prices.

On the foreign meddling, my guess is -- it's hard to imagine anyone could do that successfully. It's a blunt instrument, and my guess is it wouldn't do it. As somebody who has worked in Washington for a good part of my career, we often -- I often hear conspiracy theories about this and that, and my general argument for why they're wrong is that assumes a level of competence that isn't there. (Laughter.) And I would apply that argument here as well.

MALLABY: And Joyce?

CHANG: So JPMorgan is forecasting for equities about a 14-percent return this year, so (Fortune ?) 500, you know, for the equity markets. And what I've noticed --

MALLABY: We've had a lot of that already.

CHANG: We've had a lot of it already. And I think what investors are trying to do is lock in what they made in the first quarter, which was in some cases what they were forecasting for the full year, what with this uncertainty ahead.

But what I have seen over the last couple of weeks is that you've had a real breakdown in some of these correlations, where everything was very correlated. And I detect that there is more, you know, bullish sentiment right now about U.S. equities, and because of the strength of corporate balance sheets. So that's, you know, JPMorgan's forecast on the equity markets.

You know, on the whole issue of foreign meddling, I have to just say that, you know, look, if you act unilaterally, you're going to have retaliation, so there's that whole question of who's the first mover, you know, in the whole Iran situation, who's going to do that in a unilateral way, face retaliation, and will you get something that, you know, involves more global coordination, which has been very difficult?

So I think the approach has been sanctions, which seems to be having some effect, and, you know, that's what they're going to stay with. But I have seen recently, though, that some of those fears on Iran seem like they have actually dissipated a bit over the last month compared to, you know, a bit earlier this year.

MALLABY: Vincent, Kafka believed in devious bureaucracy.

REINHART: No doubt about it. But meddling is hard to do, and it's not just one country that might be thinking about what it could do to affect the election outcome. And perhaps they offset; I don't know.

And I sort of agree with Lewis's point. It assumes a level of competence that probably -- and an ability to predict the consequences of the campaign, the consequences on two campaigns.

With regard to equity prices, our call's fairly straightforward. The world's a really risky place. And with such risk, it's tough for investors to have conviction and therefore tough to get durable wealth creation. Therefore we'd say the equity market is going to be considerably lower relative to today.

In particular, despite the fact we have known since 1786 that there would be an election, equity investors haven't really -- their window of observation hasn't embraced November or December 31st yet, but it's beginning to happen. As that happens, we're going to be spending the summer and into the fall looking at in-trade quotes on who's going to be president, who's going to win the House, who's going to win the Senate, and then we're going to be multiplying that in to what we hear on Sunday morning talk shows about what they do in power. That's not good for markets.

MALLABY: OK. We apologize for running over by 203 seconds, but it's been a great meeting. Thank you very much.

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THIS IS A RUSH TRANSCRIPT.

SEBASTIAN MALLABY: I think we can get going.

For those of you who don't know me, I am Sebastian Mallaby. I work here at the council. I direct the Greenberg Center for Geoeconomic Studies.

I think we've been doing these -- this version, this iteration of the World Economic Update -- I've been chairing it for a bit over two years. Every time I do it, somebody comes up to me afterwards and says: Why do you depress me so much? This economic news is terrible. And I say: I'm just a messenger.

I was hoping to be a better messenger this time, with a pretty nice first quarter, that overnight the markets have sold off. It's just my luck.

I'm hoping that the rest of this panel is going to be more optimistic than I just was. It's a very -- I think veterans, all of you, on this stage -- Lew Alexander over there, United States chief economist at Nomura; next to me here, Joyce Chang, global head of emerging markets at J.P. Morgan; and here Vincent Reinhart, chief U.S. economist and co-head of global research at Morgan Stanley.

Last time Vince came to speak here, he managed to invoke "Rebel Without a Cause." In the recent Morgan Stanley video, he invoked the Lincoln assassination. So I'm waiting, Vince, and you better not let us down. We want the follow-up. We need culture -- we need culture; we need history. (Laughter.)

Just a couple of housekeeping points: Remember to turn those things out that go bleep -- off, completely off. They mess up the sound system. I think we have C-SPAN here, so we care a lot about the sound system today. And secondly, this is on the record. So keep that in mind.

Let's start, Joyce, with the eurozone, still the most turbulent part, I think, of the global economy. We had the LTROs in December and February. They seemed to stabilize things. We've just had the announcement of a big new -- or (it's a ?) new -- whether it's big or not, a question -- fire wall agreement. Joyce, are we out of the acute phase of this crisis in Europe?

JOYCE CHANG: The acute phase of the crisis, which I would define as liquidity, I think we're out of right now. But the chronic phase of the crisis, which is the economic adjustment and the pain of that economic adjustment -- I mean, we're embarking on that for a very, very long road. We're forecasting a recession of 1 1/2 percent contraction in the economy this quarter. If you look at the fire wall, that's not what's going to move the market. It's LTRO that moved the market. That really led to the risk rally. And if you look at where the European Central Bank balance sheet now as a percentage of GDP, I mean, it's in line with Bank of Japan, 30 percent of GDP expansion.

So acute, meaning that the systemic liquidity issues have been addressed through LTRO, not necessarily through the fire wall or other actions -- I think that's over. But the chronic economic painful adjustment -- take a look at Spain, I mean, 23 percent unemployment, a fiscal deficit that was 8 1/2 percent of GDP, well above what their target was, and a recession. So that chronic phase is going to extend for, you know, a long time.

And I think that's not just the European story. If you look at developed countries at large, the debt burden -- the public sector debt burden increased by almost 23 percentage points since the onset of the global financial crisis.

MALLABY: So Vincent, we've had three countries in Europe so far that have had formal support programs: Portugal, Greece and Ireland. How long before Spain gets one too?

VINCENT REINHART: That importantly depends on the willingness of the leaders of the rich countries to continue to send resources to keep the enterprise ongoing. I worry, as Joyce has explained, about the chronic aspect. We have a continent in which a large number of countries will be shrinking as part of fiscal consolidation, and the poor rich countries expect to have export-led growth. Not exactly obvious to me who they'll be selling to. And particularly if we get past the funding stage, could believe that the euro would appreciate, and they won't be selling to the rest of the world either. And so the chronic aspect of it is going to be when do people see the benefits of keeping the exercise ongoing.

Now, back to the immediate question, Spain is the first tranche, the funding, which is essentially a programming exercise the IMF used to do in the 1960s: What's the official resources; what do they have to roll over; how much can they contract? And the answer is it's going to be (close to what I'm saying ?) and importantly depends on the market aspect, how wide are the spreads?

MALLABY: But aren't they in this kind of debt-deflation cycle where they're crunching down the fiscal deficit; every time they do that, they drive more people out of work; demand falls, so then they have a worse deficit, and I mean --

REINHART: Right, yeah, think about the debt sustainability condition. It's a ratio. It's the current stock of debt, expected future debt. On the bottom is the real cost of borrowing and real growth. When you try to consolidate, you don't do anything good to real growth. And therefore, you make your -- often you make the sustainability probably even worse. The only moving part there is the real cost of borrowing. And so what we're seeing is increasingly they'll use their domestic financial institutions as the repository of the debt they can't otherwise sell.

So in some sense the answer to your question is, how much more room is there to impose on the European financial system the forced -- semi-forced ownership of debt in periphery countries?

MALLABY: Right. But even that would not solve the the growth problem.

REINHART: No.

MALLABY: So Lewis, Greece, on the other hand, is a great story. It's completely in compliance with its program. That is because the program's only been there for 10 minutes, but how do you -- (laughter).

LEWIS ALEXANDER: I agree. No, no, I think you raise -- you sort of highlight the important question. I very much agree with the way both Joyce and Vincent have characterized this in terms of the LTROs made a huge difference. The fact that the ECB has been willing to use its balance sheet that way has been very important. But ultimately this does still depend on Greece, in particular, being in agreement with the Europeans for continued funding.

And there is this fundamental issue of the Greeks have to make commitments that the rest of Europe is willing to fund. They do not have a primary surplus at this point. And as long as that's the case, you run the risk that if that basic political equation breaks down, then we're sort of going to be back in a more acute phase.

And we've got a Greek election coming up and that is going to be very difficult, and so while we're definitely in a different phase than we were in December, there is the risk that we go back to a world where you see the potential of a breakdown of what has supported the funding for Greece and then Greece's ability to stay in the eurozone becomes an issue.

So, you know, I very much agree we're kind of in a different world and the long-run growth issues are sort of the predominant ones, but the tail risks associated with that are very much there. And we still have, how, exactly, are we going to deal with Portugal? The official policy is no PSI for Portugal, but you kind of look at the numbers on that and raise -- one can easily raise questions about that. And then all of the broader financial consequences of that are still on the table.

MALLABY: In the case of Spain, the Portuguese-Spanish integration is quite disturbing.

ALEXANDER: Those are all -- those are all sort of complicating factors. And those things can just make the ECB's problem worse. And I think we're in a different phase, things are going better, but there are those risks. Those tail risks are definitely out there.

MALLABY: Vincent, would you say that the fundamental theme in all these debates about Europe ends up being that you have one camp that sort of has doom and gloom and breakup, and another camp, the optimistic camp, whose thesis is muddle through? And the question is, if you only can put muddle through as your optimistic scenario, well, if you muddle and muddle and muddle along a tightrope, if the tightrope is infinitely long, you will wind up falling off.

REINHART: I think it's also it's -- I mean, it's inherently a risky path, and so while one can imagine it working in some sense, it doesn't take large deviations to sort of put you over the edge. And I think that is the problem that sort of people and markets have to face.

Now, the Europeans have successfully managed to walk that so far, and each time, we have come close to the edge. Say, for example -- at the Cannes summit or when the Greeks proposed a referendum, you know, we came, arguably, very close to a disruptive breakup and people kind of pulled back. And I think there are some very strong incentives for the system to continue to manage in that way. But it is difficult. It's dangerous for the system to be kind of constantly on edge. I think it is a drag on global growth to the extent that everyone, I think, looks at downside risk in Europe as something you have to filter in to how you think about the outlook, and that affects your decisions.

Now, I think at the moment one of the reasons things are looking a little better in the U.S. is that big downside risk that we were facing last fall with respect to an imminent crisis in Europe has faded a bit, and that's part of what has gotten, I think, people more optimistic. But it's not hard to imagine that that comes back into people's radar, and I think that's an important aspect of how you think about the outlook going forward.

MALLABY: I want to put all of you on the spot. Three years from now will there be 17 members of the euro, 16 or fewer?

REINHART (?): I think fewer.

MALLABY: Fewer. Joyce?

CHANG: I think it will be the same. There will just be more debt restructuring and deeper haircuts. I don't think it's so much about exiting the euro as restructuring the debt.

MALLABY: OK. So fewer, 17 and -- ?

ALEXANDER (?): Fewer.

MALLABY: Fewer. OK. All right. We have a sort of prioritization here. (No one's on the ?) 16, Greece-only camp.

Let's talk a bit about the U.S. And maybe I should start with you, Vincent. We had the Fed minutes out yesterday. And you had been arguing in the month or two before that the chances of QE3 were rather high. Have you changed your mind?

REINHART: Certainly. You have to respond to what they say. It's an open and transparent Fed, and they're telling you something that matters.

We'd been thinking there would be about a 2-in-3 chance of some form of balance sheet operation in the first half, and that had three parts. We have a forecast where the economy grows essentially at trend but that we had been above trend and we come back to trend; that's the second part. In the third part, there's an election coming, and the Fed would be reluctant to want to step -- act during the campaign season. But if you logically see the window close at the end of the first half, you are more likely to want to act in the first half.

What the Fed told us was that it was data-dependent, that it -- policymakers would be willing to act if there was evidence of a cooling in economic growth. So they're not in the mode to buy insurance in advance of that. Their forecast of 2-out-of-3 chance was essentially 1-out-of-3 chance they'd want to buy insurance; 1-out-of-3 chance that given our forecast of a cooling in growth, they'd have enough reason to act; so we're down to 1-in-3 now.

MALLABY: So you changed your view because of the -- what the minutes tell us. But are they making a mistake? I mean, they're still -- we still have an economy operating way below capacity. Your projection, and I think most people's, is that inflation is leveling off, if anything, for (the scope ?) to put that insurance in place. You're below capacity. You've got space to try to buy more insurance. Why -- is it just politics, I guess is the question?

REINHART: So you don't have to put it in terms of the Morgan Stanley forecast. It's the FOMC's own forecast. They admit there is a lot of resource slack, and they assert that the temporary increase of inflation is -- that, rather, the increase in inflation now is only temporary and that inflation expectations are well-anchored. So they are short of both of their goals.

And so the real risk is that 2-out-of-3 chance they don't act. And in that case, it's possible it was just a growth spurt, we'll see the economy come back to trend, and it will be June, July, August when they come to appreciate that but then be hesitant to act immediately in the heat of the election season.

So I think that timidity could prove to be a mistake. In the same way, in 2010 they waited probably too long to nurture the green shoots. They only marked on "QE2" in November as evidence that the economy was softening started to accumulate as early as the spring. I think we could be in a replay of that.

MALLABY: I want to come to Joyce in a second for the international aspect of this monetary stance in the U.S., but maybe Lewis first. You know, part of this is what's -- is the kind of discrepancy between the employment data, which have been fairly strong, and the GDP data, which have been less strong. How do you see that conundrum?

ALEXANDER: Yeah, that's a -- that's an important aspect of how you see the outlook. The chairman has obviously stressed this in his statements and in -- and that is very much, I think, part of the what the Fed is struggling with.

I think when you look at it, basically, over the last four quarters, you've had GDP growing only about 1 1/2 percent, while you had the unemployment rate coming down a full percentage point. That's a very unusually positive performance, and the Fed has been pretty clear that they don't expect that to continue.

What's driven that performance is primarily two things. It's a combination of relatively weak productivity growth and very weak labor force participation. So you've seen people exit the labor force, and you've seen low productivity.

Now, I think the Fed has argued, and I think we would agree with them, that those trends are not likely to continue. And consequently, I think that the pace of improvement in the labor market is likely to slow. And I think that's part of what creates the argument for them doing more.

If I could just add kind of one aspect to the way Vince just -- the way that Vince talked about the near-term issue, I think the other problem they have is financial conditions. And I think -- I'm -- you saw in the way the market reacted to the minutes yesterday -- essentially their conundrum, if you like -- that if they make it clear that they're not going to do QE, there is the chance that rates will rise, that equity prices will fall and credit spreads will widen. And they will, in some sense, engender a tightening of financial conditions that they do not want.

I think one of the things that all the policymakers have been pretty clear on is that they believe at this moment we need to have continued very accommodative policy. And the market's own reaction to what they do can sort of create -- can create a situation that they don't want.

And so I think that one aspect, in addition to the way Vince characterized it, and I would say that would push them in that direction, is if you actually get into one of these feedbacks where, in anticipation of them not going, markets start to sell of, and then you get an effective tightening of financial conditions, which then undermines things, I think that is one of the trickiest challenges they face.

Be prepared, because of that, for confused communication because right now they've embarked on two sets of unconventional policy. One is the ongoing balance sheet operation, but the second is managing interest rate expectations by offering the assurance that rates would stay low till late 2014. If you look at money market futures, markets are contesting that view. They have priced in a tightening before late 2014. Fed Reserve officials are going to have to protest that, but -- and how do you protest that? You emphasize how much slack there is; you emphasize how much room there is for the economy to expand, how well inflation is contained. When you hear that, don't assume that they're signalling that they'll do QE. They're actually defending what they've already done.

MALLABY: It's an interesting conundrum about the way that central banks function in the sense that the theory has been, you know, if we communicate more clearly, more extensively and more openly, then the markets would get exactly what we want to do, and so there'll be none of these miscommunications. But lo and behold, they do that, and we're still talking about potential miscommunications.

But I want to come to Joyce and ask, you know, if there is a sustained recovery that the Fed appears to be more willing to believe in now, what does that mean for emerging markets, emerging market currencies and the global outlook?

CHANG: Well, for emerging markets' currencies, much of the story has been a dollar-weakening story. So you've seen in recent weeks a pull-back in a lot of the EM currencies, because there is a question: Are we at a turning point right now? It's a dollar-weakening story, you know, at a turning point, particularly when you look at the growth prospects, you know, for Europe.

I would, you know, just, you know, add to Vincent and to Lew's points, when the message has been no further asset purchases by the Fed, but we want zero interest rate policy to continue to 2014, and the G4 central banks, you know, at large have signalled that -- so that's still made emerging markets a pretty attractive place to be just given how low yields are.

So, you know, peripheral Europe at the beginning of the year was, like, at 7 percent. It's now down at 5 percent. You know, emerging markets is at 6 percent. You have four times the growth. You have China alone as 50 percent of the contribution to global growth.

So I don't -- I think that for capital flows into emerging markets, it's still a fairly robust picture just given where interest rates are likely to stay for the foreseeable future. The question, though, for the currencies, though, is are you through with this -- (inaudible) -- currency appreciation trend? And particularly in Asia, where rates are very low, are you looking at a scenario where rates have to go up?

But overall, when you just look at what G4 central banks have done, I mean, like, $6 trillion of, you know, balance sheet, you have to be looking at a period where we're heading into higher rates and higher volatility, particularly after the first quarter that we've had, where, you know, asset classes -- the risk rally has been very strong risk on. So you've had a market that's been very range-bound over the last few weeks. But emerging markets looks like an attractive place to be on the growth differential, which is only widening. The yield differential -- you're getting paid more for being in emerging markets.

Now, for the currency slope, can you still have the currencies appreciate? That's more of a question mark at this point in time, particularly given the appreciation we've had over the last few years for some of the currencies.

MALLABY: Do you think that in terms of the way the global system is perceived to operate, the wave of dissatisfaction that we've heard out of emerging markets are going to continue? I mean, just to recap, I'd say that, you know, the first shock comes in 2008 when China particularly holds vast amounts of dollar assets and suddenly realizes, gee, the U.S. capital markets aren't that safe, and they talk about dollar hegemony, and they want to change that. Then you get the kind of currency war rhetoric more recently, with the Brazilians leading that. Do you think that as -- you know, as things go forward, we're going to hear more of that dissatisfaction about the way the global monetary system works coming out of the BRICS and other emerging market economy?

CHANG: Well, I think you are hearing that dissatisfaction. But until you see, you know, countries like China really make deeper progress on currency convertibility, interest rate liberalization, where else can they go, right? I mean, so it's one thing to talk about the opportunity in emerging markets, but you have a lot of distortions as far as, you know, macroprudential controls and what is investable, the size and the liquidity of these markets.

So there is, I think, growing dissatisfaction, but emerging markets are still in many ways going to proceed very slowly on how they manage the capital inflows that are coming in given some of the risk associated with that. So we're still in an environment where, you know, there are not that many investable assets for just the size of the reserves that we're talking about. I mean, emerging markets now have 80 percent, more than 8 trillion (dollars), of the global foreign exchange reserves, and where can you invest most of that, just given the size of the emerging markets?

MALLABY: Vincent, I think you've argued that the kind of level of distortions around capital controls in emerging markets are converging, in a way.

REINHART: Mmm hmm. So it's a couple things. The first is, expect more capital controls, on average. Why? Because in 2009 half the economies in the world were in recession, but if it was an advanced economy, it was because they had a financial crisis. If it was an emerging market, it was because they had a demand shock. You snap back from demand shocks. You grow more slowly as a consequence of having a financial shock.

So that growth differential that we had going into the financial crisis, where EM was growing at a lot faster than advanced economies, is only going to widen. That implies that emerging market economies are going to be dissatisfied with the very, very accommodative monetary policies in the advanced economies and therefore going to want to reclaim a measure of independence. The way you do that is put on capital controls.

But they're starting from a very uneven base, and what -- and that gives China the opportunity to liberalize at its own pace but the Brazils and more globalized economies to tighten at their own pace, and they'll sort of converge in the middle. On average, (there/they ?) will be more.

MALLABY: Lewis, let's ask another question here about kind of global governance. You've got, on the one hand, the U.S. proposing a new president of the World Bank and some commentators observing that the Nigerian candidate seems to be much better qualified. You've got a fight going on about IMF resources, with the Europeans hoping that the emerging markets will kick more money in to match what they've promised.

How do you see that part of the governance of the global economic system evolving?

ALEXANDER: Well, in some ways, if you look back over the last several years, I would argue the G-20's been a success, if you look at the role they played in 2008 and whatnot, and the evolution that we've seen from the G-7 back in the '90s up until where we are now. I think there's some real momentum. And say, for example, the commitment that was made in Seoul on the G-20 summit to sort of change IMF governance I think is a very positive thing.

But I think if you look at kind of what's happened with Europe and what's going on here, it's taken a bit of the steam out of that momentum, and I think that is something to be concerned about.

I think about the situation of the U.S., and one of the things that's interesting is -- I've been doing a lot of looking at sort of polling data on what sort of priorities voters have in the context of the fiscal challenges we face. One of the few areas of consensus is less money for foreign aid.

Now if you translate that into what's on the agenda for the fund, that's a material issue.

MALLABY: For the IMF, you mean.

ALEXANDER: Yes.

MALLABY: Yeah.

ALEXANDER: The G-20 essentially made a commitment to try and complete the changing governance of the fund by September of this year, and frankly the chances of getting that through the U.S. political system this year is slim to none. And frankly if you were to try and do it, it would fail and you would be -- you would have to take a step back.

I think about the risk, in some sense, and when I look at all those things, and the U.S. taking a step back, frankly, from sort of being part of sort of global governance with being a real risk and this -- the -- in some sense the debate over the World Bank, I think, raises some real issues there. I -- you know, I have personally felt for a long time that we ought to open these things up. But I think there is a bit of a risk, just from the U.S. perspective, that if we kind of take less of a leading role in those things, that our overall commitment to the process is going to wane.

At the same time, you see what's going on in Europe, where they are, in some sense understandably, obsessed with their own problems. And that, in and of itself, has also taken some of the impetus away from the sort of the global governance side of things.

And you know, at the same time, there's obviously, you know, a bit of a reticence on the part of the Chinese to sort of step into the breach. And it feels in contrast to what it felt like in 2008, where I think there was sort of legitimate -- there was a real commitment to this, and it actually added to the policy response.

You get a bit of a sense of things kind of pulling apart, in a way, that I think is problematic. And I think it -- you know, I mean, the realities of an election year in the United States are what they are, and I think it would be a mistake to try and push this agenda now, because you'd get the answer -- you'd get an answer you don't want. But it does raise risks about where we're going.

MALLABY: I want to open it up to the audience, to members in a second. Because of the talent in the room, I want to get questions. But let me just put one last thing to all of you, maybe starting with Joyce. Is there a crisis sort of over the horizon that we haven't talked about, that we haven't focused on? Is it Turkey or some other economy that's running a massive current account deficit that's going to be in trouble? Is there anything you worry about? Is it oil prices spiking with Iran? What's in your kind of risk set looking out six months or 12 months?

CHANG: Looking out six months or 12 months, I don't think it's an emerging markets crisis, because even though you have a country like Turkey that is more vulnerable to higher commodity prices, that has a current account deficit -- doesn't have a funding problem, and it has a pretty deep domestic investor base. And I think that situation is manageable.

And you know, frankly, the higher commodity prices on the whole, that actually benefits emerging markets a bit more. So I don't think the crisis is actually one that would be forthcoming from emerging markets.

I think near term, it still comes back to Europe. It still comes back to Europe that -- you know, have we graduated from acute to chronic, but is it really that Greece was a kicking-the-can-down-the-road restructuring; that an exit from the eurozone is something that gets, you know, more debate, you know, over the next six to 12 months; and it comes, you know, back to Europe?

You know, the big surprise last year wasn't Europe; it was the U.S. ratings downgrade. That's what sort of started the whole sell-off last year. So we're getting into a U.S. cycle again -- you know, another debate about the debt ceiling.

So I don't think it's in emerging markets. I think medium term the markets will continue to focus on China, just because there isn't as much information available, you know, and because there are more question marks about how we're finally seeing that shift in growth in China, you know, from 11 1/2 percent to 8 1/2 percent, which in my opinion is not a hard landing. They've talked about that for a long time; now it's actually happening, but everybody's worried about that. I mean, that does pose some uncertainty over the medium term.

MALLABY: Any over-the-horizon shock you want to predict?

REINHART: December 31st, because --

MALLABY: (First of all ?)?

REINHART: -- because on December 31st, an unstoppable force meets an immovable object. We have adverse debt dynamics, and we have a legislative sudden stop on the equivalent of 4 1/2 percent contraction of GDP, around the same time we're talking about the debt ceiling.

MALLABY: And the ability of the U.S. political class to reach sensible compromise is not as robust as --

REINHART: Not proven. Yeah.

MALLABY: Yeah, OK. (Laughter.)

ALEXANDER: I very much agree with Vince that that's like the pre-eminent risk.

I just want to put something on the other side, which is I think there is an upside to the U.S. as well, which is if you get an electoral outcome that actually allows you to do things, I think we're lining up to do some fairly major things that are positive, in addition to some sort of long-run fiscal deal.

I would -- I would point out that, you know, just in the last couple of weeks, there have been a bunch of plans that have been put out on the fiscal side. The differences in those plans isn't really about stabilizing debt; they all do that. The difference is in -- is in the vision of government that you have.

And so I think if you get a clear outcome from the election on one side or the other, there's the potential for both doing a big fiscal deal, but that would include things like we're getting ready to do a major tax reform, which is, I think, potentially a very positive thing for the economy. I think we are lining up to do mortgage finance reform. So I think if you get an outcome of the election that essentially puts gridlock to the side, there are -- there are very positive outcomes that come of that.

Now, you look at the polls and ask yourself the question: How likely is that political outcome? And it is clearly not the most likely outcome.

So I -- you know, partly, and as I think about how we think about the second half of the year, it's just going to be very complicated, because there are -- is -- there are very negative outcomes that are possible, and I would argue there are actually positive outcomes that are positive -- possible, and it is going to depend on the complicated interactions of how -- what we get out of the election.

REINHART: So in some sense, the good news is we are so inefficient in the delivery of fiscal policy that there is no one direction we have to go -- that is, it's about taxes, it's about appropriations process, it's about entitlements, it's about the way we budget, it's the lack of rules. So you could actually contest the election on two different views of what -- how big the government should be, opportunity versus safety, marginal structure of tax rates -- two different views contest the election, and whoever wins puts it in place.

The problem is, if we don't contest the election on those issues, then it's very difficult to put it in place after the fact.

ALEXANDER: And I agree with that, but I think what --

MALLABY: It sounds like you want a parliamentary system. That's dangerous when --

(Laughter.)

ALEXANDER: Well, but one of the things that we are shaping up for -- I think those choices are going to be much clearer this time than they are normally. The Republicans, to their credit, have put on the table a credible budget plan that is in full detail and is very severe. It's not the plan I would choose, but it is a very clear vision for how you get fiscal consolidation. I think the Democrats have a very different vision of how you approach that same problem, and in some sense I think you are going to have very clear choices presented to the electorate.

Now, it's an election. It's complicated. These are -- these are not issues that are easy for people to understand. One of the things that jumps out of the polling results on this is it's interesting that there is consensus in the electorate across the political spectrum in some areas that is encouraging.

For example, you ask people, both Republicans and Democrats, would you be willing to raise taxes -- do you think it's a good idea to raise taxes on people who make more than $250,000, and the answer is yes. And you get majorities even among Republicans for that. I think that's encouraging. You look at some categories of spending and say, should we -- is this an area we should cut? And you see some areas where there's consensus. Unfortunately, on the spending side, that tends to be in relatively narrow areas. It tends to be, like, getting out of Afghanistan, farm subsidies, foreign aid. And unfortunately, that's not going to do it.

One of the -- you know, one of the places a little more troubling when you look at this is when you ask them about Medicare and Social Security, you tend to get majorities on both sides not for less, but for more. The Republican numbers on Medicare are fascinating. Twenty-one percent of Republican voters would support cutting Medicare, 24 percent would support spending more, which puts the -- sort of the Republican plan in a sort of an interesting context.

So I -- look, when you look at those numbers and ask the question, if the election were held today, would you get a sensible response from the electorate on the fiscal challenges we face, I think the answer is probably no.

CHANG: And both of you seem to be saying the chances of a bipartisan solution look incredibly slim; the electorate may not force this issue. So we are still at a phase where it is really kicking the can down the road. There isn't necessarily a drop-dead date that's 2013, because if it can be postponed, will it be postponed?

ALEXANDER: Well, I think the odds of a -- you know, a bipartisan solution of the sort we had in, say, 1983 on Social Security, unfortunately, given the political alignment, is low. To me the good outcome for policy is a sweep either way. It's all Republican, all Democrat. That's the clearest way, in my mind, for where you're going to get progress on all of these things.

If we get the most likely outcome, which seems today to be the president gets re-elected, the Republicans take control of the Senate and retain control of the House, that is problematic. And that is the outcome where I am much less confident that we get, you know, progress on all the long-run issues.

I personally think the problem of the beginning of the year will be handled in some way, but it's likely to be messy and noisy and have adverse effects from our vantage point. S&P downgrade seems possible, another one, Fitch downgrade. Sorry.

REINHART: (Inaudible) -- you'll be happy to know that this reminds me of my second-favorite quote from Kafka, which is from the "Country Doctor," which is, writing prescriptions is easy, dealing with people is hard. (Laughter.)

MALLABY: OK, let's go to members. Who's got a question? I see one right in the aisle there. Please identify. Hi.

QUESTIONER: Ken Brody?

MALLABY: Microphone there, Ken.

QUESTIONER: Ken Brody from Taconic Capital. A little twist on the question that you asked, Sebastian. There's some discussion among economic Democratic elites that's a sort of hopeful discussion on our economy, and I'm interested in the reaction of the panelists to it. For one, as you discussed, GDP growth has been inconsistent with the employment numbers. And typically, the GDP numbers are less reliable than the employment numbers. We've had a lot of revisions there, admittedly on the downside, since 2008. But national income accounts, which should be about where GDP is, are a good bit higher than GDP.

And putting these facts together, the hopeful Democrats say this is probably a pretty good indication that GDP growth has been stronger than we have seen reported and that we believe. And I'd like some reaction.

MALLABY: So, Vincent, are we richer than we thought?

REINHART: So that if you look at gross domestic income, it's increased faster than gross domestic product over the last year. We've seen some revisions.

Problem is that the spread between the two does vary a lot over time and can reverse itself. So it's tough to know. It's true, for instance, we got more household employment in the last month than payroll gains. However, when you look at it from the trough, we got more employment than household -- these are erratic readings on the economy.

There is clearly the -- a possibility of a breakout on the high side. We had an inventory bulge in the end of last year. That led to hiring. Hiring leads to income. Income leads to sales. Sales leads to sales expectations. And then all that cash that is on nonfinancial firms might start getting to be employed.

But I work backwards for, you know -- and you know -- and hope is a strategy. Hope is a thing with feathers. (Laughter.)

But when my optimism flutters upward, I think that the world's a risky place. We have an ongoing sovereign crisis and banking crisis in Europe, we have the possibility of elevated energy prices, and we have a fiscal cliff coming. Those are not the baseline outcomes, but the presence, the tail -- those tails to potential outcomes are reasons investors shouldn't have conviction. And if investors don't have conviction, you don't get the wealth creation that pulls an economy up relative to trend.

MALLABY: Byron Wien. There's a microphone right here.

QUESTIONER: Byron Wien, Blackstone. I think you're all too complacent about Europe. It seems to me that the European Central Bank --

MALLABY: They're supposed to be the optimists, Byron. Come on.

QUESTIONER: Oh, yeah.

MALLABY: (Chuckles.)

QUESTIONER: I'm trying to be -- get to their side.

The European Central Bank has changed its spots totally from focusing on inflation to focusing on shoring up the banking system and keeping the economy afloat. That's likely to continue for three years or so. But three years from now, isn't there a very strong possibility of a breakup? Because none of these countries are really going to be able to make the fiscal changes that are necessary. They're going to -- growth is going to be slow or negative. You're not going to be able to implement the austerity with the work rules that exist there. So consequently, three years from now, the ECB will have run out of money, and Europe's structural problems will still endure. Am I too pessimistic?

MALLABY: (Do you want to take ?) that?

CHANG: Well, even the next three years, I think, are pretty difficult. I mean, you'll -- not just after three years. I mean, if you look at just Spain and Italy between now and the end of 2014, they have 800 billion of gross sovereign funding needs. So the next three years are hard.

I'm -- it could be about a breakup of Europe, or it could be that you have weaker Europe and stronger Europe, which is the equivalent of a breakup. That -- it is just very clear that the fiscal pact, you know, cannot be held amongst all of the countries.

And I think the -- you know, the focus will be, you know, less on the Greece-Portugal than on the Italy and Spain, and what happens with those two, because that's 800 billion of sovereign gross funding needs, not even counting the bank recapitalization needs that they're going to have.

MALLABY: But Lewis, maybe just for me to follow up on that -- I mean, in some sense, what Byron is asking about is, is this sort of superman central bank thing an act that's going to be revealed to be a cartoon? I mean, otherwise, you know, you have a long debate in Europe about the EFSF bailout fund. It's supposed to have 440 billion euros of bailout capacity. And then one fine day in December the central bank says, you know what? Four-forty (billion euros) -- nah, we'll just print half a trillion (euros) in one day, and then we'll do it again in February. I mean, so there's this kind of macho central banking, and Byron is saying it's going to end in tears.

ALEXANDER: I would distinguish -- I would respond to that in the following way. The central bank can provide liquidity, and liquidity is very important in a funding situation, and that is the contribution they have made.

That was obviously an issue in terms of the response to -- I mean, if you go back to where we were a year ago, there was this perception that sovereign risk within the eurozone was a limited thing and very concentrated. Essentially what we went through in the fall was an adjustment to a new world where there's serious sovereign risk within the eurozone, and that generated pressures that the ECB could respond to.

What the ECB cannot respond to is this fundamental question that there are fiscal imbalances that need to be funded and are not going to be funded by the private markets. And it fundamentally depends on the political relationship between the countries that need the funding and essentially the European institutions' willingness to provide it.

There is a set of -- a political set of challenges, if you can think about it, between Greece and Germany. The Greeks have to commit to doing certain things -- right? -- in order to make it politically feasible for the Germans to fund them. And as long as they can find a balance between the Greeks' willingness to make commitments and to some degree actually deliver on them, in a way that is consistent with the political constraints on Germany on providing the funding, this thing can go on.

And, you know, as somebody who's watched European integration from this side of the Atlantic for decades, I'm always struck by we tend to underestimate sort of the commitment of the Europeans to that process. I fully agree with you that there are risks and there are parts of this that are likely to continue. My response to Sebastian's question was fewer than 16 down the road. And, you know, is that too optimistic? I don't know. But, look, there are very big challenges. I think there are -- there are risks of accidents along the way.

I don't think the ECB -- I mean, I think the ECB has done what it can do, and I don't think it ultimately faces a problem, in the same way that I tend to think the Fed is perfectly able to exit from its current situation and that will all be manageable in a reasonable way. I don't see that as the core problem. There's a different problem that is very tough to manage.

REINHART: I mean, monetary policy can be a bridge, but it has to be a bridge to somewhere. And so if there isn't a fiscal consolidation -- (inaudible) -- then there's nowhere to go to.

And before we give the ECB high marks on everything, their attitude towards public -- private-sector involvement has been unhelpful, because they have put -- essentially what they said is they don't participate in the haircuts in the Greek arrangement. But what that means is, when the ECB buys sovereign debt, it actually places itself senior to everyone else, and so it doesn't remove sovereign credit risk in its open market operations. That then raises the question, in a sovereign crisis in the future, what exactly will the ECB do?

MALLABY: Another question. Right over here.

QUESTIONER: I'm Chris Harkin McDonough (ph) from Jiff (ph) Brothers Investments. I have a question for Joyce.

I was struck by your response on what the EM countries are willing or not willing to do on exchange rate appreciation. Having traveled through Asia, I guess I share a lot of that, that they seem very unwilling to allow further appreciation. But I guess the question I have is, what would you look at -- other than seeing prices move -- what would you look at as a signal that the EMs are actually allowing, you know, the euro -- the dollar to depreciate more substantially to allow both regions to grow their way out of their problems through exports, which is kind of what both need and can help in rebalancing the global economy? But given their unwillingness, there's got to be something that you might be looking for as some sort of policy change or some sort of economic change that would signal a greater willingness.

CHANG: Yeah, I don't see the greater willingness right now. In fact, if anything, I think that there are emerging markets that are willing to look at more unorthodox policy mixes, because, you know, they have their own domestic agenda. And I think, going back to just the point --

MALLABY: You mean unorthodox mixes in order to prevent depreciation of their currency.

CHANG: Yes.

MALLABY: Yeah.

CHANG: Yeah, more -- and we've seen that across the board in a number of countries, particularly in some of the commodity exporting countries, that they've had appreciation pressures.

But, you know, I go back to the point that Lew made about, you know, the G-20; how are you going to get this kind of coordination with emerging-markets countries and with developed countries? I mean, for emerging-markets countries, you still have such a big income differential that to try to convince emerging-markets countries, where you have, you know, a standard of living which is -- the key objective they're looking at, that they're still thing to bring up to, you know, provide resources for a bigger firewall for countries that have a, you know, 35,000 (dollar), $40,000-per-capita income.

I mean, I think that for emerging-markets countries, you know, now it is more about what are their own domestic self-interests. You know, they have a deeper domestic investor base that's also increasing in size as well. So I'm not so sure that you get a (catalyst ?) that comes on some global policy coordination that's going to result in an agreement that will work, because, I would agree with Lew, it seems to me that you had a moment in 2008 and 2009 that looked more effective than it's become now. I think the European crisis has made that harder, because convincing poorer countries to bail out richer countries is just something that's politically very difficult. And we go back to the politics in all of these countries, when we talk about Europe and when we talk about the U.S. I mean, emerging markets has its own set of politics as well.

MALLABY: It sounds like the climate change debate a bit, where, you know, the rich countries say, you guys are growing emissions faster, and the emerging markets say, yeah, but you still emit more, and so why should we take -- I see questions; let's go right there in the back, and we'll come here in a second.

QUESTIONER: Hi. David Malthus (ph), with Enseema (ph). I wonder if you could comment on China. There is, you know, two schools of thought. One is that they're in trouble, so that's showing up in the currency not strengthening. China has recently raised its quota on bank lending and yesterday raised its quota on foreign investment into China. Is it headed in the right direction or is it still headed for a harder landing? Thanks.

MALLABY: You want to try that?

REINHART: China is a very opaque economy, and the line between the public and the private sector is extremely indistinct. What that means, however, is officials have lots of levers of policy to keep demand growing quickly. And our own forecast is they'll succeed in that; that they can shift, essentially, credit and capital and get some infrastructure building out of the private sector, they can support credit; and so that, if anything, growth is going to be very well-maintained in China.

MALLABY: OK. Did you have a question here? There's a microphone coming.

QUESTIONER: Betty Masham (ph), Gerholding (ph). If Sarkozy is not re-elected, will there be a spillover to the rest of Europe?

MALLABY: That's actually a great question, because it relates also, I think, to the German political situation, where there is also pressure from the opposition on Merkel to change her stance towards austerity versus growth. So this -- it seems like both in France and in Germany, the two core economies, you could get political shifts that made more space for pro-growth policies.

Lewis.

ALEXANDER: I'm not going to pretend to be an expert on French politics. I do --

MALLABY: I didn't ask you about the Andalusia election in Spain. Come on.

ALEXANDER: Fine. (Laughter.) Look, I do think the German -- the German situation is sort of a very complicated one in the sense that I think there is actually more support for Europe outside of the government than sort of within the government. And there is this problem within the German government that it's a relatively narrow base that is taking the most hawkish positions.

I think Merkel unfortunately is in the position of trying to sort of lead a coalition that has that at the base, and it's a tough challenge for her to walk that line. I think having a partner in France who she could work with was very important, and my guess is they will continue to find a way to do that. But it will make things harder, I think, for them to sort of manage going forward.

I'm -- you know, my impression is that, you know, the French is -- the French is -- the way they see these problems is ultimately consistent with sort of resolving the issues in Europe sort of regardless of which side wins on the election, so I'm not sure it's a -- it's a long-term issue. But it's going to make what is already a difficult process harder, at least for a while.

MALLABY: Joyce, one thing that could come out of these political shifts in Europe could be a transactions tax, right, because the German opposition is saying that's their condition to supporting what Merkel wants on the fiscal pact. Is that something your clients worry about?

CHANG: I -- and I think that most clients still feel that that's something that they probably will avoid at the last moment, or that for one country to do that unilaterally is probably unlikely to happen, that we've seen on a lot of these regulatory and risk issues is that that's where -- there wasn't been more coordination. I mean, all sides are, you know, actually worried about the amount of regulatory arbitrage that could occur. So, you know, there has been, you know, questions about the pace at which, you know, the U.S. is moving versus Europe. But I think -- and that's where we've seen more delays and more, you know, postponement, even though these become, you know, political issues. So I don't think that's come up, you know, as a burning issue, you know, more immediately.

But I would say that just on this political question -- (inaudible) -- all of the peripheral governments have been overthrown, and Belgium as well. So it's -- if you look at the trend in Europe -- I mean, look at all of the periphery, and, you know, your question on France, you know, it is -- it is -- I think the risk still does come back to, you know, politically, how can this hold together, given the kind of adjustment, you know, that needs to occur in Europe for them to make --

MALLABY: Of course, a key debate is, you know, is France periphery or is France core?

Let's go to a question right here. Lady in the aisle.

QUESTIONER: Yes, Carole Brookins, former USED at the World Bank. What oil price or energy price over what period of time becomes a real game changer in your models?

MALLABY: Game changer for U.S. growth or -- (inaudible) --

QUESTIONER: Well, for U.S. growth and world growth.

REINHART: I'll speak for myself. I think -- in general, I think these things are not cliffs; they're not sort of -- generally, they're not -- there's no question that higher oil prices are a -- generally a drag.

We did see in this first half of 2008 when gasoline prices hit $4 a gallon, you saw very discrete kind of changes in consumer behavior. Having been to $4 a gallon before, I don't think we're going to -- we're going to see that again. I think if we're talking about normal supply and demand in the context of coming into a driving season, when things are going to go up probably until June, I don't see that as a big issue. If we get a supply disruption out of the Middle East -- there are obvious scenarios under which that could happen -- that is a different kettle of fish. I don't think that's the most likely thing to happen, but it is certainly one of the things that would be on my list of risks.

CHANG: Yeah, and you know, I'd also look at whether it's a supply shock or a demand shock that's causing the change in oil prices. So, you know, the first half of last year you had a 33 percent move in oil prices that was largely off of a supply shock with Libya. And if you look at where we're at currently, you know, sort of the 120 (dollar), 125 (dollar) range, I mean, we estimate that that's the same -- maybe it takes .25 percent off of growth -- I mean, not a huge move off of growth. So whether it is a supply rather than demand shock, you know, I think, you know, makes a big difference. I'd also put the risk of -- it seems like sanctions is the path they're going. I would put the risk of military conflict as an unlikely scenario at this stage in the game.

But you know, there isn't necessarily a price, but what we look at, at least in emerging markets, is, you know, what is the break-even price for these countries where they're budgeting the price of oil and whether they're saving the windfall or spending it. And I'd say in emerging markets, most countries have been really pretty conservative. They have budgeted oil, you know, conservatively, maybe a good, you know -- you know, $30 below, you know, where it's at right now. So I'm -- it's more of a problem for the developed, you know, markets -- countries. And right now the current trend seems to me in some ways less worrisome than what we saw a year ago given the move we had in the first half of the year.

MALLABY: Vincent has been sneaking a peek at the chartbook he's concealed in his lap. (Laughter.) (Inaudible.)

REINHART (?): So I think from the U.S. perspective, it's all about gasoline prices. And the evidence suggests that households basically pay for higher prices at the pump by cutting back on other parts of consumption as long as gasoline prices are within prevailing norms. Once they break out more significantly from prevailing norms, then they cut back in total. If we remain around where we are, then that means it's a problem for lodging -- you know, lodging or food away from the home or components of consumption, but not for overall consumption. It's a modest drag for economic activity because we are a net oil importer. Our chief risk is we've now essentially rolled back the earlier decline, so we're at the high end of prevailing norms. And so any increase from here on would more likely be associated with more restraint.

MALLABY: One last question. I saw the one in the aisle there first.

QUESTIONER: (Inaudible.) Where do you all think the Dow will be in the first week of November? And do you --

MALLABY: (Inaudible) -- specify which day in November, just so -- (laughter) --

QUESTIONER: And do you think that any industries or countries such as Iran will make any unusual attempts to influence the outcome of the election, say by constricting oil supplies?

MALLABY: OK, so there's two parts of that: foreign meddling and where will the Dow be on election day.

ALEXANDER: I thankfully am an economist and not an equity strategist, so I feel it's acceptable -- (laughter) -- for me to not give you a straight answer to that question. Having said that, one of the things we are thinking about is how the uncertainty around the election will actually sort of affect markets. There's the economics of the fiscal cliff and whatnot, but there's also how are markets going to react in anticipation.

If you actually look at what happened last year around the debt ceiling and whatnot, the interesting picture you get is that the primary effect of the uncertainty that was created by that showed up in weaker equity prices, as opposed to higher interest rates. And so there's a sort of an interesting question, if you're facing, you know, fiscal chaos, how do markets respond to that? And I think the -- certainly the experience last year would suggest that that will show up as uncertainty about the economic outlook, uncertainty about earnings that translates into weaker equity prices, as opposed to people decide they want to sell Treasurys. And I would suspect that that will -- would be the pattern.

So to the extent that you come into the election with one of these uncertain outcomes that we kind of talked about earlier, my guess is you're not going to get the reaction of, oh, my god, people are going to look up and decide they don't want to hold Treasurys. It's going to be, there's more uncertainty, the economic outlook is likely to be weaker, and that will mean weaker equity prices.

On the foreign meddling, my guess is -- it's hard to imagine anyone could do that successfully. It's a blunt instrument, and my guess is it wouldn't do it. As somebody who has worked in Washington for a good part of my career, we often -- I often hear conspiracy theories about this and that, and my general argument for why they're wrong is that assumes a level of competence that isn't there. (Laughter.) And I would apply that argument here as well.

MALLABY: And Joyce?

CHANG: So JPMorgan is forecasting for equities about a 14-percent return this year, so (Fortune ?) 500, you know, for the equity markets. And what I've noticed --

MALLABY: We've had a lot of that already.

CHANG: We've had a lot of it already. And I think what investors are trying to do is lock in what they made in the first quarter, which was in some cases what they were forecasting for the full year, what with this uncertainty ahead.

But what I have seen over the last couple of weeks is that you've had a real breakdown in some of these correlations, where everything was very correlated. And I detect that there is more, you know, bullish sentiment right now about U.S. equities, and because of the strength of corporate balance sheets. So that's, you know, JPMorgan's forecast on the equity markets.

You know, on the whole issue of foreign meddling, I have to just say that, you know, look, if you act unilaterally, you're going to have retaliation, so there's that whole question of who's the first mover, you know, in the whole Iran situation, who's going to do that in a unilateral way, face retaliation, and will you get something that, you know, involves more global coordination, which has been very difficult?

So I think the approach has been sanctions, which seems to be having some effect, and, you know, that's what they're going to stay with. But I have seen recently, though, that some of those fears on Iran seem like they have actually dissipated a bit over the last month compared to, you know, a bit earlier this year.

MALLABY: Vincent, Kafka believed in devious bureaucracy.

REINHART: No doubt about it. But meddling is hard to do, and it's not just one country that might be thinking about what it could do to affect the election outcome. And perhaps they offset; I don't know.

And I sort of agree with Lewis's point. It assumes a level of competence that probably -- and an ability to predict the consequences of the campaign, the consequences on two campaigns.

With regard to equity prices, our call's fairly straightforward. The world's a really risky place. And with such risk, it's tough for investors to have conviction and therefore tough to get durable wealth creation. Therefore we'd say the equity market is going to be considerably lower relative to today.

In particular, despite the fact we have known since 1786 that there would be an election, equity investors haven't really -- their window of observation hasn't embraced November or December 31st yet, but it's beginning to happen. As that happens, we're going to be spending the summer and into the fall looking at in-trade quotes on who's going to be president, who's going to win the House, who's going to win the Senate, and then we're going to be multiplying that in to what we hear on Sunday morning talk shows about what they do in power. That's not good for markets.

MALLABY: OK. We apologize for running over by 203 seconds, but it's been a great meeting. Thank you very much.

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