World Economic Update

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

MALLABY: OK, I think we can get started. My friend, Greg Ip here, was just saying the good thing is you guys are having lunch; therefore, you’ll be very happy, you’ll doze off. If we say something dumb, you won’t notice—(laughter)—so we’re going to get in there before you’ve quite finished lunch, then you will be kind of a bit angry about being interrupted. It will be much more stimulating.

All right, so I’m Sebastian Mallaby. Welcome to today’s Council on Foreign Relations World Economic Update. I work here at the Council.

On the far—over there, we have Monica de Bolle, senior fellow at Peterson Institute for International Economics; Greg Ip, in the middle here, chief economics commentator, the Wall Street Journal; Vincent Reinhart, chief economist and investment strategist at BNY Mellon Asset Management North America, newer to that job than you are to these panels. Vincent has been doing this for a while.

And we’re going to address the world economy where the baseline outlook is of course good. Growth last year, 3.8 percent. The forecast for this year globally about the same. There was an interesting piece sent out by Morgan Stanley— Chetan Ahya—who does a thing called “Sunday Start” sometimes, and it’s a little bit lighthearted, so maybe I’m picking on a soft target here, but he said, you know, the outlook is great. The only thing is, you know, there’s a lot of policy stimulus underpinning all this, so we could worry about maybe two things, he said. He said, when you’re—maybe credit tightening in China and possibly financial instability in the U.S. But, you know, when you actually look at the news, you observe Argentina, you observe the oil price jumping up, you think about trade tensions, it seems to me that there’s more to talk about than some Wall Street commentators were implying.

All right, so we’ll start with Argentina and emerging markets. So Monica, you know, a year ago, Argentina was issuing a 100-year bond, and Macri was a darling of the markets, and now, interest rates have been jacked up to 40 percent, and they’re going to the IMF. What went wrong?

DE BOLLE: Well, Argentina is a very fascinating and interesting case always, and it never ceases to interest and fascinate. And I think this latest episode is one more to add to that long list that they have.

Generally speaking, when you look at the underlying macro trends in Argentina—I mean, sure, Macri has done a lot in terms of advancing some reforms, in terms of establishing himself as a solid political figure in Argentina, which is always a very challenging thing for anyone who is not, you know, from the traditional Peronist camps. But the underlying macro imbalances were always going to be the big risk to the gradualist strategy that he was trying to put in place. So there was always the possibility that at some point if, you know, the gradualist approach hadn’t been seen to its conclusion, that Argentina would be hit by some kind of external shock that would then turn into a—kind of an Argentina-specific shock, given the imbalances that it has. And I think that’s exactly what we’ve seen.

What’s interesting, I think, about the case of Argentina, aside from several other things, is that we have seen a classic balance of payments crisis occurring in a country that has an inflation targeting regime and a floating exchange rate regime—yes, heavily managed, but nonetheless a floating exchange rate regime at the same time. And the traditional policy responses—so the jacking up of interest rates to 40 percent, the foreign exchange interventions that Argentina has done—they have been typical responses that occur when countries are trying to defend some kind of pay, which, you know, we know wasn’t the case here. But the problem really is that you had—with the very high devaluation of the peso, you started to have—and with very high inflation and very far from the target—you started to have this conflict about, you know, what do you do when you have a devaluation, a run on the peso, inflation rates that are very high from the target, preserves that are not going to be sufficient to hold the situation if it turns into a sort of an Argentina-specific panic, which is what seems to have happened. And in the end, you know, the response to all of this was, go to the IMF and try to get some IMF support to back up at least what remains of the reform effort.

MALLABY: You know, one thing I wonder about—and maybe I’ll throw this at Vincent or Greg, whichever wants to—but, you know, there was this famous moment in IMF history when Michel Camdessus was standing over Suharto, the Indonesian leader, as he signed an IMF agreement. I guess this was late ’97, early ’98. And that image of the, you know, cross-armed technocrat, you know, ordering the rethinking of all the micro-regulation of the Indonesian economy became a symbol of kind of political overreach by the fund, and so now the fund has tried to cultivate a more tolerant, sort of friendlier image. And the question is can that be sustained through this Argentina test because if you don’t impose conditions, then you’re being nice, but then you may be allowing them to get away with too much. If you do impose conditions, the attempt to rebuild—not so much credibility, but friendliness in the eyes of the emerging markets, it goes out the window. So, I mean—do you want to go first, Greg, and then—

IP: Well, it will depend a lot on the outcome, of course. If it ends up doing the trick and Argentina does pull itself together, then everybody can walk away saying, mission accomplished. And I guess I’m moderately optimistic that in fact that will happen. I mean, notwithstanding that they are having the problems you described, I don’t think the serious—you’re not—they’re not facing the kind of cliff that they would if they’d had a fixed exchange rate and all their borrowing had been in dollars.

And I look at the policy program of the Macri government, and it’s hard for me to argue that they’re doing anything fundamentally wrong there. So I would say that odds are that Argentina will come out better having gone to the IMF than if they hadn’t, and the IMF will look pretty good.

And this will not be the first time, by the way, that they—a country has done this. I believe Mexico and Poland have both—and Colombia have all actually accessed—not actually accessed—I’m not sure what the term is. They got these credit lines but never actually needed them. In some sense, that was already proof of concept.

There is a bigger issue, of course, which is IMF has had so much of its resources tied up with Greece and Europe that it really took away from its, you know, ability to deal with its traditional client base, and at the same time, it found itself unable to actually impose a conditionality it wanted on the European clients. And it’s kind of a slightly different question, but that’s where I’d end up.

REINHART: I would first say there is a precedent for saying mission accomplished too early. And the idea that I’m from the IMF and I’m here to help is a little at variance with their history. I think there’s a couple things to look at. From the IMF’s perspective, their brand name has been significantly tarnished by Greece, with lots of hand-wringing about the advice they were giving and their expectation of conditionality. It’s true that conditionality wasn’t as specific as restricting the clove monopoly, I believe, was—

MALLABY: Exactly, yeah.

REINHART: But this is important to the IMF because they have to show it’s a useful institution, they have to show it’s a useful institution with a country that has a long history of resenting impositions by the IMF. So there’s an opportunity for Madam Lagarde to allow—you know, give President Macri the opportunity to make some hard changes, not say it’s imposed by the IMF. There’s a window; let’s hope they take it.

The fundamental problem is about both stocks and flows. We’ve got to remember that the—President Macri inherited a terrible economy in terms of no reserves, implosion in activity, incredible statistics, and a wage bill—government wage bill that was not sustainable. So they are working from a very low base, trying to walk a very fine line between how much you do to please international investors, and how much change you can do and keep voters on your side. They may have walked that line a little—veering too closely to the voter because, frankly, global investors were too accommodating. And that meant, in essence, they had essentially an overvalued peso exactly at the wrong time. That sets up the flow imbalance; i.e., current account deficits of 5 percent.

The major thing to remember is the precipitating event was actually pretty small. It was the 10-year Treasury flirting with 3 percent in a relatively—

MALLABY: Kind of bad harvest, as well.

REINHART: Yes. Right, true. But we have exposed problems with even the smallest of stress tests. That should be concerning.

MALLABY: Which raises a question about whether this becomes a broader global EM issue. Maybe Monica can have a crack at that one. Is—do you see other EMs—emerging markets that are vulnerable? Where do you expect to see trouble?

DE BOLLE: Well, there are certainly a lot of other emerging markets that are vulnerable—not perhaps to the extent that Argentina is, but Turkey is a case in point, and we’ve seen, you know, the turbulence affecting the Turkish lira more or less in the same way that we’ve seen it affect the Argentinian peso.

There are countries in the region. There are countries like Ecuador, for example, that have been facing a lot of problems for a number of years now, and of course, you know, Brazil, which is also mired in its own problems. But it is—in each of these cases there are particularities to each that sort of help see them through, so in the case of Ecuador, we now have oil prices going up, and that’s helpful to them. In the case of Brazil, the main imbalance is fiscal. The current account is actually—has actually—you know, the deficit has actually gone down quite substantially. Brazil doesn’t have a lot of foreign debt to contend with. In fact, it has practically no foreign debt to contend with.

So the solutions would probably be, you know, adjustment—a big adjustment under the new administration, whatever that happens to be. So in all, I think the turbulence will be there, it will be affecting these countries differently. They will have to find ways to deal with it. For now, the only country I really see as really having to go to the IMF, even before they did, is Argentina.

IP: What I think is interesting about Argentina is that it’s the first clue that this episode of Fed tightening is going to have broader consequences. So predictably, every Fed tightening cycle has at some point led to a financial accident. In 1981-82, Volcker’s disinflation caused the Mexico default and Latin America crisis. In 1994, it was the Mexico peso tequila crisis; ’97-98, the East Asian crisis. You could even say in 2007, you know, it caused the mortgage crisis, which then rippled abroad.

So, you know, the Fed has now been tightening for a little bit—year and a half, two years, I guess—and we haven’t seen much. Maybe this is a sign that we’re finally starting to see something. That doesn’t tell us how severe it’s going to be, but to go back to what Vincent was saying, is this is what happens when the federal funds rate is basically 1 ½ (percent), and the 10-year Treasury is 3 (percent). It tells you that the world is still highly leveraged to what happens here.

The world is highly dollarized. I mean, I was looking at research this week for a column, and the extent to which—I mean, it’s astonishing. Argentina’s trade with the U.S. is only about 15 percent of the total, but 85 percent of its imports are invoiced in dollars. Its dollar-denominated debt is over one-third of GDP, and that story is repeated to a varying extent around the world. So that’s what worries me.

REINHART: I mean, that goes back to Monica’s earlier point: why is an economy with a floating exchange rate acting like it feels the need for an interest rate defense, and the answer is another stock problem. The debt-to-GDP ratio of Argentina has gone up 10 percentage points in just a couple of months. Why? Because it is not denominated in their own currency. And so you have a flow problem. How do you get new funding to meet the ongoing current account deficits, and you have a stock problem, your balance sheet looks increasingly untenable, and that’s why an interest rate defense is not credible. How you have 40 percent rate—real rate—nominal rate and a growing debt-to-GDP ratio?

MALLABY: I think, Greg, you were saying that there was a table used in a Fed presentation recently. Is that—yeah, that—

IP: That’s right. Yeah, Jay Powell on Tuesday gave a speech where he said, look, stop—the Fed is not the big deal you think we are for emerging markets, and besides, emerging markets are very robust now. They have much better policies, and their debt-to-GDP ratios are starting to go down.

I looked at that chart and I was wondering, well, the GDP is denominated in local currency and the debt—a lot of it is denominated in foreign currency. As these currencies pay off—or, sorry, start to decline, maybe that chart doesn’t look so great.

MALLABY: Right. So we’re talking there about the Fed and its effect on the global picture. Let’s talk about the Fed in a domestic context now.

John Williams, the incoming president of the New York Fed, recently resuscitated that term from the 1990s, that we’re in a Goldilocks economy—unemployment, 3.9 (percent); inflation still totally under control. Vincent, do you share that view? Do you think that there’s nothing to worry about?

REINHART: That worked out well last time, right? (Laughter.)

So in the near to medium term, the U.S. outlook looks pretty good. We have growth momentum, the unemployment rate is low and falling. We have financial accommodation. Despite the selloff in equity prices, financial conditions are easier than they were a year ago. And we have fiscal stimulus. Indeed, our problem is we have too much stimulus in the sense that the last time we were in a situation where you had the cyclically adjusted budget deficit deteriorating so much and the unemployment rate falling was 1966, ’67, and that didn’t work out very well.

So near term—all that said, we’ve got growth, we’ve got job gains, and we only have modest upward pressure on inflation. From the Fed’s perspective, I think they conclude inflation expectations are well-anchored. That gives them the ability to be symmetric with regard to their inflation goal. They don’t know how much they’re tightening. They are on track to tighten one percentage point a year—just use every one of those press conference meetings—and they will know when they—where the equilibrium real federal funds rate in passing. They’ll overshoot, they’ll see the behavior of inflation, and then they’ll have to—have to cut back.

So Federal Reserve’s perspective—I think they—they’re in a relatively good spot, investors understand what they are doing, the macro economy is performing well. Obviously, there’s risks on both sides of that.

MALLABY: So Greg, I mean, you know, Vincent has just confirmed that, you know, it pretty much is Goldilocks. Things are going great, so can you make the case in favor or Trumponomics?

IP: I’d like to, but I can’t yet.

So what is Trumponomics? It’s basically three pillars. One is deregulation. Another is tax cuts-slash-tax reform, and the third is, you know, fixing these unfair trade agreements.

So let’s first of all look at the main numbers, and I was just running some data today because I was curious myself what they would show me. Since Trump took office, non-farm payroll growth has averaged 182,000 per month. It’s a very good number. The prior three years had averaged 217,000 per month. Now that’s statistically insignificant in terms of the difference, so you can’t see anything in that indicator that suggests an inflection point.

GDP growth in the last twelve months was 2.9 percent. That was better than the average of the prior three years of 2.4 percent, but a huge part of that was because of things having nothing to do with the United States; specifically oil. There was a big collapse in oil which knocked the bottom out of U.S. energy investment, and then oil came back last year, which had the reverse effect.

Now Jason Furman has sensitized us to the value of looking at a measure of GDP that strips out net exports, federal spending, and inventories. It’s called—if you want to look this up—Final Sales to Private Domestic Purchaser, and it has a value that it’s not very volatile. That was 3 percent in the last 12 months. It averaged 3.2 percent in the prior three years. So once again, statistically I can’t see much of an inflection point.

So what about deregulation? So the—I fundamentally believe the deregulation we’ve had should have a positive effect, but when the Goldman Sachs folks actually looked at the specific sectors that were most leveraged to deregulation, they could find no sign of outperformance.

Now I would venture that the one area where I think we’ve seen benefit is in genetic—is in drug prices because Scott Gottlieb at the FDA has significantly ramped up genetic drug approvals, but nowhere else can I see it. Even coal—I mean, there’s been a boom in coal jobs. That mostly has to be doing—due to exports.

What about trade? Net exports did contribute to U.S. growth in the first nine months of last year, but that is seen to be mostly because the rest of the world was growing quite strongly and became decisively negative in the fourth quarter of last year. And I think most of the forecasters I talk to think the trade deficit will widen in coming years because of the big ramp-up in domestic spending and fiscal stimulus here in the United States.

So finally, what about tax reform stimulus? Now the whole idea of the corporate tax cut, the expensing was that you would bolster the incentives to invest. That would raise productivity growth that would raise long-term growth. So we should see that in equipment spending. And indeed, equipment spending has been very strong for the last four or five months. But according to JPMorgan, it’s exactly as strong—actually, slightly less strong than you would have anticipated given everything that was happening up until the end of November. So once again, very hard to see that sign. And we also don’t know whether it’s just a timing effect, whether all it was—a like pull forward investment they were going to make anyway.

The final point I would like to make is that the theory of the Trump case is that they weren’t just going to give us like a—you know, what they disparagingly referred to during the Obama era as sugar-high economics, you know. Some Keynesians stimulus had died out. We were supposed to get 10 years of 3 percent growth. So we won’t know for quite a few years whether we’re going that direction.

But think about this: the 3 percent growth we’ve had in the last 12 months came while the unemployment rate fell almost a full percentage point. At that rate, it’s going to go to zero in three or four years. That’s not sustainable, so I would say very much, even though I think fundamentally this tax reform should help, I haven’t seen the evidence yet. I expect to, but I haven’t yet.

MALLABY: What about you, Monica? What do you—

DE BOLLE: Well, let me—let me take it a step further and bring trade into this—into this discussion because while I agree with everything that has been said, the uncertainty that we now have over what’s going to happen with trade and how that hits us back, and how that hits the economy back in ways that are not necessarily good is a big question mark and is also a big part of the story of why we’ve seen markets reacting in the way that they have. Sure, a lot of it has to do with, you know, the change in the trajectory of Treasury bills and where they’re going, but a lot of it also has to do with this uncertainty.

So if there—you know, if the U.S. is going to be imposing—well, it already is imposing tariffs on steel and aluminum. If it does go through with its threats to impose, you know, more tariffs and specifically targeting China, and then we have the retaliation and that kind of scenario, we’re looking at a situation that, you know, in—macroeconomically speaking, we haven’t really dealt with in a very long time.

And I think this is the kind of uncertainty that perhaps may already be seeping through in the economy in terms of affecting, you know, investment and investment prospects, and so on, but also, and more generally, the prospects for inflation because to the extent that on top of all of this, of what we just said, you have tariffs. Tariffs are equivalent to a negative supply shock, and in having a negative supply shock, you are pushing inflation up and you are pushing output down.

So this is sort of where I think, you know, just as we’ve gone optimistic, less optimistic, and even less optimistic—(laughter)—I would bring trade policy into this.

MALLABY: You could throw in immigration presumably, too. Those restrictions are another kind of negative supply.

DE BOLLE: Exactly. Exactly.

REINHART: I take great offense at being ever viewed as optimistic. (Laughter.)

And so what I worry about—yeah, near-term outlook for the U.S. economy is good. We’re printing 190,000 jobs per month over the last 12 months, the unemployment rate is going down. It isn’t sustainable. I worry about the combination of stimulus leaning into that, and I think we have a Fed who is willing to accommodate that and accept an overshooting of its inflation goals. It’s not often you get a central bank writing down a forecast that says we’re going to have to do more than we think in the long run, and we will miss our goal—probably the right strategy—but one, I think, chief concern is what are we doing to foreign attitudes toward the safe asset. We have the dollar value we do because we are viewed as a safe haven. We are picking fights with major holders of U.S. Treasury securities. We’re also creating the opportunity for a major competitor to walk in and perhaps change invoicing patterns in parts of the world, and that has permanent effect. And if, at the end of the day, we win some on trade negotiations—which there is scope to do so—but we are viewed as a less safe and reliable trading partner, and we have eroded some the use of the dollar everywhere, that’s permanent.

MALLABY: So you’re saying that there’s scope for some wins in a tough trade negotiating stance. Maybe Greg could comment on this, but it strikes me that, on that, it’s quite important to make a distinction between NAFTA, where we’re kind of down to negotiating the details of, you know, local content and cars, and that feels like you could—we should be able to get a deal on that—to China, where, you know, last week it was a case of, you know, U.S. delegates going to China and basically telling them that they shouldn’t be in high tech, which is an absurd request that’s just going to be ignored. And it seems to me that if you just take a step back for a second, you say nearly all trade deals, you know, concluded—the big ones anyway since the second world war take place because you’ve got this huge geopolitical weight in the United States. The United States wanted these deals and was able to kind of use its own market as a carrot to get other people to sign on. And on the whole, the U.S. was doing this from a position of strength where it felt that probably other economies were complementary and not directly competitive with the things that the U.S. wanted to keep hold of.

Now, all of sudden, you’re negotiating with China, which is 4X the size of the U.S. in terms of population. They do want to compete head-on in things like AI, and they are strategic and potentially military competitors, and they have a huge amount of pride in not losing face in negotiations.

The notion that we’d get any kind of deal with China seems to me—I’m guessing that NAFTA, very doable; China, incredibly daunting. What do you think?

IP: I think I’d probably be in the same place. So the thing with NAFTA is it’s—one of the things that is pushing the sides towards agreement is the fact that the president doesn’t have a lot of congressional support to rip up NAFTA. Pat Toomey had a piece in the Journal I think just today or yesterday saying we’re not going to let you do that, Mr. President. And if you look at it state by state—if you look at like Kentucky, for example, their exports to China are a rounding error, but their exports to Mexico and Canada are quite significant. So Mitch McConnell is not going to allow the president just to, you know, rip up NAFTA like that.

But when you follow debate on China, what’s striking is how many people agree with Trump, right, including a lot of people who otherwise disagree with him on almost everything else. There is a lot of support in Congress, among business, and among U.S. allies—first of all, broad agreement that China is basically a bad—is not a good neighbor in terms of trade and that a tough stance is required.

So, number one, that I think stiffens the spine of the Americans; in fact, it actually tends to make them, I think, ask for even more. We went from a hundred billion to demanding two hundred billion off the bilateral balance.

Now, so I think that actually sets up a more antagonistic relationship with the Chinese. Now the point that you’ve raised is to what extent do the Chinese have leverage and are willing to suffer pain because they don’t want to accede to American demands. Well, first of all, I would say that the United States does begin this from a position of strength. As an economist, I know trade deficits don’t matter, but if I’m a politician, I know they do matter, and the reason why Mexico, and Canada, and Korea, and Europe, and China didn’t want to change any of these trade agreements is they all like the way they are working right now, and a lot of them do see it the way Trump does. They like the fact that they have surpluses with the United States. So they are willing to accept concessions—and the Chinese are no different—in order to preserve the bulk of what’s left.

To me the risk is that the United States overreaches—is that they demand things and then they—that the Chinese cannot deliver, and the Chinese—also the economic leverage is on the side of the United States insofar as their exports to us mean more to them than our exports mean to us—the political leverage is all on their side. First of all, President Xi doesn’t have to worry about what his legislature or his voters think that much. He does have the ability to target specific districts here in the United States, and they have demonstrated a willingness to suffer a lot of economic hardship in order to make geopolitical points.

I go back to—I think it was in 2012 when there was a very, you know, intense confrontation with Japan over the Senkaku Islands, and the Chinese allowed riders to attack and destroy Japanese factories, and that led to a collapse in Japanese tourism and investment in China. That was a price China was willing to pay. And when you see that the U.S. negotiating strategy is itself somewhat, you know, fractured among people of very different views—you have Steve Mnuchin and Larry Kudlow over here who consider themselves free traders, and then you have Robert Lighthizer, Peter Navarro and Wilbur Ross over here who are not—I think that elevates the risk of an accident.

MALLABY: Monica, can we go to Europe, and maybe particularly to what seems to be the new heart of the matter; namely, Italy.

You’ve got a situation where, if you go back four or five months—June, in particular the EU Summit in June, was supposed to be the moment at which systemic strengthening was going to be brought in such that there would be more risk sharing across the Eurozone, more stabilizing fiscal transfers, something in the direction of deposit insurance so that you’d get a stronger banking union. All of things are supposed to make the system more resilient to the next shock.

Now, if we do get a populist government in Italy, it implies that fiscal restraints as favored by Northern Europe are going to be not quietly ignored, but rather loudly ignored by the Italian government. And the response is going to be that any residual willingness there might have been to do these structural strengthenings of risk sharing goes away.

So do you think Europe, on a kind of five-year view, is going to have another crisis, and next time it could be worse?

DE BOLLE: Well, I don’t think we can rule that out certainly, especially if there is the—if there is, as there is now, the clear possibility of having a populist government in a country as important as Italy.

The thing that strikes me about Italy and the current situation in Italy is a bit the same thing that strikes me about—in an entirely different context and not necessarily to do with populism—but this disconnect that usually is pervasive in markets between sort of what’s going on politically and what kind of policies markets are expecting. So this kind of disconnect that we’ve seen play out in different places in Latin America—Brazil being one of them—where we saw for a long time, you know, just markets completely disconnected from the political reality that, you know, that there was a lot of dysfunction on the ground, we see the same sort of thing happening in Italy right now.

So my concern—I mean, back to your question—certainly there is a concern down the road in terms of what happens to Europe, say, in five years, but there is also a very short-term concern, which is what kind of market correction will there be if indeed you get a populist government elected in Italy with the kind of, you know, mindset on policies that is completely disconnected from what markets think.

MALLABY: Anybody else want to weigh in on Italy and the broader European outlook?

Greg? Vincent?

IP: Do you know if Five Star—has Five Star renounced their commitment to a referendum on the euro?

MALLABY: They’ve renounced that, yeah, and when they—when the Five Star Movement gets into an alliance with the League—it sounds like soccer, but it’s actually politics, we should—(laughter). Yeah, so, I mean, I think their main concern is not so much that they want a referendum on getting rid of the euro because they’ve back off that. The concern is more that they are quite explicit that the budget rules which are part of what Northern Europe holds dear to are not going to constrain them.

REINHART: So I think the best evidence that there is an ongoing problem in the European experiment is—this is going to be pretty wonky sounding—it’s TARGET2 balances, that within the euro area, one national central bank can have an overdraft that is (O-reserved ?) to another, and the fact is TARGET2 balances on absolute value are on the order of 7/8ths of a trillion of euros, and that is essentially—the German Bundesbank accepting large asset holdings done involuntarily because of transactions to Spain, Italy, Portugal. And we’re talking about sums that amount to about 20 to 25 percent of the nominal GDPs of the overdrafters and the recipient.

What is that? That actually is the shadow cost of holding the European system together because the great advantage of the euro thus far—the system thus far is, yes, you can have capital flight, but the capital flight stays in the same currency. You get out of Spain, you get out of Italy, you go to Germany.

At what point can you—they continue to internalize that, and at what point, when there comes time for the ECB to begin to adjust monetary policy does—is that capital flight internal. If it goes outside, then they are going to have a shock.

MALLABY: OK, let’s invite members to come into the conversation. Remember this is on the record. I see one question right now already, right there, and we will go around the room.

So please state your name, and just one question.

Q: Yes. Good afternoon. My name is Sean McIntosh with the U.S. Department of State.

My question is probably for—likely for Dr. Reinhart in that while you note that U.S. macroeconomic outlook was very good, I just want to get your position on the financial markets because the Shiller P/E Index and the Buffett indicators are all above average, and those would seem to indicate that we’re due for another market crash. So how would you react to that?

And then just a bit of an aside, you mentioned the U.S. dollar as a safe haven is under threat. How do you see, as credible, cryptocurrencies or even the Chinese renminbi as being an alternative safe haven?

Thank you.

REINHART: OK, so there—that packs a lot of questions in there. I would say that the near-term outlook for the U.S. economy is favorable; that does encourage leaning into risk taking.

The issue about equity markets isn’t their volatile performance in 2018; it’s why were they so unvolatile in 2016 and ’17 when the world was so obviously a risky place—that the volatility we’ve seen in equity markets—I mean, we have seen intra-24-hour swings in capitalization on the order of $4 trillion. I don’t know what we learn about the macro economy in 24 hours that would lead to such rational revaluations—is in fact a more—a return to a more sensible appreciation of some of the risks associated with that.

Yes, it’s true some valuation measures say that equities are stretched, but it’s also true that in the first quarter earnings performance was remarkable, that—in terms of public policy, we have changed corporate tax rates. There is a return of cash, there is going to be—most likely—higher dividends and fewer buybacks in the near future.

There’s—yes, there are pockets of excesses—it’s a market economy—but banks are well-capitalized, and the Federal Reserve is on a glacial path to remove accommodation. It would stop at the first hint of financial stress. So I think I would be inclined to say that, yes, an investor can be acceptive in that sort of environment.

What about cryptocurrencies? At the end of the day—oh, so among other things, there’s been no week in the last three years in which the intra-weekly movement of Bitcoin was lower than that of the S&P 500 in percent terms, and I think there’s only been two weeks that it was lower than the weekly changes in oil prices. It is incredibly volatile. It is incredibly volatile because it’s not anchored by a government policy, that ultimately we value a currency because it is accepted by a counterparty that is very important in our lives—that’s the government—and until you can pay taxes with it and get your refund check in it, then it’s going to be volatile.

MALLABY: Karen?

Q: Thank you. Karen Johnson (sp), consultant.

Well, sometime in the last week or so, Larry Summers ran secular stagnation up the flagpole again, and he acknowledged that—all the various optimistic things that you have spoken of in the last half hour with us. But he said the fatal flaw in this optimism is a failure to realize the extent to which a fairly modest, positive, optimistic, nice macroeconomy is rested on years and years of extraordinary stimulus from the Fed, and now we’ve added fiscal stimulus. And we have not put that into our thinking adequately, and that fundamentally there is something far weaker in the growth mechanism driving the economy that, without this degree of stimulus, we would quickly slip back into secular stagnation.

I just wonder what your thoughts are on that argument.

MALLABY: And it’s global. That’s the other thing. It’s—

Q: Yes.

Greg, yes.

IP: I thought Larry’s op-ed was pretty persuasive. I mean, as Larry pointed out, the fact that you have high growth isn’t—does not disprove secular stagnation. His argument was the only way we’ve been able to get high growth and low unemployment is with asset bubbles and fiscal stimulus, and we have both those things right now. And we still have only a 3 percent bond yield. So to the extent that the bond yield tells us what the balance is between the demand for capital—i.e., investment—and the supply of it saving, it still kind of looks like we have a shortfall of investment relative to saving.

And I think this is a real dilemma for the Fed. One of the things that Jay Powell brought to them when he came to the Fed was this fundamental awareness that there is no divine coincidence that says that the policy that gets you price stability is also the policy that gets you financial stability. You know, in pushing so hard to get to their 2 percent inflation target, they may have to ramp up so much financial speculation that they are, like, just laying the groundwork for the next asset bust.

I’ve wondered whether the reason the Phillips curve has broken down—that is to say we see these very low unemployment rates without high inflation—is because every time we try to get to these low rates of unemployment, before the inflation can come out, some kind of asset bubble explodes on us. And I—to me, that is, you know, wrapped up in a very big set of challenges for the Fed this year.

MALLABY: Yes, let’s go over there.

Q: Allan Wendt, formerly with the Department of State.

Would Italy be better off if it got rid of the euro so that it could devalue its currency?

MALLABY: Vincent, do you want to take that?

REINHART: Yeah, I think Monica would—

MALLABY: Or Monica? Monica?

DE BOLLE: Well, I’ll take a stab at that and then pass the word on to Vincent.

That’s the question we always ask ourselves whenever we see a country in the Eurozone with a very big imbalance. It was the same question we asked of ourselves with respect to Greece. The answer that we always come back to is the fact that balance sheets are now all in euros in Italy, so if there were to be an exit, let’s say, the pain of that exit would likely be enormous. And we have no benchmarks, no reference points, nothing that can actually tell us what happens.

And this—moving away from the question about Italy and more generally about countries that belong to monetary unions or countries that have de facto adopted the dollar as their currency, we have never seen countries that have done the reverse. So we have never had these episodes, so we don’t know how they play out. But probably what happens is a very disruptive, you know, initial or possibly long-lasting economic scenario that just simply makes the whole exercise not even worth thinking about.

REINHART: OK, I would say that getting from here to there is sort of hard to conceive, and so that’s why you don’t try, but we do have an economy even larger in size than Italy, with worse demographics, with a higher debt-to-GDP ratio, and its own currency—Japan—and having its own currency hasn’t necessarily helped them come to a solution.

MALLABY: OK, I’ll stick on this table for one more, and then we’ll come over there.

Q: Bill Courtney, RAND.

Are the Europeans, on average, making progress on structural economic reform? If the U.K. does pull out of the EU, will there be less impetus in the EU for structural reform?

MALLABY: Greg, turn? Do you want to have a shot at that? Structural reform—

IP: If you look at what France has been doing, it’s pretty phenomenal, you know what I mean? And all of that began after, you know, when Macron came into power, which all took place after Britain had already voted to leave the European Union.

It just strikes me that structural reform, to the extent that it has ever happened in Europe, has always been motivated internally, not by the presence or absence of external pressure within the European Union. So my view, if France has a few good years and Macron is reelected, that’s the most positive news on structural reform you could hope for.

REINHART: They’ve been slower on banking reform and financial reform generally, and I think it’s difficult to know how to do it if the global financial center is no longer part.

IP: But wouldn’t you say that that’s kind of second order—

REINHART: Yes.

IP: —in terms of the things Europe has to fix?

REINHART: Yeah, sure, sure. No, I think that’s right, and you would have to add Spain, too—Ireland and even Greece in terms of reform of some aspect of labor.

MALLABY: OK, let’s go here. Yeah.

Q: Thank you. Jonathan Chanis.

It’s been noted that the Fed is willing to overshoot its inflation target. Isn’t it possible that the bond market may at some point come to believe that the Fed is behind the curve and then force it to tighten much more rapidly than is expected?

REINHART: We’ve been waiting for the bond market vigilantes for a while. (Laughter.) I do think there are symmetric risks to Federal Reserve policy. Basically what I think happened is Janet Yellen almost carved into stone a path in which you tighten at every press conference meeting, you give an enormous lead time, and that was at the time sufficient in their forecast to get inflation back to 2 (percent) and no overshooting of the nominal federal funds rate. That was the fall of last year.

Since then we’ve gotten an enormous amount of fiscal stimulus, and probably a better-performing global economy, and higher oil prices than envisioned at that time, and so the FOMC has a choice. Do you try to change the path that you are guiding markets to, or do you tolerate an overshoot of inflation and therefore an overshoot of your policy rate?

I think they basically decided to do the latter and not the former, that they risk unanchoring market expectations about policy if they were to try to pick up the pace or guide to a—guide to more than that. And so in an environment in which they don’t know what the equilibrium real federal funds rate is, they’re just going to tighten until inflation tells them, and that does involve some overshoot. And they’ll say, well, inflation expectations are well-anchored, and so it looks like a price-level target, that’s pretty close to an optimal policy. That’s got two sets of risks, and the one is you ask them why does inflation rise slowly and behave so well—it’s because its expectations are well-anchored. Then ask the next question, why are expectations anchored—the answer is, truthfully, I don’t know—(laughter)—and that indeed it is a risk, and in retrospect, an extremely unfortunate comment would be Secretary Mnuchin’s one where he was—allegedly said that he was in favor of Powell because he was the most pliable of the candidates. That’s a risk.

There’s also the risk on the other side that oil prices are higher, the Fed’s program to keep tightening until they are told by markets to stop—that may be overtightening.

MALLABY: All right, let me just persist on this one point and link it up to what Karen was asking about and Greg’s answer.

So, you know, it feels like there’s a similarity between how the economy is poised now and the dilemma for the Fed with how things were, let’s say, in 2005 or 1999. So in those cases you had inflation that was fine. You had pretty much, you know, full employment, and if there was a source of instability in 1999, it was that tech stocks were going nuts, and in 2005, the real estate thing was already beginning to pump up.

So an inflation-targeting Fed looks at this and say, our job is to target inflation, inflation seems under control. We can tighten very, very gradually. And looking back, in both cases, there was a bubble, it blew up, and the bubble blowing up caused trouble.

So why, in the face of a sudden surge of fiscal stimulus, would you not have a sudden surge of commensurate monetary tightening given that you’ve got this risk that you’ve lived through twice before, which is that if you simply target inflation—the price of eggs may be very stable, but the price of nest eggs is going nuts. Why not run policy a little tighter—which is perfectly justifiable given the credit stimulus—I mean, the fiscal stimulus—and take some of that financial sector risk off the table?

REINHART: Because it is a remarkably risk-averse entity concerned about the reaction to a marked change in its policy. If the Fed—

MALLABY: What’s the worst that could happen? Are you—we talking about the market reaction or are we talking about political reaction first of all?

REINHART: Oh, I don’t think it’s political reaction.

MALLABY: OK, so it’s the market—

REINHART: I think it’s the market reaction, that we saw the 10-year flirting with 3 percent as a risk even for emerging market economies. Think back to the taper tantrum—this is an institution scarred by that, that if there is a deep irony that before the taper tantrum they were frank in criticizing the 2004 to 2006 policy realignment as too gradual and too telegraphed. It not just made the yield curve steeper than it would be otherwise, strengthening the carry trade and adjustable rate mortgage finance. It also made them safe because it was so clear what the Fed was going to do.

MALLABY: Right, right.

REINHART: After the taper tantrum, what are they doing? They are more gradual, they’re more contractual even as they continue to say all decisions are data-dependent and made meeting by meeting.

MALLABY: So you’re suggesting that the Fed is colored by the effect of its policy on emerging markets.

REINHART: Markets—financial markets generally.

MALLABY: But taper tantrum was more of an effect on emerging markets that—I mean, if you look at domestic markets, the worst that could happen is the markets get worried, they don’t like it, they’re scared, they fall—that might be quite good. I mean, a correction might be healthy. But a global—

REINHART: But I mean, to Greg’s point, I think Jay Powell does bring to the building less concern about that.

IP: Correct, in fact, that was a point that I wanted to emphasize. So I think if you are looking for differences between the Yellen regime and Powell regime, that really is one of them. If you look at the stuff Jay has said over the years, he is clearly not quite as, you know, rigid about this: no, we shall not use monetary policy to target asset bubbles. He doesn’t say he’s going to do it, but he clearly seems to be a little bit more open-minded about it.

I mean, I suspect that once he actually—if he’s actually faced with, you know, evidence of severe financial imbalances, does he come down to it and do it? Probably not, but a couple of things I want to point out—so all through the period through the volatility spike that we had the last few months, you saw no sign—none, not a scintilla of evidence that the Fed was going to see this as a reason to change its plans, which is quite different from what happened with the China situation.

Now the backup is different. We have a tighter economy as well, but nonetheless, I think that’s an interesting bit of evidence. You actually even had people like Kaplan in Dallas welcoming this volatility. I’m not sure I would encourage central bankers to go out welcoming market volatility. That said, I think that was also relevant.

And finally, on the point of like—I think, Sebastian, you have been very, I think, articulate on this in your writings—that the, you know, addiction to forward guidance is basically an invitation to take risk. At his first press conference, Jay Powell was asked—five ways to Sunday—you know, what are you going to do next. And he kept saying, we made one decision today—just one decision—and he refused to engage on the future path of interest rates.

So I’m not sure if I would call that a regime change, but it’s definitely an inflection of some kind, which suggest that there is an awareness, as you were saying, Vincent, in the building now that that’s something they need to pay attention to.

REINHART: And I would say it’s not just less concern about financial stability. It’s also less rigid concern about hitting that inflation target at 2 percent.

IP: Yeah, and just one last thing.

REINHART: Yes.

IP: Eric Rosengren, if you are a Fed watcher, is somebody you really want to watch who has been fascinating because he was very dovish on policy for many years, and in the last few years he has turned hawkish. And he has turned hawkish because of asset prices. And when he is asked, well, doesn’t this mean you will not hit your inflation target, and he says, that is exactly what it means. It means that it will take us longer to get to 2 percent. But I’m interested in getting 2 percent over the long term—10 to 20 years—and if we inflate an asset bubble that explodes, that will push us away from our target in the near term. That’s a—I’m not sure I agree, but it’s an internally consistent story that I think may be shared by more than one person at the Fed.

MALLABY: Over here. Yeah.

Q: Thanks, Sebastian. Nelson Cunningham at McLarty Associates.

I spent half the morning today working on an issue that hasn’t come up yet today, and it also happened to be the issue that Jim Hoagland first raised with me as we walked in, which is this: how are the Europeans going to react to secondary sanctions imposed by this administration with the end of the JCPOA and the Iran agreement? If the Europeans decide to stand four-square for the agreement with the Iranians, that means they will have to protect their companies from secondary sanctions, and they will have to push back on this administration.

This administration, meanwhile, will think that any trade with Iran is throwing a lifeline to a criminal regime. Aren’t companies going to get caught in this crossfire between—if you try to truly separate the European financial systems from the American financial systems so that Europeans can do business in Iran, and what does this do to the position of the euro versus the dollar? Does it make it more of a global currency?

I want to focus mostly on the risk, though. Do you see a risk in the economy if we get into a sanctions war between the U.S. and Europe?

MALLABY: I’d just say one thing, and then whoever wants to can come in. But it just—both on this and on the China stance, the administration’s position seems sort of so demanding of compliance by other countries—you know, so unrealistically demanding that if you game it through, you know, the likelihood of just total breakdown in relations is so big, you have to factor in the possibility that the Trump administration just walks it back.

And I—I mean, maybe—you know, I’m sort of thinking aloud slightly, but the—you know, if you got into U.S. sanctions on kind of European champion companies—Airbus, whatever—you know, the escalation potential is so big that—I don’t know, I think the, you know—you look at the pattern on North Korea diplomacy, you know, maximalist taunting of Kim Jong-un followed by the possibility of a summit, clearly this is somebody goes out a long way and then sometimes comes back—it’s my thought.

DE BOLLE: Yeah, just to—this is on an unrelated but somehow tangential point to your question. There is currently also the standoff between the U.S. and the EU on the steel and aluminum issue, on the 232, and I think—to Sebastian’s point—this is going to be kind of a thermometer, I think, in a sense, for us to see whether that walking back is possible. So we’ve seen hinted in the press recently that the administration might be willing to go with a quota that is equal to 100 percent of the average of steel exports to the U.S. from the EU over the past three years, and that this is something that would be acceptable to the EU. That’s a big walk-back for the administration if it happens. And I think, you know, even though it’s obviously not related—or not directly related to the Iran issue, it tells us something about how these things play out and how these things interact.

REINHART: Yeah, there was a—it was an amazing display of extraterritoriality to lump Boeing and Airbus together to say you have to void those contracts.

DE BOLLE: Yeah.

REINHART: And I think there is risk, but to the earlier part of the conversation, that we diminish the status—our status—as a reliable partner in trade and in finance, and that is an opportunity for the euro area, it is an opportunity for China.

IP: If I could, one of the driving factors behind Make America Great Again or “America first” is this presumption that the United States has been reluctant to use the leverage that it has as the largest geopolitical and economic presence. And so one of the theories of their unilateral approach to trade is that we can do what we want and they won’t retaliate because we’re too important, and I would say that thus far they have proven correct—is that most of these countries do not retaliate.

Japan never retaliates. They have never retaliated—in 30 years they have never retaliated. Mexico didn’t even retaliate under NAFTA when they had the right to retaliate. In Europe right now you a schism between France, which wants to basically retaliate against the United States, and Germany, which doesn’t, and one of the reasons is because France basically exports almost no steel and aluminum to the United States and Germany exports a lot. So if German companies and Merkel—and it’s very difficult to tell the difference sometimes—are told choose between your market in Iran and your market in the United States, I think it’s no contest.

MALLABY: Paula, yeah.

Q: Thank you.

MALLABY: Coming up—

Q: I’m so glad—oh, I’m sorry. I’m so excited you called on me, Sebastian. (Laughter.)

Paula Stern, and I’m so glad this conversation got all the way to include every country except China on this retaliation issue, that the presumption of the Trump administration has been that they are so powerful, we need to exert our power, and other countries will bend.

My question to you is will that work with China in the negotiations, and I would love it if you all have an estimate on what the impact is on world growth if the total retaliation that the U.S. and China that has been contemplated through all the various barriers that the president has threatened to put up—does it really amount to that much?

DE BOLLE: So may I take a stab?

MALLABY: Sure, yes.

DE BOLLE: So we’ve just done—over at the institute, we’ve just done an exercise trying to get to that—on answers to that question—a quantitative answer to that question. Now of course this is done using all these general equilibrium models, and you can, you know, criticize them back and forth and—a lot, but the bottom line is you would get—if there were to be retaliation by China and then cross-retaliation by the U.S.—so that kind of trade-war scenario—the bottom line is that you get a lot of trade diversion. And with a lot of trade diversion, yes, you get a lot of disruption, but ultimately, you don’t get a bit impact on global GDP.

MALLABY: But you might get quite a big impact on global geopolitics.

DE BOLLE: You do. That you do. (Laughs.)

Q: But what about the first on China? Do you think that the president can apply the kind of leverage that he has on NAFTA, Japan—all the other countries that you mentioned—(inaudible)—China?

MALLABY: I think two fact points—yeah, two fact points on that—on China is that, you know, the request that the bilateral surplus be reduced by 200 billion (dollars) implies a reduction of more than 50 percent of what it was last year—more than 50 percent—and furthermore, this is a time when China is tightening and, you know, therefore this—the trends would—you know, there’s a fiscal stimulus in the U.S., there’s a credit contraction in China, and so you would expect the thing to expand, not contract.

So I just do not see how you get that number. And furthermore, nor do I see when, you know, Xi Jinping has nailed his political colors to China 2025, which is their version of Make America Great Again, they’re not going to give up their ambitions in high tech.

IP: So one mistake I think we in the media have often made—or people in general—with Trump is to always assume that his first, you know—the first thing he puts on the table is his final offer. I think the man is a negotiator, and we’ve seen this like when he was—during the campaign, I remember he was describing his tax plan. He was negotiating before the sentence had ended, you know what I mean? (Laughter.) Well, you know, I’m saying 15 percent, but we’ll probably end up at a number higher than that, he says. (Laughs.)

So from that I would say is that what—we’re not going to get $200 billion, and I don’t think Trump considers $200 billion to be what—an acceptable outcome. And I would say, first of all, he is already getting the Chinese to respond. So Xi Jinping has already said that they will lift the foreign joint venture requirement on automobiles. We reported this—that they’re ready to actually commit to increasing their imports from the United States. The number won’t be 200 billion (dollars), but it won’t be zero. And therefore, I think that in these situations where China realizes they’ve got a good thing, and they are willing to give up some of that good thing to avoid it becoming a really bad—motivates both sides towards a solution.

REINHART: Yeah, just to underscore that, I’d like to make two points. One is this is the art of the deal midstream. Looking at the—listening to the initial statements is no way predictive of where they wind up.

And I am struck by the following: in some sense we are surprised that a politician has been delivering on campaign promises. (Laughter.) These aren’t—these shouldn’t be surprises in that he did talk about tariffs on China as a lever for negotiation. He did talk about ripping up NAFTA. What I find striking is he didn’t say any of that last year about China. Why? Because he recognized that President Xi had not yet consolidated power and would not be in a position to brook a foreign insult.

What did the White House do? They waited till they had a negotiator on the other side with even probably a stronger hand than they might have hoped.

Why are we suddenly, you know, accelerating the discussion on NAFTA? Well, there’s a Mexican presidential election, and so what you are seeing is this sense that, oh, they’re sensitive to local conditions, looking for a negotiating partner.

The second part with regard to China, I think it’s well within their ability to give the president headlines. In the history of such negotiations, however, the Chinese are willing to give the U.S. those headlines and then take some back in terms of state and local regulations, and things like intellectual property rights. A Chinese firm is two hierarchies. It is the firm hierarchy, and the party within the firm, and so they can say they are protecting intellectual property rights, but unless it sinks in to the party members in that same firm, that doesn’t happen.

MALLABY: OK, we need to wrap it up, but thank you very much, Vincent, Greg, Monica, and thank you to all of you. (Applause.)

(END)