Interview with Prof. Carmen M. Reinhart, Senior Fellow of Peterson Institute for International Economics

By Zhang Feifei
Published: 2011-02-10

The interview began with a question on the possibility of international capital reversal. Prof. Reinhart responded  that it is still premature to talk about sudden reversals, but not too premature to think about it. She thinks the real trigger for a reversal of flows lies in not what happened outside the emerging market, but inside.

She doesn't see the interest rate raise as a trigger for the Fed in the year 2011, but believes continuation of QE is a very reasonable expectation. She is not optimistic about US economic recovery in the near team, and is happy to see the internationalization of the RMB and believes it is experiencing "de facto" liberalization.

She considers high unemployment in the US to be guided by its massive debt, not the RMB. However, she believes the RMB should appreciate. "With large capital inflow, the real exchange rate will appreciate through nominal appreciation or inflation; relying entirely on inflation is a risky path", she said.

Professor Reinhart pointed out that the next crisis in advanced economies will be a fiscal crisis. Austerity and financial repression are two prescriptions to get rid of the debt problem. "Keep interest rates low, you allow inflation to create a bubble. Interest rates are also kept low by creating greater capital volumes for government debt."

Excerpts from the interview below:

Economic Observer: Could you describe the general picture of current international capital flows and the fickleness of capital flows in emerging markets and the likelihood of an abrupt reversal? Many Chinese scholars think this might happen in 2011 with the tightening of the currency policies of the United States. Do you share the same concern?

Carmen Reinhart: Right now the global situation is such that the advanced economies of the US, Japan, and Europe are mired in high levels of government debt, high levels of private debt and face slow growth and higher unemployment. So international interest rates are once again very low and there's a surge for yield. That's where the emerging markets are in the capital flow cycle. Usually the capital inflow cycle is something that most emerging markets welcome up to a point. "Up to a point" meaning you can have too much of a good thing. That's why you should raise the possibility for sudden reversals.

I think right now it's still premature to talk about sudden reversals, but it's never too premature to think about it. It's premature to expect a sudden reversal because international interest rates are likely to remain quite low and growth prospects in the advanced economies are dimmer than emerging markets. So what I would look for right now is to avoid the roller coaster, to avoid the problems that come when you have large capital inflows and there are sudden reversals, like Mexico '95, like the Asian crisis '97/98.

A smoother landing can be achieved through policy by focusing on orders of magnitudes, which is too much of a good thing. It's not blocking all capital inflows, but dealing with orders of magnitude. And also I would be looking for signs that firms are borrowing short term and borrowing in dollars. That's an early sign that vulnerabilities could be on the rise. But let me reiterate, bottom line is that this cycle still has some time to go. This emerging market cycle has some time to go before the risk of sudden stops emerges.

Economic Observer: When did this cycle begin?

Carmen Reinhart: Emerging markets did attract flows, but in more moderate amounts before the crisis. 2008 and 2009 were years of intense global turmoil. So I think this particular cycle we can date to 2010, or late 2009, when things started to calm down after the 2008/2009 global turmoil. Interest rates in Europe and the US continued to come down and remain low. It becomes clear that emerging markets weathered the global crisis pretty well in that emerging markets took a hit in their exports, took a hit in their output, but recovered much more robustly, than certainly anything that we've seen in advanced economies or are likely to see. So I would date this cycle to the "as the dust settles" period after the 2008/2009 turmoil.

Economic Observer: Do you think the climax of this cycle is during the QE policy, especially the QE2 policy?

Carmen Reinhart: Yes. But what I'm suggesting is that the QE policy is not something that is likely to be reversed in the near term. Unemployment issues remain very much in the forefront of policy concerns in the US and Europe.

With unemployment issues still at the forefront of the concerns with mounting debt, it is difficult to see the motivation for pull-back and rising interest rates in advanced economies. Rising interest rates in the advanced economies has often been a trigger for a reversal of capital inflows. It is hard to see the basis for that in the very near term as a policy decision in either the US or Europe.

Economic Observer: So you are a little bit pessimistic about the US economy in 2011?

Carmen Reinhart: Yeah. I presented a paper in the end of August of last year which is called After the Fall. In that paper we look at the decade after a severe financial crisis and compare that to the decade before the severe financial crisis and we found that recoveries not withstanding growth in the decade after the financial crisis remains lower, about 1 percent lower; unemployment rates remain higher, especially for the advanced economies, unemployment rates in the decade after a severe crisis are about on average 5 percent higher. Asset prices, particularly real estate remain depressed. So that's not exactly an uplifting picture. It is not saying that recovery is not underway, but it is suggesting very much along the lines of the work that I have done in the book with Ken Roger,This Time is Different, and the more recent work shows that those recoveries that occur after financial crisis are relative to your normal recovery. So the long answer to your question is no, I'm not very optimistic about having the robust rebound that many are hoping for in Europe and US.

Economic Observer: In your mind, when will the FED raise interest rates? 2011?

Carmen Reinhart: I doubt it. It would take substantive improvement in the employment picture; it would take signs that inflation in the US is picking up steam. And certainly if there is one thing that the US doesn't lack right now its debt. We have a lot of debt - a lot of public debt, a lot of private debt. And raising interest rates when you are highly leveraged is a risky proposition. I don't see a pressing trigger for the FED to raise interest rates this year.

Economic Observer: If the CPI in China goes above 6 percent, is there a risk this could be a trigger?

Carmen Reinhart: I think the inflation in China is a lot higher than the official numbers. So I cannot say that it's not already 6. So absolutely there is a risk in that inflation keeps rising. There are no silver bullets when you are talking about managing large capital inflows. The exporters hate it when the nominal exchange rate appreciates. So there's a political-economic problem with allowing exchange rate appreciations that are not widely popular. At the same time, inflation getting out of hand is also not widely popular. Because ultimately it means that you have to correct it and corrections tend to involve substantive increases in interest rates and tightening monetary policy, which are also unpopular. To answer your question, I think it can go higher but I do think it's already much higher than the official number suggested.

Economic Observer: With the fundamental problems of the convertibility and capital control unresolved, how do you judge recent moves by People's Bank of China to internationalize the RMB?

Carmen Reinhart: I doubt it will happen very soon, but I think it will happen, and I think it should happen. It is simply because China's position in the world economy has grown enormously. So the financial side at some point is going to catch up with the real side. So a convertible RMB is part of that growth in the big sense that the relative importance of China in the world economy would call for a convertible currency. Is it gonna happen really quickly? China's approach towards things has tended to be on the gradual side, right? I think actually many things are happening de facto rather than by ruling, meaning that financial liberalization has been an ongoing process in China.

Economic Observer: Do you think the unemployment problem could be solved by the appreciation of RMB?

Carmen Reinhart: The employment problem in the US is heavily influenced by its massive debt overhang. Everyone agrees that Japan didn't handle the banking crisis well, it waited too long to write down bad loans, there was too much forbearance, and the fact is that all the bad loans on the bank's balance sheet delayed recovery and the resumption of normalcy.

I am very much afraid that there is still a big debt overhang in the US. The real housing prices have been falling by about 30 percent, and loans remain at book value. The unemployment issue in the US is importantly tied to firms.

Non-financial firms are in good shape. They do not have a lot of debt, have a lot of earnings, but non-financial firms don't go out and hire if demand is highly uncertain, so the unemployment issue in the US is importantly tied to the debt overhang which is slow to wind down.

Truth be told, I think the RMB should appreciate not because of the US, because with large capital inflow, with growth differentials being what they be, the real exchange rate is going to appreciate one way or another. You either do it through nominal appreciation or you do it through inflation, relying entirely on inflation is a risky path, appreciation won't solve the US problem, but it will help mitigate the inflation pressures here.

The current problem for the US as regards to debt is two-fold. One is it's time to write off loans to try to clean up bank balance sheets and household balance sheets. Second, it's time to formulate a plan to deal with the deficit. The whole idea that the debt profile for the US is going to resolve itself on its own volition is really not founded on any historic pattern that I'm aware of. Debt to GDP share seldom come down simply because you grow your way out, so I think truthfully, we'll get the same song and dance the US is continue to say "appreciate the RMB", and China will continue to say no, but truthfully, I don't think RMB appreciation will do much for the US. It really makes more sense in regards to China's domestic inflation concerns.

The thing that concerns me the most is if the currency issue leads to a retaliatory trade position. If the outcome is nothing happens to the currency but we don't have a bad trade outcome, that's OK, if the outcome is that the currency issue leads to more protectionist measures, that's worrisome for everyone.

Economic Observer: What do you think as the largest crisis facing advanced economies?

Carmen Reinhart: I think the next crisis which advanced economies will be a fiscal crisis. That's what I wrote in the book- From Financial Crash to Debt Crisis. We've had the booming assets crisis, we've had the boom in private leverage, we had the bursting of the bubble, and as a consequence of the downturn we are struggling with weak recovery and facing a buildup in public debt, so the next challenge for advanced economies in real time is solvency and debt problems.

The next financial crisis is not around the corner and it's not because of regulation.

Economic Observer: You were the chief economist and the vice president of Bear Sterns in the 80s, how do you view the fall of this bank during the crisis? Do you think Wall Street is learning its lessons now?

Carmen Reinhart: Lessons learnt? No, no.

I think temporarily, during the height of the boom in the US, real estate prices between 2000 and 2006 rose more than the 100 years preceding the boom – that tells you something.

I bring this up in the context of Bear Sterns because a lot of the excessive risk taking and leveraging was driven by the expectation that the subprime market would continue forever - prices would continue to rise and your collateral would continue to rise in value and therefore your leverage would continue to rise.

I think the financial industry, as a whole, is somewhat more timid in the wake of the crisis, but at the same time, I don't have a reason. Remember, the book Ken and I wrote spans a long time and people are forgetful, so in the next round, the risk taking won't be in subprime lending, it will be in something else.

I really don't think the lessons have a long shelf-life.

We included in the book an advertisement that says we don't have to invest in bubbles, we are not like the self-seen bubbles, those reformers were misinformed, they were ignorant. There are accounting firms; we can access all kinds of data. That ad is from an accounting firm, from September 1929, one month before the stock market crash that lead to the Depression, so I'm not really optimistic. It is common place that after a crisis, financial firms reduce their appetite for risk, you see they hold more government paper, they hold more excess reserves, and are more selective towards their lending. That's all common place. But that won't last very long.

Professor Carmen M. Reinhart is a Dennis Weatherstone Senior Fellow of Peterson Institute for International Economics. She served as the Professor of Economics and Director of the Center for International Economics at the University of Maryland.

She held positions as Chief Economist and Vice President at the investment bank Bear Stearns in the 1980s, then she spent several years at the International Monetary Fund. Her latest book (with Kenneth S. Rogoff) entitled "This Time is Different: Eight Centuries of Financial Folly" (Princeton Press) documents the striking similarities of the recurring booms and busts that have characterized financial history. 

This interview was conducted on Jan. 19 in Beijing, China. It was transcribed by Zhang Feifei and Fan Yang.