Radical Signs

Speaker’s Corner From The Practice September/October 2020
A conversation with Daniel Tarullo

David B. Wilkins, faculty director of the Center on the Legal Profession, recently sat down with Daniel Tarullo, Nomura Professor of International Financial Regulatory Practice at Harvard Law School and former member of the Federal Reserve Board, for a conversation on our macroeconomic outlook in the context of the public health crisis. This conversation took place in front of a virtual audience of lawyers as part of Harvard Law School Executive Education’s Leadership in Law Firms: Optimized for Online program.

David B. Wilkins: Thank you very much for taking the time to engage with us, Dan. It’s really a great pleasure to have you back here at Harvard Law School. I’ve known Dan for many years and have watched his incredible career with nothing short of admiration. I’m not going to repeat Dan’s credentials here, except to say that through his service on the Federal Reserve Board as a statutory governor, on the Federal Open Markets Committee, as an adviser to presidents, Dan has really been at the center thinking about macroeconomic policy for many years. And he has agreed to give us his take on these issues in our current context, and particularly what they mean for lawyers, for clients, and for you as advisers to those clients going forward. So, Dan, first of all, welcome, and thank you very much for being here.

I want to start out by asking you this: there’s been a lot of discussion about where exactly we are in the economic cycle. Are we headed for a V-shaped recovery, a U-shaped recovery, a W-shaped recovery? Or will it be some other shape? Could you give us your candid assessment of where we are, and where you see us going in the next six, 12, and 24 months?

Daniel Tarullo: The shape of any recovery is determined by the interaction of two sets of forces. One is the nature of the economic shock that led to the problems in the first place, and the second is the nature of the policy responses to it.

The conventional letters that you are alluding to—a V-shaped recovery, where you have a dramatic drop and then an equally dramatic rebound; a U-shaped recovery, where you have a recession that bottoms out and then moves back up again; or the feared L-shape, where you go down rather rapidly, and then you don’t come up—are all basic forms developed over the postwar period in which recessions and recoveries were the predictable interaction of two things: (1) central banks stepping on the brakes progressively harder in response to inflation, which of course brought the economy to a slower pace or sometimes to a screeching halt depending on how expertly the central bank handled it, and (2) the reaction of both the central bank and fiscal authorities to the substantial slowing of economic activity.

For example, a classic V-shaped scenario would be inflation comes along and, at some point, the central bank says, “We’ve got to stop it.” They raise rates significantly, borrowing goes downhill, there’s a lot of readjustment, and the economy goes into recession. At which point the central bank says, “Whoa…,” takes its foot off the brakes, and then hits the accelerator by rapid reductions in interest rates often supported by a fiscal stimulus. That pattern is not the one we’ve been confronting in the last two serious downturns—neither the great global financial crisis of the 2007–2009 period nor the current COVID-19 pandemic.

To answer your question of where the economy is headed today, I think we have to switch from letters to symbols. Back in 2009, the operative symbol was the Nike swoosh—a pretty sharp downturn followed by a gradual upward slope in the economy, which eventually exceeded the high point of the beginning of the downturn. This time around we really don’t know, but since last April the symbol I’ve been using is a modified radical sign or the square root sign (“√”).

Why? Because you have the rapid, unprecedented drop in March and April as the economies of the world shut down. Then, as there was relaxation of the shutdown, you had an equally rapid but only partial rebound. A radical sign has a purely horizontal line after the upturn, but for us it will likely have a gradual upward direction, with the complication of kinks in it along the way and perhaps periods where it goes down.

This is where we get to the interaction of the policy with the etiology of the crisis. The etiology was COVID-19, the shutdowns, and fear. The policy that matters is, yes, economic policy—fiscal stimulus and monetary stimulus—but also, and unlike past economic recessions, public health policy as well. And so, the shape and kinkiness of the slowly moving upward curve that we’ve now entered is very dependent on the efficacy of public health policies intermixed with the wisdom of economic policy.

The difficulty is, if interest rates are under 1 percent, and then a recession hits, you can’t use interest rate cuts to produce the amount of stimulus that you’ve needed in the past to produce a V-shaped or a U-shaped kind of recovery.

Wilkins: That’s exactly where I wanted to go, because I think for every country represented by this wonderfully diverse group of lawyers, their central banks and governments are now trying to decide how to respond. You’ve mentioned two things that I want to come back to. One is how much do central banks and governments worry about inflation? How much do they worry about putting too much stimulus into the economy? And, on the opposite side, are they willing to put in more stimulus? Here Chairman Powell, who is himself a lawyer, has basically said that he’s not going to worry about inflation for the foreseeable future and that he is urging Congress to put in more stimulus, which so far they have not done. How do you see that playing out? And not just here in the United States but across the world economy, because these things are all related.

Tarullo: Even before COVID-19, major central banks around the world, particularly in the mature economies—Japan, the European Union, the United Kingdom, Switzerland, the United States—were all aware that inflation had been quiescent, to put it mildly, for well over a decade. Growth had slowed in an apparently secular fashion. As a result, interest rates were likely not to rise nearly the amount that they had historically risen after recessions. In a normal period of moderate growth, you’d typically have interest rates around 4 percent, which reflected a couple of percentage points of inflation, and then a couple of percentage points of real interest rates on top of inflation. What that level of “normal” interest rates allows, from a monetary policy standpoint, is that when a recession comes, the central bank has 400 basis points of room to cut in order to stimulate the economy. The difficulty is, if you never get above 75 basis points—if interest rates are under 1 percent—and then a recession hits, you can’t use interest rate cuts to produce the amount of stimulus that you’ve needed in the past to produce a V-shaped or a U-shaped kind of recovery.

There may need to be more coordination between fiscal and monetary policy.

All these concerns predated this past January and February when COVID-19 became such a big issue. When we look at the chronic inability of Japan, for well over two decades, to get inflation up and when we look at the persistence of negative interest rates in the European Union, we in the United States knew that those were risks for us as well. So even prior to COVID-19 the Fed had begun a process of rethinking what monetary policy should look like and how to prepare for the inevitable recession. Unfortunately for the Fed, it didn’t have time to get its review done before COVID-19 hit and it had to respond.

So what’s the circumstance we’re in now? Well, the Fed immediately slashed rates to zero, did massive amounts of liquidity provisions, and, as Chairman Powell has put it, the Fed is “not even thinking about thinking about raising interest rates.” Well, in some sense, markets—at least trading markets—like that because that’s giving assurance that for a long time rates will be low.  But that posture also reflects, to some degree, the relatively less effective nature of current monetary policy.

The old cliché about pushing on a string is something that the Bank of Japan has been experiencing firsthand for quite some time. We at the Fed felt some of that in the 2009–2010 period. And now I think it is much more a shared experience of central banks around the world—at least in mature economies. What does that mean? It means two things: (1) fiscal policy is front and center because that’s the real stimulus that’s available, and (2), and this is a more controversial observation, it means that in order to have a sustained recovery, there may need to be more coordination between fiscal and monetary policy—which all of you lawyers will immediately think probably means less independence for central banks and a paradigm shift from where we’ve been in the United States, at least since the early 1950s. Until recently, the idea of the independence of the central bank was thought imperative as an inflation-control device. If we are in a period of secular stagnation, or something resembling it, that may well no longer be the case.

I should note, there are a number of emerging-market economies and developing-country economies in which there is room for monetary policy stimulants—there’s no question about it. But for many of those countries, there is a different tradeoff because they have to worry about the reserves that they hold. They don’t have the freedom that the Fed or the European Central Bank or the Bank of England would have to simply reduce rates.

Wilkins: For the lawyers in the room here who are advising clients and trying to figure out the economic headwinds, what would you advise them, or their clients, to look at to see whether or not their governments are trying to get this balance right between fiscal and monetary policy that you’re talking about?

Tarullo: I would say that in nearly all mature economies, and in many emerging-market economies, they might look toward the fiscal measures that are being taken because that’s where the real oomph is going to come from. But I do want to note that for some governments there are shorter-term constraints. We all may have longer-term constraints, but for some they can be shorter term. That’s definitely one thing to look at.

Interest rates will remain low well into the future. That means that for well-rated corporations, financing is likely to be readily available for some time to come.

The second thing, quite frankly, is public health policy. Until some combination of treatments, vaccines, and herd immunity has taken root, there are going to be constraints on recovery—because the demand for output in many parts of our economy is just going to be constrained by limits on face-to-face contact.

The final thing I would say is what Chairman Powell has said, what Christine Lagarde has said in Europe, what Andrew Bailey has said in the United Kingdom, and what many other central bankers are saying: interest rates will remain low well into the future. That means that for well-rated corporations, financing is likely to be readily available for some time to come. Now that gives people like me who worry about financial stability a little bit of nervousness. But for the individual company, it does mean that things like acquisitions, retiring of older debt, or whatever things you may have in mind that require large, reliable, and affordable forms of financing are very likely to be available indefinitely.

Wilkins: Dan, I think you’ve just gone where I want to go because there is a flip side to that, and I know you’ve thought very deeply about it because one of the other things you were very much involved in was the regulatory processes that were put into place after the global financial crisis. And, as I think you rightly say, the lawyers whom you’re speaking to now are some of the most influential advisers to financial service companies and other large institutions who are either covered by or in the ambit of that kind of regulation.

As somebody who both cares deeply about the strength of the economy but also as someone who cares deeply about the risks to it, what kind of advice would you like to see these lawyers giving their clients? How should they think about this kind of tradeoff at the level of advising clients?

Tarullo: Any business or household tries to improve its own economic position given the background environment. The CFO of a company, for example, may feel that it is not the healthiest thing for the economy as a whole for Triple B–rated companies to be loading up on even more debt. But that same CFO, who is thinking about her own company and whether it should take on more debt given its pricing right now, may very well come to the conclusion that the company has a duty to its shareholders and the well-being of our employees, so it makes sense for that particular company to take advantage of low rates and assume more debt. I think it’s a difficult position for the individual company, and certainly for lawyers for an individual company, to navigate systemic versus discrete interests.

What I would say is that, to qualify a bit of what Chairman Powell and other central bankers are saying, nothing is forever. Whenever any economic actor is thinking about a horizon, nothing beyond eight quarters of projections means much of anything. Now, if you asked me what my baseline expectation is, my baseline expectation is that rates will be low and interest rates will be low in 2025. What’s my confidence interval in saying that? It’s well under 100 percent! I think that “the only thing we can expect is something unexpected is going to happen” is probably a good way to think about any major corporate strategic planning exercise.

Wilkins: Factoring into that is a wave of focus on reimagining capitalism that has gone on from the Business Roundtable to BlackRock to Goldman Sachs to the United Nations Global Compact to the World Economic Forum, particularly around issues of corporate responsibility in the community. We think of this here in the United States as a racial justice, but around the world, it’s playing out in terms of other forms of inequality. How should lawyers be thinking about these trends as they’re trying to frame advice for their clients, not just about what the law says but how the clients increasingly ought to think about operating in this complex environment?

The biggest risk of financial instability right now is associated with the potential for political instability during the presidential election period.

Tarullo: Here I’m probably stepping out of my expertise as a law professor and even my experience as a central banker. Let me put it this way: Yesterday I was being interviewed by a journalist who asked how likely I thought it was we were going to have another episode of financial instability this fall. He had an endogenous theory that it might happen based on what’s been happening within markets. I hadn’t thought about it until he asked me, but my reaction was, you never know, but I didn’t think it very likely that there would be an endogenously generated period of financial instability in the next four months. I just haven’t seen the buildup of some of the potential stress points that would lead to that kind of reaction.

But what did occur to me is that the biggest risk of financial instability right now is associated with the potential for political instability during the presidential election period. That concern led directly to the broader observation that there has been a tearing of the social fabric in this country. Maybe it’s not the worst it’s been since the 1850s, but it’s pretty high by any metric. And it is not, in my judgment, something that is cyclical or transitory, or that will die down with COVID-19. It’s the cumulative effect of a secular decline in growth in the United States and most other mature economies; a secular increase in income inequality, certainly in the United States and other European countries (though not in Japan); and, in the United States, the reminder once again of the country’s failure to confront head-on and over a sustained period of time the legacy of slavery and the broader sense in which our institutions of government are not fully adapted to the kinds of demands that are being placed upon them. That sometimes translates into calls to reimagine or remake capitalism.

I would say the era of true corporate leadership in the United States seems to have waned. Too many CEOs found that they were punished for spending time on public-interest things over the bottom line. But if I were a CEO of a major U.S., French, British, or Japanese company, I would be asking myself the question, “Do we need to take some risks politically, economically, and maybe within our own company to effect change?” But I would also say that we do have to jump in together, from all sides of the political spectrum, if we want to preserve a more or less stable, well-functioning market economy. There’s a classic collective action problem here. When I do talk to CEOs, I make that point. None of them really resists it analytically, but they don’t know how to get from here to there.

Wilkins: You’ve worn all these hats, and one of the first hats you wore was as a lawyer. You were actually a practicing lawyer at Arnold & Porter. But now you’re a law professor, and ironically a number of the people sitting on the Fed right now are also trained as lawyers. Chairman Powell is a lawyer. Christine Lagarde is a lawyer. And I wonder if you think there’s relevance to being a lawyer, either positively or negatively, in thinking about playing a role in these important economic institutions moving forward.

Tarullo: I would say it’s not a coincidence that after eight and a half years on the Fed, I came back to a law faculty rather than somewhere else, like a public policy school. I’m most comfortable with my foundation being that of a law professor. I think the reason for that is because of the way we approach the inquisition of topics—not of students, but of topics. I value honing critical capacities and—this is really important—forcing people to see arguments on other sides so that they don’t become, as economists can sometimes be, “married to their model.” We force ourselves to see things from multiple angles, and yet in the end, we as lawyers act because we have to act. And I do find that a very valuable thing to be able to do. We probably need to teach our students more quantitative skills to stay up with a lot of the data analytics that are being generated. But in terms of intellectual discipline, I think that lawyers continue to have an advantage.

Daniel Tarullo is the Nomura Professor of International Financial Regulatory Practice at Harvard Law School and a former member of the Federal Reserve Board.

David B. Wilkins is the Lester Kissel Professor of Law at Harvard Law School, vice dean for Global Initiatives on the Legal Profession, and faculty director of the Center on the Legal Profession.


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