By Lawrence Summers The new year will begin with the greatest divergence for a generation between the general view of global risks as reflected by conventional wisdom and the risks as priced in financial markets. While the commentariat has been more alarmed about the state of the world than global markets for some years, the gap increased in 2006 as markets became more serene and everyone else grew more anxious. The headlines and opinion writers focus on how the US is badly bogged down in wars in Afghanistan and Iraq; on an increasingly unstable Middle East and dangerous energy dependence; on nuclear proliferation that has already occurred in North Korea and that is coming in Iran; on the potential weakness of lame-duck political leaders in the US and other major democracies; on record global trade imbalances and rising protectionist pressures; on increased levels of public and private sector borrowing combined with record low saving in the US; on falling home prices and middle class economic insecurity. At the same time, financial markets are pricing in an expectation of tranquility as far as the eye can see. Stock prices in the US are at all-time highs. The risk premiums to cover the possibility of default that corporations or developing countries have to pay to borrow money are at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options are near record lows. Why the divergence between the headlines and the markets? Will the journalists or the investors be proved right about the state of the world? Or will the divergence continue? Read more

By Lawrence Summers A recent meeting with the incoming freshmen of the 110th House of Representatives made clear to me some of the forces that will shape American economic policy in the next few years. Coming from very different parts of the country and very different political perspectives, the new members of Congress have in common that they have all heard from the anxious middle class. They feel under enormous pressure to respond not just to the economic insecurity that middle-class voters feel, but also to voters’ resentment at what they see as disproportionately prospering corporate elites. If the new Congress sees itself as having a mandate for anything in the economic area, it is for policies that “stand up” for ordinary Americans against the threat they perceive from corporate and moneyed interests. These populist impulses have roots much deeper than campaign rhetoric. In the past, real wages and corporate profitability have moved together – increasing during economic expansions and when the US became more competitive, declining in recessions and when it encountered significant competitive threats. The unique feature of the current expansion is the divergence between the fortunes of capital and the fortunes of labour. While workers normally receive about three-quarters of corporate income, with the remainder going to profits and interest, the Economic Policy Institute has calculated that, since 2001, labour has received only about one-quarter of the increase in corporate income, as real wages have failed to keep pace with productivity growth. Indeed, for most groups of workers, wages have not kept pace with inflation over the past several years. College graduates have been particularly hard hit, with their wages struggling to keep pace with inflation over the past five years. At the same time, profits per share for companies in the Standard & Poor’s 500 index have increased at an annual rate of more than 10 per cent, even after taking into account inflation over the past four years. Read more

Richard Nixon’s Treasury secretary, John Connally, famously remarked that “the dollar is our currency, but your problem”. He would be right again now. The rest of the world normally wants a strong dollar. Yet the dollar is now in a bear market. How long might this go on? The plausible answer must be: a while yet. Since early 2002 the dollar has been on a steep downward path: on JPMorgan’s trade-weighted real exchange rate it has depreciated by 23 per cent since February 2002. This is the third such sustained decline since Mr Connally’s remarks. The first was during the early 1970s. The second was from 1985 to 1988. On each of the two previous occasions, the depreciating real exchange rate also helped generate a big adjustment in the balance of payments. This was strikingly true in the 1980s. The same thing is happening again. Between 1996 and 2004, real US domestic demand grew faster than real gross domestic product every year. This was necessary, I have previously argued, if GDP was to rise in line with potential, given the prevailing real exchange rates and the weak rate of growth of demand in much of the rest of the world. Over these years, cumulative growth in US real demand was 39 per cent, while GDP grew by 33 per cent. The difference was the real increase in the deficit in trade in goods and non-factor services. The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free – click ‘Comments’ below Read more