Today the National Bank of Hungary (the country’s central bank) abandoned the currency’s ERM-style trading band (15 percentage points fluctuation margins in either direction from a central parity of 282.36 forints to the euro). At the end of the trading day, the market rate was 263,57; the abandonment of the band was from the ‘strong’ side of the band. It was meant to give the forint greater scope for appreciation than would have been possible with the band in place (the band would have ‘capped’ the forint at 240 to the euro).

The NBH was right to can the band. An exchange rate target zone or exchange rate band is the worst exchange rate regime designed by man or dog. It combines the major weaknesses of any fixed or managed exchange rate regime - lack of flexibility combined with, ultimately, lack of commitment - with those of a market-determined exchange rate regime - the exposure of producers, consumers and portfolio holders to large and sudden swings in the nominal and real exchange rate, often caused by nothing more fundamental than one of the many manifestations of foreign exchange market psychosis.

For reasons understood only by the authors of the Treaty of Maastricht (and quite possibly not even by them), membership of the ERM for a period of 2 years preceding the examination date for full (stage 3) membership in the EMU, is a prerequisite for becoming a member of the Euroclub. So for countries willing to join and with some hope of meeting all the other criteria as well (inflation, interest rate, public debt, public deficit, central bank independence, good table manners etc.) entering the ERM makes instrumental sense. The 2-year ERM purgatory remains at best, an exercise in futility and an investment without any prospect of a positive return; at worst it exposes a candidate Euroclubber to unnecessary risk of financial and macroeconomic instability.

Clearly, the Hungarian authorities have given up on joining the eurozone for the time being. Quite wisely too. They have serious economic problems on their hands; not meeting the criteria for eurozone membership is the least of these. Growth is the lowest of any CEE country (1.3% for real GDP in 2007; maybe around 1.5 in 2008 - with a global economy that is slowing down and an effective real exchange rate that may be appreciating in the short term). Inflation is high, starting off January 2008 at 7.1% (on a year earlier). Private sector unit labour costs rose by 8.0 percent in 2007. It will have to be a lot less than that if domestically generated inflation is going to be anywhere near the Bank’s target. (more…)

After a 49-year rule, Fidel Castro has decided to give up the presidency of Cuba, although he will continue to lurk in the background exercising influence as and when his failing health permits, through his position as first secretary of the ruling Communist Party. The most likely successor as president is his younger brother Raúl Castro, essentially Fidel without the charisma and without the beard. He represents perhaps a minor improvement in administrative competence, but no change in anything of substance.

Even during the late sixties-early seventies, when almost every western male is his late teens or early twenties sported a poster of Che and/or Fidel on his wall, that particular cultural bacillus passed me by. I was fortunate that my father took the time to explain to me that this duo stood for a repressive, totalitarian regime. My father spent his entire life fighting totalitarian regimes at home and abroad. This started in earnest when he was 18 and the Nazis rolled into the Netherlands, but like much of his vintage of European and American democratic socialists, his political education began with the Spanish civil war. After World War II he was, as a Dutch trade union official for the Metal Workers, then as Secretary General first of the European Trade Union Confederation and later of the International Confederation of Free Trade Unions, involved in resistance to communist dictators in central and eastern Europe and in China, fascist dictators in Spain and Portugal, fascist Colonels in Greece, military dictatorships throughout South America and in Indonesia, white racist regimes in Rhodesia and South Africa, black dictatorships throughout Sub-Saharan Africa, repressive regimes in North Africa, the Middle East and elsewhere in Asia.

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A while ago I argued in this blog that the US might benefit from a recession, because it was highly unlikely that the fundamental adjustment required in the US economy – a substantial increase in the national saving rate – is achievable without a period of growth below potential. Others have made similar points, and not just the usual European suspects, with post-colonial chips on their shoulders and an excess of Schadenfreude whenever the US trips over a banana peel. In recent contributions to the FT, Chrystia Freeland (Canadian, I believe) and Ricardo Hausmann (Venezuelan, when last I met him) have also made the point that the US needs, or would benefit from, an early serious slowdown in economic activity/recession. As the proud owner of both a US and a UK passport (and the former owner of a Dutch passport), my motives are, of course, beyond suspicion.

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In a Senate Finance Committee hearing held Tuesday, January 22, Jim Bunning, R.-Ky., exploded after Congressional Budget Office director Peter Orszag noted that "Chairman Bernanke and many economists" believe that the risk of a recession in 2008 "is substantially elevated relative to normal conditions." Bunning bellowed: “Please don’t bring Chairman Bernanke into this, because he’s been wrong so many times … Chairman Bernanke and his predecessor put the U.S. economy in this situation by their monetary policy. And now they are getting into the business, the Federal Reserve, into advising the Congress on fiscal policy, which is none of their darn business. So, I get a little upset sometimes when our Federal Reserve gets into our job, which is to try to stimulate the economy if we think it’s in dire straits.”

Senator Bunning has a point.  To borrow a felicitous phrase of Alan Blinder: central bankers should stick to their knitting.

Chairman Bernanke has played a prominent, high profile public role in gathering support for a fiscal stimulus package to counteract the US slowdown/recession.  On Thursday, January 17, for instance, in testimony to the House Budget Committee, he backed calls for a fiscal package to stimulate economy, but stressed such a plan should be "explicitly temporary." … "Any program should be explicitly temporary, both to avoid unwanted stimulus beyond the near-term horizon and, importantly, to preclude an increase in the federal government’s structural budget deficit," He went on to say that the nation faced daunting long-run budget challenges associated with an aging population, rising health-care costs, and other factors, and that a fiscal program that increased the structural budget deficit would only make confronting those challenges more difficult. "Fiscal action could be helpful in principle, as fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone," .

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This post is a slightly expanded version of a comment of mine on Larry Summers’ op-ed article in the FT on January 6, 2008 "Why America Must Have a Fiscal Stimulus".

Larry Summers wants a tax cut for the US of between $50 billion and $ 75billion. Robert Rubin, the former US Treasury Secretary, wants a fiscal stimulus worth $100 billion.  Who bids more?  And on top of this, the chairman of the Federal Reserve Board has declared (using either the royal ‘we’ or speaking for the FOMC): “We stand ready to take substantive additional action as needed to support growth and to provide additional insurance against downside risks.”

I consider further policies to stimulate demand in the US economy undesirable.  The US needs a fall in domestic absorption (the sum of private consumption, private investment and government spending on goods and services, or ‘exhaustive’ public spending) to support a lasting depreciation of the US real exchange rate.  Such an increase in the relative price of traded to non-traded goods is in turn required to reduce the US trade deficit to sustainable levels, say by a permanent three percentage points of GDP.

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The Democratic Party has well-established and well-deserved ugly credentials as a hotbed of populist protectionism.  Occasionally, we find a pearl among the Democratic swine.  Bill Clinton, who never wavered in his support for free trade, even when it was electorally costly, is an example.  Unfortunately, this wisdom and courage has not rubbed off on his wife, Senator Hillary Clinton, who is running hard and scared for President of the USA. The other Democratic candidates are, if anything, even more lamentably protectionist than Senator Clinton. The Republicans aren’t much better, but they don’t matter this election, because George W. Bush has made certain that the next president of the USA will be a a Democrat.

When educated persons are deeply ashamed of what they are about to say, they tend to either invoke God or spray the name of a Nobel Laureate around, as a form of mental smokescreen.  Senator Clinton goes the Nobel route.  Quoting:

I agree with Paul Samuelson, the very famous economist, who has recently spoken and written about how comparative advantage, as it is classically understood, may not be descriptive of the 21st century economy in which we find ourselves.”

This statement is complete codswallop.  Granted, Senator Clinton, who doesn’t understand the first thing about economics (as demonstrated by her disastrous attempt at health care reform in the first (Bill) Clinton administration), may not understand precisely why she is talking rubbish.  But the benighted adviser who fed her this bit of misinformation can be presumed to be aware that they are feeding their candidate a bill of goods.

One of the great things about intellectual property rights is that you cannot plagiarise yourself.  I will therefore shamelessly reproduce a chunk of a comment I posted on July 1, 2007, on the FT Economists’ Forum in response to a careless piece of writing by Larry Summers which, come to think of it, ran along the same lines as the quote from Senator Clinton. Here it is:

In support of his claim that "If globalization is taken to mean a combination of more openness and growth of developing countries it is not even altogether clear that it benefits America in aggregate", Larry invokes Paul Samuelson’s elegant paper on the welfare effects on a nation of growth abroad. The appeal to Samuelson’s (correct) analysis should, however, be taken with a pinch of salt.

Samuelson’s paper deals with the effect of growth abroad on home country welfare in a world with two countries (or regions) that have fully integrated (free, competitive) trade in goods and services throughout (both before and after growth abroad takes place). There is no capital mobility or labour mobility. Samuelson’s analysis is intuitive: if growth abroad (whether through total factor productivity growth or the hard way) is concentrated in sectors where the home country used to have a comparative advantage, the terms of trade may turn so badly against the home country that everyone in the home country is worse off. A nation of candle-makers and candle-exporters who don’t have many productive alternative uses for their labour and capital resources may well be worse off when the rest of the world starts producing cheap gas lamps.

However, despite getting clobbered by this technological change abroad, the candle-makers’ nation can do no better for itself than imposing the optimal tariff and trading away. This was true also before the rest of the world invented and produced the gas lamp. Even with the optimal tariff, the candle-makers’ nation can be worse off than before. ‘Shutting off’ globalisation does not mean reducing openness in the sense of reducing trade. The only way to restore the status quo ante is to stop the rest of the world from producing gas lamps.

Back in the real world, the analogue would be to stop India from producing software, operating call centres and providing back office functions to the world at large. It would mean to stop China from acquiring or re-inventing and then using modern technological and managerial know-how to create a mighty manufacturing machine. You would have to stop both technology transfer and internal R&D and other knowledge creation in the Chindias of this world. This, fortunately, is as impossible as it would be immoral. The genie is out of the bottle.

Given that China, India, the other BRICS and ultimately most other emerging markets and developing countries will acquire modern technology, management techniques and governance institutions, the best response of the old industrial countries (the OECD countries, say) is to trade freely, with just the optimal tariff separating them from truly free trade. Even if the old industrial countries were to be worse off as a result of the growth of the emerging markets and developing countries (a theoretical but not a practical possibility for most countries, although individual groups of workers and owners of capital could well be worse off), they would minimize the extent of the welfare loss by optimal tariff-qualified free trade. Going self-sufficient would mean that the candlemakers would have to eat their own candles.

The optimal tariffs are optimal only from the perspective of the countries setting them. Globally they are welfare-reducing. Intelligent bargaining-with-side- payments at the level of the WTO should ensure that the optimal response of the old industrial countries to the rise of the new giants is unqualified free trade.

Whatever happens, the candle-makers can never get their export markets back. Living with it and trading despite it, is the only efficient policy. Using domestic distributional instruments to meet domestic distributional objectives is the other blade of the policy scissors.

So, no Senator Clinton, you are quite wrong about comparative advantage.  Paul Samuelson is, not surprisingly, absolutely right.  Despite outsourcing and off-shoring, despite alleged Chinese currency manipulation and the threat of Sovereign Wealth Funds from the Gulf and the far East owning most of Main Street before long, comparative advantage continues to provide the valid foundations for pursuing free trade, preferably multilaterally, but if necessary unilaterally. The exercise of national market power is the only reason to depart from this, if you are confident that there will be no retaliation.

There is more to international economic policy than trade policy of course, and I encourage Senator Clinton to develop new initiatives in the fields of intellectual property rights, multilateral surveillance by the IMF, migration policy, global regulation of internationally mobile financial institutions and instruments, co-operation in tax policy, including tax administration and a co-ordinated crackdown on tax havens and "regulators of convenience". 

Signs of overheating in the US economy?
The US economy grew at an unsustainable 4.9 percent rate in the third quarter of 2007, which includes almost two months since the ‘official’ start of the financial crisis on August 9.  Admittedly almost a full percentage worth of this growth was inventory accumulation. If his was unplanned, it may predict future planned inventory decumulation. Even 3.9 percent GDP growth, though, is still well above the Fed’s estimate of the growth rate of US potential output (recently revised down to 2.5 percent per annum) and even above the slightly more optimistic estimate of potential output growth of around 3.0 percent per annum of the Bush administration and many private forecasters.  So the recent evolution of the output gap makes for higher inflationary pressures. 

It’s true that the US housing market is a little shop of horrors, with further horrors to come.  Falling domestic construction activity cut about 1 percent off the economy wide GDP growth rate last quarter.  However, residential construction, at barely 4.5 of GDP is a small (and shrinking) contributor to economic activity.  Its weakness has been more than offset by the strength of the internationally exposed part of the US economy, boosted by the vanishing US dollar and a still-strong level of global economic activity.  Exports (about 12% of US GDP now), grew 19 percent and contributed 1.4 percent to economy-wide growth.  A further contribution to demand growth for US production will have come from the import-competing sectors. 

Domestic inflationary pressures coming from a growing output gap are reinforced by the decline in the US dollar and the increase in the dollar price of oil and gas.  The rise in the real price of oil and gas also increases the output gap, as it lowers the path of US potential output because of the role of oil and related energy inputs in US production. 

The rising inflationary pressures are reflected in elevated inflation expectations. On Thursday  November 29, US break even inflation (calculated from nominal and index-linked bond yields) were 2.32 at a 2-year horizon and 2.51 at a twenty-year maturity.

There are indeed many pointers to a slowdown of domestic demand growth.  Although there should be no significant negative wealth effect on US consumption from the decline in US house prices (what the average American consumer loses as a homeowner (s)he gains as a consumer of housing services), the decline in housing wealth will impact consumption negatively through the ‘housing wealth as collateral for consumption loans’ channel.  The financial turmoil has raised the cost and reduced the availability of external funds to the household sector.  Three-month Libor has recently stood more than 60bps above the official policy rate rate, and the spread of three-month Libor over such measures of the market’s expectation of the official policy rate over a three month horizon as the overnight indexed swap rate (OIS), is close to 100bps.  Because many loans to households and non-financial corporates are priced off three-month Libor, there has been a significant degree of effective interest rate tightening, countering the  relaxation of monetary conditions associated with the weakening of the US dollar.

The cost of external finance to the non-financial corporate sector has also gone up, but I doubt whether there has been a corresponding tightening in the availability of external finance for established non-financial corporates.  The balance sheets of the non-financial corporate sector are strong and they are, on average, saving more than they are investing.  Established non-financial corporates may well look like attractive borrowers to banks who are no longer willing to lend to other financial institutions because of the pandemic of mutual mistrust among the financial institutions. Of course, new businesses without a track record will be badly affected by the credit crunch.

Groans and moans from a bloated financial sector
Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is nigh. It’s not.  There used to be a time when most financial institutions were intermediating directly between the ultimate private spending units in the economy - households and non-financial corporations. Most financial markets also had either households (or their direct representatives - institutional investors like pension funds or insurance companies) or non-financial corporates or the state as participants.  No longer.  Many, perhaps most, financial institutions are involved only very indirectly and peripherally with the intermediation between ultimate savers and ultimate investors or with the management of portfolios of ‘outside’ assets.  Their counterparties are other financial institutions.  Both sides of their balance sheets include mainly ‘inside’ financial instruments.

This layering or pyramiding of financial institutions and the explosion of new financial instruments created by them was to a significant degree driven by the twin motives of regulatory avoidance and tax avoidance.  Part of it reflected genuine institutional and technical innovation not driven by regulatory and tax efficiency.  This may well have contributed to more efficient risk trading during normal times and under orderly market conditions.  These developments also make abnormal times and disorderly market conditions more likely and the associated financial crises deeper. The failure of regulators to keep up with the proliferation of instruments and institutions, the lack of transparency of many of the new instruments and institutions (negligible reporting obligations, mysterious governance practices) has reinforced the periodic eruptions of euphoria and hubris that are inherent in financial capitalism.   

The good news in all this is that much of the financial sector has become quite detached from the real economy.  The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect.  Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic  significance happens.  Much recent financial intermediation amounts to the creation of vast artificial lotteries that are used not to hedge previously unhedgeable and non-diversifiable fundamental risk, but rather to allow the taking of larger unhedged positions by speculators with more resources (mostly other people’s money) than sense. Imagine, for instance, a world without hedge funds, SIVs and conduits.  That world would be somewhat more stable and transparent than the one we have now, but not significantly different. 

All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment.  In my view, rather little of it does.

Prospects for US aggregate demand
Direct effects of the financial crisis on investment are so far limited to household investment (construction) and investment in the financial sector.  While any decline in investment, no matter where it occurs, has a negative impact on aggregate demand, from a medium- to long-term perspective, a contraction in the size of both the residential construction sector and the financial sector is necessary and desirable, as both had expanded way beyond what made fundamental sense.  We will come out of this crisis with secularly smaller residential construction and banking sectors (I include in the banking sector: private equity funds, sovereign wealth funds, hedge funds, SIVs, conduits, other off-balance-sheet vehicles created by investment banks and commercial banks, as well as investment banks and commercial banks; after all, a hedge fund is just a bank without capital, reporting obligations, governance, supervision or regulation).

Corporate investment outside the financial sector should not, for reasons outlined earlier, be significantly adversely affected by the effect of the financial crisis on the cost and availability of external finance.  Retained profits are significant and strong balance sheets make established non-financial corporates attractive borrowers for financial sector lenders that no longer wish to lend to other financial intermediaries.  But a material contraction in aggregate demand would depress investment, especially if that weakness of demand were expected to last significantly longer than in the cyclical downturns of the recent past, which all were short-lived.

What can we say about the prospects for non-investment aggregate demand in the US?  Government spending on goods and services, especially at the Federal level, is unlikely to fall as a share of potential GDP in the run-up to an election year.  If anything, a fiscal stimulus of some kind, working either through public spending on goods and services or through the tax-transfer side of the Federal budget, and then through household disposable income, or through current and expected future business profitability, is likely.  The external  contribution to aggregate demand is likely to continue to roar along, both through export demand and through import-substituting domestic production.  That leaves private consumption.

There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly.  And so it should.  The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the  contribution of the US  (necessary and long overdue) to  global rebalancing.  Consumption growth will have to fall significantly and may well have to become negative for a year or two. 

The notion that higher private saving means lower private consumption, barring a disposable income miracle, is apparently news to such distinguished economists as Larry Summers and Martin Feldstein.  Both have argued for many years (in the case of Feldstein indeed for decades) that the US saving rate has to increase significantly.  While some of this increase in the national saving rate could occur through an increase in public sector saving, the bulk will have to come through an increase in the private saving rate.  Indeed, I have not heard any recent plea for tax increases or public spending cuts from either Summers or Feldstein.  So private consumption growth needs to weaken; indeed, the level of private consumption may well have to fall temporarily, to enable the real-exchange-rate-depreciation-assisted ‘crowding in’ of a smaller US trade deficit. 

However, as soon as there is any sign of weakness in consumer demand, both Feldstein (who mooted a 100bps Fed rate cut at the August 2007 Jackson Hole  conference) and Summers (who  wants the Fed to cut aggressively to forestall a recession brought about by weaker construction activity and consumer demand) run to the nearest exit from the home of intertemporal sustainability screaming for a Fed bail out.  Summers in particular appears to be willing to make any opportunistic sacrifice of economic good practice in order to minimise the risk of a short-term slowdown.  He has proposed, for instance, that the two GSEs (government sponsored enterprises) Fannie May and Freddie Mac be allowed to weaken their balance sheets further to make off-budget (from the point of view of the government) quasi-fiscal transfers to financially challenged home owners unable to service their mortgages. He has also argued in the FT’s Economists’ Forum of 25 November 2007, that "…fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens." 

Where is the logic in calling for a higher saving rate when whenever a higher saving rate threatens to materialise, policies and gimmicks are invoked to lower the saving rate again?  Summers’ recommendations for avoiding a downturn are an example of the kind of weak-kneed opportunistic approach to demand management policy in the US that has reinforced what appears to be structurally low private saving propensities in the US these past 40 years or so. There are serious consequences, both internal and global/external of this opportunistic myopia.  Domestically, private and public provision for old age and retirement is becoming progressively more inadequate.  Externally, the US has moved inexorably from being the world’s largest external net creditor to being the world largest external net debtor.  This has weakened and will continue to weaken the global power and influence of the US and its government. It is difficult to go against the wishes and interests of those who own a growing chunk of you.

Surely the time for a consumption slump in the US is now, when the weakness of the US dollar and the strength of global demand will mitigate the impact on aggregate demand and employment?  If not now, then when or under what circumstances? 

Is the Fed kak-handed or a captive of the markets - or both?
Throughout the crisis, the Fed’s communication policy with the markets has been atrocious.  My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.

The speeches by Vice Chairman  Donald L. Kohn on November 28 and by Chairman Ben S. Bernanke on November 29 had as their sole purpose to clean up the mess left by careless speeches  earlier in  November by assorted FOMC members who had left the impression that  it would take a miracle (or a disaster) for the Fed to cut rates at the December 11 meeting.  The self-evident superiority of a strategy where FOMC members say nothing in public that in anyway anticipates future Fed rate decisions has obviously not occurred to anyone.  The Fed’s monetary policy actions (decisions on the Federal Funds target rate) and its liquidity policy actions (decisions on the discount rate, on eligible discount window collateral policy, on eligible discount window counterparties and on its open market operations, both through repos and through outright purchases) speak louder than any words.  The written statements released following FOMC meetings and other policy actions fill the rest of the information gap.  Anything else is, at best, cheap talk.  At worst, it confuses the markets and puts the Fed in the awkward position it has found itself in so many times recently. Too often, ambiguous signals extracted from unnecessary speeches by FOMC members force the Fed to choose between appearing to be a captive of the markets (by validating the markets’ expectations - which tend to be very close to the markets’ wishes - regardless of whether these expectations make any sense) or appearing to be desperate to re-establish its operational independence and room for manoevre by deliberately surprising the markets - ‘teaching them a lesson’.

There obviously are deeper divisions among the Board members and in the FOMC as a whole, than I have ever witnessed before.  The Vice Chairman, Kohn, is an unreconstructed anti-inflation targeting old-style dual mandate man.  Mishkin believes in inflation targeting and appears to be genuinely convinced of the merits of the dual mandate.  Bernanke is an inflation targeter who can live with the dual mandate, but only because he believes that the best, or even the only possible, way to stabilise the real economy is to pursue  a low and stable rate of inflation in the medium term.  Several of the Regional Fed Governors only pay lip service to the dual mandate and are lexicographic price stability targeters at heart.  Janet Yellen, however, is a committed dual mandate proponent. 

What is equally striking as the disagreement about the operational mandate is the fear of the financial markets among key Board members, regardless of their view on the Fed’s mandate.  They fear a large fall in the stock market; they fear  financial  market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks.  We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy.  The collapse of the multilateral trading system was the final nail in the coffin.  Perhaps our central bankers have studied the 1930s too much.

Conclusion

Financial markets and private financial institutions deserve the attention of the policy makers. They are an important part of the transmission mechanism of monetary policy and an important source of shocks that could have implications for systemic stability; the information conveyed by asset prices and other market indicators must be monitored carefully and interpreted thoughtfully.  But they only matter to the extent that they impact on the real economy.  Today’s overgrown, bloated and highly vocal financial markets and institutions are getting more attention than they deserve. 

The Fed and other US policy makers appear to be constitutionally incapable of taking the long view.  Instead they are flailing about in a desperate attempt to minimize any short-run economic pain.  By doing this, they also prevent necessary and unavoidable medium-term and long-term adjustment.  This institutionalisation of myopia and resistance to change may well be an accurate expression of the unwillingness and inability of the US polity and public to take the long view in virtually any area that matters, be it monetary policy, fiscal policy, infrastructure investment, energy pricing and security or global warming.  It is probably the clearest evidence that we can expect an accelerated decline in the global role of the US.

To answer the question in the title of this blog: probably not yet.  But I would not cut the Federal Funds target rate either.

Denmark grows up

Denmark is likely to hold a referendum on its relationship with the European Union.  The referendum proposed by Anders Fogh Rasmussen, its newly re-elected prime minister, is not a referendum on the EU Reform Treaty (aka Constitution-lite), although it is possible that Denmark will also hold a separate referendum on the EU Reform Treaty. Instead, the Referendum proposed by Rasmussen concerns the four opt-outs Denmark negotiated as part of the Maastricht Treaty.  The four opt-outs concern Denmark’s participation in  (1) the common currency (full EMU membership); (2) EU defence policy; (3) EU cooperation on justice and home affairs and (4) EU citizenship.

The reasons for Denmark’s change of heart are obvious.  As regards Eurozone membership, the Danish currency is umbilically linked to the euro via a fixed exchange rate.  Danish interest rates follow those set in Frankfurt for the Eurozone with a lag of a few hours.  Might as well save the transaction costs of converting Danish kroner into euros, get a voice in setting monetary policy for the Eurozone (and for Denmark) and have access to a serious lender of last resort, rather than one which can only issue kroner.

Non-participation in EU defence policy means that Denmark has to stand on the sidelines with military actions it approves of, and even feels strongly about, such as the EU presence in Bosnia-Herzegovina, Macedonia and probably soon also in Kosovo.  Since 2002, the EU has engaged in sixteen operations outside the EU, using civilian and military instruments in several countries in three continents (Europe, Africa and Asia).

Justice and home affairs concerns issues like immigration, asylum and external border controls, and the European Arrest Warrant.  With free mobility of persons among the Nordic countries, Denmark of course had little capacity for a national immigration and asylum policy.

The European Citizenship exemption is of symbolic significance only.  I wonder how many British citizens realise that they are citizens of the European Union as well as of the UK.

The Danish prime minister wants Denmark to be a full player in the EU.  The only way to achieve that is to be a full member.  The opt-outs stand in the way.  Therefore, they have to go.

Are there lessons here for the UK?

Time for the UK to grow up

Under the existing Treaty, the UK has two opt-outs.  It is not required to join the common currency and it does not participate in the Schengen Agreement, which abolished border controls between member states (currently 13 EU members plus Iceland and Norway), and created the Schengen Information System for the purpose of maintaining and distributing information related to border security and law enforcement.

The Reform Treaty will, if ratified, add a number of further UK opt-outs, the famous ‘red lines’. They are:

• Defence: the UK want to remain in control of its  defence and foreign policy; there must be no European defence cooperation which weakens NATO.

• Treaty changes: the UK opposes the removal of the national veto for major decisions on the EU’s future.

• Tax: the UK wants to retain the national veto on taxation mattes, including such matters as  cross-border tax fraud.

• Justice and home affairs: the UK does not want majority voting to undermine its common law system. It also wants to continue to be able to carry out frontier patrols.

• Social Security: the UK wants the national veto to be retained for changes in social security systems.

• European resources: the UK wants any changes to the EU’s right to raise certain funds to be agreed by unanimity alone. This protects the British annual EU budget rebate, secured by Margaret Thatcher in the 1980s.

The UK is punching far below its weight in the European Union.  It is not listened to, has very little influence on the decision-making processes of the Commission or the Council of Ministers, and is not taken seriously most of the time.  The prevailing attitude of the other European members states varies between amusement, bemusement and irritation.

Reasons for giving up the two existing UK opt-outs

Some examples.  Ecofin, the council of the ministers of finance or of the economy of the 27 EU member states, has become an insignificant rubber-stamping body for decisions made by the Eurogroup, the council of the minsters of finance and the economy of the Eurozone members, currently 13 in number, with Cyprus and Malta joining on January 2008.  The Eurogroup doesn’t formally exist in the European Treaties to date.  The Reform Treaty will be the first ‘constitutional’ EU document to recognise its existence and to specify its competencies.  It will continue to do the job Ecofin did before the common currency was created, on January 1, 1999.  The EU is not an EMU member; it does therefore not participate in the Eurogroup meetings.  After January 2008, the UK’s influence on EU decisions in the monetary, fiscal, financial and macroeconomic areas will be less than that of Malta.  The only way to pull your weight in the EU is by belonging to the Eurozone.

This argument for the UK joining the Eurozone is reinforced by the growing recognition that there are no real benefits and some real costs to the UK of monetary independence. The notion that a small open economy like the UK, with unrestricted international mobility of financial capital, could use national monetary policy actively to stabilise the real economy, is a prime example of the ‘fine tuning fallacy’.  In addition, the manifest incompetence of the Bank of England in its liquidity management (both at its discount window (the standing lending facility) and through its open market operations), and the far superior, albeit still imperfect, liquidity management policies and practices of the ECB, suggest that it makes sense also from a financial stability perspective for the UK to contract out monetary policy to the ECB. 

The Bank of England’s superior procedural transparency and accountability would not necessarily be lost as a result of the UK joining the Eurosystem.  The Governor of the Bank of England could, as a member of the Governing Council of the ECB, insist on a vote being taken on the ECB’s interest rate decision (there never has been a vote on monetary policy at the ECB since it was created).  Failure to accommodate this request would result in a public statement by the Bank of England Governor expressing his/her belief that the reported interest rate decision was null and void because of procedural irregularities. 

When votes are taken, the UK Governor could and should make public his/her own vote.  Indeed, I would recommend that a UK Governor make public his/her recollection of all votes cast, and that he/she publish his/her version of the minutes of the Governing Council meetings.  It would not be long before the Governing Council would (a) vote, (b) publish the individual votes and (c) publish the minutes of the meeting.

The UK’s failure to join the Schengen agreement is an example of costly xenophobia.  With more than thirty million tourists each year making visits to the UK and with free mobility within the EU for citizens of all EU member states in no more than five years, it is clear that any hope of effective border control has gone out the window.  Freeing resources currently wasted on checking arrivals from the Schengen Area and allocating these resources intelligently and selectively (using Bayesian profiling) to vetting entrants from outside the Schengen Area would in all likelihood enhance national security, especially if it were accompanied by the effective sharing of information and joint policies drawn up and agreed by majority voting on selected justice and home affairs issues.

Reasons for giving up the proposed new UK opt-outs

The decision on how to assign political competencies - at the supranational level, at the national level or at the sub-national level - has been approached in two complementary ways.  The legal-constitutional-political science approach appeals to the principles of Federalism which, in the case of the EU, was renamed and given the rather unappealing sobriquet of ‘principle of subsididiarity’.  This means that a political competency is assigned to the lower level unless there are significant benefits from assigning it to the higher level.  This applies to the allocation of competencies between the supranational European authorities and the national authorities.  It also applies to the allocation of competencies between the national authorities and the sub-national authorities, provinces/counties/cantons and municipalities.  It applies to the allocation of competencies between a municipality and its wards.  Most importantly, it applies to the allocation of competencies between any of the organs of the state and the individual citizens: when in doubt, leave the government out.

The economic approach applies cost-benefit analysis to the assignment of functions and competencies to the different tiers of the state.  Economies of scale and externalities will favour centralisation of decision making and (possibly) of provision, that is, assigning a function or competency to a higher tier of government.  Diversity of views, preferences, interests and tastes and the speed with which the quality of information about all these relevant characteristics deteriorates as the government agency is further removed from the citizen or interest group (that is, heterogeneity and lack of information), will favour decentralisation - assigning that function or competency to a lower level of government.

For example, boundary-crossing environmental externalities should be handled at the level closest to the domain of the externality.  In the case of greenhouse gases, this is the world, but since the EU is as close as Europe gets to world government, the EU is the natural level at which decisions should be taken. Other environmental externalities are national or subnational (ground water pollution, cleanliness of beaches etc.). Border-crossing public health issues (foot and mouth disease, bird flu, CJD etc.) should be handled at the EU level.  Occupational health and safety issues should be left to the national authorities, as are most, but not all, social security issues and most tax matters.  Defence and foreign policy are obvious EU competencies.  Education is a national or subnational compentency etc. etc.  It is clear that, from this perspective there have been both Type 1 and Type 2 errors in the assignement as tasks to the EU level.  Working hours (as per the Working Time Directive) are not an example of returns to scale or border-crossing externalities.  They should be repatriated to the national level.   

Following this economic logic, foreign policy and defence should be the first EU member state competencies to be assigned to a supranational authority. This makes sense for the UK also. The last time any European nation (not counting Russia) tried to pursue an independent national foreign and defence policy was in 1956, when the UK and France undertook their last colonial adventure in Suez (the Falklands War falls into ‘The Mouse that Roared’ category and does not count). Since then, only Germany among European nations has had a foreign policy that matters at all.  And Germany has no military presence or significance.  Today, the nations whose foreign and defence policies make a difference are the US, Russia (much diminished but still  somewhat relevant to the many countries it borders) and, coming up fast, China and India.  Despite having but the most anaemic version of a foreign and defence policy, the (mainly) soft power of the EU is already more significant regionally and globally than the foreign and defence policies of the UK, France or Germany individually. 

Outside Whitehall, no-one much cares about or pays attention to UK foreign policy, and the UK’s armed forces are no  longer capable of independent action anywhere that matters.  When we try to visualise a indicator of  international political and military power that spans the range from the US down to,say, Denmark, the UK and France will be much closer to the Denmark end than to the US end. So the choice for the UK, as for the other European nation states, is either no foreign or defence policy, or an EU foreign and defence policy.  An independent national foreign or defence policy in Europe is an extreme example of a buck-naked emperor.

I am not sure what I prefer: no foreign or defence policy in Europe or an EU foreign and defence policy.  The last time foreign and defence policies mattered in Europe - in the first half of the 20^th century, the European nation states made the most dreadful mess of it, bringing humanity two World Wars and unimaginable horrors. Perhaps soft power is all that Europe can be trusted with.  But regardless of whether one prefers an EU foreign and defence policy or no foreign and defence policy in Europe, it is key to recognise that even for the UK, France and Germany, the time of being significant players in the global diplomatic, military and economic arenas are gone.  They have become small countries.

As regards future Treaty changes, I believe the days of national vetoes are gone.  But so are the days of national votes or national referenda.  Future Treaty changes should be decided by the European Parliament (with a suitably qualified majority) and/or by a referendum of the EU electorate in a single Europe-wide referendum.  If national votes are to play a role in this (either at the national parliamentary level or through national referenda), the requirement should be that a qualified majority of the member countries vote in favour (say two third plus 1).  But no national vetos in European matters.

As regards taxes and social security, the economic principles of economies of scale and externalities on the one hand and of heterogeneity and incomplete information on the other hand, suggest that no blanket statements like: ‘all tax measures to be subject to national veto’ are likely to be wrong.  Most of social security should clearly remain at the national level.  But the cross-border portability of past national contributions and/or acquired national entitlements has to be ensured.  Otherwise we all will end up working in the country with the lowest takes and retiring in the country with the highest benefits.

Clearly, tackling tax evasion and avoidance will require supranational decision making that cannot be vetoed by tax havens like Luxembourg. Indeed, where the EU has the power, it should compel the co-operation even of non-EU member states like the Switzerland or strange entities like the Channel Islands, the Isle of Man and Monaco.

Justice and home affairs are an area where I very much hope the UK will rethink its opt-out.  Without a written constitution, with no separation of powers, and with probably the most toothless Parliament in the EU, the Executive branch of government in the UK has greater power than the Executive in any other European Country; indeed the UK government is not subject to any effective checks and balances except the blessed bloodymindedness of the British people.  I very much appreciate having the European Court of Justice between me and a UK government that emasculates the right not to make self-incriminatory statements to the police or in court, and that does more damage to habeas corpus than any government since Magna Carta was signed.  The notion that the UK will continue pre-1973-style border checks on visitors to the UK from other EU member states, when within 5 years we will have unrestricted mobility of people within the EU (and probably around 35 million visitors yearly to the UK) is extraordinary.  Even if the authorities were to be willing and able to inflict these indignities on the travelling public (British and non-British), such national control measures would be woefully ineffective.

Last and definitely least, the British Rebate.  Why the other EU members allowed Mrs. Thatcher to get away with that outrageous bit of cheek, I have never understood.  There is no justification for continuing it even for just another year.  If that means a larger net UK contribution to the British budget, so be it.  The reason for this increased budgetary burden will be that the UK government didn’t have the guts to veto the Common Agricultural policy compromise.  You break it, you own it, is a good principle.

Conclusion

It is time for the UK government (and a large part of the British public) to grow up and start making a difference in Europe.  Sure, the UK is unique and different.  So are the other 26 EU members.  The UK has much to offer the EU.  It has sidelined itself for too long.

A short list of dos and don’ts for the government to consider.

• Adopt the euro as soon as you can.

• Join the Schengen agreement immediately

• Forget about the British rebate.  Veto the CAP budget instead, at the earliest opportunity.

• Make up your mind as to whether you want a European foreign and defence policy or no foreign and defence policy.  Don’t daydream about an independent national foreign and defence policy.

• As regards taxation and social security, apply the economic criteria of economies of scale and externalities vs. heterogeneity and incomplete information.

• Let future changes in European constitutional arrangements be jointly decided by (1) the European Parliament and/or the European electorate (through EU-wide referenda), and (2) national parliaments an/or national referenda, with support of a qualified majority of the member states required for ratification.

First, the good news. The US housing slump is unlikely to drag the US economy down very much. It is true that up to now, the major source of weakness in the US economy has been the housing sector. At the end of Q2, 2007, the Federal Reserve Board reported the market value of the US residential housing stock $21.0 trillion and single family mortgage debt at $10.1 trillion. About 14 percent of the mortgage debt, $1.3 trillion, say, is sub-prime. According to the Case-Shiller data, since the end of 2006, the average US house price may have fallen by 5 percent or so, knocking about one trillion dollars of the value of the US housing stock. The brain behind these data, Bob Shiller of Yale University, believes a further decline, over a period of years, of 15 percent is in the cards.

The reason for the good news is that there is no first-order wealth effect from a change in house prices on private consumption; a decline in house prices is a redistribution from home owners to consumers of housing services, that is, from landlords to renters. The fundamental value of a home equals the present discounted value of the flow of housing services its yields, now and in the future. This is also what those who live in the home expect to pay for it, now and in the future, either as rents or, if they are owner-occupiers, as the opportunity cost of the imputed rental income they forego by living in their homes. The FRB/US econometric model used recently by Governor Frederic S. Mishkin of the Federal Reserve Board in his Jackson Hole Conference paper  to analyze the US housing market erroneously attributes the same wealth effect to housing wealth as to stock market wealth, and thus assigns it a marginal propensity to consume of 3.8 percent rather than zero, which would be the number suggested by economic theory.

The good news is qualified because housing wealth is collateralisable wealth and can therefore help to relax liquidity and cash-flow constraints faced by households. The scope for financing consumption through mortgage equity withdrawal is reduced when house prices fall and this may cause a temporary fall in consumption. To allow for this collateral effect, Mishin raises the marginal propensity to consume from 3.8 percent to 7.6 percent.  Emulating this, I will raise my estimate of the combined wealth and collateral effect of housing price changes from zero to 3.8 percent. The impact on annual consumption of the 5 percent decline in house prices would then be $38 billion. With a $ 12 trillion annual GDP, this is a decline in demand of just over 0.31 percent of GDP – not quite the stuff recessions are made off. Even if, over the next three years, house prices were to continue to decline at a 5 percent rate, this would give us a further cumulative decline in demand of just over 0.9 percent GDP.

The decline in home prices, and the increased cost and reduced availability of finance for homebuilders and home purchases will no doubt further depress the demand for new housing. However, construction is a smallish sector in the US - only about 4.5 percent of GDP in 2007. Since 1975, the share of construction in GDP has not fallen below 3.7 percent (in 1992 and 1993). It seems unlikely that the construction sector will decline by as much as an additional one percent of GDP.

The sub-prime crisis, like any financial crisis, is first and foremost a distributional question

The sub-prime crisis, the write-downs by commercial banks and investment banks of CDO and other ABS exposures, the ABCP meltdown and related financial kerfuffles are first and foremost a redistribution of financial wealth from creditors to debtors. All these derivative claims are ‘inside’ financial claims – for every creditor there is a matching debtor. These write downs and write-offs do not in and of themselves destroy any net wealth.

The only assets for which there are no liabilities – ‘outside assets’ - are, in a closed economic system, the stocks of natural resources, physical capital, human capital and goodwill. We can take the value of equity as the best approximation to the value of the stocks of privately owned physical capital, of goodwill and of natural resources owned by private corporations. The value of the housing stock owned by households can also be measured reasonably accurately. Publicly owned infrastructure capital and human capital cannot be valued using readily available market prices.

All other financial instruments, including sub-prime mortgages, ABCP and all asset-backed securities are inside instruments for which changes in valuation do not change aggregate wealth but just redistribute it. That does not mean that such changes (and the precise circumstances under which they occur) don’t matter for aggregate demand or supply. In general they will not be neutral. But it is important to recognise that for every unhappy banker who writes off $200,000 of mortgage debt, there is one happy mortgage borrower who now will no longer have to service that debt.

Where the redistribution involved is from investment banks (and ultimately from the shareholders in these investment banks) to sub-prime borrowers the net redistributional effect on aggregate consumer demand may well be positive. Of course, defaults, personal bankruptcy, foreclosures and other reassignments of property rights involve real resource costs. A single foreclosure on a sub-prime mortgage has been estimated to cost as much as $50,000. With as many as 2.2 million families with a subprime loan made from 1998 through 2006 who expected to lose their home to foreclosure in the next few years, a real resource cost of $110 billion will be incurred.

Furthermore, the losses suffered by the banks will lower their regulatory capital. So will the need to take back on balance sheet a whole range of illiquid assets that had been parked in a variety of off-balance sheet vehicles like sivs and conduits. Ratios. How large could these numbers be? Banks have currently written down sub-prime backed assets to the tune of about $40bn, and assorted pundits estimate this number will rise to $60 billion soon. Ben Bernanke, during his testimony before the Joint Committee of the House and Senate on Thursday, November 9, gave a guestimate of $150 bn for the total losses suffered eventually by the financial system because of the subprime debacle; earlier this summer he had mentioned a figure of $100 bn. Even $150 bn seems low. New subprime issues in 2004, 2005 and 2006 were $363, $465 and $449 bn respectively. By 2004, any attempt at quality control in subprime origination had already gone out of the window, so I would expect that most of these loans will default before long, unless there is a major bail-out by the Congress. How much of the almost $1.3 trillion of subprime lending during these three years is covered by the value of the properties held as collateral is unknown, as there is no prior experience of lending to such a large subprime population. A loss of $150 bn would be just be under 12 percent; that seems low, and one could easily conceive of it being as high as 20 or 25 percent. In addition, losses will be made on subprime loans made before 2004 and after 2006, and on higher-rate loans, including Alt-A and prime loans. A $250bn to $300bn eventual loss on all mortgage-related exposure would seem to be in the ball park.

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit. In addition, US commercial banks have, through unused liquidity commitments, obligations of up to $350bn to sponsored conduits that used to fund themselves with ABCP; they also are exposed to the risk of having to take back and hold up to $140bn of loans taken out for failed leveraged buy-out type deals, and are warehousing, at a loss. an indeterminate but significant amount of loans and other assets that were intended for securitisation, or packaging into other complex structures. The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.

Possibly more serious than the objective magnitude of the losses that banks will ultimately have to face is the uncertainty, indeed ignorance, about where the losses are likely to hit. The opaqueness of many of the new financial instruments and the lack of transparency and minimal reporting obligations of many of the new financial institutions, is that we still don’t know who is exposed to what - who owns what and who owes what and to whom.

If all banks were required to mark to market or mark-to-model their assets and off-balance-sheet exposures using a common, verifiable methodology, we would not have the current situation where everyone is either trying to pass possible badly impaired illiquid hot potatoes on to a less well-informed counterparty, or trying to delay recognising the losses on those assets they cannot get rid off, in the hope that something will turn up and make all the bad things go away. It has even led to a proposal to create a kind of private market maker of last resort (the Single Master Liquidity Enhancement Conduit aka ‘Superfund’ proposed by Citigroup, Bank of America and J P Morgan Chase). There is a real risk that a facility of this kind would permit on a much larger scale the reciprocal taking in of each other’s dirty laundry at sweetheart prices that is rumoured to take place already among some banks. There is a grey area, with a thin line hidden somewhere in the middle, between wanting to prevent panic sales at fire-sale prices and trying to manipulate the market to as to avoid the recognition of the true magnitude of the losses that have occurred. In the mean time, lack of trust combines with ignorance about the true value of what’s being offered for sale to produce a de-facto buyers strike.

If the progressive reduction we are seeing in the willingness and ability of banks to lend, extends to lending to the non-financial sector (households and non-financial corporations), there could be further effects on the real economy. I believe households in the US are vulnerable to this, because they are highly indebted by historical standards and have been running financial deficits for many years. Non-financial corporates, however, are in rather good financial shape, both as regards the leverage in their balance sheets (low) and as regards their financial surpluses (adequate). In addition, non-financial corporates have the option of bypassing the banking system altogether and going to the domestic and international capital markets directly. I expect to see more disintermediation by the non-financial corporate sector at the same time that we see re-intermediation of the off-balance-sheet non-financial vehicles into the banking sector.

Other credit risk mis-pricing problems

Subprime mortgages were not the only area of credit where lending and borrowing discipline collapsed. Similar reckless behaviour could be observed in unsecured consumer lending, including credit card lending, and with car loans. Both credit card receivables and car loans have been securitised on a large scale, and indeed both assets have been combined with mortgage loans in CDOs and other complex structures. 

Good news and bad news from the rest of the world 

The major source of demand strength is the US economy is the external sector. This is not surprising, as the rest of the world is growing faster than the US and the real effective (that is, trade-weighted) exchange rate of the dollar has dropped like a stone. Exports are a much more important source of demand in the

US (12.0 percent of GDP in 2007Q3) than they were in 1975, for about 8.5 percent of GDP or in 1965, when they were 5.2 percent of GDP. From its peak in 2002Q1 the broad effective real exchange rate of the US dollar had depreciated by 25 percent by 2007Q3. The precipitous decline of the nominal and real exchange rate of the dollar since September can easily have added another 5 percent to the cumulative real depreciation rate. In real terms, the dollar today is as weak as it has been at any time since 1970.

It is therefore not surprising that the growth rate of real exports has been pretty spectacular recently (9.6 percent in 2007 Q3 on a year earlier). There is no doubt that, if the dollar stays weak (let alone weakens further) and if global growth slows down only modestly, the growth of export demand can easily more than compensate for the decline in residential investment. 

Since the last quarter of 2003, the US terms of trade (relative price of exports to imports) has declined by eight percent, that is about two per cent per year. The US trade balance deficit averaged about 5.4 percent of GDP. As a result of the terms of trade deterioration since 2003 Q4, the US has suffered an annual real income loss equal to two percent of 5.4 percent of GDP, that is 0.11 percent of GDP, which is tiny.

An index of the real oil price (West Texas Intermediate divided by CPI) peaks at 48.8 in the first half of 1980, following the second oil price shock. The latest official data, for September 2007, have the index at just over 38.4, after a trough of 6.9 at the end of 1998. Since September, the oil price has risen by a further 25 percent while the increase in the CPI has been negligible. The real price of oil today therefore again stands at around 48 – its all time peak. This oil price shock will have a marked negative effect on potential output, and will increase future inflationary pressures through the output gap channel. This adverse potential output effect of an increase in the relative price of oil is over and above any general price level effect from an increase in the dollar price of oil. If potential output weakens more than aggregate demand, the ugly word ‘stagflation’ will have to be dusted off. Inflationary pressures in the US have for a long time been higher than acknowledged by the Fed. Headline CPI inflation for the 12-month period ending September 2007 was 2.8 percent, while core inflation, the will-0’-the-wisp that used to be viewed by the Fed as a good predictor of headline inflation in the medium term, was 2.1 percent. There is no doubt that the collapse of the dollar and the explosive increase in the dollar price of oil will give further momentum to US inflation, just at the time that the growth rates of both actual and potential output are declining.

For the Fed, these are interesting times indeed. 

A final feature of the contribution of the rest of the world to the economic prospects for the US is that growth in the rest of the world, including the key emerging markets of China, Russia, Brazil and to a lesser extent India, is much more fragile than is generally appreciated. The mis-pricing of credit risk extended to the emerging markets. While sovereign risk in China and Russia is virtually absent, credit risk and other risk attached to private financial instruments is high. Neither China nor Russia benefits from the rule of law. There is no minority shareholder protection, creditor or bondholder protection, nor do we find any of the other institutions and fora for the resolution of property rights disputes taken for granted in the advanced countries. Administrative or regulatory expropriation has been a common phenomenon in Russia, Kazakhstan, Venezuela, Argentina and may also become a recurring phenomenon in resource-rich African countries and in other South-American countries. In my view these non-sovereign, private risks are significantly underestimated and underpriced.

There is also more sovereign risk than is priced in by the markets affecting emerging markets that do not have huge foreign exchange reserves and whose external surpluses are either vulnerable or absent altogether. Argentina and the Philippines are examples, and even a reasonably well-managed country like Turkey is more vulnerable to internal and external shocks than its ratings suggest.

The risk to global growth outside the US is therefore higher than generally recognised, and skewed to the downside.

Conclusion 

The destruction of value and wealth thus far in the US as a result of the housing sector crisis is manageable. Its effects are mitigated and could well be more than offset by the strength of the export sector. However, the sub-prime crisis is but the tip of the credit risk mis-pricing iceberg. Unsecured consumer loans and car loans, and the large stock of ABS backed by credit card receivables, are waiting to join the credit risk-repricing party.

The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year. 

Continued global economic growth and dollar weakness are a necessary condition for the US to avoid a serious slowdown, or even a recession. While both may continue to materialise, the risks to global growth are higher than generally recognised and rising.
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Reference

Frederic S. Mishkin (2007), “Housing and the monetary mechanism”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. 2007/40, August.