UK Economy

Dubai is not systemically significant.  If its troubles open our eyes to the likely imminence of the start of the final leg of the journey from household default through bank default to sovereign default, it may do some systemic good, by alerting fiscal policy makers to the vulnerability of their nations’ fiscal-financial positions, and by educating citizens and voters to the urgency of deep fiscal burden sharing.

The markets today were in a bit of a tizzy because the Dubai World Group, a holding company owned 100 percent by Dubai’s government, and Nakheel, a wholly owned subsidiary of Dubai World, imposed a debt restructuring and debt service standstill - failed to perform on their debt or, in ordinary if not legal language, defaulted on their debt.  The combination of the Islamic holiday of Eid and the Thanksgiving holiday in the US boosted the magnitude of the financial market kerfuffle.

I don’t see what the big deal is.  Dubai has experienced for most of this decade the craziest construction boom seen in the Middle East since the construction of the Great Pyramids.  That boom turned to bust – as booms invariably do.  Property developers tend to be highly geared and very procyclical in their revenue flows and access to the capital markets.  During construction slumps they drop like flies.  Because the property sector is risky (ask Donald Trump), its creditors tend to get better interest rates than the sovereign rate.  Dubai is no exception to this rule.  If you earn a risk premium during good times, you should not moan when the borrower defaults from time to time when the going gets tough.

What is so important about H.R. 1207: the Federal Reserve Transparency Act of 2009 aka the ‘Audit the Fed’ bill? This bill “To amend title 31, United States Code, to reform the manner in which the Board of Governors of the Federal Reserve System is audited by the Comptroller General of the United States and the manner in which such audits are reported, and for other purposes.” may not sound terribly exciting, but in addition to making the Fed accountable for its quasi-fiscal activities, it could well set an important precedent for the enhanced accountability of operationally independent central banks everywhere.

The difference between data and information has been underlined emphatically by the release on Friday, October 23rd, of the UK GDP data for the third quarter of 2009.  Those who make a profession out of providing point forecasts of future GDP had converged on a figure of +0.2% for the quarterly growth rate.  What came out was -0.4%.  Shock horror!  Never mind that anyone providing point forecasts of anything without also offering at least some information about of the rest of the probability distribution of future outcomes  (variance, skewness, kurtosis, single-peakedness etc) is either a fool, a knave (or both) or caters to an audience consisting of bears of very little brain.  No matter that the first release of a quarterly GDP forecast in the UK bears little if any systematic relationship to the ‘final’ release, which is often provided years later.  Although we hope that successive data revisions get us closer the the theoretical concept of GDP, we have, of course, no practical way of verifying that.  We are like the proverbial blind man looking in a dark basement for a black cat that isn’t there.

The euro has become a currency on steroids.  Its relentless nominal and real appreciation since the end of 2000 was briefly interrupted in the second half of 2008, but resumed with a vengeance during 2009.  The strength of the currency is hurting the exporting and import-competing sectors of the Euro Area.  Unemployment and excess capacity continue to rise.  The euro’s excessive strength is also contributing to a significant and persistent undershooting of the rate of inflation the ECB deems to be consistent with price stability in the medium term: headline HICP inflation in December 2008 was 1.60 percent in December 2008, hit zero in May 2009 and has been negative since then.

In a post a few days ago, (After subverting bank insolvency, our leaders are now about to make a mess of liquidity) , I argued that hard budget constraints were the defining characteristic of a well-functioning market economy. Many/most of the advanced industrial countries were weakening or even undermining the capacity of their financial sectors to intermediate efficiently by permitting a softening of the budget constraints of banks and other financial institutions that were deemed systemically important and/or were too politically connected to fail.  I noted that the concept of the soft budget constraint (SBC) came from professor János Kornai, a great economist and a Nobel prize winner (the overlap is by no means perfect – there are type I and type II errors)(CORRECTION: As pointed out in a comment on this post, Professor Kornai has not (yet) won the Nobel prize. My bad, as the teenagers in my family would say.  In my defense, he ought to have been awarded the prize already, preferably instead of the large efficient markets cohort that did receive it.)

Professor Kornai’s classic book Economics of Shortage, analyses a fatal internal contradiction in central planning – how soft budget constraints became a defining feature of a centrally planned economy and were central to its astonishing inefficiency and eventual downfall.  In a paper co-authored with Eric Maskin and Gerard Roland (“Understanding the Soft Budget Constrained”, published in the Journal of Economic Literature, December 2003, vol. 41(4), pages 1095-1136), Kornai argues the wider applicability of the SBC concept to economies other than centrally planned economies. For those with access to JStor, the paper can be found here.

I am pleased and honoured that this blog can bring you the following short note in which professor Kornai explains the relevance of the SBC to an understanding of the causes and consequences of the financial crisis of 2007-2009.

The G-7 (USA, Japan, Germany, UK, France, Italy, Canada) was taken off life support at the IMF – World Bank Annual Meetings. So was the G-8 (the G-7 plus Russia), although even fewer observers noticed or cared.  Since international organisations are never formally killed off, the G-7 and G-8 will simply be allowed to fade away. They reflected the economic and geopolitical distribution of power in the immediate aftermath of World War II.  When reality changes, even international organisations eventually catch on and up.  Germany, the UK, France and Italy are global bit players at best now.  They only matter if they act jointly.  The way to do this is through the EU – but with a twist.

For global economic and financial governance, the G-20 is supposed to take over from the G-7/8.  It consists of the ministers of finance and central bank governors of the G-8 plus Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Saudi-Arabia, South Africa, South Korea and Turkey. The tally is completed by the European Union, represented by the rotating Council presidency and the European Central Bank President. The Managing Director of the International Monetary Fund  and the President of the World Bank, plus the chairs of the International Monetary and Financial Committee (IMFC) and Development Committee of the IMF and World Bank, also participate in G-20 meetings on an ex-officio basis.

In addition, a few countries have managed to elbow their way into the G-20 meetings for specific issues where they view themselves as playing a globally significant role.  As far as I can tell they achieved this by throwing their toys out of the pram and/or threatening to hold their breath and making a scene. The Netherlands fall into this category.  They base their claim to be invited (which was effective on three occasions thus far) on the country’s generosity as development aid donors, obviously not heeding the Talmudic view that giving charity and boasting about it, is actually a sin.

I spent the past weekend in Istanbul at the seminar jamboree that precedes the IMF-World Bank Annual Meetings.  Ministers of finance, central bankers, government officials and international civil servants all agreed on one thing: there would be no premature exit from quantitative easing, credit easing and other unconventional expansionary monetary policy measures such as the ECB’s enhanced credit support.

All those in a position of authority subscribed to the view that there was a major asymmetry between the risk of exiting too late and exiting too early: exiting too late would only cause minor overheating problems that could easily be corrected.  Exiting too soon would cause irreversible damage, because after a too early exit, policy could not be re-activated again.

Nobody explained the analytics or empirics to support that view.  It simply became an accepted truth.  In the world of mathematics and formal logic, there are two modes of proof: deduction and induction.  In economics, as in the other social sciences, we have three modes of proof: proof by induction, proof by deduction and proof by repeated assertion.

Be that as it may, the world is being flooded with official liquidity by the leading central banks of the overdeveloped world.  Because of the depressed state of the real economy in most advanced industrial countries (large negative output gaps whose magnitude continues to grow, high and rising unemployment rates), this official liquidity flood is unlikely to generate an overall (private plus public) liquidity flood in the overdeveloped world.  Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states.  This has the further advantage of keeping the regulators happy, even if it does not do much for would-be private borrowers from the zombified banking system.

Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule.  We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and – eventually – busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe.  China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk.

Unless there is a major change of direction among global economic and financial officialdom, we are at risk of ending up with a world in which liquidity provision is privatised and insolvency risk for banks is socialised.  This would be the exact opposite of what makes sense: solvency is (or should be) a private good and liquidity is (or should be) a public good.

Sometimes economics can be helpful even if it does not allow you to make point predictions with any degree of confidence. This is the case, for instance, when it can rule out certain combinations of outcomes for different economic variables as unlikely or even nigh-on impossible. An example of such an unlikely configuration of outcomes is (a) a strong and sustainable recovery of the US economy and (b) a strong (let alone a strengthening) US dollar. A very similar statement can be made about the prospects for a speedy recovery of the UK economy

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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