By Martin Wolf

“We told you so.” The Bank for International Settlements has long warned of the dangers of unrestrained credit growth and asset price inflation. In this year’s annual report, the last to be prepared under the direction of William White, its long-serving Canadian economic adviser, it felt free to point out how right it had been. But it did so with restraint: “Rather than seeking to apportion blame,” it says, “thoughtful reactions must be the first priority.”

The report provides just such reactions. But it also describes the mess created by those who ignored its earlier warnings. “The current market turmoil in the world’s main financial centres is,” it claims, “without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless.”

As readers of BIS annual reports would expect, this one gives good answers to four big questions.

The remainder of this column can be read here. Debate from our expert panel appears below.

By Fred Bergsten

The global economy has clearly decoupled from the US and world growth remains close to 4 per cent in spite of the absence of any increases in domestic US demand. Continued expansion abroad, especially in the emerging market economies, has in fact cushioned the slowdown and so far prevented recession in the US. Hence we are also experiencing the first episode in history of reverse coupling, in which the rest of the world pulls the US forward rather than the opposite.

The most striking feature of the current global economic situation is that the US is the only major country that is seriously contemplating recession and that has adopted aggressive expansionary policies to combat that risk. Most other countries are more worried about inflation than slower growth. Many are experiencing reduced growth, to be sure, but part of their slowing is a natural cyclical reaction to four years of near-record global expansion, at more than 4½ per cent from 2004 to 2007, and the need to focus on price stability. The additional losses because of the housing and credit crises in the US amount only to a couple of 10ths of 1 per cent in most areas, including Europe and Japan. It will reach a full percentage point or more only in the fastest growers such as China, where expansion will remain near 10 per cent. Many of these cuts are in fact welcome as their central banks are tightening monetary policy rather than easing it.

Global growth is thus still likely to approach 4 per cent in both 2008 and 2009 in spite of the sharp slowdown in its largest single economy. The emerging market economies, which now account for half of world output calculated at purchasing power parity exchange rates by the International Monetary Fund, are still expanding at 6-7 per cent. Even the nearest neighbours of the US – Canada and Mexico – are nowhere near recession and have altered their policies much less forcefully. In spite of the international transmission of substantial financial as well as real economic shocks from the US, the traditional relationship where “the world catches cold when the US sneezes” no longer holds.

The second striking feature is the reverse coupling of the global economy. Over the past two quarters, the US has recorded positive growth at an annual rate of 0.8 per cent (in spite of the pronouncements of many observers that recession had already set in). Its “net exports of goods and services”, the gross domestic product equivalent of the current account balance, have strengthened at an annual rate of almost 1 per cent of GDP during that period. Hence the totality of recent US expansion has been provided by the strengthening of its trade balance. Domestic demand has been falling but the US has been saved from recession by the rest of the world.

The improved US trade performance of the past two years is due partly to the substantial, if lagged, restoration of the country’s price competitiveness as the dollar declined by a trade-weighted average of 25-30 per cent since early 2002, reversing most of its excessive run-up during the previous seven years that produced unsustainable current account deficits exceeding 6 per cent of GDP. Equally important, however, is the continued robust growth of the world economy. Every percentage point by which the rest of the world expands domestic demand faster than internal growth in the US produces gains of about $50bn (€32bn, £25bn) for the US external balance. Weighted by US exports, foreign growth exceeded US growth by about 2 percentage points in 2007 and will do so by an average of about 1.5 points this year and next as decoupling persists. Taken together, these currency and comparative growth factors have already improved the real US trade balance, and hence GDP, by almost $150bn since 2006, with gains of another $150bn or so likely through 2009. (The nominal US trade and current account deficits will not improve as much because of the sharp rise in the price of oil imports.)

The Organisation for Economic Co-operation and Development’s new Economic Outlook projects that more than 80 per cent of all US growth in 2008-09 will derive from continued strengthening of its external position. Exports have been climbing at an annual rate of about 8 per cent, at least six times as fast as imports. Unless domestic demand takes an unexpected further fall in the quarters ahead, reverse coupling of the global economy will thus have prevented the US recession that was so widely predicted and feared. Presidential candidates and members of Congress who believe that the US is losing from globalisation should take note of this export-led growth and its creation of excellent new jobs, and recognise the folly of backing away from international trade at a time when it is providing critical gains for their country.

These international macroeconomic developments also provide another telling indication of the shifts in global economic power. As noted, the emerging market economies make up about half the world economy, so their growth of 6-7 per cent assures reasonably strong world output increases even if there were no expansion at all in the rich countries. China alone accounts for 10 per cent of the global total, so its annual expansion of 10 per cent generates a full percentage point of world growth all by itself. The steadily rising diversification of global economic leadership is paying huge dividends to all its participants, most dramatically during this episode to the US as export-led growth saves it from at least the worst ravages of its housing bubble and associated policy errors.

The writer is director of the Peterson Institute for International Economics

By Lawrence Summers

It is quite possible that we are now at the most dangerous moment since the American financial crisis began last August. Staggering increases in the prices of oil and other commodities have brought American consumer confidence to new lows and raised serious concerns about inflation, thereby limiting the capacity of monetary policy to respond to a financial sector which – judging by equity values – is at its weakest point since the crisis began. With housing values still falling and growing evidence that problems are spreading to the construction and consumer credit sectors, there is a possibility that a faltering economy damages the financial system, which weakens the economy further.

After a period of intense activity at the beginning of the year with the passage of fiscal stimulus legislation, strong action by the Federal Reserve to cut rates and provide liquidity and the introduction of anti-foreclosure legislation, policy has again fallen behind the curve. The only important policy actions of the past several months have been those forced on the Fed by the Bear Stearns crisis. It would be a mistake to overstate the extent to which policy can forestall the gathering storm. But the prospects for a more favourable outcome would be enhanced if four actions were taken promptly.

First, the much debated housing bill should be passed immediately by Congress and signed into law. It provides some support for mortgage debt reduction and strengthens the government’s hand in its troubled relationship with the government-sponsored enterprises – Fannie Mae and Freddie Mac. While it is an imperfect vehicle – too limited in the scope it provides for debt reduction, insufficiently aggressive in strengthening GSE regulation and failing to increase the leverage of homeowners in their negotiations with creditors through bankruptcy reform – it would contribute to the repair of the nation’s housing finance system. Failure to pass even this minimal measure would undermine confidence. Continue reading "What we can do in this dangerous moment" »

By Martin Wolf 

Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one. Last week I argued that exchange-rate regimes were a link between these distinct events. This week, let us look at how to sail on these storm-tossed seas.

The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way. So what have we learnt about the world economy as a whole? The answer is that it is running into limits on resources, at least in the short term.

Our civilisation is based on fossil fuel. But since the end of 2001, the real price of oil has risen some six-fold. Today, the real price is higher than since the beginning of the previous century. As the World Bank notes in its Global Development Finance 2008, global oil supply stagnated in 2007. This, argues the report, “contributed to the large decline in stocks in the second half of 2007 and to sharply higher prices”*. These increases may prove temporary, as happened after the spikes of the 1970s, or permanent. We do not yet know.

The remainder of this column can be read here. Debate from our expert panel appears below.

By Martin Wolf

Inflation is always and everywhere a monetary phenomenon - Milton Friedman

What explains the combination of a “credit crunch” in the US with soaring commodity prices and rising inflation across the globe? Are these unrelated events or part of a bigger picture? The answer is the latter. So far this is not a return to the 1970s. But action is needed to keep this true.

Inflation is a sustained rise in the price level: the result of too much money (or purchasing power) chasing too few goods and services. A one-off jump in commodity prices is not inflation. Nor need such a jump cause inflation. But a continuous rise in the relative price of commodities is a symptom of an inflationary process.

The remainder of this column can be read here. Debate from our expert panel appears below.

Privatisation was one of the great achievements of the Thatcher era. But it is becoming increasingly evident that the transfer of monopolies into the hands of regulated companies that own, run and develop the assets is flawed. This is excessively costly to consumers. It is also an obstacle to investment in risky long-term assets such as airports, nuclear power , electricity and gas networks.

This is not to argue that privatisation is devoid of benefits. Where competition could be introduced into the newly privatised industry, as in the case of telecommunications, the gains were huge. Elsewhere, privatisation was the way to allow essential activities to escape from the dead hand of Treasury curbs on public investment. Private finance was more expensive, but investments were at least made.

Yet, as recent work by Oxford University’s Dieter Helm makes clear, it is time to review the model. The bundling together of different functions in one regulated entity, and the rules on costs, particularly of capital, need rethinking.

A regulated utility consists of a set of assets, an operating function and a co-ordinating function. The second, in turn, consists of two activities: running the business day to day and planning and implementing investment projects. Professor Helm argues, persuasively, that lumping all these together has led to inefficiency and a rip-off of consumers*.

The remainder of this column can be read here. Click through to read the debate from our expert panel.

By Martin Wolf

Is it possible for the vast mass of humanity to enjoy the living standards of today’s high-income countries? This is, arguably, the biggest question confronting humanity in the 21st century. It is today’s version of the doubts expressed by Thomas Malthus, two centuries ago, about the possibility of enduring rises in living standards. On the answer depends the destiny of our progeny. It will determine whether this will be a world of hope rather than despair and of peace rather than conflict.

The challenge is stark. World real incomes per head could rise 4.5 times by 2050 and world population by 40 per cent. This would mean a sixfold increase in global output, concentrated in the developing world (see charts). Is such an increase feasible? The answer he gives is: yes and no – yes, because changes in incentives, technology and social and political institutions would make a benign outcome feasible; and no, because the path we are now on is unsustainable. Professor Sachs is an optimistic prophet of doom. He falls in between those environmentalists who see no solution and those free-marketeers who see no problem. The remainder of this column can be read here.

Read the debate - contributors so far include Jeffrey Sachs, Paul Collier, William Easterly, Dennis Bennett and Brian Davey.

Today, almost two-thirds of humanity lives in high-income or high-growth countries. That proportion is up from less than a fifth 30 years ago. Unfortunately, the remaining 2bn live in countries with stagnant, or even declining, incomes. What makes this even more important is the worrying fact that some two-thirds of the 3bn increase in global population expected by 2050 will live in countries today enjoying little or no growth.

The overriding challenge is to shift more poor countries into the high-growth category. This is addressed by the recently published Growth Report, product of a commission consisting mainly of policymakers from developing countries, under the chairmanship of Michael Spence, a Nobel-laureate economist at Stanford University.

So what does the report contribute? Nothing useful, argued William Easterly of New York University (this forum, May 28). He suggested, instead, that its pragmatism represented “the final collapse of the ‘development expert’ paradigm that has governed the west’s approach to poor countries since the second world war”.

Thereupon, Professor Easterly promptly offered his own expert opinion, namely, that “more economic and political freedoms are associated with much less poverty”. This is true. But it is harsh, to put it mildly, for Prof Easterly to condemn the report when he offers what appears to be even emptier advice.

The remainder of this column can be read here. Debate from our expert panel appears below.

Read the debate - contributors so far include William Easterly, Michael Spence, Martin Wolf and Clive Crook.

By Lawrence Summers

After a modest interval with no big financial shocks, policy attention is turning to the task of preventing future crises and managing those that occur. While the deliberations will take quite a while to play out, there is some time pressure – because of the moral hazards created by the Federal Reserve’s extension of credit to investment banks and authorities’ desire to act before the sense of alarm created by recent events abates and complacency returns.

Proposals for changes in regulation and crisis response have come from many quarters, including the US Treasury and private sector groups. They offer important ideas on rearranging regulatory responsibilities – such as the Treasury’s suggestion of an enhanced role for the Federal Reserve with respect to investment banks and its call for a consumer financial regulator – and raise critical issues, such as that of procyclicality induced by regulation. They also contain a certain amount of essentially content-free calls for worthiness. So far missing from the debate has been a set of principles describing the properties of any desirable regulatory regime, against which proposals can be evaluated. Different observers will assign priority to different issues – here would be my list of six principles.

Continue reading "Six principles for a new regulatory order" »

Silliness is abroad in the UK. Some are arguing in favour of a looser monetary regime. I responded to this two weeks ago (“Britain must not cut loose its anchor”, May 15). Others are even muttering in favour of joining the eurozone, now celebrating its 10th birthday. Even my colleagues on the Lex column argued last week that the UK was close to meeting the economic tests for joining. The only obstacle to entry Lex could find was political.

Lex is wrong. Whether the UK meets arbitrary tests at a particular moment is irrelevant. What is right today may be wrong tomorrow. If a country is to join the eurozone, its people must be willing to cope with the consequences forever, however unpleasant they may sometimes be.

True, at present exchange rates, entry looks more plausible than for the past 12 years. The implied rate of the old D-Mark against the pound was 2.46 on May 23, well below the rate at which sterling was put in the old exchange rate mechanism in 1990. The real effective exchange rate measured by JPMorgan is 7 per cent below its average since the beginning of the 1980s. At present rates, adoption of the euro looks reasonable.

The remainder of this column can be read here. Comment from our expert panel appears below.

Read the debate - contributors so far include Willem Buiter and Andrew Smithers.