By Martin Wolf

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.

Perhaps the most striking characteristic of the banking sector is its profitability. Between 1997 and 2006, for example, the median nominal return on equity of UK banks was 20 per cent. While high by international standards, this seems not to be exceptional. In 2006, returns on equity were about 20 per cent in Ireland, Spain and the Nordic countries. In the US they were a little over 12 per cent. Returns in Germany, France and Italy seem to have been close to US levels.

As Andrew Smithers of London-based Smithers & Co and Geoffrey Wood of the Cass Business School at the City University London note in a splendid report, from which I have taken these data, long-run real returns on equity in the US have been a little below 7 per cent.* Another study estimated the global real return on equity in the 20th century at close to 6 per cent.**

The remainder of this column can be read here. Debate from our guest economists appears in the comments below.

By Lawrence Summers

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.
Several streams of data indicate how much more serious the situation is than was clear a few months ago.

First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago.

The remainder of this column can be read here. Debate from our guest economists appears below.

By Martin Wolf

Is the US going to experience a recession? Two answers must be given to this question: nobody can be sure; and it does not matter. A much more important question is whether the US economy continues to experience a “growth recession”, by which is meant a lengthy period of sub-trend growth. The answer is that it will.

The standard US definition of a recession is two quarters of negative economic growth. This demands both too much and too little: too much because it requires an absolute fall in output, which is an infrequent event in a growing economy; too little, because it is consistent with rising unemployment and declining capacity utilisation. But a lengthy growth recession is likely to be far more disturbing even than a sharp recession, provided the latter ends swiftly.

Most analysts believe that the trend rate of growth of the US economy is around 3 per cent a year. Growth at below that rate, then, is a growth recession. This year, the expectation is for growth of about 2 per cent. Next year, suggests the consensus, it will be a little above 2 per cent. That would mark a cumulative shortfall of about 2 per cent of gross domestic product over two years. So the US is already in a growth recession.

The remainder of this column can be read here. Debate from our guest columnists appears below.

The plight of Northern Rock remains a huge embarrassment for both the UK’s policymakers and its financial sector. The authorities confronted a bank run, only to end up guaranteeing the bank’s deposits and funding at least £20bn ($40.9bn) of its liabilities, so far. Many believe government subsidy will be needed if another institution is to be cajoled into taking Northern Rock over. Yet, it still has positive value in the stock market. That is indeed remarkable. So who is to blame for the debacle and what lessons should the UK learn?

Let us call a spade a spade. The blame for the vulnerability of Northern Rock lies with its management, which did not seek to insure their institution against disruption to its funding. The fact that it is the only significant UK bank whose financing imploded during the crisis demonstrates that its problems were specific and home-grown, not generic and so the fault of others.

How far are the authorities also to blame? Most critics believe the regulator, the Financial Services Authority, shoulders a good part of it. This is understandable, given the scale of the debacle. Yet what is not clear, at least to me, is what it should have done. Should it have compelled the bank to insure itself against the risk of a disruption to its liquidity? How far do we want regulators to micro-manage institutions, anyway? Would it not be better to let mismanaged institutions go under, while protecting small depositors effectively? Answer: yes, it would.

The remainder of this column can be read here. Debate from our guest economists appears below.

By Martin Wolf

“The increase in China’s energy demand between 2002 and 2005 was equivalent to Japan’s current annual energy use.” This nugget of information, buried in the International Energy Agency’s latest World Energy Outlook, tells one almost all one needs to know about what is happening to the world’s energy economy.

Neoclassical economics analysed economic growth in terms of capital, labour and technical progress. But, I now think, it is more enlightening to view the fundamental drivers as energy and ideas. Institutions and incentives provide the framework within which the development and application of useful knowledge transforms the fossilised sunlight on which we depend into the stream of goods and services we enjoy.

This is the world of abundance that China and India are now joining. Nothing short of a catastrophe will stop them. For the pessimists, however, particularly climate-change pessimists, catastrophe will follow. What is certain is that the challenges ahead are huge.

The remainder of this column can be read here. Debate from our guest economists appears below.

by Willem Buiter

The announcement that the UK Treasury had authorised the creation of a Liquidity Support Facility for Northern Rock at the Bank of England came on September 13, 2007.  The Treasury’s announcement of a guarantee for all of Northern Rock’s deposits (not just the retail deposits) and most of its other unsecured credit followed on September 18.  Two months have passed now, and Northern Rock is still on life support, having drawn over £20 bn from the LSF - just under 20 percent of its assets.   

What went wrong and what lessons can be learnt?

(1) The Tripartite arrangement between the Treasury, the Financial Services Authority and the Bank of England, for dealing with financial instability is flawed. Responsibility for this design flaw must be laid at the door of the man who created the arrangement - the former Chancellor and current Prime Minister, Gordon Brown.  The Treasury, as the dominant partner in the arrangement, also bears primary responsibility for its operational performance. 

The main problem with the arrangement is that it puts the information about individual banks in a different agency (the FSA) from the agency with the liquid financial resources to provide short-term assistance to a troubled bank (the Bank of England).  This happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997.  It’s clear this separation of information and resources does not work. 

(more…)

By Martin Wolf

Mexico’s Carlos Slim is now the richest man in the world, or so Fortune magazine has told us. His ascension is fascinating. This is not only because he is extraordinarily rich. It is also because the manner in which he has accumulated his wealth tells us much about the capitalism that is spreading across the globe.

Estimated at $59bn, Mr Slim’s fortune is equal to 6.6 per cent of Mexico’s gross domestic product. Bill Gates, in contrast, at about $56bn, is worth a mere 0.4 per cent of US GDP. Even at its peak John D. Rockefeller’s wealth was less than 2 per cent of US GDP. The richest person in the US would need $900bn to possess the same wealth, relative to US GDP, as Mr Slim does relative to Mexico’s.

Does this extraordinary accumulation of wealth in a single man’s hands matter? One reason someone might think so is that it implies extraordinary inequality. If, for example, one assumed a real return of 6 per cent a year, the Slim family’s permanent income would be $3.6bn a year. On World Bank figures, the average income of Mexico’s poorest 10 per cent was $1,200 per head in 2005. So the Slim family’s permanent income equals the current incomes of 3m of Mexico’s poorest people. I am no egalitarian. But this surely needs some justification.

Furthermore, vast concentrations of wealth are sure to have political consequences, inciting corruption and populism. Thus, it seems sure to weaken both the legitimacy and effectiveness of fragile democracies. These dangers are evident. But one can counter that the drive to accumulate wealth is the spur to entrepreneurship.

The remainder of this column can be read here. Debate from our guest economists appears below.

By Martin Wolf

Does a country have the right to determine the composition of its population? If so, how should it do so? These questions are hard to answer. That is presumably why the British government has run what amounts to a “stealth” immigration policy. But that approach is now unworkable. The time has come for a debate. That debate should focus on whether restricting immigration is legitimate, desirable and feasible. Only then can one decide what policy to pursue.

The UK government is in difficulties on this topic, for three reasons. First, the inflow has been substantial. Between 1997 and 2006, gross immigration was 4.8m and net immigration 1.6m, or 7.8 per cent and 2.6 per cent of the 2006 population, respectively. The latest projections suggest that the population might rise by 4.4m between 2006 and 2016, with immigration generating close to half of this increase.

The second reason is that the government seems to have little idea how many immigrants are in the country. It has just had to admit that the number of foreign-born workers who had arrived since 1997 was 1.5m. Foreigners also seem to have filled more than half of the additional jobs created since 1997. Aware of the potential political risks, the government has announced the continuation of controls on workers from Romania and Bulgaria, and introduced a point system to manage immigration of workers from outside the European Union. A panic-stricken Gordon Brown, prime minister, has even proclaimed “British jobs for British workers”.

The third and most fundamental reason is that the government never made a case for such levels of immigration. So how should one go about having such a debate?

The remainder of this column can be read here. Debate from our guest economists appears below.