January 23, 2008
The financial turmoil is like an elephant in a dark room
By Martin Wolf
“I was gradually coming to believe that the US economy’s greatest strength was its resiliency – its ability to absorb disruptions and recover, often in ways and at a pace you’d never be able to predict, much less dictate.” Alan Greenspan, ‘The Age of Turbulence’.
We all hope that Mr Greenspan proves right about the US economy. The Federal Reserve’s rate cut on Tuesday will succeed if Mr Greenspan’s view is correct. Yet many fear he is wrong. Many, too, blame him for the current mess. So how did the world economy fall into its predicament?
One view is that this crisis is a product of a fundamentally defective financial system. An email I received this week laid out the charge: the crisis, it asserted, is the product of “greedy, immoral, solely self-interested and self-delusional decisions made throughout the 2000s, and earlier, by very real human beings at the very top of the financial food chain”.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Pierre-Yves Gauthier, Alphavalue (guest contributor): Your piece in today’s FT makes for fascinating reading, as always.
May I suggest another “contributor” to the elephant size crisis? Excess regulation. You and your peers repeatedly and pointedly wrote in the past about the unintended consequences of the likes of Basle II and Solvency II. Under the pressure of regulation, regulated actors eventually behave as unregulated ones. They no longer want to be seen holding risk. And they are pleased to cash on their new role as irresponsible agents. The poor regulated guys who continue to bear risks are unlikely ever to make a profit as they suffer from the regulation straitjacket and their investment behavior is so predictable that any non-regulated player (say hedge funds) will arbitrage it. In short, excess regulation turns every would-be principal into an agent. The man in the street is left to carry the principal can. Then there is no choice but central bank intervention.
Posted by: Pierre-Yves Gauthier | January 23rd, 2008 at 8:50 am | Report this commentKeerthi Angammana, HSBC Emerging Markets strategies:
‘Bernanke, Buchanan, and the Inflation Solution’
That’s not Buchanan like in Pat, of course, but like in James M., the economist,
and winner of the Nobel Prize in 1986. Buchanan battled the spread of Keynesian
orthodoxy on several fronts, and one of his lines of defense was that regardless
of where you stand on the merits of an underlying economic theory, its
implementation by elected officials is more likely to be biased towards public
approval rather than the public good. Indeed, having noticed the vigor with
which Alan Greenspan now defends his own record, one recognizes that the need
for public approval is not limited to mere politicians. So when Bernanke went
before congress last week and endorsed a $150B stimulus package to support an
economy that he is projecting not to go into recession in 2008, was he really
convinced that even the slightest chance of a recession was such a misfortune,
was he trying to save the banks from their past folly, or was he simply having a
Buchanan moment? We argue that they are all related, and that inflation is the
logical consequence.
For the record, Bernanke can hardly be blamed if he seeks the approval of his
electorate. Indeed, he would hardly be human, if he didn’t wish to insert his
own picture into the iconic C-SPAN images of Greenspan triumphantly returning to
the Senate after finding and defeating yet another deflationary windmill, and of
Senators lining up to throw their knickers at him. But putting aside the seeds
of inflation that may have been sown during the Greenspan years, and which may
yet reap us a Volker, let us take a closer look at the current credit crisis.
It is clear to all observers that the current lack of liquidity in the markets
is not the cause, but is a symptom of, what is a solvency problem in the US:
Fools and others, encouraged by crooks and others, have borrowed money that they
have no hope of paying back. One way of preventing the gullible from defaulting
on their accomplices, and bringing down the banking system, is for their rich
uncle, say like the US government, to write a check to the guilty. But any such
step is likely to cause auntie, say like the US voter, to pick up the rolling
pin. Any promises to take both naughty nephews behind the woodshed for a lesson
in fiscal and moral responsibility are unlikely to make her put it down. So as
Buchanan may have predicted, this option is just not on, at least not for the
moment.
That said, when somebody owes money to somebody else, and can’t pay it back,
some form of default is inevitable. The risk of a direct default of course, is
that the foundation of our financial system may not be up to the task of
handling that kind of concentrated exposure on a large scale. And this would
certainly keep a central banker awake, as it rightly should. You could avoid the
concentrated risk, however, if there was a way to quietly and stealthily
transfer wealth from lenders to borrowers, and a controlled amount of inflation
may have a certain appeal in this regard. So we speculate that inflation is
not a policy constraint, but is perhaps a policy objective. Once the banks have
been brought from the brink, a proper recession then be safely engineered to get
inflation back in the tube, or so the plan goes. How else do you explain a
prescription that proposes to save those who dug themselves into a hole by
spending too much, by encouraging them to spend even more?
But a strategy that tries to inflate away the debt of the insolvent is not a new
one. It was tried by Latin American central banks in the eighties and nineties
to save their governments from defaulting, and the outcome was predictable:
Galloping inflation, sky-high rates, and eventual default. This fact is clearly
not unknown to policymakers and politicians. But yet, as Buchanan may have
predicted, the siren song beckons. For who ever got voted out of office for
proposing rate cuts, tax cuts, or fiscal stimulus? They do of course,
eventually, but in politics the yield curve is steep, and a vote today is worth
many tomorrow. So we conclude, following Buchanan, that in a world that is in
the thrall of Keynesian sophistry, popular solutions to most financial problems
have a certain gravitational pull towards being inflationary, and hence our
conclusion.
We close with a quote from Buchanan: “This self-indulgent generation has
Posted by: Keerthi Angammana | January 23rd, 2008 at 9:30 am | Report this commentborrowed itself into unpayable debt. Now the folks from whom we borrowed to buy
all that oil and all those cars, electronics and clothes are coming to buy the
country we inherited. We are prodigal sons, and the day of reckoning
approaches”. And that’s Buchanan like in Pat, of course, not James M., and for
the first (and perhaps the only) time, we find ourselves agreeing with something
he’s said.
Alistair Milne, Cass Business School (guest contributor): Martin, good comment today… but you miss one aspect of the big picture (maybe this is a camel not an elephant and what I am touching is the hump).
The boom in bank credit is the long drawn out consequences of developements since the early 1980s (a) credit market deregulation (b) new lending technoligies and instiutions, of the early 1980s.
Taking the long view, maybe what we are seeing now is a secular not cylical change: the dawning realisation that we have reached the limits of the credit driven macro growth of the past 25 years.
Whither then the world economy?
Posted by: Alistair Milne | January 23rd, 2008 at 9:33 am | Report this comment