July 16, 2008
A year of living dangerously for the world
by Martin Wolf
It is now almost a year since the US subprime crisis went global. Many then hoped that the repricing of risk would be no more than a brief interruption in the progress of the US and world economies. Such hopes have been disappointed. The woes of Fannie Mae and Freddie Mac, the tumbling stock markets and the climbing oil prices make clear how far the turmoil is from its end. It has, in all likelihood, not even passed the end of its beginning.
So where is the world economy now? And where might it go? Here are some preliminary answers to these questions.
The answer to the first comes in two main parts: continued financial distress and commodity price rises.
The performance of banking stocks tells one most of what one needs to know about the financial crisis. In the US, the epicentre of the distress, banks had lost half of their market value between a year ago and the end of last week, relative to the S&P composite index.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Robert Wade: Martin’s wrap-up column gives an opportunity to put four big questions about the crisis.
(1) Why have consumption and employment held up as much as they have in the most crisis-affected countries; and are we about to hit a threshold, followed by a rapid decline in both? The robustness of consumption and employment — so far — is mysterious.
(2) How can policy makers curb the growth of asset bubbles? This is hardly my subject, but here there seems to be a “knowledge gap” almost as yawning as the one about how to get out of the Great Depression, prior to The General Theory. Until it is filled, those who say that financial authorities should not even try will have the upper hand. Until it is filled, the post-Bretton Woods architecture will continue as the default, with its three fold division of responsibility: central banks keep inflation at a low level using short-term interest rates; regulators ensure that individual financial firms act prudently; and capital markets determine asset prices and investment allocation.
Filling the knowledge gap entails discrediting the “new classical” view of financial markets and the various forms of the efficient markets hypothesis derived from it, which presume that financial markets are flexible, that information is almost perfect, that financial markets reach equilibrium by themselves and clear continuously. Hence asset markets cannot become substantially over- or under- valued. Any proposed policy intervention to curb bubbles is dismissed, from this perspective, as “financial repression”, an automatic negative.
Buttressing the efficient markets hypothesis is the claim that bubbles cannot be identified until after they burst. Yet there are empirically well-grounded indicators. The recent paper by Carmen Reinhart and Kenneth Rogoff (“Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison”, manuscript, Feb 5, 2008 ) shows strong regularities in the movement of house prices, stock prices, and the current account deficit across 18 banking crises in industrial countries since the Second World War. Claudio Borio and Philip Lowe (“Monetary policy: a subtle paradigm shift?”, World Economy, 4, 2, 2003, 103-19) develop a composite indicator of crisis based on divergencies of asset prices and credit volumes from their long-term trend; and show that the indicator predicts 60% of crises, with a very low rate of false positives. In short, it is simply not plausible to claim that we cannot spot bubbles until they burst, and therefore cannot expect authorities to take counter-cyclical actions.
However, the policy discussion concentrates too much on monetary policy and the central bank, and too little on other kinds of instruments. While there are obvious problems in the idea of curbing houseprice inflation by means of the central bank’s short-term interest rates (not least because the resulting increase in interest rate volatility would encourage speculative behaviour), houseprice inflation can be curbed by a combination of other instruments. They include taxation of capital gains on second and third houses; and restriction of credit for property purchase during a bubble – perhaps with the degree of control over the composition of loan portfolios linked to the degree of deposit protection provided by the state.
The crisis might even generate support for structural reforms in the mortgage market. Until Thatcher in the UK, mutual building societies had a near monopoly on mortgages. The government controlled the rate of interest on mortgages, and set it to stimulate or depress house prices and house-building activity more or less independently of the general bank rate. There is a lot to recommend the return of such an arrangement.
Short of such a reform, the question remains: should the consumer price index include any reflection of house prices, and if so, how?
(I was reminded of the oddity of the housing market on a recent visit to Auckland, NZ. Lots of houses are for sale but prices have fallen in many parts of the city only a little. Adjustment has come in the form of a drastic fall in the volume of transactions.)
(3) What is the impact of the crisis on the degree of consensus among economists about the desirability of the “free market” approach to society’s production and distribution problems? Surveys of American economists in 1979, 1990 and 2000 show a high and stable degree of consensus with positive and normative propositions about economic openness (free trade, floating exchange rates, free capital mobility) and about domestic microeconomics. Compared to colleagues in continental European countries they are substantially more “free market” . In surveys done between 1979 and early 1980s, 79% of American economists said they “generally agree” with the proposition that tariffs and import quotas lower economic welfare, as compared to, at the other end, only 27% of French economists. (See Bruno Frey, W. Pommerehne, F. Schneider, and G. Gilbert, “Consensus and Dissensus among Economists: An Empirical Inquiry,” American Economic Review, 74 (1984), 986 94; and Dan Fuller and Doris Geide-Stevenson, “Consensus among economists: revisited”, J. of Economic Education, Fall 2003, 369-87.)
Martin said in an earlier column that the current crisis is a huge blow to the credibility of the Anglo-Saxon financial model. One might therefore expect to see some weakening of the above consensus among American economists (and British too). On the other hand, American academic economists tended to be deeply suspicious of Keynesian economics during and after the Great Depression (it endorsed excessive “government intervention”, and it was foreign). The feedback from events to cherished beliefs may be blocked this time too. We’ll have to wait to see until the 2010 survey of American economists’ opinions.
It would be a good thing if economists’ settled convictions began to awake. Then American-shaped global organizations like the World Bank and IMF might be less insistent that the Anglo-Saxon variety of capitalism is the best model for all; and might support a diversity of economic institutions which allow citizens collectively more scope than present assumptions permit to regulate market competition so that it advances a notion of the common good whose characteristics are defined in political debate. The great drive for “juridification” of neoliberal standards deep inside the borders of each state – as seen in the conditions for WTO membership – has lost sight of the advantages of diversity of political economy arrangements. It is the same mistake as assuming that a large organization should adopt a single overarching software program, as distinct from developing “middleware” programs which allow different programs chosen by decentralized sections to communicate with each other. Charles Goodhart and Avinash Persaud have been warning about the way that homogenous standards and homogenous information in banking amplify financial pro-cyclicality, because when firms operate in similar mode they similarly miscalculate and generate systemic rather than idiosyncratic distress. My point is really just a generalization of theirs.
(4) Why did the G8 leaders breath not a word of worry in their communiqué of June 2007 (just weeks before the onset of the subprime crisis, about which many observers had been warning for months, and some for years) ? More generally, what are the determinants of the content and tone of G8 economic communiques, and what is their epistemological status? “We noted”, said the communiqué of June 2007, “that the world economy is in good condition and growth is more evenly distributed across regions….[There would be] a smooth adjustment of global imbalances which should take place in the context of sustained and robust economic growth”.
One wonders whether the G8 leaders meeting in July 2008 showed any concern about why they got it so wrong. Were they nonchalant about – or even oblivious to — the gap between what they anticipated in June 2007 and what began to happen only weeks later? If so, should the rest of us be worried at their nonchalance, or should we treat G8 communiques say as empty words, determined by the most optimistic common denominator among the participants?
In any event, the up side of the crisis is its impetus to re-regulation. Ian Macfarlane, governor of the Reserve Bank of Australia said in 2001, “if they can’t sort them [financial crises] out, then the only ultimate answer is some form of re-regulation. I’m not for a minute thinking it’s going to happen in the next decade. But I would not rule out the possibility that in 25 years, if we had a lot of bad experiences, and we go through another cycle, we might seek some very clearly thought out regulations” (quoted in an excellent paper by Stephen Bell and John Quiggin, “Asset price instability and policy responses: the legacy of liberalism”, J. Economic Issues, 40, 3, 2006). Hopefully Macfarlane will have got the timing wrong, and we will not have to wait till 2026 and “a lot of bad experiences” and “another cycle” before there is serious re-embedding of global finance.
Posted by: Robert Wade | July 21st, 2008 at 10:52 am | Report this commentAndrew Smithers: The world suffers from both financial turmoil and inflation and, if the latter problem is played down, we have the risk that it will become embedded, through premature monetary ease. I am therefore concerned at Martin’s description of current problems as financial turmoil and commodity price rises. Referring to inflation as commodity price rises is like referring to the stock market bubble of 2000, when the US stock market in aggregate reached its greatest observed overvaluation, as a dot-com share price rise, or Holland’s 17th Century mania as “strong buying of rare tulips.” The use of such euphemisms encourages the denial of past errors and increases the risk of their repetition. It is favoured by those responsible for the errors, such as the Greenspan Fed and its myrmidons and by those who wish to preserve the discredited Efficient Market Hypothesis, according to which bubbles are impossible as assets can never be mispriced.
As recently as October 2007, the IMF forecast that CPI inflation for 2008 made would average 2% in advanced economies. The latest 12 months rates are 5% for the US, 3.8% for the UK and 4.0% for the Eurozone. This contrast makes it clear that the rise in inflation has come as a dramatic shock, and it is thus highly probable that the world economy has been growing at an unsustainable rate and is further above its equilibrium output level than is generally recognised.
It follows that world output needs to grow well below trend to bring inflation down and the current financial turmoil is likely to see that this need is met, since it has left banks with insufficient equity capital, which, combined with the collapse of the non-bank lending market, will now restrict credit growth. It is therefore likely that we will have below trend growth at least through the remainder of 2008 and 2009. The twin problems thus combine to give us a good chance of muddling through.
Among other possible outcomes, neither of the really bad ones seem to me as likely. These are: (i) too rapid a recovery, which causes inflationary expectations to pick up and puts us back into the problems of the late 1970s and early 1980s when a large loss of potential output was needed to bring expectations down or (ii) a prolonged worldwide recession resulting from demand weakness, in response to asset price falls, so sharp that stimulatory monetary policy becomes ineffective.
Major policy errors, notably by the Fed, have led to this bad combination of inflation and financial turmoil, but I am optimistic that we will get through without too much distress, but with enough to have learnt that central banks must be concerned with asset prices. There is, however, a strong a priori case that if central banks have two objectives, CPI and asset prices, they need two policy instruments. Charles Goodhart and Avinash Persaud’s suggestion of adjustable equity ratios for banks, which could be raised when asset prices become too high, seems to me an admirable idea. While its primary purpose is to offset the pro-cyclical nature of bank lending, its subsidiary advantages include those of not being introduced now, when banks have too little equity capital, and of providing a long-term route to the higher equity ratios which banks need.
Assuming that my optimism is justified, there are still problems of adjustment, which I expect to depress the longer term growth rate of advanced countries, which has already been declining almost unnoticed. (The IMF shows advanced economies growth p.a. as 2.7% from 1989-1998 and 2.6% from 1999 to 2008, while world growth accelerated from 3.2% to 4.4%).
The relative rise in raw material prices seems to have been too great to be attributed solely to their usual volatility. It thus appears as if the growth in the output capacity of different sectors of the world economy, such as services, raw materials and manufacturing, has not been well aligned to growth in demand and this fits with the general assumption that the developing economies have a much higher marginal demand for goods and raw materials than the developed economies with their relative bias for services.
This indicates a need for the growth of world capacity to shift from services to goods. As the latter have a much higher capital/output ratio, the trend growth rate of the world economy will slow unless the investment ratio rises. As this is unlikely in the short-term, as demand slows, it emphasises the need for a period of slow growth if a resurgence of inflation is to be avoided. Looking longer term, it implies an adjustment to the past rates of change in the relative prices of raw materials, goods and services.
The trend rate of output in advanced countries is thus likely to slow, unless the investment ratio rises. Either slower growth in total output or a higher investment ratio will depress the growth of consumption, and this will be aggravated by deteriorating terms of trade.
Voters’ expectations are unlikely to be met if consumption slows and the political response will, on past experience, tend to aggravate the problems. Since Martin has been such an admirable opponent of political nonsense in the past, I hope that he will return from an excellent holiday refreshed for the coming battles.
Posted by: Andrew Smithers | July 21st, 2008 at 11:19 am | Report this commentMartin Wolf: Robert Wade has asked some important questions. So here are some preliminary responses.
First, he asks why consumption and employment have held up so well. This is a really interesting question, particularly for the United States. I would not be surprised if the desired household savings rate were to jump quite suddenly, which would push the US into a deep and prolonged recession and force a rapid readjustment of the global pattern of current account deficits and surpluses. But this has not yet happened. The triggers would be three: declining household wealth; diminished access to credit; and rising unemployment.
Second, Robert asks what policy makers can do about asset price bubbles. I agree that these have become a big concern. It might be noted, however, that they have occurred in countries with decidedly non-Anglo Saxon financial markets (Japan), as well as in countries with such markets. They seem to have become an epidemic. I agree, too, that one can make a reasonable job of identifying them ex ante. So Alan Greenspan is wrong.
What then can be done about them? I think there are three mechanisms: monetary policy; countercyclical systemic regulation; and outright financial repression. I am in favour of “leaning against the wind” in monetary policy, but agree with Robert that there are limits to this, not least because such a monetary policy is quite likely to destabilise the economy. I am strongly in favour of countercyclical systemic regulation, which means countercyclical capital and margin requirements (so at the peak of a housing boom, down-payment requirements would rise). It is also true that owner-occupation is highly tax-preferred in many countries. I see no case for such preferences. But it is important to make any new regulatory system as transparent and as targeted on specific weaknesses as possible.
Third, Roberts ask about the impact of the crisis on the credibility of the free-market approach. I cannot speak for others. What it has certainly shown is that the present combination of free markets with substantial implicit guarantees is highly defective. Some countries might wish to go in an even more free-market direction. But most will prefer more regulation. The broader point is, indeed, that we are going to have to let a thousand flowers bloom. Most of the highly regulated varieties are going to be stunted, I would guess. But we can no longer confidently recommend the Anglo-Saxon model for everybody.
Finally, why did the G8 leaders breath not a word of all this in June 2007? Because they did not know what was going to happen. They were in good company. While most serious observers expected a significant correction in asset markets and in risk spreads in financial markets, what has happened has taken most observers’ breath away. This is already a significant financial crisis, as I have argued on many occasions. How significant its legacy will be should become more obvious in the coming years.
Posted by: Martin Wolf | July 25th, 2008 at 4:34 pm | Report this commentMartin Wolf: I would like to comment on Andrew’s important remarks, as follows.
First, I agree that the sustained rise in commodity prices is a symptom of inflationary pressure. It suggests that global growth exceeds the rise in capacity. I have made this argument in previous columns. It was a mistake not to have made it again in this column. Nevertheless, how far the rise in commodity prices is a one-off adjustment and how far it is part of a continuous inflationary process is still uncertain.
Second, I agree that the current financial turmoil is itself a form of monetary tightening and, as such, will tend to squeeze inflation out of the system. In other words, it has allowed official interest rates to be lower than they would otherwise have needed to be.
Third, I agree on the importance of asset prices in monetary policy and also that the idea of countercyclical adjustment of capital ratios for banks is an attractive idea.
Fourth, I agree that at the world level, the growth of supply has not matched the growth in demand, not just in aggregate, but in composition. There will have to be greater investment in the supply of commodities, particularly energy. Fortunately, there is a huge surplus of savings in the emerging world, plus Japan and parts of western Europe (at close to $1,900bn a year, or about 4 per cent of world output). In the past decade or so, much of this surplus was absorbed by excess consumption in a limited number of high-income countries, particularly, the US. If this consumption binge now ends, as it seems certain to do, there will be savings available to finance higher investment.
Fifth, it is not so clear that this greater investment needs to occur mainly in the advanced countries. Much of it will need to occur in developing countries themselves. Also important will be a move to less commodity-intensive patterns of demand. Again, that will be particularly important in developing countries. This is why one of the most important policy changes now needed is to allow pass-through of the high commodity prices inside developing countries.
Finally, I agree that all this will be politically painful.
Posted by: Martin Wolf | July 27th, 2008 at 3:45 pm | Report this commentAndrew Smithers: I have been on holiday and have only just seen Martin’s comments.
Very unusually, Martin seems to have misinterpreted one of my comments. I did not suggest that greater investment needs to occur mainly in advanced countries, but that advanced countries need to invest more if their growth is not to slow. As Ken Rogoff wrote: “Is it not now clear that the main macroeconomic challenges facing the world today are an excess demand for commodities and an excess supply of financial services?” As the capital/output ratio of goods, particularly raw materials, is higher than that for services, particularly financial, this means more investment for the same growth rate. As the UK and US, the countries with the most overblown financial sectors, have large trade deficits, the finance of extra investment must come from higher domestic savings, so the possible existence of large worldwide excess savings does not solve their problem. The alternative to slower growth in the UK and US is higher domestic savings; either route involves very slow growth of consumption and probably therefore unhappy voters.
Posted by: Andrew Smithers | August 12th, 2008 at 3:38 pm | Report this comment