July 30, 2008
The world cannot grow its way out of this slowdown
By Kenneth Rogoff
As the global economic crisis hits its one year anniversary, it is time to re-examine not just the strategies for dealing with it, but also the diagnosis underlying those strategies. 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? If so, then it is time to stop pump-priming aggregate demand while blocking consolidation and restructuring of the financial system.
The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast. There is nothing sinister in this. The world has just experienced perhaps the most remarkable growth boom in modern history. Given the huge cumulative rise in global growth during the 2000s it is little wonder that commodity suppliers have found it increasingly difficult to keep up, even with sharply rising prices.
For many commodities, particularly energy and metals, new supply requires long lead times of five to 10 years. In principle, the demand response is more nimble, but it has been greatly dulled by a wide variety of subsidies and distortions in fast-growing emerging markets.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Martin Weale: It is impossible not to agree with this. Since easy credit and low interest rates in the United States were the cause of this crisis, it is hard to see how they should also be the cure. They have led to very low levels of savings, particularly in the US. Proponents of fiscal expansion are simply saying that, now that the private sector finds it difficult to borrow the public sector should do it for them. Much discussion of the crisis is confused because it does not pay attention to the macro-economic background. It focuses on the problems of the financial sector rather than the macro-economic imbalances which fuelled this.
Posted by: Martin Weale | July 30th, 2008 at 9:49 am | Report this commentAnne Krueger: This is right. The commodity price boom followed, rather than preceded, the oil price increase this time; in the 1970s it was the otherway around. But the resemblances are striking. In the 1970s, fiscal stimulus was tried and the result was a higher rate of inflation and stagflation.
Ken’s analogy with the airlines is interesting. Most of those in difficulty have not disappeared but have gone into Chapter 11 bankruptcy reorganization and re-entered. That has kept the financial structure of the industry weak and partially accounts for the severity and frequency of airline difficulties. Had more airlines folded and the physical capital been sold at auction, the survivors would be healthier now.
Posted by: Anne Krueger | July 30th, 2008 at 6:59 pm | Report this commentMartin Wolf: Ken’s superb column and Martin’s interesting comments raise an important question, namely, what macroeconomic imbalances led to the present financial mess? This happens to be the subject of my forthcoming book, Fixing Global Finance (Johns Hopkins University Press and Yale University Press). (I apologise (a little) for the shameless self-promotion.)
The basic thesis is that the deficiency of savings in the US is the mirror image of excess savings in the rest of the world, with the latter largely driving the former. The important point today is that the surplus savings in the rest of the world have not gone away. On the contrary, last April the IMF forecast aggregate current account surpluses of the surplus countries at around $1,900bn this year.
So what is going to happen to them?
One possibility would be a big increase in desired savings in the US, not offset anywhere else. That would lead to a global slump.
Another (and, I think, far more likely) possibility would be that the increased savings of the US private sector (households plus corporations) would be offset by increased public dissaving - i.e. a huge increase in the fiscal deficit, not just in the US but in other chronic deficit countries, such as the UK and Spain. This would surely start raising questions about fiscal sustainability and perhaps create another crisis down the road. Certainly, if the fiscal deficits are to explode, it would be better if the spending were on productive investment, rather than consumption.
A third and far more desirable alternative would be for the surplus countries to absorb more of their savings at home. This would be particularly desirable - economically, socially and politically - for China, which generates about a fifth of the world’s surpluses. It would be less desirable for already rich countries like Japan and Germany and oil exporters with small populations.
In any case, the biggest macroeconomic question is how (or even if) these imbalances will unwind. They provided the background conditions for the crisis. If they continue to exist on this scale, they will surely lead to new crises down the line.
I also wish to add a comment on Ken’s views on the need for the financial sector to shrink and for the commodity sector to expand.
Both are problematic.
The problem with the shrinkage of the financial sector is that it comes via falling asset prices, losses and insolvency of important institutions. Political pressures from the financial sector and from the public at large make it almost impossible to allow the required shrinkage. In practice, the necessary financial sector contraction will be slowed and a large increase in the fiscal debt (explicit or implicit) is accumulated.
The expansion of the commodity sector is difficult in a mirror image way. Just as it is hard to let the capital in the financial sector shrink, it is also hard, in today’s world of resource nationalism, to let the capital in commodity production expand.
In short, the adjustment ahead is going to be very painful, both at the global macroeconomic level and at the level of the two sectors on which Ken rightly focuses attention.
Posted by: Martin Wolf | July 30th, 2008 at 7:14 pm | Report this commentI agree with Ken Rogoff’s analysis (and Martin Wolf’s interpretation) of the global imbalances leading to the current crisis. One point I do not agree with is that high commodity prices are “prima facie evidence that the global economy is still growing too fast” and that “it will probably take a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels (perhaps $75 per barrel in the case of oil, down from the current $124).”
High oil prices are not a sign that we have grown too fast, they are a sign that demand for oil has gone up. Yes, the two are closely related, but there’s a crucial degree of freedom in play: energy intensity.
High oil prices in the 1970s prompted a decrease in oil per unit of output, a trend that has continued to a lesser extent since then. It is no secret that climate change, one of the other major crises facing the world at the moment, will require us to make large strides in that direction. (McKinsey introduced the useful concept of “carbon productivity” and shows why it needs to – and, crucially, how it can – rise tenfold by 2050.)
Energy prices – and oil in particular – have risen so dramatically for a deep underlying reason, albeit one that’s possible to express in simple terms: demand has gone up, while the resources themselves are becoming ever scarcer.
The best answer to high oil prices is using less oil, not scaling back the use of capital and labour to bring oil prices down to “trend.”
Gernot Wagner is an economist with the Environmental Defense Fund in New York.
Posted by: Gernot Wagner | July 30th, 2008 at 9:35 pm | Report this commentJeff Frankel: There is a lot of sense in Ken’s column. But I am not sure about the emphasis on drawing a tougher line with the ex post bailouts, which may be futile advice.
Consider two other areas where moral hazard is an issue: commercial banks and river banks. Many economists would prefer that the government refrain from helping the victims of panics and floods, respectively. The worry is that if those who overlend or overbuild do not bear the full costs of their mistakes, they will have no incentive to be more careful in the future. But I think we figured out some time ago that in practice no democratic government will ever ex post turn its back on poor shivering families who appear on TV huddled in front of the ruins of their flooded out homes (or banks). It is wiser that we recognize this fact, and design a regulatory system that explicitly incorporates federal flood insurance and deposit insurance, and charges for them up front. We already do this for commercial banks. To me, the lesson of recent months is that we need to do it for a wider range of financial institutions.
As a final tweak, I can’t help noting that central bank governors, Treasury secretaries, and chief executives who make the most noise about the evils of moral hazard and bailouts ex ante, are no more likely to stand firm ex post than others. If anything, the reverse. I am thinking, for example, of how - ten years ago this month — the Clinton Adnimistration finally pulled the plug on continued IMF loans to Russia, despite well-founded fears of systemic contagion - while the Reagan Administration in the 1982-84 international debt crisis and the Bush Administration in the 2001-03 Argentine crisis, for all their laissez-faire rhetoric, never pulled the plug on anyone.
Posted by: Jeff Frankel | July 30th, 2008 at 10:45 pm | Report this commentGernot Wagner is right: in the medium to long run higher energy prices should lead to more efficient use. But in the short run, technology and the capital stock are essentially fixed. In the short run, therefore, energy supplies and the use of the capital stock are strict complements, not substitutes, as Ken Rogoff assumes. Even in the long run, energy and capital are, I would imagine, more complements than substitutes. So the growth of the world economy will continue to depend on growth of inputs of commercial energy, as it has done over the past two centuries. If so, greater scarcity of energy would slow the world’s potential rate of economic growth, even in the long run, compared to what it would have been without the scarcity.
Posted by: Martin Wolf | July 31st, 2008 at 12:25 pm | Report this commentI agree of course with Martin Wolf (and Ken Rogoff’s implicit assumption) that traditional energy sources and capital are indeed mostly complements – in the short-run more so than in the long-run, but even then.
The question, though, is the composition within the energy sector. Traditional energy sources – oil, coal and gas – have seen dramatic price increases, while alternative energy sources – wind, solar, and many others including e.g. battery storage technologies – have seen dramatic price decreases.
Given the profound transformation currently underway in the energy sector, it will not take long for true substitutes to emerge. This still does not mean that capital and energy overall are substitutes. It will apply to capital and ever scarcer traditional energy sources, e.g. oil.
Posted by: Gernot Wagner | July 31st, 2008 at 3:03 pm | Report this commentJeff Frankel is, of course, right. Bail-outs seem inevitable, of almost everybody, except perhaps shareholders. The answer, he rightly concludes, is tougher ex ante regulation of a wider set of institutions. But it is important to stress how difficult this is.
First, in the current crisis, it is far from clear that regulated commercial banks were more responsible than relatively unregulated investment banks, to put it very mildly. The difference was only that, in a liquidity squeeze, institutions with access to (explicitly or implicitly) insured deposits have a huge advantage. Commercial banks have survived relatively well, because of the guarantees their depositors rightly believe they enjoy. But there is little evidence that regulation of the commercial banks’ lending and securitisation activities did much good. On the contrary, much of their activity was successfully and disastrously dedicated to getting round prudential regulations, particularly on capital.
Second, regulatory arbitrage is alive and well. If the regulatory net, particularly on capital, is stretched to investment banks, the activity will probably move out to hedge funds. Everybody is congratulating themselves on how well the hedge funds have done this time. Perhaps we should wait for the next crisis.
Finally, never underestimate the ability of the financial industry to halt, divert or vitiate regulatory efforts. Ambitious people with intense personal interests at stake, paid tens of millions a year, always run rings around hapless and unpopular regulators paid in the tens of thousands. Moreover, in a period of euphoria everybody hates the regulators (or central bankers) who try to halt the party.
So Ken is surely right, too. Sensible insurers insist not only on the payment of premia (as Jeff recommends), but on large co-payments. In this case, too, those who took the risks must take a good part of the losses.
Posted by: Martin Wolf | August 1st, 2008 at 10:04 am | Report this commentMartin Wolf: Here is another response to Gernot. I agree there are long-term opportunities for substitution within energy supplies. I agree, too, that the incentives for doing so have increased. But the dominant current position of fossil fuels and the capital requirements of alternatives are so enormous that it is hard to believe there will be a near-term transformation in the connection between economic activity and demand for fossil energy.
Posted by: Martin Wolf | August 1st, 2008 at 5:34 pm | Report this commentDesmond Lachman: Kenneth Rogoff is certainly correct in asserting that the recent huge spike in international commodity prices is prima facie evidence that the global economy has been growing too rapidly. However, he would seem to be too quick in jumping from this assertion to the conclusion that it is time for policymakers in the world’s major economies to stop pump priming aggregate demand and to allow financial firms to go out of business.
Professor Rogoff arrives at his policy prescription of benign neglect by overlooking the extraordinary constellation of out-sized shocks presently hitting the US economy, which up till now has been the primary engine of global growth. These shocks include the most severe housing market bust since the Great Depression, the most wrenching credit crunch in the postwar period, an oil price shock on the scale of that in 1979, and falling share prices that have wiped out around US$11 trillion in global household wealth since the start of the year.
The danger of a policy of benign neglect in the face of this perfect economic storm is that the global economic slowdown, which is already in evidence and which has already resulted in a 15 percent decline in commodity prices from their recent peaks, could morph into a deep and prolonged recession on the order of that experienced between 1980 and 1982. This risk would appear to be all too real at a time when the US housing market crisis shows every sign of deepening, the painful financial market de-leveraging process is gaining pace, and US banks are now contracting credit at the fastest pace in the past 40 years.
In the present global context, policymakers should be more mindful of the experience of the 1930s and of Japan’s lost decade rather than of that of the 1970s. In particular, they should be alert to the very real risk of a very much deeper and longer global recession than is necessary to bring international commodity prices down to more reasonable levels.
Posted by: Desmond Lachman | August 4th, 2008 at 7:58 pm | Report this comment