By Charles Wyplosz

In 1971, with the greenback weak and falling, US Treasury secretary John Connally famously told the rest of the world that the US dollar was “our currency and your problem”. Thirty years later, with the dollar strong and still rising, Robert Rubin, his successor, no less famously stated that “a strong dollar is in the interest of the United States”.

These days, because the dollar is weak and falling, we would have expected US officials to return to Connally’s mantra but they unexpectedly chose Rubin’s. On reflection, glorifying a strong dollar when it is so weak means they do not care. Connally without compassion, if you prefer.

Jean-Claude Trichet, president of the European Central Bank, is thereby left bemoaning “excessive exchange rate moves”. This, too, is an extraordinary statement. In the past week the dollar has barely lost 1 per cent vis a vis the euro. That is significant, but “excessive”? Yes, he may be reacting to the 6 per cent dollar depreciation in the past month. Or to the 17 per cent change over the past 12 months. Or perhaps the 31 per cent depreciation since the dollar was last strongish in late November 2005.

Well, currencies float. They are bound to be sometimes overvalued and sometimes undervalued. This is what they do and these numbers are not especially large by historical standards. Margaret Thatcher, former UK prime minister, was right when she said that exchange rates were a matter for markets to decide.

Of course, markets react to monetary policies. As the US economy faces a recession, a weak dollar is in the country’s interests. As inflation exceeds its own definition of price stability, a strong euro is in the interests of the eurozone. End of story? Not quite. (Continued)

Charles Wyplosz is professor of economics at the Graduate Institute of Geneva. The remainder of his column can be read here. Comment from our expert panel and guest members can be read below.

By Michael S Barr and Laura D Tyson

The US economy is caught in a vicious downward spiral of declining home prices, escalating foreclosures, rising losses on mortgage-backed securities, and disappearing liquidity. The liquidity crisis has spread rapidly from the mortgage market to engulf other forms of consumer credit, commercial real estate, and municipal and corporate debt.

Alarmed by the spectre of a prolonged economic slowdown, both the Federal Reserve and the US Congress have acted aggressively to stimulate demand through monetary and fiscal levers. The US Treasury has pressed mortgage holders to restructure mortgages and suspend foreclosures on a voluntary basis. But the continuing turmoil in financial markets confirms that these actions are not enough. Restoring confidence and liquidity in credit markets requires bold action to restructure the overhang of distressed assets and contain the losses in the US housing and mortgage markets.
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By Dani Rodrik and Arvind Subramanian

First large downhill flows of capital – from rich countries to poor countries – led to the Latin American debt crisis of the early 1980s. In the 1990s similar flows begat the Asian financial crisis.

Since 2002 the flows have been uphill, from emerging markets and oil-exporting countries to the developed world, especially the US. But the outcome has not been very different. So, it does not seem to matter how capital flows. That it flows in sufficiently large quantities across borders – the celebrated phenomenon of financial globalisation – seems to spell trouble.

Causes and consequences vary, depending on which way capital flows. Developing country borrowing was associated with unsustainable fiscal policies (Latin America) and inappropriate exchange rate policies (Asia). But the financial sector was not blameless: for every overborrower there was an overlender.

The pathologies were different when the US went on a borrowing binge. Large current account surpluses and the associated savings glut in the rest of the world fed a global liquidity boom, which stoked asset prices. Even though the roots of the subprime crisis lie in domestic finance, international capital flows magnified its scale.

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

By Lawrence Summers

The American economic outlook remains highly uncertain. But macro­economic policy is now properly aligned, as the economy will benefit over the next several quarters from fiscal and monetary stimulus. To the extent conditions warrant and inflation risks permit, monetary and fiscal policy are appropriately poised to provide further stimulus.

Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far, such as the “teaser freezer” limits on resetting mortgage interest rates and increased federal support for mortgage lending, have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.

It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean more than 10m would have negative equity in their homes and more than 2m foreclosures would take place over the next two years.

Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.

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By Lawrence Summers

Markets and perceptions of the economic outlook change rapidly. Even two months ago most observers doubted predictions of a US recession, saw no need for a fiscal stimulus, and thought that inflation fears should constrain monetary policy. Now, Washington is more or less settled on a stimulus package that will exceed $150bn; markets at one point last week expected a Fed funds rate below 2 per cent by September. The debate about recession is now about how deep and global its impact will be.

There is enormous uncertainty around economic or financial forecasts. It is possible that pessimism will recede as declining interest rates and dollar exchange rates increase demand. It is more likely, though, that the situation will deteriorate further as perceptions of declining growth increase credit spreads and risk premiums in financial markets, leading to reduced lending, borrowing and spending exacerbating the pessimism about growth.

Perhaps inevitably given the complexity of the problems, policy measures have seemed ad hoc and reactive: measures to increase bank liquidity one week; to help homeowners avoid foreclosure another; to work towards fiscal stimulus another; to lower interest rates most recently. Confidence would be well served by a comprehensive programme of measures that offers the prospect of accelerating growth and insures against a prolonged downturn. Until that happens, it will be difficult for confidence to return.

Substantial monetary and fiscal stimulus is now in train. This will reduce the severity of any recession and provide some insurance against a protracted downturn. Along with macro-economic stimulus in the US, there is the need for further policy development in three other areas – repair of the financial system, containing the damage caused by the housing sector and assuring the global co-ordination of policy.

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

By Tito Boeri

European unemployment has fallen to a level not seen for more than 25 years. Long-term unemployment has been declining even more: Europe is no longer a place where half of all job-seekers have been on the dole for more than 12 months, as in the mid-1990s.

The disappearance of mass unemployment is not the result of a shrinking pool of labour; in fact the average employment rate in the European Union has increased by more than 6 per cent in 10 years. This is the only area in which Europe is approaching the ambitious economic targets set at the Lisbon summit in 2000.

These developments are the result of reforms that have reduced employment protection and increased the rewards attached to participating in the labour market. Larger immigration to countries with the biggest regional unemployment differentials, Italy and Spain, has also been important. It has contributed to remarkable wage moderation in Europe, by preventing the overheating of local labour markets where there is a shortage of native workers. Governments, however, are not capitalising on these successes.

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

By Lawrence Summers

The odds of a 2008 US recession have surely increased after a very poor employment report, growing evidence of weak holiday spending, further increases in oil prices, more dismal housing data and further writedowns in the financial sector. Six weeks ago my judgment in this newspaper that recession was likely seemed extreme; it is now conventional opinion and many fear that there will be a serious recession. Markets now predict the Federal Reserve will provide further stimulus to the economy by cutting rates by an additional 125 basis points on top of the 100 basis points they have already been cut so that rates fall to the 3 per cent range.

There is now a compelling case for the president and Congress to create a programme of fiscal stimulus to the US economy that could be signed into law in the next several months.

Given the market’s prediction of Fed policy actions, the debate now is not about whether or not to provide macro­economic stimulus. That question appears to be settled. The question is whether it is better for all the stimulus to come from discretionary monetary policy or for some of the stimulus to come from discretionary fiscal policy. A diversified policy approach seems clearly preferable in that (i) in a world where judging the impact of policy measures is difficult, the outcome is less uncertain with a diversified mix of stimulus measures; (ii) the proximate impact of fiscal policies is felt by the families bearing the brunt of recession, in contrast to monetary policies whose immediate impact is on financial institutions; (iii) use of fiscal policy reduces the amount by which interest rates have to be reduced, thereby reducing downward pressure on the dollar, which in turn contributes to upward pressure on US inflation and international instability; (iv) partial reliance on fiscal policy mitigates the various risks of bubble creation associated with excessively low interest rates.

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

By Daniel Gros The global economy has been hit by two shocks: the subprime lending crisis and high oil prices. The latter have faded into the background as prices have stabilised near record levels. But it would be a mistake to underestimate their importance. The recent surge in oil prices makes a rebalancing of the global economy more difficult, but it might in fact facilitate adjustment to the “subprime” credit crisis. The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits? Apart from the US, there are only two regions large enough to contemplate a shift in the external position of this order of magnitude: the eurozone and Asia (Japan and China).

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

By Lawrence Summers

Central to every policy discussion in response to a financial crisis or the prospect of a crisis is the concept of moral hazard. Unfortunately, there is great confusion in many quarters about the circumstances when moral hazard is, and is not, a problem. The world has at least as much to fear from a moral hazard fundamentalism that precludes actions that would enhance confidence and stability as it does from moral hazard itself.

The term "moral hazard" originally comes from the area of insurance. It refers to the prospect that insurance will distort behaviour, for example when holders of fire insurance take less precaution with respect to avoiding fire or when holders of health insurance use more healthcare than they would if they were not insured.

In the financial arena the spectre of moral hazard is invoked to oppose policies that reduce the losses of financial institutions that have made bad decisions. In particular, it is used to caution against creating an expectation that there will be future "bail-outs".

Moral hazard forms the basis for criticism of a wide range of measures including, among others; large International Monetary Fund loans to countries experiencing financial panics; public sector actions to facilitate co-ordination of creditors, as in the famous 1998 case of the New York Fed and Long Term Capital Management; lender of last resort activities by central banks through their discount window; aggressive cuts in interest rates following collapses in asset prices; and the extension of government guarantees or quasi-guarantees to liabilities of financial institutions, as in deposit insurance or the US government’s support for the credit of mortgage lenders Fannie Mae and Freddie Mac.

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By Lawrence Summers For some time now, the large flow of capital from the developing to the industrialised world has been the principal irony of the international financial system. In 2007 this flow will total well over half a trillion dollars, a figure that will be comfortably exceeded by the build-up in reserves and sovereign wealth funds (SWFs) in developing countries. Indeed, Morgan Stanley has estimated on reasonable assumptions that there is now close to $2,500bn (£1,200bn, €1,800bn) in SWFs and that this figure will increase to $5,000bn by 2010 and $12,000bn by 2015. Inevitably, and appropriately, countries possessed of publicly held foreign assets far in excess of anything needed to respond to financial contingencies feel pressure to deploy them strategically or at least to earn higher returns than those available in US Treasury bills or their foreign equivalents. Even without this pressure, SWFs are now growing at a faster pace than the global rate of new issuance of traditional reserve assets. (more…)