By Martin Wolf 

When a wave of destruction hits, everybody looks for somebody to blame. Alan Greenspan, former chairman of the US Federal Reserve, once lauded as the “maestro”, has, to his discomfort, become the scapegoat. But even though I dare to disagree with him on some points, much of the criticism is highly unfair. Mr Greenspan remains the most successful central banker of modern times. More important, blame distracts from the challenge, which is to understand what happened, why it happened and what we should do.

As Mr Greenspan pointed out in his response to his critics in the Financial Times on Monday, the housing bubble was not unique to the US. On the contrary, as the background chapter on housing in the International Monetary Fund’s latest World Economic Outlook shows, US experience was far from exceptional. On the contrary, the biggest apparent overvaluations occurred in Ireland, the Netherlands and the UK.

The chart shows the proportionate increase in house prices between 1997 and 2007 that cannot be explained by the fundamental drivers: affordability (the lagged ratio of house prices to disposable incomes); growth in disposable incomes per head; interest rates (short- and long-term); credit growth; changes in equity prices; and changes in working-age population. Thus, the rises reveal the extent to which a country has experienced what seems to be a bubble. The US is in the middle ranks.

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

By Martin Wolf 

You have enjoyed a debt-financed spending spree. But times are now harder: you find it impossible to roll over your debt; you have to pay much higher interest rates than before; or you find that the value of the assets you pledged as collateral is now less than your loan. What can you do? Provided enough of you are in trouble, you call for help from the fairy government-mother.

Thus, George Magnus of UBS, among the wisest analysts of this crisis, has already observed, with some approval, that the crisis “is spawning an array of well scripted but highly unconventional public policy responses” – that is to say, rescues of various kinds.*

Over-indebted individuals have just three choices: reduce spending below income, sell assets they own to somebody else or, if the worst comes to the worst, default. But one person’s debt is another person’s asset, one person’s expenditure is another person’s income; one person’s sale is another person’s purchase and one person’s default is another person’s loss.

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

By Lawrence Summers

Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.

There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

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By Martin Wolf 

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

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

By Martin Wolf 

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.

Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.

Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.

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

By Alan Greenspan

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal. Although inventories of vacant single-family homes - those belonging to builders and investors - have recently peaked, until liquidation of these inventories proceeds in earnest, the level at which home prices will stabilise remains problematic.

The remainder of this column can be read here. Comment from our expert panel and guest members can be read below.

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 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

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 Charles Wyplosz

The combined central bank injection of liquidity last week was impressive. Still, more than five months after the interbank market froze, banks’ thirst for cash seems unquenchable. The central banks have done everything they can to keep financial markets orderly. They took the risk of feeding the moral hazard beast and what did they achieve? So far they have avoided the much-feared “Big Crunch”, but the end of the tunnel is not yet in sight. The time has come to ask the harder question: do commercial banks get it?

The big commercial banks hold mountains of cash, probably because they still have mountains of sickly off-balance-sheet liabilities that they are unwilling to acknowledge. Or it is because they fear that other banks are in that position and that this could trigger the Big Crunch. Or they just think that other banks think that way. Prudence is a much-needed virtue in banking, the more so because it has been forgotten in recent years.

But the further cash injection will not provide the permanent solution: the return of interbank lending. For that to happen, banks need to be reassured about each other. Recapitalisation is the only solution. Three big banks – Citibank, UBS and Morgan Stanley – have shown the way in recent days. They remind us that large losses must be financed by fresh share issuance. It matters little who provides the cash. We should not let concerns about sovereign wealth funds stand in the way of a permanent solution.

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