By Lawrence Summers

Three months ago it was reasonable to expect that the subprime credit crisis would be a financially significant event but not one that would threaten the overall pattern of economic growth. This is still a possible outcome but no longer the preponderant probability.

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.
Several streams of data indicate how much more serious the situation is than was clear a few months ago.

First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago.

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By Martin Wolf

“At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’.” Walter Bagehot.*

Panic follows mania as night follows day. The great 19th-century economist and journalist, Walter Bagehot, knew this better than anybody. Lombard Street, his masterpiece, is dedicated to the phenomenon. It is devoted, too, to how central banks should deal with its results.

Ours has been a world of the “no income, no job, no assets” 100 per cent mortgage; of the “do what you like with our money, as long as you pay the fees” covenant-light loan; and of the “in go poor credits and out comes a triple A-rated security” financial alchemist. It has been a world of confidence, cleverness and too much cheap credit.

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By Jeffrey Garten

The growth of government-owned investment companies, often called sovereign wealth funds, has caused a lot of hand-wringing in the US and Europe – and rightly so.

Washington has asked the International Monetary Fund and World Bank to establish a code of good practice for SWFs. Berlin is eyeing new legislation to deal with these funds, modelled on US procedures for screening incoming foreign direct investment. Brussels is considering a European-wide set of guidelines. But so far no western government has had the courage to admit that dealing with SWFs may require departures from the conventional liberal orthodoxy concerning global trade and investment flows. Yet this is precisely what is needed.

When relatively few SWFs existed, such as Singapore’s Temasek Holdings or the Kuwait Investment Authority, the challenge they posed to the global financial system and to market-based cross-border investment was small. But now sovereign funds in countries such as Saudi Arabia and Russia are becoming active, Beijing is establishing the government-owned China Investment Corporation, and Japan and South Korea are contemplating similar SWFs. Moreover, the amounts under sovereign management could soar from about $2,500bn today to $12,000bn in 2015, according to Morgan Stanley.

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By Willem Buiter

The UK government is con­-sidering reclassifying cannabis from a class C drug to a class B drug, carrying higher penalties for using and dealing. As an economist with a strong commitment to personal liberty and responsibility, my preference would be to see all illegal drugs legalised. The only exception would be substances whose consumption leads to behaviour likely to cause material harm to others.

Following legalisation, the production and sale of these drugs should be regulated to ensure quality and purity. They should also be taxed, as are tobacco products and alcoholic beverages. Greater resources should be devoted to educating the public, especially children and teenagers, about the health hazards associated with the drugs; more money should be spent on the rehabilitation of addicts.

Ideally legalisation should occur simultaneously in a number of neighbouring countries, preferably at the level of the European Union. When the Netherlands became an enclave of tolerance of drug use, drug users from all over Europe congregated there.

Willem Buiter is this week’s guest commenter while Martin Wolf is on holidays. The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.

“In Rome everything is for sale.” – Prince Jugurtha in Sallust’s ­Bellum Jugurthinum “Yes to market economy, no to market society.” – Lionel Jospin, French Socialist ex-prime minister It is capitalism, not communism, that generates what the communist Leon Trotsky once called “permanent revolution”. It is the only economic system of which that is true. Joseph Schumpeter called it “creative destruction”. Now, after the fall of its adversary, has come another revolutionary period. Capitalism is mutating once again. Much of the institutional scenery of two decades ago – distinct national business elites, stable managerial control over companies and long-term relationships with financial institutions – is disappearing into economic history. We have, instead the triumph of the global over the local, of the speculator over the manager and of the financier over the producer. We are witnessing the transformation of mid-20th century managerial capitalism into global financial capitalism.

The remainder of Martin Wolf’s article can be read here (FT.com subscription required). Discussion from our guest economists is free.

The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn.

The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.

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China will do what it considers to be in its own interest. That should surely be self-evident. What is not self-evident is how it does – and should – identify that self-interest. That is almost always more difficult than naive realists tend to suppose. This is true of its policy towards North Korea. It is just as true of its policy towards the exchange rate.

The Chinese government seems to believe its interest lies in maintaining a highly competitive real exchange rate for as long as possible. The evidence also suggests it can do so for a long time. But should it do so?

Economic theory indicates that a fast-growing developing country should have an appreciating real exchange rate. This is known as the Balassa-Samuelson effect, after the late Bela Balassa of Johns Hopkins University and the Nobel laureate Paul Samuelson, who discovered it independently of each other.

The argument is straightforward. Economies contain two sorts of activity: tradeable – manufacturing and services that can be supplied readily at a distance; and non- tradeable – haircuts, childcare and so forth. With economic development, productivity in the former tends to rise faster than in the latter.

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.

China represents something new in the history of the modern world: a developing country that has a vast global impact. This is why Hank Paulson, the US treasury secretary, has followed Robert Zoellick, former deputy secretary of state, in calling for it to be a “responsible stakeholder”. But China will behave as the US wants only if it perceives that this is in its own interests. Again, the US should not be surprised. This is how Americans view their own country’s international obligations.

At present, the most vexed issue between the two countries is the payments “imbalances”. Many in the US complain that China is manipulating its currency, to preserve excessive competitiveness. Certainly, China has a large current account surplus, forecast by the International Monetary Fund at $184bn this year, or 7.2 per cent of gross domestic product. No other country has as big a surplus.

The starting point then must be whether it makes sense for a poor country to export so much capital. The answer, I would argue, is “no”. But we must then also ask why China is running such large surpluses. The short answer is that it is saving even more than it is investing at home. This is true by definition. In China’s case, this surplus is largely being invested in its vast foreign currency reserves, now some $1,000bn (or 40 per cent of gross domestic product).

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.

The world economy is enjoying a glorious run. In 2003, 2004 and 2005, it had its best years since the early 1970s. Yet that is no encouraging parallel. The torrid expansion of the early 1970s led to a period of inflationary turmoil. We must ask whether the extraordinary growth of recent years also hides dangers – different, perhaps, but still significant. The answer, alas, is yes.

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The International Monetary Fund is in financial crisis. That will give its critics reason to cheer. But its supporters should cheer as well, for the reason the IMF is facing financial disaster is that its clients are not. The Fund needs crises, just as doctors need illnesses. But this particular doctor has been too successful. As a result, Fund credit outstanding has fallen to its lowest level in 25 years.

Bad news for the Fund is excellent news for its borrowers. Financial markets herald the reduction in the perceived riskiness of emerging market finance. Spreads have, as a result, collapsed. Investors are also pouring money in: last year, according to the March 2006 report from the Washington-based Institute for International Finance, the foreign private sector poured $400bn into the group of emerging market countries on which the IIF focuses attention.

“We do not need this money, thank you,” said the recipients. So, they pushed the money right back out again. Remarkably, a paper by three senior Fund researchers suggests they may have been right to do so: Developing countries that have relied more on foreign finance have not grown faster in the long run, and have typically grown more slowly. Does this mean that foreign finance plays no role in development? Not at all. What this does mean, however, is that there seems to be no benefit to being a net importer of capital. Emerging countries should smoke in the capital markets, but not inhale.

The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.