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The Conseqences of the Crisis

Fall 2012 Tête À Tête

The Conseqences of the Crisis

The Conseqences of the CrisisGB speaks with the world’s leading financial columnist about what happened, where we are, and what may await

GB: What is different about the current economic crisis vis-à-vis past crises?

MW: I have to admit that I do not know what happened in all past crises – there have been so many. Let us start with what I think is not different. It is perfectly clear that ever since financial capitalism emerged – arguably, at some point in the 17th century – there has been a repeating tendency toward some combination of credit expansion, financial speculation and asset price bubbles. The combination of these three things has been seen hundreds of times over the course of the history of financial capitalism. In that sense, there is nothing new about today’s crisis.

However, among crises, this one is exceptional in a number of respects. First of all, it is exceptional in the significance and number of economies that have been affected. The crisis has affected a number of extremely large economies, and above all the hegemonic economy of the US, and therefore the hegemonic financial system – again, that of the US – in a profound way. The last time that so many important economies were affected was in the 1930s.

Second, the expansion in leverage that occurred in many economies prior to the crisis was exceptional in its scale and breadth. This expansion in leverage was also exceptional because of the extent to which it affected households. This seems to be the first major crisis that has predominantly been a household debt crisis.

Third, it is exceptional because of the nature of the modern financial system – that is to say, the high degree of international integration. This is to a significant degree a market- and securities-based financial system, rather than a classic banking-style financial system. It has very complicated chains of interconnection between institutions. As a result, the toxic paper got into the entire global financial system. When it became obvious that there was a very real question about the value of the financial paper that had been created during the previous bubble phase, the confidence in counterparties collapsed, and the financial system largely ceased to function as a system.

That really was quite new. In the past, it has normally been relatively easy to know which institutions are vulnerable, and private agents have been reasonably confident in dealing with quite a wide range of counterparties. In this case, the financial interconnections among private parties essentially collapsed – because of the very nature of the system.

Finally, the housing bubble of this particular crisis occurred in quite a wide range of countries. And so in that sense, too, this was really a highly global crisis.

The combination of these four factors made this a more devastating financial crisis than the world had ever seen. However, it is important to add one other contextual element here. The asset price bubble and subsequent crisis coincided with the creation of the euro – an important experiment that shares many of the characteristics of the 1930s gold standard. That has added a great measure of inflexibility to the system as it tries to manage the crisis – a crisis that, again, is exceptional in its extent. The 1930s were clearly blighted by attempts to maintain gold parities when they were no longer economically viable. That problem is immensely greater in the context of the Eurozone.

GB: What is the endgame of this crisis?

MW: Up to now, despite the severity of the financial crisis and the pressure for deleveraging, we have avoided a global depression. In late 2008 and early 2009, the world economy began a path that coincided very closely with what happened in the early 1930s. But this collapse was prevented and reversed by the other respect in which the crisis proved exceptional – the scale and intensity of the policy response. We have never had a policy response on the scale that we observed in late 2008 and early 2009 – that is, in terms of the support given to the financial sector, the monetary policy adopted, and the fiscal positions taken or at least the fiscal deficits accepted, and the deliberate stimulus imparted. I would argue that all of this was, in the aggregate, sufficient to prevent a depression, and to generate a very, very modest recovery.

In terms of the endgame, the question is: will we have a relapse? Will the weak recovery become a strong recovery? Or will we simply continue with this very feeble recovery – what I sometimes refer to as a ‘Global Japan’? At this stage, the only answer that we can give is that we do not know. We could have another depression – probably triggered by a meltdown of the Eurozone and a catastrophic debt crisis inside the US. These are the most likely triggers, and are certainly perfectly possible. We could have a vigorous recovery that would probably follow from a credible resolution of the Eurozone crisis. I do not regard that as very likely. A recovery might also follow a very clear indication that the US economy is beginning to expand strongly. I do not expect that either, whoever the president may be. So that is the second possibility. The first is more likely than the second, but neither is very likely.

The third possibility is, as mentioned, what I call the ‘Global Japan,’ which is simply a long-term and painful deleveraging process, which is offset neither by strong fiscal expansion (something near impossible now, politically if not economically) nor by monetary policy (the only monetary policy that would now be effective would be exceedingly extreme – helicopter money, as it were). Most probably, therefore, we are looking at a long period – possibly as much as a decade – of weak growth in the developed world, with all of the attendant risks, political and economic, associated with that type of future.

It is not clear whether we can speak of a real endgame. It may just be a new state – what my friend Mohamed El-Erian calls the “new normal,” which is just dismal. In this “new normal,” we all become a bit like Japan – ageing, slow-growing societies, with weak final demand, corporations that accumulate cash, and governments that run horrifying deficits – but with no satisfactory driver of demand. That seems to me quite a plausible view of the future of advanced countries.

I should say that I have been arguing that this was the likely future since 2004 – simply by pointing out that the only way in which the US could grow, given its extraordinarily large structural external deficit, is through household debt accumulation. That remains the case to this day. If the US does not grow strongly, then I do not see what else could drive the developed world in any plausible way. Final demand is certainly not going to explode in Europe.

GB: Is there a new equilibrium in policy thinking in respect of managing such crises?

MW: There seem to be two major conclusions coming from this crisis. First, the crisis has demolished the intellectual edifice of respectable academic and policy thinking about all macroeconomic policy and financial sector policy prior to the crisis. In essence, the crisis demonstrated that the pre-crisis orthodoxy – both ‘new Keynesian’ and ‘new classical’ views – on how the economy worked was wrong. There is no way to get around that simple and brutal fact. That means that it will be very difficult to reconstruct policy in the long-run without having a re-established core wisdom that makes sense of these events. In this sense, we are like engineers whose bridges have just fallen down: we cannot go ahead and build the same bridges without finding out why they fell down in the first place.

At the moment, the discipline of economics has become very narrow. The discipline is inevitably going to have to rethink what good policy is. That has to be based on some idea of how the economy actually works – not how economists imagine that it works, in their theories. The most likely response from economists will be to pretend that the crisis never happened, and to persist with the dominant model – because the model is elegant and beautiful, and is in all of the textbooks. Besides, it is what economists know. But pretending that the crisis never happened is very difficult, as the malaise that it will bequeath will be deeper and last much longer than most optimists would allow.

In addition to the problem for economics – and, ultimately, as Keynes said, policy-makers operate in the shadow of economic thinking – we have two specific policy problems that have been created by the crisis. The first is: how do we minimize the duration and extent of the malaise and vulnerability? What set of policies, domestically and globally, do we need for that purpose? There is no agreement on this, and that is because of the intellectual problem at the heart of the economics discipline. There is no agreement on what is the right macro policy – that is, on the right monetary policy, the right fiscal policy, and the right policy on dealing with debt overhangs.

The second policy challenge depends in part on how we rethink economics, as well as on geopolitics, which is reconstructing the world’s monetary and financial order. For the long-term, this inevitably involves reaching satisfactory agreement with rising powers like China on how such a system should operate, because I think that one of the factors generating the crisis was a fundamentally dysfunctional relationship between the exchange rate and reserve accumulation policies of rising powers like China. In other words, in addition to everything else that has happened in this crisis, the crisis occurred at a time of transition in global economic power – a transition in which the relative weight of the developed countries in the world has been declining very rapidly. This rapid decline in relative weight has problematic parallels with the 1920s and 1930s, which saw the rapid rise of the US.

In the end, then, we have to fix economics. We have to work out a way of getting out of the crisis, and getting back to reasonable growth and reasonable employment levels. Otherwise, I think that our politics are going to become impossible. And we have to fix the global economic system. This is a long-term process of reconstruction that is as profound as that which faced the world in the 1940s and 1950s after the Great Depression and WW2. This is the task that lies before us.

GB: You say that there is a parallel between rising Asian power today and rising American power in the 1920s and 1930s – that is, in terms of the crises in both periods. However, in both cases – today and in the 1920s to 1930s – the crisis originated in the US, but with America’s economic power rising in the first case, and diminishing in the second. Is the parallel really apposite?

MW: I was not really emphasizing the precise origin of the crisis. What I was trying to say is that, to some degree, a crisis of this type is a crisis of the economic system. In the case of the 1920s to 1930s, from the macro policy point of view, the fundamental problem was the chronic surpluses of the US, the dependence of the rest of the world on the continuing flow of credit from the US, the collapse in that flow of credit as a result of the crisis, the consequent banking collapse, and then the economic collapses in Europe that triggered the collapse of the Creditanstalt bank in Austria, Germany’s economic collapse, the collapse of the gold standard, and all of the rest of it. In some fundamental respects, it was a crisis of an interlocking system, in which the rising power was unaware of its responsibility to the overall system.

In the present day, China is the dominant creditor country. The world’s largest debtor – the US – also happens to be the world’s issuer of the reserve currency that everybody else wants. This helped to trigger a series of imbalances that helped to destabilize the financial system, and that in turn helped to trigger the meltdown. So the players involved are playing different parts. But the mise en scène is, in some sense, the same. We see changes in relative economic power that have changed the way in which the system works. People do not deal with that very well. They do not fully understand what it means. The result is a crisis that becomes very difficult to handle.

The one good thing about our crisis is that the country at the epicentre of the crisis – the country that imported all of the capital that could not be used properly, or was not used properly – is, as mentioned, the issuer of the reserve currency. This means that it has tremendous degrees of policy freedom. If this had not been the case, we would now certainly be in another Great Depression. The fact that the US has this degree of freedom, which Germany or Austria or France did not have under the gold standard, has meant that the US has been able to respond to the crisis as a debtor country. This, of course, is not a normal situation. Still, I cannot believe that, some 20 or 30 years from now, the Chinese and other countries will tolerate a global monetary system in which the world money is created by a country that has proved itself so irresponsible, and that is such an enormous debtor. What is unclear is what the alternative would be, and how it would work. Before we figure all of this out, of course, I believe that we are quite likely to see further shocks and crises – even if their precise nature is difficult to predict.

GB: Do you foresee differences in the endgame to this crisis as between the North American, European and Asian theatres?

MW: If I know anything today, it is how little I know about the future. But I can talk about some of the stresses. As I have said, I think that the US has the potential for a weak recovery. Over the next several years, the scenario would be as follows: there will be some recovery in the housing market; people will begin to borrow a little more; the savings rate will fall a little more; corporations will start to invest; the government deficit will shrink very, very slowly; monetary policy will remain supportive. There will be some species of ‘muddling-through’ recovery – that is, something in keeping with what we have seen over the last two or three years. I cannot foresee – given the external deficit situation and the implausibility of an export-led growth model of any scale for the US – much more than that. The level of debt – both private and public – in the US economy remains exceedingly high. Another debt-led boom is therefore highly unlikely. Limping growth, however, seems plausible. If the US could get itself into a situation of running a fairly substantial external surplus, then the situation would be very different. Still, I cannot see who would run the counterpart deficits. The US is too big to pursue the export-led growth model.

Europe, for its part, is in a really terrible mess. The core problem in Europe is that it has no strong internal source of aggregate demand at all. Its most competitive – that is, its least financially stressed – economy is Germany. But Germany has chronically deficient aggregate demand. It imports demand from its trading partners, and none of its trading partners in Europe is now in a position to export demand to it. So Germany must get this demand from the rest of the world – not from the US, but from Asia. Even so, this imported demand from Asia will not be strong enough to give Germany really strong growth. As such, as the rest of Europe goes down, German growth is getting weak. The rest of Europe – the big and important countries – is going to contract fiscally. This is a continent with chronically weak private demand and rapidly ageing societies. The EU is too big to be driven by exports – even with a country like Germany in the middle of it. This leaves aside the possibility that there will be a cumulative wave of defaults – including a default by Italy, which would devastate the European and wider banking sector. (Italy, after all, is the world’s third largest debtor.) I am not predicting that, but it is certainly plausible.

The optimistic scenario for the EU over the next two or three years is stagnation. The pessimistic scenario is depression – a depression with manifestly huge financial consequences. Europe looks terrible, and that affects the US, too. The US is an important trading partner – but above all, it is an important financial partner. A lot of American companies get a lot of their profits from Europe – so even though Europe is not dynamic in terms of additional profits, its weakness certainly affects American companies and their profits.

As for Asia, the crisis has very profound implications for the continent – implications that are beginning to become very obvious in the problems currently being experienced in China and India. China and India are very different, of course. In the East Asian case, prior to the crisis, an important part of the growth was driven by two things – net exports outside of the region and, associated with these, colossal investment booms, above all in China. After the crisis hit, China responded by increasing investment spending – largely to offset the drag from net exports. This created bubble phenomena and bad debt phenomena. The problem is that there is no basis in China for rapid growth driven by consumption, because the share of household disposable income in GDP is so low. China therefore risks falling into the Japanese trap very prematurely. The Chinese need a colossal investment rate in order to absorb both the corporate sector’s financial surplus and the household surplus. But the Chinese are going to start running out of decent investment opportunities. This means that the country’s growth rate is going to slow. If the growth rate slows, then the warranted rate of investment will fall. That in turn means that the growth rate must slow even further. And so on. So there is a real danger that China will find itself growing much more slowly than it thought it would. And the levers connected to faster growth will not be that easy to pull.

All of this affects everyone else in Asia, because China is such a huge source of demand. Still, in the end, I have absolutely no doubt that Asia – and I am talking about East Asia here – is going to come through this crisis successfully. That said, there is never again going to be a time when Asian growth will be driven by consumers in the developed world. Asian growth is going to have to be driven by consumers in the Asian world. This is obvious and logical. China is going to have to become rather like the US of the late 19th and early 20th centuries – that is, a mass consumption economy. This is not at all impossible, but it is going to entail a big shift. Certainly, this is a very big challenge for the new Chinese leadership. The risks of failure are significant, as are the complexities involved in navigating this new path. I certainly would not wish to bet against the Chinese – they are extremely capable and intelligent.

As for India, its problem is that it may be reaching the upper limits of the type of growth rate that it can generate with the sorts of reforms that the country introduced in the 1990s. The Indian economy and political system do not work very well. The Indians have great problems in generating mass education, in infrastructure, in their legal processes, and, of course, in their ability to decide things. They need an important set of very difficult governance reforms, as demonstrated by the catastrophe over the power sector this past summer. It is not clear that they are going to get that. And if a government led by Manmohan Singh cannot do this, then who is going to do it?

Because of what I have said about these two Asian giants, and because of what I said about Europe and America, I think that many other countries in Asia are going to find life difficult. Their traditional partners and their new partners – the big Asian giants and the old, developed countries – are all not going to do as well as they might have hoped.


Martin Wolf is Associate Editor and Chief Economics Commentator at the Financial Times. His most recent publications are Why Globalization Works and Fixing Global Finance.

(Photographs: Courtesy of Martin Wolf)

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