Repairing the World's Financial System

For globalization to endure, poor nations must stop lending, start borrowing.

In a recent poll, 60% of U.S. respondents said they believed an imminent economic depression was “likely.” Retirement accounts have lost more than $2 trillion in value over the past year, and the Dow Jones Industrial Average has dropped more than 30% from its apex in the fall of 2007.

Where do we go from here? Martin Wolf, chief economics commentator of the Financial Times and author of the recently-released book Fixing Global Finance, has some surprising answers.

Futurist: Everyone is terribly concerned about the global economy. Investors have seen their stock portfolios decrease by 30 and 40%. What do you see the global economy doing in the next five years?

Wolf: The only honest thing one can say is that one doesn’t know. There are two or three very powerful reasons we don’t know. First, we really can’t forecast economies. Forecasters always miss turning points. They can tell you what will happen only if things remain as they are. Turning points are inherently unpredictable. The consequences when things do change are always unpredictable for the same reason, because a lot of other things are likely to change at the same time. That’s the first point.

Second point is that the forces now at work are unbelievably rare and, in this combination, have never been seen before. Ever. That makes looking back on anything that’s happened in history almost useless. It gives you some guidance; there are better and worse guides. But there is no clear guide that will give you more than a conceptual idea of what’s going on.

Third reason is that it really depends on what people, policy makers above all, actually do. There are choices to be made. So far, in the run up to the crisis and through this crisis, most of the choices made have turned out to be bad choices. Because they’ve been made they’ve been bad choices. We ended up with the worst of all possible worlds at the moment. If people go on making bad choices, we’re going to wind up with a depression lasting many years. If they make what I think are the right choices, we may still end up with a severe recession but we may avoid a severe depression. Those are, I think, the most important things to understand. Anyone who claims to know what’s going to happen is lying.

The forces at work, however, are at least moderately clear. We’ve got three gigantic things happening at the same time that are forcing the world in the direction of recession, or worse. First, for a very long period, household consumption in the United States and a number of other smaller developed counties, particularly the United Kingdom, Australia, Spain, played a very large role in supporting demand around the world, at home and abroad, because these households were spending much more than their incomes consistently and borrowing, consistently, to make up the difference in an era of easy credit. This was supported by a series of asset-price bubbles, far-and-away the most important in this regard was the house price bubble in the recent years, which has ended in these countries starting in the United States in 2006. Because households are losing wealth, or have been losing wealth, reinforced by the collapse in equity markets, they are cutting back on their spending very quickly. If they do that, that guarantees an enormous recession. To give you a relevant example, the U.S. consumer has been spending all his or her income, borrowing a lot more besides, and savings rates have hit zero. The consumption has been a little over GDP, so it’s the principal source of demand in the U.S. economy. If households go back to saving at a more normal rate of their income, which will be somewhere in the neighbor of 6% to 8% of disposable income, that alone, if it happens quickly, will reduce GDP on the demand side by about 5 %. That will feel like a depression. It will certainly be worse than any recession since the war. The first thing that is happening is immense pressure on the high-spending households.

The second thing happening is an extraordinary expansion of the credit system and the financial sector in the world, particularly in these developed countries. By extraordinary, I really mean extraordinary. Over the last 25 years or so the balance sheet of the financial sector of the United States has grown about six times faster than GDP, generating an extraordinary increase in income for the people in the financial sector, and this has led to a massive increase in leverage and low capital ratios. This expansion of the balance sheet of the financial sector financed enormous indebtedness in household sectors in the United States and United Kingdom. Household indebtedness has doubled in relation to disposable income over the last decade.

 As a result of the decline in asset prices and the losses associated with that, the feared losses given the very slow capitalization and the very small expertise-base of much of the sector, the financial sector is effectively decapitalized, i.e. bankrupt. And if it were properly, rigorously, evaluated, a large part of it would look bankrupt, and government would recapitalize. As a result, today’s financial sector wants to lend less, reduce its balance sheet, get people to payback the money it lent, and that leads to the third problem, which is that credit is much more difficult to obtain than it used to be as a result of what happened in the financial system.

You add these three things together and you have an enormous contractionary force operating in the countries that generated very large and buoyant demand growth over the course of the last decade. You have to ask yourself, if they save more and spend less what is going to offset it? What might offset it to get us out? When you think about that, you realize it can’t be investment. Companies invest less in recession. Companies will follow households. That leads you with two sources of demand, one is government, which will spend upwards. It might be financed by the printing press, even by the central bank. That is part of the short term solution in my view. Governments are credit worthy, everybody wants to lend to them. Government spending is a temporary solution. It’s a good one. It will help households to go through a period when they’re saving more, improving their balance sheet. It will take a long time. Household wealth is declining at the same time. The other thing that will help these countries is export growth. You look at U.S. growth in the last year or so, most of it has been generated by exports. That leads you to the final big problem; for exports to grow form the economies that are so big, you need very strong and rigorous demand from the countries which are not heavily burdened by debt. Unfortunately, most of these counties have shown no willingness to increase their spending at large rates, with the marginal exception of China, again, only marginal.

For all these reasons, we can expect a deep and self-fulfilling recession--prevented from becoming a depression--by enormous increases in fiscal deficits to levels like 10% of GDP or more. This will be financed perhaps by borrowing from the central bank. It’s going to take a long time before demand grows in the private sector of these debt-afflicted economies, and I don’t see anything very strong coming from the rest of the world.

There are two other elements, one of which is promising, the other is sort of interesting. The promising one is we no longer have any inflation concern. Commodity prices are collapsing. That’s shifting income back to households, making it easier to save and spend more without cutting back on their consumption. But their real incomes are higher. It’s also removing income from the high-saving countries, which is helpful. It’s lowering inflation; that’s allowing banks to be aggressive in their interest rate policy, which should help households. That is really quite a positive element. The second element is what’s happening in the stock markets.

 You’ve seen that we’ve been in a structural bear market at least since 2000. We had an enormous overvaluation, particularly the developed world in 2000, this foresees a long recovery because of the aggressive monetary policy of the fed which had the consequences we now see in terms of the balance sheet of the financial sector.

Their collapse is now leading to a further collapse in the value of stocks. But I do believe that on a fundamental basis, if you look at long-term underlying valuations, stock markets are beginning to look fairly valued or even cheap--not incredibly cheap, but cheap given the proper understanding of the risks. There was a reason there was an equity risk premium. So that may, in time, once we start stabilizing and the economy becomes better, induce people to start buying stocks, supporting them, giving some stability to stocks. Getting out of this will require aggressive action by governments to prevent total collapse in demand and a total collapse in the financial system. They’ve taken dramatic actions on the later. No body can reasonably think that core financial institutions... they have not done enough on the former to get demand growing again, To get much bigger fiscal boosts in my view to get it growing the deficit in the short run and much more aggressive action to make sure newly re-capitalized institutions at least provide financing to business.

So if those things all go well, ALL go well, I think we can avoid a depression, have just a very deep recession, and see weak recovery of some kind in 2010 or 2011. But this is bound to be the deepest global recession since the war, the first one on which all the developed countries are in recession. It’s going to be a very slow process.

Futurist: This issue of stimulating demand and what government can do to do it; one view says don’t increase the deficit too much it harms the national balance. Others say if you have to stimulate demand through stimulus and not issuing tax rebates. Is there some way government might work against the psychology a little more, like send out a stimulus of hundreds of billions but then say, in order to fight deflation, we’re going to institute a sales tax particularly on commodities and we may even experiment with wealth taxation, to prevent hording of stimulus, the way the government is now considering mandating that the banks lend the money they received as part of the bailout package? What else can government do to stimulate demand?

Wolf: There are some interesting points of view as to how to use the combination of monetary and fiscal stimulus in these situations. It should be understood that once you get into the current U.S. situation when interest rates are so low, you can’t separate monetary and fiscal policy. The best ways monetary policy can support the economy is not by lowering interest rates anymore, because they’re already so low, but either by directly lending to the business sector, which increasingly the FED is doing, or by lending to the government to spend. The government can avoid accumulating large debt by the simple expedient of financing its additional borrowing by borrowing short term from the banking system or borrowing from the federal reserve. In the present situation of extreme liquidity preference, where everyone wants to hold cash, there is no inflation risk associated with that whatsoever. In the long run, that may be different. It’s perfectly reasonable for the government to borrow short term and give it to people and things where they know it will be spent. They can spend on investment and projects that can be done quickly. That would be a good thing to do. They can finance the poor, who always spend money, employment compensation, that will be spent. There are plenty of things you can give money to people for that will be spent. Generalized income tax cuts, where most tax is paid by the well of, won’t be a useful way to lend to the economy. But it would at least give strength to the balance sheet of the household sector. The government should do all of theses things on an exceptionally large scale.

It’s important to remember that we got out of the Great Depression essentially by a huge public works project called the Second World War. I‘m not recommending war, but it’s a reminder of what can be done. There are some risks with such projects. If a country with a large current account deficit prints money like this, maybe the currency will be dumped. It would be better therefore if everyone does it at once. But in a deflationary situation like this, I think the United States, perhaps a bit less the United Kingdom, can get away with substantial increases in domestic liquidity money, because I don’t think other countries would dump U.S. currency; it would destroy their own competitiveness. If it forces them to destroy their own money supply, it would not be a very good thing. Now then there are lots of details you could start discussing. There are many ways to provide money to get it spent. Once we get the household sector back in shape, the stock market at a reasonable price, and people again start buying stocks and finance companies through the stock market or through debt, then you will want to see the government deficit start to diminish. That’s why I think the best forms of stimulating the economy have to be things the government wouldn’t ever do.

For instance, unemployment compensation is related to the Great Depression. Similarly, funding large scale investment programs which, once they’re finished, they’re finished. If you’re’ talking about large, permanent spending increases, say a reform to universal health-care systems, those must be funded by permanent increases in taxation or some reduction in spending. Not part of this package. In the long run, when everything gets back to being healthy, you would expect deficits to shrink. You would expect the private sector to spend more, revenue to improve. The government’s need to spend diminishes. It will all go away again.

In the end, it would be sensible to move back into surplus, withdraw the money you’ve printed, or you can start selling bonds to mop up the money. Clearly, at the very end of the process, government deficits will be higher than they are now but household indebtedness will be smaller, with luck. It’s important to understand this clear borderline between private and government indebtedness doesn’t work at the macroeconomic level. There’s a relationship between the two. When households have large amounts of debt they can’t pay, they stop servicing. It is the government that comes in by printing its own debt, which everyone will then want, and that’s what’s happening now. So I think the process will be reversible later on. It has always been possible to reduce deficits and debt provided the policy is reasonably discipled. Right now, it’s a question of spending and financing by borrowing from the system in the short term, and not worrying about bond finance and just making sure we get through the next two or three years without a total self-fullfing and reinforcing collapse in the economy.

Futurist: Looking ahead even more long-term, one of the thing I like about your book, you write that the United States is as much a victim of others’ misfortuntes. You talk about global savings and how developing nations in particular have fallen into this strange habit of giving surplus money to the United States in the form of loans, but really they should be spending it domestically, and developed nations should be spending more in developing nations. This is a much more healthy flow of capital. Did I sum up the point correctly?

Wolf: I think you’ve done it admirably. It is a central theme of my book. It’s an interesting point that nearly all serious professional economists--there are exceptions--would agree completely with me, yet this is seen as a controversial view. There are two big points in this book. The first is the United States is embedded in the global economy.  It’s the biggest economy but its still smaller than the rest of the world. It’s roughly 1.4 of the economy and the rest is 3.4. What the rest of the world does actually has an enormous effect on the United States. It’s not just one way. It so happens that for reasons I lay out at length in my book, the rest of the world undertook a series of actions. In response to a financial crisis of an earlier decade, they pushed up deficits and gave themselves large export services and large export capital, to sustain large export surpluses particularly in the case of China but not only China. That, in my view, created strong deflationary and recessionary pressure in the United States You think about it, the import surpluses are withdrawal from a country, domestic demand going abroad. The U.S. Federal Reserve, not totally consciously, chose to offset this deflationary pressure by greatly expanding domestic demand; it was purely accidental. The same thing followed from the Bush tax cuts in the early part of his administration. The United States was responding to these external pressures. I don’t think it responded intelligently, unfortunately. It allowed this later financial mismanagement. And so, in the end, a large part of the domestic U.S. counterpart of this lending turned out to be borrowing by fundamentally insolvent households by assets that were fundamentally overpriced, intermediated by a financial system that turned out to be undercapitalized.

If you think of that combination, it was the worst way to do it. It would have been better for the United States to run bigger fiscal deficits in this period and invested the proceeds in bridges and roads and railroads and whatever capital investment makes sense. The investment it did undertake was to build houses that nobody needs. It’s a sad story. The big macro-picture is, as you describe it, an important indication of the way the United States is not master of its own fate.

 This gets to the second big point, if--and I’ve already made this point--if we are going to get out of this cleanly, the U.S. economy needs to rebalance. We don’t have to go back to a big borrowing binge. We can’t run fiscal deficits of 8%-10% of GDP forever. That’s clearly unsustainable and will sooner or later destroy the credit and the currency. So the United States has to save more at home and it has to have a balance in the current account and reduce its debt that way. But the United States and the other countries can only do that without having a huge depression if other countries in the world voluntarily expand demand in relation to their financial supply and move into current account deficits themselves. These things have to work out.

The big question now is whether other countries with large surpluses understand that they are going to have to adjust to and expand demand because in fact, what is really happened here is the world has run out of large-scale, willing, and solvent debtors. Because it’s run out of them, except governments, there has to be adjustment everywhere. What’s not clear to me is that people around the world in China, Japan, Germany fully understand this. There’s a danger they won’t do enough. We’ll be reducing demand anyway. We’ll have a vicious downward spiral. It’s a big danger on the macroeconomic level, which could push us to a very deep and long recession or even a depression. It’s not just about financial system or expanding fiscal deficits, it’s also about having a view of how the longer-term adjustments in the world economy are going to happen. That will take American intellectual and political leadership, which has been totally lacking in this respect to the Bush administration. I do hope the people who take over will have a better appreciation. I know many of the economists on both sides and the economists who have been advising the Democratic side and I do think they appreciate this much better than their counterparts in the current [Bush] administration, though not in all respects. But if you don’t get a more balanced world economy, it may prove impossible to sustain a world with open capital; close it all and we will go back to the more self-sufficient financial systems and economies of fifty or sixty years ago.

This interview was conducted by Patrick Tucker, senior editor of THE FUTURIST.
12.01.08

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