[R-G] Martin Wolf on the Roots of the Global Macroeconomic Disorder

[Yoshie Furuhashi]

Martin Wolf writes that "The immediate priority ought to be adoption
of policies across the world that allow a big fall in the US current
account deficit without prolonged weakening of global economic
activity. "  Well said (though no one knows how to pull off what is to
be done).  If only leftists were as clear (though not that anyone
would listen to us).  :->  The Fed may have less ammunition than it
may need (<http://krugman.blogs.nytimes.com/2008/01/23/does-the-fed-have-enough-ammunition/>)
and the US fiscal response is probably too little of the not-so-right
kind, however, so they are unlikely to "work too well" as Wolf fears.
-- Yoshie

<http://www.ft.com/cms/s/0/8bd26b04-ce9e-11dc-877a-000077b07658.html>
Bernanke's reflation gamble may work too well

By Martin Wolf

Published: January 29 2008 19:49 | Last updated: January 29 2008 19:49

Whatever else it may be, the Federal Reserve is not boring. Indeed, by
the standards of other central banks, it is hyperactive. The shock
0.75 percentage point reduction in the Federal Funds rate of interest
last week, particularly if followed by the widely expected 0.5
percentage points on Wednesday, is a dramatic example. The Fed is the
exemplar of an activist central bank. But US fiscal authorities are
not far behind, as the $150bn (just over 1 per cent of gross domestic
product) fiscal package going through Congress demonstrates.

So what are the US monetary and fiscal authorities trying to do? Will
it work? What are the risks? Should others follow suit? The urgency of
these questions was made clear at the annual meetings of the World
Economic Forum in Davos last week. The consensus was gloomy.
Comfortingly, the Davos consensus is usually wrong. The Fed is
certainly trying to prove it so this time.

The answer to the first question is: apply "risk management". That
approach is associated with Alan Greenspan, the former Fed chairman.
But it is also central to the thinking of the Fed under Ben Bernanke.

Fed governor Frederic Mishkin, who is intellectually close to Mr
Bernanke, has articulated the underlying theory in a fascinating
recent speech.* In essence, Mr Mishkin argues that the combination of
non-linearities in the economy with uncertainty and a high probability
of extreme outcomes (so-called "fat tails") justifies the Fed's focus
on extreme risks: this is the "precautionary principle" applied to
monetary policy. At times of high uncertainty, policy should be
timely, decisive and flexible. The Fed's response to the stock market
swoon last Monday demonstrated those qualities. Even the notoriously
slow, indecisive and inflexible US fiscal policymakers are trying to
follow.

Will these actions work? We need to decide what "working" would mean.
The obvious definition is the Fed's own, namely, elimination of any
risk of a collapse into Japanese-style deflation. Alternatively, one
might take the bipartisan political objectives – a rapid return to
robust growth – as the definition of success.

The answer to this question is that the policy will work if pursued
with sufficient ruthlessness. Those who see the parallels between the
US predicament of high domestic debt, declining asset prices and a
crisis-hit financial sector and that of Japan in the 1990s might doubt
this.

"Central Bank Policy Rates" and "US Bond Yields and Implied Inflation
Expectations"
<http://media.ft.com/cms/7093ff6c-ce97-11dc-877a-000077b07658.gif>

But, despite the disturbing parallels, Japan's initial predicament was
worse: its assets were more overvalued and its companies more
indebted. Japan's response was also longer delayed. Provided inflation
does not become a huge concern, monetary and fiscal expansion will
reflate the US economy. If the worst comes to the worst, a central
bank can finance the fiscal deficit almost without limit.

True, pessimists argue that the combination of declining asset prices
(particularly house prices) with household overindebtedness and a
fragile banking system means that monetary policy is, in the
celebrated words of John Maynard Keynes, like "pushing on a string".
It may not be quite that bad. But, on its own, monetary policy will
not act swiftly unless employed on a dramatic scale. The case for
fiscal action looks strong.

Yet, in current US circumstances, monetary loosening should have some
expansionary effects: it will encourage refinancing of home mortgages;
it will weaken the exchange rate, thereby improving net exports; it
will, above all, strengthen the health of banking institutions, by
giving them cheap government loans.

This brings us to the biggest question: what are the risks?
Unfortunately, they are large. One is indefinite continuation of an
excessively low rate of US national saving. Others are a loss of
confidence in the US currency and much higher inflation.Yet another is
a further round of the very asset bubbles and credit expansion that
created the present crisis. After all, the financial fragility used to
justify current Fed actions is, in large part, the direct result of
past Fed efforts at the risk management Mr Mishkin extols.

Moreover, the risks are not just domestic. If the US authorities
succeed in reigniting domestic demand, this is likely to reverse the
decline in the current account deficit. It will surely reduce the
pressure on other countries to change the exchange rate, fiscal,
monetary and structural policies that have forced the US to absorb
most of the rest of the world's huge surplus savings.

The US seems to be getting away with its gamble, at least so far. One
indicator is the decline in long-term interest rates and the
steadiness of inflation expectations, as shown by the gap between
conventional and inflation-proof Treasury bonds. Another is recent
steadiness of the dollar. Finally, there has been no upsurge in core
inflation, though the same cannot be said of the headline variety.
(See charts.)

"US Inflation" and "IMF Forecasts for 2008 Growth"
<http://media.ft.com/cms/96ca120c-ce97-11dc-877a-000077b07658.gif>

It is conceivable, then, that the emerging Washington policy consensus
offers the right macroeconomic response to the present crisis. But it
is risky. Moreover, if the International Monetary Fund's modest
downgrading of growth prospects is correct, the action could even
prove overdone.

Above all, it would be far better if demand were expanded in the rest
of the world, as Dominique Strauss-Kahn, managing director of the IMF,
argues). This would facilitate the adjustment in the massive external
imbalances that, as I argued last week, (comment page, January 22) lie
at the root of US credit growth, debt accumulation and consequent
financial fragility.

I find it impossible to look at what the US is now trying to do
without feeling severely torn. If it succeeds it will renew and, at
worst, exacerbate the fragility, both domestic and international, that
triggered the turmoil. If it fails, the US and, perhaps, much of the
rest of the world could well suffer a prolonged period of economic
weakness. This is hardly a pleasant choice. But that it is indeed the
choice shows how weakened the world economy and particularly the
financial system has become.

The immediate priority ought to be adoption of policies across the
world that allow a big fall in the US current account deficit without
prolonged weakening of global economic activity. With this, the world
economy can exit from the crisis in better health. Without it, further
crises are sure to come. The US cannot make this choice. It rests in
the hands of the rest of the world.

*Monetary Policy Flexibility, Risk Management, and Financial
Disruptions, www.federalreserve.gov

martin.wolf at ft.coms

<http://www.ft.com/cms/s/0/18083bfa-c8f8-11dc-b14b-0000779fd2ac.html>
Why the global financial turmoil is like an elephant in a dark room

By Martin Wolf

Published: January 22 2008 20:02 | Last updated: January 22 2008 20:02

"I was gradually coming to believe that the US economy's greatest
strength was its resiliency – its ability to absorb disruptions and
recover, often in ways and at a pace you'd never be able to predict,
much less dictate." Alan Greenspan, 'The Age of Turbulence'.

We all hope that Mr Greenspan proves right about the US economy. The
Federal Reserve's rate cut on Tuesday will succeed if Mr Greenspan's
view is correct. Yet many fear he is wrong. Many, too, blame him for
the current mess. So how did the world economy fall into its
predicament?

One view is that this crisis is a product of a fundamentally defective
financial system. An email I received this week laid out the charge:
the crisis, it asserted, is the product of "greedy, immoral, solely
self-interested and self-delusional decisions made throughout the
2000s, and earlier, by very real human beings at the very top of the
financial food chain".

The argument would be that a liberalised financial system, which
offers opportunities for extraordinary profits, has a parallel
capacity for generating self-feeding mistakes. The story is familiar:
financial innovation and an enthusiasm for risk-taking generate rapid
increases in credit, which drive up asset prices, thereby justifying
still more credit expansion and yet higher asset prices. Then comes a
top to asset prices, panic selling, a credit freeze, mass insolvency
and recession. An unregulated credit system, then, is inherently
unstable and destabilising.

This is the line of argument associated with the late Hyman Minsky,
who taught at Washington University, St Louis. George Magnus of UBS
distinguished himself by arguing early that the present crisis is a
"Minsky moment": "A collapse of debt structures and entities in the
wake of asset price decay, the breakdown of 'normal' banking functions
and the active intervention of central banks". This follows an
extraordinary dependence on credit growth in the recent cycle (see
chart).

Economists would offer contrasting explanations for this fragility.
One is in terms of rational responses to incentives. Another is in
terms of the short-sightedness of human beings. The contrast is
between misdirected intelligence and folly.

"US Credit Intensity of GDP Growth" and "Fed Interest Rates and the
'Taylor' Rule"
<http://media.ft.com/cms/f573ac34-c922-11dc-9807-000077b07658.gif>

Those who emphasise rationality can readily point to the incentives
for the financial sector to take undue risk. This is the result of the
interaction of "asymmetric information" – the fact that insiders know
more than anybody else what is going on – with "moral hazard" – the
perception that the government will rescue financial institutions if
enough of them fall into difficulty at the same time. There is evident
truth in both propositions: if, for example, the UK government feels
obliged to rescue a modest-sized mortgage bank, such as Northern Rock,
moral hazard is rife.

Yet it is also evident that everybody involved – borrowers, lenders
and regulators – can be swept away in tides of all-too-human euphoria
and panic. To err is human. That is one of the reasons regulation is
rarely countercyclical: regulators can be swept away, as well. The
financial deregulation and securitisation of the most recent cycle
merely encouraged an unusually wide circle of people to believe they
would be winners, while somebody else would bear the risks and,
ultimately, the costs.

Yet there is a different perspective. The argument here is that US
monetary policy was too loose for too long after the collapse of the
Wall Street bubble in 2000 and the terrorist outrage of September 11
2001. This critique is widely shared among economists, including John
Taylor of Stanford University.* The view is also popular in financial
markets: "It isn't our fault; it's the fault of Alan Greenspan, the
'serial bubble blower'."

The argument that the crisis is the product of a gross monetary
disorder has three variants: the orthodox view is simply that a
mistake was made; a slightly less orthodox view is that the mistake
was intellectual – the Fed's determination to ignore asset prices in
the formation of monetary policy; a still less orthodox view is that
man-made (fiat) money is inherently unstable. All will then be solved
when, as Mr Greenspan himself believed, the world goes back on to
gold. Human beings must, like Odysseus, be chained to the mast of gold
if they are to avoid repeated monetary shipwrecks.

"Global Foreign Exchange Reserves" and "Commodities and Gold"
<http://media.ft.com/cms/f3d1ba10-c922-11dc-9807-000077b07658.gif>

A final perspective is that the crisis is the consequence neither of
financial fragility nor of mistakes by important central banks. It is
the result of global macroeconomic disorder, particularly the massive
flows of surplus capital from Asian emerging economies (notably
China), oil exporters and a few high-income countries and, in
addition, the financial surpluses of the corporate sectors of many
countries.

In this perspective, central banks and so financial markets were
merely reacting to the global economic environment. Surplus savings
meant not only low real interest rates, but a need to generate high
levels of offsetting demand in capital-importing countries, of which
the US was much the most important.

In this view (which I share) the Fed could have avoided pursuing what
seem like excessively expansionary monetary policies only if it had
been willing to accept a prolonged recession, possibly a slump. But it
had neither the desire nor, indeed, the mandate to allow any such
thing. The Fed's dilemma then was that the only way to sustain
domestic demand at levels high enough to offset the capital inflow
(both private and official) was via a credit boom. This generated
excessively high asset prices, particularly in housing. It has left,
as a painful legacy, stretched balance sheets in both the
non-financial and financial sectors: debt deflation, here, alas, we
come.

When I read these analyses, I am reminded of the story in which four
people are told to go into a dark room, hold on to whatever they find
and then say what it is. One says it is a snake. Another says it is a
leathery sail. A third says it is a tree trunk. The last says it is a
pull rope.

It is, of course, an elephant. The truth is that an accurate story
would be a combination of the various elements. Global macroeconomic
imbalances played a huge part in driving monetary policy decisions.
These, in turn, led to house-price bubbles and huge financial
excesses, particularly in securitised assets. Now policymakers are
forced to deal with today's symptoms as best they can. But they must
also tackle the underlying causes if further huge disturbances are not
to come along. What those responses should ideally be at both national
and global levels will be the subject of my post-World Economic Forum
column next week.

*Housing and Monetary Policy, September 1 2007, www.kc.frb.org

martin.wolf at ft.com
--
Yoshie
<http://montages.blogspot.com/>