[R-G] Martin Wolf: "A Year of Living Dangerously for the World"
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Wed Jul 16 10:15:05 MDT 2008
A year of living dangerously for the world
By Martin Wolf
Published: July 15 2008 20:18 | Last updated: July 15 2008 20:18
It is now almost a year since the US subprime crisis went global. Many
then hoped that the repricing of risk would be no more than a brief
interruption in the progress of the US and world economies. Such hopes
have been disappointed. The woes of Fannie Mae and Freddie Mac, the
tumbling stock markets and the climbing oil prices make clear how far
the turmoil is from its end. It has, in all likelihood, not even
passed the end of its beginning.
So where is the world economy now? And where might it go? Here are
some preliminary answers to these questions.
The answer to the first comes in two main parts: continued financial
distress and commodity price rises.
The performance of banking stocks tells one most of what one needs to
know about the financial crisis. In the US, the epicentre of the
distress, banks had lost half of their market value between a year ago
and the end of last week, relative to the S&P composite index.
Equity investors are not the only people worried about the health of
banks. The banks themselves are also worried. Spreads between rates of
interest on inter-bank lending in dollars, euros and sterling and
expected official rates over three and six months are now wider than
they were in March. On six-month loans spreads are now as high as at
the two previous peaks, in September and December of last year (see
Libor/OIS Swap Spread, US Banks and Agencies, US House Prices, Oil
Prices in Dollars and Europs
This is no mere liquidity crisis. The banks are expressing concern
about the solvency of their peers. One good reason for them to worry
is that the quality of the underlying collateral for much of the
lending of previous years – housing – continues to deteriorate. The
Case-Shiller 20-city index declined by 18 per cent in nominal terms
and 22 per cent in real terms between its peak in mid-2006 and April
of this year. This rate of decline is also accelerating.
It is little wonder, then, that the stock market has been showing
something close to panic over prospects for the two government-
sponsored enterprises, Fannie Mae and Freddie Mac, which have been
financing about three-quarters of all US mortgages. A formal
government takeover of these entities, whose total liabilities are
close to 40 per cent of US gross domestic product, is not out of the
question. In terms of gross government indebtedness, this would make
the US look like Italy.
Meanwhile, the price of oil is close to $150 a barrel. While an
important part of the world economy is worrying about the risks of
financial collapse and ensuing deflation, the price of the world's
most important commodity has doubled over the past year. In real
terms, the price of oil is now 25 per cent higher than in 1979, at the
peak of the second oil shock.
The soaring prices of oil and other commodities are something of a
puzzle, since global economic growth is slowing: consensus forecasts
for June have world growth at 2.9 per cent this year (at market
exchange rates), down from 3.8 per cent in 2007, largely because of
the slowdown in the high-income countries, with US growth forecast at
only 1.5 per cent this year, down from 2.2 per cent in 2007, and
growth in western Europe at 1.8 per cent, down from 2.8 per cent in
So why are commodity prices soaring when the world economy is slowing?
The popular explanation seems to be "speculation". But, since
speculation is always with us, this cannot explain why prices are
soaring now. Another popular explanation is the aggressive easing of
US monetary policy. But this hardly explains the fact that the price
of oil is rising rapidly even in euros (see chart). Nor does
speculation explain the rise in the prices of commodities that do not
have active futures markets: iron ore, for example.
In the case of oil, as Daniel Gros of the Centre for European Policy
Studies pointed out [LINK:
in the Financial Times last week (this page, July 10), speculation is
inherent in deciding whether to produce. The producers are speculators
on the future value of their resource – and rightly so, since it is
Producers will leave oil in the ground if the rise in real oil prices
is expected to be faster than the return on the alternative assets.
What determines the current price then is the expected future price.
The most important drivers have been the prospective growth in the
demand of emerging countries, particularly China, and gloom about
alternative sources of supply. China's rapid and highly
resource-intensive growth is the most important factor: growth there
is still expected to be 10 per cent this year and more than 9 per cent
So what happens to the world economy next? Here perhaps the most
important point is the uncertainty. It is possible to tell stories of
a return to rapid growth in the world economy. It is just as easy to
tell stories of something close to a financial meltdown.
Yet the balance of economic forces is contractionary: financial crises
and property price collapses in the US and a number of other
high-income countries; soaring commodity prices; and inflationary
pressures, particularly in emerging countries. It is hard to see any
outcome other than a sustained slowdown in the world economy. It is
even quite likely that the trend growth of the world economy is
considerably slower than was hoped a few years ago.
Furthermore, some of the risks could combine in dangerous ways. An
attack on Iran might push the price of oil above $200, for example.
Moreover, the creditworthiness of the US government cannot be taken
for granted. If the ongoing deleveraging of the US economy weakened US
consumption, the economy might go into a deep recession. US fiscal
deficits would then soar and long-term US interest rates might jump.
This could make the debt dynamics of the US government look very
unpleasant. A flight from the dollar and dollar bonds might even
ensue. Who would then want to be running the Federal Reserve?
The good news is that the world economy has held up surprisingly well.
The bad news is that the risks remain squarely on the downside. It
will take some luck and much judgment to pass through the storms
unscathed. It is time to take a break from the gloom. That is what I
will now do. I will be back at the end of August.
martin.wolf at ft.com
How to see world economy through two crises
By Martin Wolf
Published: June 24 2008 19:47 | Last updated: June 24 2008 19:47
Ingram Pinn illustration
Two storms are buffeting the world economy: an inflationary
commodity-price storm and a deflationary financial one. Last week I
argued that exchange-rate regimes were a link between these distinct
events. This week, let us look at how to sail on these storm-tossed
The place to start is with the world economy as a unit. The more
globalised economies become, the more appropriate it is to think of
the world economy in this way. So what have we learnt about the world
economy as a whole? The answer is that it is running into limits on
resources, at least in the short term.
Our civilisation is based on fossil fuel. But since the end of 2001,
the real price of oil has risen some six-fold. Today, the real price
is higher than since the beginning of the previous century. As the
World Bank notes in its Global Development Finance 2008 [LINK:
global oil supply stagnated in 2007. This, argues the report,
"contributed to the large decline in stocks in the second half of 2007
and to sharply higher prices"*. These increases may prove temporary,
as happened after the spikes of the 1970s, or permanent. We do not yet
Jumps in energy prices have at least three effects on the economy.
First, they increase headline inflation. In emerging economies, above
all, bad inflationary surprises have become the norm (see chart).
Second, they lower potential supply, by squeezing profits in
energy-consuming activities, forcing businesses to scrap
energy-intensive capacity, and making it necessary to invest in new
and more energy-efficient capacity.
In its latest Economic Outlook, the Organisation for Economic
Co-operation and Development discusses the consequences of such a
negative supply shock on member countries**. It makes two large
points: first, uncertainty about current levels and future growth of
potential output has risen; and, second, the adverse effects of this
may be sizeable.
The OECD estimates that the recent rise in the relative real price of
oil has lowered steady-state output by 4 per cent in the US and 2 per
cent in the eurozone and lowered potential growth, in the medium term,
by 0.2 percentage points and 0.1 percentage points, respectively. This
is not trivial: in the case of the US, the decline in the growth of
potential output must be at least 10 per cent of potential growth in
output per head. In the more advanced emerging economies – and
particularly a fast-growing industrialising economy like China – the
reduction in the potential rate of growth may well be greater still.
Third, energy price jumps alter the level and distribution of global
demand. The move from a price of close to $53 a barrel at the
beginning of 2007 to $136 now, increases the annual cost to consumers
by around $2,600bn annually, which is a tax of about 4.5 per cent on
global non-oil output. Some two-thirds of this transfer is from
oil-importing to oil-exporting countries. It is also from those who
spend to those inclined to save, at least in the short term.
This shift itself will curb the rise in global demand. So, too, will
the financial crises in the US and other high-income countries and the
closely related collapse of several huge house-price bubbles. In the
high-income countries, growth is forecast by the OECD to slow to a
little below trend this year and next. As one would expect, the
biggest decline is in the US, with gross domestic product growth of
1.2 per cent this year, almost all of which is expected to be
contributed by the rise in net exports. From being a locomotive of
growth, the US has become dependent on growth elsewhere.
Yet will this decline in the rate of growth in the high-income
countries cool an overheated world economy sufficiently? Perhaps not.
The OECD expects a decline in growth outside the OECD, but to levels
still above (a hard to measure) potential (see chart). The World
Bank's Global Development Finance does expect a marked decline in
developing country growth, though to still high levels, from 7.8 per
cent in 2007 to 6.5 per cent this year and 6.4 per cent in 2009.
Chinese growth is forecast to slow from 11.9 per cent in 2007 to 9.4
per cent in 2008 and India's from 8.7 per cent to 7.0 per cent.
Yet, as I argued last week [LINK:
global monetary policy is probably too loose, despite the adverse
impact of the credit crisis on high-income countries. In many emerging
countries output is growing quickly, with inflation rising strongly.
If, as seems likely, the world economy cannot grow as fast as people
hoped only a year or two ago, emerging economies have to be part of
the adjustment. This will become still more obvious when, at last, the
high-income countries recover fully.
Against this difficult background, what are the right responses and
how should they be distributed, across the globe? These need to be
divided into the short term and the longer term.
In the short term, the biggest monetary policy requirement is a
tightening in emerging economies, many of which now have strongly
negative real interest rates. A precondition for such a tightening is
a relaxation of exchange rate targeting. Monetary tightening is less
obviously necessary in high-income countries, though the US Federal
Reserve may have cut too far.
As important is letting the jumps in energy prices pass through, so
forcing the needed adjustments in energy use. The beneficiaries of the
subsidies offered by many emerging countries are overwhelmingly in
upper-income groups. In India, the cost of fuel subsidies is now
almost as large as public spending on education: this is scandalous.
No less important, however, is abandonment of the silly idea that
price jumps in oil or food are the result of wicked "speculation" – a
fantasy promoted by dangerous populists across the globe.
Finally, it is essential for the rich countries to cushion the poorest
people and countries against such shocks. The aim should be to reduce
the pain and to finance necessary adjustment, but not prevent it.
In the medium to long term, the biggest priority is to release energy
constraints on growth. This means increased public and private
investment in energy research, particularly in renewables. The
challenge is huge, but must be met.
The shocks are large. But the more significant one is the high price
of energy. The financial crisis was an avoidable stupidity. Rising
prices of energy are a bitter reality. The world must adjust to this
unpleasant new threat. Ideally, countries would act together. But
whether they act together or not, they must act. Otherwise, greater
danger – even a bad dose of stagflation – lies ahead.
martin.wolf at ft.com
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