Three years and new fault lines threaten

By Martin Wolf

Published: July 13 2010 22:45 | Last updated: July 13 2010 23:04

It is nearly three years since the world became aware of the coming financial tremors. Since then we have
experienced a financial sector earthquake, a collapse in economic activity and an unprecedented monetary and fiscal
response. The world economy has now recovered. But this crisis is far from over.

As Raghuram Rajan of the University of Chicago Booth School of Business and former chief economist of the
International Monetary Fund notes in a thought-provoking new book, the underlying “fault lines” are still with us.*
More trouble may lie ahead. His voice is worth listening to: in 2005, he presented a controversial, yet now acclaimed,
paper at the annual Jackson Hole monetary conference entitled “Has Financial Development Made the World
Riskier?” His answer? Yes.

We already know that the earthquake of the past few years has damaged western economies, while leaving those of
emerging countries, particularly Asia, standing. It has also destroyed western prestige. The west has dominated the
world economically and intellectually for at least two centuries. That epoch is over (see charts). Hitherto, the rulers of
emerging countries disliked the west’s pretensions, but respected its competence. This is true no longer. Never again
will the west have the sole word. The rise of the Group of 20 leading economies reflects new realities of power and
authority.

Yet this is far from the only change in the global landscape. The crisis has revealed deep faults within western
economies and the global economy as a whole. We may be unable to avoid further earthquakes.

Martin Wolf’s Exchange

Martin Wolf elicits readers’ views on current economic issues

In his book, Prof Rajan points to domestic political stresses within the US. Related stresses are emerging in western
Europe. I think of it as the end of “the deal”. What was that deal? It was the post-second-world-war settlement: in the
US, the deal centred on full employment and high individual consumption. In Europe, it centred on state-provided
welfare.
In the US, soaring inequality and stagnant real incomes have long threatened this deal. Thus, Prof Rajan notes that
“of every dollar of real income growth that was generated between 1976 and 2007, 58 cents went to the top 1 per
cent of households”. This is surely stunning.

“The political response to rising inequality ... was to expand lending to households, especially low-income ones.” This
led to the financial breakdown. As Prof Rajan notes: “[the financial sector’s] failings in the recent crisis include
distorted incentives, hubris, envy, misplaced faith and herd behaviour. But the government helped make those risks
look more attractive than they should have been and kept the market from exercising discipline.”

The era of easy credit, much of it backed by housing, is now over (see chart). Meanwhile, in all western countries, the
state supports the welfare of the individual. But the fiscal consequences of this crisis – a huge rise in deficits – will
interact with pressures from ageing, to make fiscal stringency the theme of policy for decades. The long bear market
in shares and prospects for a “jobless recovery” add further to these woes.

It is little wonder then that the politics of western countries and, above all, of the US have become discordant.
President Barack Obama – a pragmatic centrist – is vilified. On the right, the call is to overthrow the modern
government in an effort to return to the 18th century. This, then, is a crisis of government itself.

Exacerbating these internal fault lines within western economies are those in the world economy. Here Prof Rajan
notes two risks: first, the structural export-dependency of a number of economies, particularly Japan, Germany and
now China; and, second, the unresolved clash of financial systems. The interaction between global fault lines and
those inside the domestic economies of western countries, particularly the US, helped trigger the crisis and now
make it hard to rebuild after it.

As Prof Rajan notes, a number of significant countries have built their economies around exports. The resultant
dependence on foreign demand means the credit-dependence they proudly avoid at home emerges abroad. The
constraint upon them is what Prof Rajan describes as a “politically strong, but very inefficient domestic-oriented
sector”. The problem is that the countries that used to provide the demand – the US, at world level, or Spain, in the
eurozone – have over-indebted private sectors. So we see a zero-sum battle over shares of structurally deficient
global demand. This is a threat to survival of the eurozone and even the open world economy.

Similarly, it has proved extremely hard to manage the integration of market-based financial systems with ones based
on personal and even political relationships. Episodes of large-scale capital inflows from the former to the latter
ended up in crises. This then led to the huge accumulations of foreign currency reserves that helped to drive the
current crisis. Today, the risks of large-scale capital flows across frontiers are all too disturbingly evident. It may even
be hard to sustain financial integration.

The crisis, then, can be seen as the product of fault lines inside advanced western economies – above all, the US –
and in the relationships between advanced countries and the rest of the world. The challenge of returning to some
form of reasonable stability, while maintaining an open global economy, is enormous. Anybody who thinks that the
present fragile recovery represents success with these tasks is myopic, at best.

We can see two huge threats in front of us. The first is the failure to recognise the strength of the deflationary
pressures (see chart). The danger that premature fiscal and monetary tightening will end up tipping the world
economy back into recession is not small, even if the largest emerging countries should be well able to protect
themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in
management of the financial sector and in export-dependency that are needed if a sustained and healthy global
recovery is to occur.

The west is not the power it was; its debt-fuelled consumers are not the source of demand they were; the west’s
financial system is not the source of credit it was; and the integration of economies is not the driving force it proved to
be over the past three decades. Leaders of the world’s principal economies – both advanced and emerging – will
need to reform co-operatively and deeply if the world economy is not to suffer further earthquakes in years ahead.

* Fault Lines, Princeton, 2010

Fiscal default is nigh, insist the doomsayers: repent and retrench before it is too late. Yet I have a question: do we
believe that markets are unable to price anything right, even the public debt of the world’s largest advanced countries,
the best understood and most liquid assets in the world? I suggest not. Markets are saying something important.

On Monday, the yield on 10-year government bonds was 1.1 per cent in Japan, 2.6 per cent in Germany, 3 per cent
in the US and 3.3 per cent in the UK (see chart). Based on yields on index-linked securities, real interest rates on
borrowing by these governments are very low (1.2 per cent, or less, in the US, Germany and UK). Investors are
saying that they view the risk of depression and deflation as greater than that of default and inflation.

Why should it be so easy to fund such huge fiscal deficits even after central banks have stopped their buying of
government bonds? In response, here is a calculation that can be derived from the figures for fiscal and current
account balances in the latest Economic Outlook from the Organisation for Economic Co-operation and
Development: the private sector – households and corporations – of advanced countries is forecast to run an excess
of income over spending this year of 7 per cent of gross domestic product. In round numbers, this is $3,000bn. In the
US and eurozone, the implied private surplus is about $1,000bn, in each case. In Japan, it is about $500bn. In the
UK, it is $200bn.

Martin Wolf’s Exchange

Martin Wolf elicits readers’ views on current economic issues

Focus on the $3,000bn: this is the amount by which the private sectors of the advanced countries are forecast to
increase their net claims on governments and foreigners in 2010. That means massive private retrenchment, with
corporations particularly frugal at the moment.

Where could this money go? A possibility might be emerging countries. One might imagine, for example, that
advanced countries eliminated their fiscal deficits but maintained these private surpluses. That would mean an
aggregate current account surplus of $3,000bn, (or 7 per cent of GDP). The OECD region would become a mega-
Germany. Rich countries would be pouring capital into poorer ones.
In practice, however, this is not going to happen. Far from running a current account deficit of $3,000bn, emerging
countries are forecast to run a surplus: the latest from the Washington-based Institute for International Finance is for
an aggregate surplus of about $300bn, two-thirds of which will be generated by China. This is smaller than two years
before. But it still means that the emerging world will be a net provider of capital to advanced countries, not the other
way around.

That is not all. According to the IIF, the net flow of private funds from advanced countries to emerging countries will
be close to $700bn this year. But that will be almost entirely offset by an official outflow, in the form of foreign
currency reserves, of close to $600bn. These huge official interventions prevent the emergence of large net capital
inflows into emerging countries. Instead, the private sectors of the advanced countries accumulate net claims on the
private sectors of emerging countries, while the governments of emerging countries accumulate offsetting claims on
the governments of advanced countries (see charts).

The bottom line is clear: there exists, at present, a gigantic net flow of funds into the liabilities of the governments of
advanced countries. Of course, some countries can still get into difficulties. But it is quite wrong to argue that the
difficulties of a Greece or a Spain entail difficulties ahead for the US, or even the UK. The opposite is far more likely:
flight from risk entails flight into something less risky. What is the least perilous asset for the investment of gigantic
private financial surpluses? The only answer is the public debt of the big advanced countries.

These flows of funds consist only of identities. So what are the causal factors? Maybe, the collapse in private
spending in the wake of the financial crisis was caused by terror of the fiscal deficits to come. Maybe, the moon is
made of green cheese, too. There is also next to no sign of crowding out in capital markets. The plausible hypothesis,
then, is that the fiscal deficits were a response to the collapsing desire to spend of the crisis-hit private sector. Fiscal
policy could have been tighter. But the result would have been a depression.
What then of the future? Suppose there is no significant change in policy in emerging economies. Then if a fiscal
contraction in advanced countries is not to cause a slowdown, even a second recession, it must be accompanied by
an upsurge in private spending.

The argument must be that improved confidence in the long-run sustainability of public finances would lead to greater
private consumption and investment spending now, even if there is no significant effects on interest rates or the
exchange rate. I am highly sceptical of this argument (see “Why it is right for central banks to keep printing”, Financial
Times, June 22, 2010). But grant that this is true. Then the best policy is to slow the long-term growth in spending on
age-related programmes. This comes out clearly from the discussion of long-term fiscal trends in the excellent new
annual report from the Bank for International Settlements.

The arguments for a dramatic short-term fiscal contraction, however, are weak. Yes, we are enjoying a recovery. But
economies are still far below peak levels of activity and also below almost any plausible estimate of the long-term
trend (see chart). This is particularly true in the US, where unemployment rates have shot up by far more than in
other advanced countries. Unless the US has suddenly become continental European, why should equilibrium
unemployment have jumped by as much as that?

My conclusion, then, is that the advanced countries remain highly short of demand. In this environment, rapid cuts in
fiscal support make sense if, and only if, monetary policy can be effective on its own and expanding the interest-
elastic parts of the economy is the best way to climb out of the hole. There is reason to doubt both ideas.

At the summit of the Group of 20 countries in Canada, leaders pledged to “halve fiscal deficits by 2013 and stabilise
or reduce government debt-to-GDP ratios by 2016”. It would make far better sense for governments to focus their
efforts on altering the long-term trajectory of spending. They may hope that retrenchment now will spur on private
spending. But what is their plan if it turns out that it does not?