Reasons for the Crisis: Message 10/10

x) The day after tomorrow, the world will be different. 

We may be walking towards a world where governments will have a much larger role in all economies;  where financial intermediationwill be a state-controlled "utility";  where "deglobalization" will happen;  where societal preferences for consumption will be subdued;  and where there will be more than one globalreserve currency.  Developing countries will have true autonomy-----they will now have to rely more on their own internal capacity.  And the "new USA" will still count on its fundamental advantages (unparalleled rule of law; inside track in science and technology; growing population; unmatched military) but it will be a more frugal place, and no longer the engine of growth for the rest of the world.

Reasons for the Crisis: Message 9/10

ix) The multilaterals will become bigger before they become fairer.  

Enlarging the financing power of multilaterals, especially the IMF, has been the correct move, and more of it may still be necessary.   This could be complemented with new liquidity and guarantee facilities, especially for the private sector.  Welcome are also the various new or enhanced forums for global policy coordination (like the G20).  But there is no illusion that global governance will change much any time soon because, in any grand bargain, the power of European countries will have to be trimmed, something that is not seen as politically feasible.  

Reasons for the Crisis: Message 8/10

viii) Macroeconomics will move towards growth-targeting. 

Calls for central banks to go beyond inflation targeting are becoming louder.  Those calls range from asking central banks to target credit or asset prices, to plainly asking for targets on short-term aggregate demand or on the so-called "output gap".  Behind this, there is an increasing recognition that the state (not just the central bank) can and ought to target short-term growth.   This is reinforced by two related factors:  financial markets will remain dysfunctional for a while, and fiscal/monetary stimuli have recently been shown to work better when firms are credit constrained.  The question is which institution should be in charge of "growth targeting", and with which tools.   As central banks begin to lend directly to the private sector ("quantitative easing"), in effect they begin to manage a parallel and unlimited fiscal budget.  It is then a matter of time before Congresses lay claim on that budget, and the central banks lose their independence.

Reasons for the Crisis: Message 7/10

vii) Finance will become simpler.  

There is a general recognition that the market cannot keep financial agents in check.  At some point, they become so systemically important that they cannot be allowed to fail and have to be bailed out.  So a regulatory system is necessary.  The question is of whether that system can continue to rely on markets at all.  Basle II is all but dead.  Its focus on single-bank capital adequacy, internal risk models and credit ratings is seen as grossly inadequate to take care of systemic risk, the procyclicality of marking assets to market, or the intrinsic conflict of interests of credit rating agencies.  Technical ideas to fix those problems abound:  creating a "systemic risk tax" not unlike carbon emission taxes;  shifting capital requirements towards the funding structure (rather than the asset structure) of financial intermediaries;  demanding FDA-type of "health certifications" for new financial instruments;  focusing on the vulnerabilities of the "financial network" using the same protocols that govern the internet;  and so on.  But these sound more like attempts to fix the system that failed than to create a new one.  More likely, the financial industry will become a "utility", whereby a single or a few private suppliers get a government license to provide a standardized service at a regulated price and under heavy supervision.  This will make financial innovation more unusual.

Reasons for the Crisis: Message 6/10

vi) The poor will suffer less than the middle-class. 

In developing countries, the main contact point between people and crisis will be the contraction in labor demand (not a sudden change in relative prices or a sudden loss of wealth, as in the past).  This will affect primarily urban formal workers in tradable sectors.  That is, it will affect proportionally more the middle classes. The poor were already credit-, demand- and productivity-constrained.  So the usual mechanisms to cushion the social impact of the crisis may not suffice.   Social assistance may need to be complemented by social insurance.

Reasons for the Crisis: Message 5/10

v) The export-led development model needs rethinking.  

The rich world's absorptive capacity will not come back to its previous level for a while, if ever.  Emerging markets will need to rebalance their sources of growth towards domestic and "south-south" demand.  The new internal reliance will not apply just to output;  it will also apply to inputs, as foreign savings will not be available to fund investment.  This will be accompanied by an appreciation of the real exchange rate in developing countries, as the price of tradable goods will be depressed and calls for their subsidization will multiply (directly, through trade protection, undervalued currencies, or financial repression).  Completing a new round of trade negotiations will become more difficult.   Small economies will suffer the adjustment the most.

Reasons for the Crisis: Message 4/10

iv) The impact on developing countries will be slow but harsh.  

Contagion is happening through four main channels:  export demand; remittances; commodity prices; and financing flows.  But most emerging markets will be spared the symptoms of past crises----huge devaluations, interest rate increases, inflationary spikes, banking collapses, debt defaults.  Instead, the initial impact will come through an interruption of foreign bank finance to the domestic private corporate sector. This will slow down trade and delay investment projects.  The early data shows that already.  This will be followed by increasing difficulties in rolling over government debts in 2010 (the next iceberg).  The availability of external funding will be further impaired by the crowding-out effect of heavy borrowing by rich countries to pay for their stimulus programs.   So, less exports, less investment and less fiscal space will bring growth to a halt among developing economies, and may complicate the solvency of those that do not have deep domestic financial markets.

Reasons for the Crisis: Message 3/10

iii) By now, there is little else policy-makers can do.  

After some understandable, initial hesitation, the overall policy response to the crisis has been reasonable.  But the contraction in global aggregate demand is likely to be so big that, even with the best of coordination, it cannot be offset by fiscal stimuli and monetary easing.   The auction system for trading in toxic assets recently announced by the US is a step in the right direction, but it will take a long time to work, if it works at all.  Bank nationalization will not add much;  de facto, it already happened.  There is no first-best policy responses left (the numbers are just too large and the information too weak).  

Reasons for the Crisis: Message 2/10

ii) Things will get worse or much worse before they get better.  

The consequences of the crisis have not yet fully unfolded.  On the one hand, the global rebalancing of saving and consumption patterns has barely started. US consumers are said to have lost $13 trillion in wealth, something that should cut their consumption by about half-a-trillion dollars a year.  Their "deleveraging" (debt reduction) process has barely begun.   On the other hand, the flow of credit will not really restart until the balance sheet of the largest banks is cleared of the bulk of toxic assets.  The problem is that we do not have yet a price for those assets which, to make matters worse, continue to lose value as the real economy contracts.  Housing prices are still too high compared to their true rental value, so further downward corrections will take place.  By now, the toxicity is spreading to asset classes beyond mortgage-backed securities (credit cards and auto loans in particular).   And all this assumes that three low-probability-huge-impact risks will not materialize:  a "sudden stop" of capital flows to the US (by China among others); a global run away from the dollar; and a spiral of trade protection.  

Reasons for the Crisis: Message 1/10

On April 20 and 21, I attended a special meeting of the "Growth Commission" which took place at Harvard. 

It was an impressive, closed-door gathering of some of the best minds in the profession. There were four Nobel laureates (Akerlof, Scholes, Solow, Spence);  a line-up of academic luminaries (Acemoglu, Aghion, Banerjee, Calomiris, Cooper, Feldstein, Frankel, Hausmann, Ito, Kenen, Portes, Romer, Rodrik, Sheng);  renown current and former policy-makers (Ahluwalia, Boediono, Blejer, Han, Malan, Venner);  leading market players (El-Arian, O'Neill, Steer);  and international civil servants (Dervis, Watanabe).  Ngozi, Danny, Justin, Lars and Otaviano led the Bank's participation.     

There were more than 30 presentations in two days, over an agenda that focused on the global crisis.  Below are the "Ten Main Messages" I carried from the meeting:   

i) The crisis has many culprits.  A series of interconnected factors combined to produce the crisis, some causative and some amplifying.  First, excess liquidity creation by the US in what appears to be a loss of control by the Fed.  Second, a consequent mega imbalance between savings and consumption across the world (roughly, the US consumed while the rest of the world saved).  Third, failure of regulation, especially over the segment of the financial industry that was left to operate on its own because it did not technically take deposits but grew so large as to carry massive systemic risk (the "shadow banking" of, among others, hedge funds and special investment vehicles).  Fourth, subsidies to housing, from the tax treatment of mortgage interest to the implicit guarantees of Freddie Mac and Fannie Mae.  Fifth, pro-cyclical accounting principles that mechanically marked assets at market prices even when there was no longer a market.  Sixth, myopic underestimation of tail-end risk ("black swans" events).   Seventh, global lack of sound and liquid financial assets, which kept investors pouring money into the US.   Eighth, agency problems between shareholders of financial institutions and their celebrity managers ("fake alpha" traders).  Ninth, unbridled "animal spirits" in the form of greed and herd-like behavior by investors.  And, tenth, securities so complex that only a few traders could tell good from bad ("snake-oil securities").