Thursday, July 9, 2009 2 comments ++[ CLICK TO COMMENT ]++

A look at the global meltdown

Some say the current economic crisis has tarnished the reputation of economics. On the contrary. I feel that the crisis has finally re-invigorated economists. For the first time in many decades, serious research, not to mention consideration of alternative policies, is being undertaken. What would have seemed radical a decade ago is being discussed openly. There are a lot of theories floating around and no one knows who is right but it does make for an interesting show. Too bad we are all actors in this show, with our lives playing critical roles.

One of the outcomes of the current crisis has to be the rising popularity of books dealing with it. I haven't read any such book yet, mainly because I am so far behind on my reading of the classics, which are more important to my investing life. In the mean time, I do keep up by reading essays, reviews, and articles dealing with books or the subject matter covered in the books. One such article is Robert Skidelsky's look at Martin Wolfe's Fixing Global Finance. His essay takes a detailed look at two popular theories that purport to explain why things unfolded as they did, and who may have benefitted from all this. Some Americans may not like Robert's conclusion that America's imperial pursuits were partly to blame but it's well reading his thoughts. If one has time to kill and is interested in this topic, do check it out.

It's a long essay and here is a long excerpt from it:

The two most popular explanations to have emerged are the "money glut" and the "saving glut" theories. The first blames the crisis on loose fiscal and monetary policy, which enabled Americans to live beyond their means. In particular, Greenspan, chairman of the Federal Reserve in the critical years until his retirement in early 2006, used low interest rates to keep money too cheap for too long, thus allowing the housing bubble to get pumped up till it burst.

The second explanation sees cheap money in the US as a response to a "global saving glut" originating in East Asia and the Middle East. The "exorbitant privilege" enjoyed by the US dollar as the world's key currency allowed the US to pursue a fiscal and monetary policy that pushed domestic demand for goods and services well beyond domestic output, thereby absorbing the foreign savings hurled at it. The trouble was that foreign, and particularly Chinese, "investment" in the US economy, which in recent years has taken the form of buying US Treasury bonds, failed to create a corresponding flow of American tradable goods and services with which to repay the borrowing. As a result, America's domestic and foreign debt just went on increasing. In the technical jargon, both the US current account deficit and its debt-financed housing boom were unsustainable: it was unclear whether the dollar or the housing bubble would collapse first.

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Wolf's most recent book, Fixing Global Finance, marks a turning point in his worldview. Written in 2007, just before the first signs of the current financial crisis were starting to register, it explains how unprecedented macroeconomic imbalances have repeatedly created the preconditions for financial crises over the last three decades. It offers the reader a chance to test Wolf's predictions and prescriptions a few months after they were made.

Wolf's main argument is that the microeconomics of finance is intimately intertwined with the nature of the global macroeconomy. If the latter is not sound, the former will not be sound either. His eight chapters take us through a detailed account of the role of exchange rate regimes—i.e., policies used to maintain currencies at a desired level against the dollar—and their influence on balance of payments and, ultimately, on the availability and use of credit in domestic economies.

It was the large macroeconomic effects of financial crises in emerging markets in the 1990s that enabled America to become what Wolf calls the "borrower and spender of last resort."

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Despite the density of its argument and its skepticism about the possibility of reform in the short term, Wolf's book offers important pointers to the way ahead. But his story is only half-told. He has very little to say about America's responsibility for both creating and ending the system of global imbalances. For the fact is that the present system has suited the United States—specifically the power holders in the United States—just as much as it has those in China. The phrase "it has enabled the Americans to live beyond their means" is too vague to be useful. One needs to ask: which Americans? Certainly many middle- and low-income American households have been given opportunities to borrow beyond their means.

But secondly, the American–Chinese symbiosis has been excellent for US business profits. American businessmen have been complicit in Chinese "super-competitiveness" by arranging for manufacturing jobs to be moved to China from the US in order to cut costs. The decline in US manufacturing and the growth in nontradable services, and the financial operations that secured this restructuring, have enabled financiers and businessmen to earn huge profits that should have been shared with their workers. Morally, the financial community has been living well beyond its means. But perhaps above all, by getting other countries to finance its imperial pretensions, the US government has been able to live beyond its means. Wolf refers in several places to the "exorbitant privilege" of the US dollar, but omits entirely to discuss the political benefits that this privilege buys.

This points to the main weakness of Fixing Global Finance: the lack of a historical perspective. The history of the overprivileged dollar, after all, goes all the way back to the 1960s. Its roots lie in the failure of John Maynard Keynes's plan for a Clearing Union, which he worked out during World War II. The Keynes plan was specifically designed to prevent creditor countries from hoarding reserves by trading at undervalued currencies. If they did not spend their surpluses, the surpluses would be confiscated and redistributed among debtor countries. In this way a global balance between saving and investment would be secured through a balanced trade position, which would in turn allow fixed, but adjustable, exchange rates.

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2 Response to A look at the global meltdown

Daniel M. Ryan
July 10, 2009 at 1:51 AM

One of the unanswered questions about the bubble is why Greenspan held down rates for so long. The only answer I've come across tend to either impugn the man's public-spiritedness or dole out the same old cynicism. "Greenspan wanted to keep his job"; "Greenspan wanted to help his buddy Bush"; "Greenspan loved power"; etc, etc. All of them can be debunked though a few well-placed questions.

One point about something in the excerpt: I've noticed that real skill in prognostication tends to go hand-in hand with skepticism about reform. Maybe the insightful prognosticators know too much about human beings to get their hopes up.

Sivaram
July 10, 2009 at 11:04 AM

A lot of people blame Greenspan but I'm not as critical of him for what happened in early 2000's (I am not a fan of him in general though). The long term rates stayed low even after the FedRes started hiking rates (recall the so-called conundrum). I don't think the FedRes is the root cause of the problem. It was the foreign central bank buying, which kept long term rates really low. In other words, I guess I"m in the second camp in the quote above (i.e. savings glut theory).

The flaw with Greenspan--many on the right will disagree with me--is that he seems to believe the market is almost always right and less regulation is always best. In reality, the market can be completely wrong, especially during bubbles.

Just like how he did nothing about the massive stock market bubble in the late 90's because he thought the stock market is more right than anyone, I suspect he relied excessively on market behaviour in the early 2000's. The stock market looked weak, and real estate, although in a bull market since the mid-90's, wasn't really showing strong signs either. I don't know if you were investing or following the markets closely in the early 2000's (I started seriously investing aroudn that time) but the stock market was really weak. I think Greenspan was trying to boost stocks, and possibly real estate as well.

My view is that the major flaw is that Greenspan always cared more about asset prices, such as stock prices or real estate prices, than about the economy. The FedRes was really agressive after every serious stock market sell-off irrespective of the economy or whether stocks were cheap.

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