Paul Krugman and Uncertain Markets
September 18, 2010
In a review of three recent books (by Raghuram Rajan, Nouriel Roubini and Richard Koo) on the global crisis, the Nobel Laureate Paul Krugman (and his wife Robin Wells) provides a fascinating and succinct analysis of the crisis: what were the causes and why it morphed into something so serious. An article on what needs to be done to finally get us of this mess will follow. We are indeed fortunate, to have a brilliant economic mind such as Professor Krugman (possibly the brightest economist of his generation), to be out there in the public arena distilling complex economic and financial issues in a clear and easy to understand manner. While one may not agree with his political leanings, it is difficult to argue against his economics! To summarise:
- While aggressive policy actions were successful in averting a repeat of the Great Depression, we continue to be mired in the consequences of the crisis – anaemic economic growth and high intractable unemployment.
- There continues to be furious debate of the effectiveness of the monetary and fiscal measures taken so far, and loud proclamations about what we must not do – but precious few suggestions on what must be done now to dig us out of the hole.
- There currently exists a “self-induced paralysis” on part of policy makers and economists who are unable (unwilling?) To make sound proposals to address the critical issue of mass unemployment.
- There are four popular explanations of the great North Atlantic real estate bubble which caused housing prices to rise from 1997-2007 by 175% in the US, 180% in Spain, 210% in the UK and 240% in Ireland.
It seems the bubble largely got started by the global savings glut, but then developed a momentum of its own, aided and abetted by financial innovation and lax regulation. Bubbles are a recurring feature of financial markets and the real estate bubble was a “white swan” – not a highly unusual event, albeit much bigger than most.
- Low Interest Rate Policy of the Fed: the prolonged period of low rates in the aftermath of the bursting of the technology bubble is not the main cause of the real estate bubble as it was justified from a perspective of supporting what was an usually slow recovery and to avert a deflationary trap. In addition, the ECB was not half as aggressive as the Fed in decreasing rates but the real estate bubble was a North Atlantic phenomena.
- The Global Savings Glut: this provides the most plausible explanation as Asian and Middle East countries ran huge trade surpluses, by generally maintaining undervalued currencies, in order to accumulate large hoards of foreign currency reserves to provide insurance against a repeat of the Asian financial crisis. These assets were ploughed into long-term bonds and other assets in the North Atlantic countries which drove down long-term rates, thereby fuelling demand for spending and housing. This was again a North Atlantic phenomena, as long-term rates fell even more in some European countries like Spain and Ireland.
- Out of Control Financial Innovation: while financial innovation and dodgy practices may have made the effects of the housing bust more pervasive, they are unlikely to have been the main cause - the riskiest assets were typically kept by the banks resulting in a concentration of risk in the financial system, the bubble in Europe was inflated generally without complex financial instruments , and the housing bubble was matched by a commercial real estate bubble which was financed mainly by bank lending.
- Moral Hazard Created by Government Programs: this explanation does not hold water as the huge growth in the sub-prime market was not underwritten by government agencies like Fannie Mae and Freddie Mac, but by private mortgage lenders and few of these institutions were banks and therefore subject to the Community Reinvestment Act (which encouraged banks to lend to their local communities).
The technology crash of 2000-2002 was a $5 trillion hit to US household wealth while the housing bust was not a much bigger $8 trillion hit (taking into account inflation and economic growth in the interim) – so why did the latter morph into the worst global crisis since the 1930s?
This was because of the excessive build-up of debt and leverage in the financial sector, but more importantly, among non-financial players like households and the largely unregulated and unsecured “shadow banking” sector.
By 2007, the shadow banking sector accounted for about 60% of the US banking system and soon became the “heart of what would become the mother of all bank runs” as per Roubini.
In Europe, this took a different form with banks making loans far in excess of their deposits, and funding the balance through wholesale funding (i.e. from other banks and investors). When the wholesale market froze-up the governments had to step-in the guarantee the banking system, in some cases well in excess of their GDPs. However, this wasn’t just a crisis of the banking system because restoration of confidence in the banking system has not brought about strong and sustainable economic growth.
Banks were only part of the problem, with the most likely answer lying in the theories of the late Hyman Minsky, a heterodox and long-neglected economist whose moment has finally come.
Minsky held that eras of financial stability set the stage for future crises, as players engage in ever-more-risky speculation with ever-larger quantities of debt. This game goes on as long as asset prices keep rising, but sooner or later the music stops as the market realises that prices cannot rise for ever, and the focus shifts to the excess debt – i.e. the “Minsky moment”.
The shift of focus to debt and its repayment becomes destructive as everyone’s attempt to pay off debt by selling assets leads to a vicious circle of falling asset prices and rising distress. The de-leveraging process has wider economic consequences as households and private players attempt to pay down debt by cutting spending, which reduces the economy’s income and keeps it persistently depressed.
In the short run, the only way to avoid a deep downturn is to offset the private sector’s pay down of debt by an increase in government debt – until the private sector pulls back. The surge in budget deficits globally, was arguably even more important than the financial rescue, in preventing the crisis from developing into a full blown replay of the Great Depression.
Paul Krugman makes a convincing case in favour of the global savings glut/imbalance being the main cause of the global crisis, and why the de-leveraging process is likely to hold back economic recovery until the debt overhang is reduced to reasonable levels on a historical basis. Martin Wolf of the FT has also argued for a while that the global imbalances lie at the root of the crisis, and unless they are tackled in a serious and coordinated manner we are just laying the seeds for the next crisis. It is worrisome to note that global imbalances continue to grow, and countries seem to have embarked on unilateral policies to maintain weak exchange rates to support their export industries and access foreign private demand. As mentioned last week, this is likely to cause increasingly fractious retaliatory trade policies and begin to reverse the process of globalisation.
Markets were stronger on the back of better than expected economic data last week – but remain in an uncertain and volatile trading ranges (see graph below from Sy Harding). I continue to believe there is more downside risk, to economies and markets, over the next two months as the downturn in leading economic indicators results in downside surprises in production and unemployment claims with the usual time lag. The growth contribution to US GDP of the stimulus package and inventories (which have contributed most to growth so far) is likely to be -1% for the 3rd quarter and peak at -2% for the 4th quarter of this year (a swing of considerable 6-7 points!).
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