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October 10, 2009

Economist's View - 3 new articles

"Global Imbalances and the Financial Crisis: Products of Common Causes"

Maurice Obstfeld and Kenneth Rogoff attempt to sort out the role that global imbalances played in the financial crisis. This is the introduction to their paper:

Global Imbalances and the Financial Crisis: Products of Common Causes, by Maurice Obstfeld and Kenneth Rogoff, October 2009 (Conference Draft): In my view … it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. --Ben S. Bernanke1
Introduction Until the outbreak of financial crisis in August 2007, the mid-2000s was a period of strong economic performance throughout the world. Economic growth was generally robust; inflation generally low; international trade and especially financial flows expanded; and the emerging and developing world experienced widespread progress and a notable absence of crises.
This apparently favorable equilibrium was underpinned, however, by three trends that appeared increasingly unsustainable as time went by. First, real estate values were rising at a high rate in many countries, including the world's largest economy, the United States. Second, a number of countries were simultaneously running high and rising current account deficits, including the world's largest economy, the United States. Third, leverage had built up to extraordinary levels in many sectors across the globe, notably among consumers in the United States and Europe and financial entities in many countries. Indeed, we ourselves began pointing to the potential risks of the "global imbalances" in a series of papers beginning in 2001.2 As we will argue, the global imbalances did not cause the leverage and housing bubbles, but they were a critically important codeterminant.
In addition to being the world's largest economy, the United States had the world's highest rate of private homeownership and the world's deepest, most dynamic financial markets. And those markets, having been progressively deregulated since the 1970s, were confronted by a particularly fragmented and ineffective system of government prudential oversight. This mix of ingredients, as we now know, was deadly.
Controversy remains about the precise connection between global imbalances and the global financial meltdown. Some commentators argue that external imbalances had little or nothing to do with the crisis, which instead was the result of financial regulatory failures and policy errors, mainly on the part of the U.S. Others put forward various mechanisms through which global imbalances are claimed to have played a prime role in causing the financial collapse. Former U.S. Treasury Secretary Henry Paulson argued, for example, that the high savings of China, oil exporters, and other surplus countries depressed global real interest rates, leading investors to scramble for yield and underprice risk.3
We too believe that the global imbalances and the financial crisis are intimately connected, but we take a more nuanced stance on the nature of the connections. In our view, both of these phenomena have their origins primarily in economic policies followed in a number of countries in the 2000s (including the United States) and in distortions that influenced the transmission of these policies through financial markets. The United States' ability to finance macroeconomic imbalances through easy foreign borrowing allowed it to postpone tough policy choices (something that was of course true in many other deficit countries as well). Not only was the U.S. able to borrow in dollars at nominal interest rates kept low by a loose monetary policy. Also, until around the autumn of 2008, exchange-rate and other asset-price movements kept U.S. net foreign liabilities growing at a rate far below the cumulative U.S. current account deficit. On the lending side, China's ability to sterilize the immense reserve purchases it placed in U.S. markets allowed it to maintain an undervalued currency and postpone rebalancing its own economy. Had seemingly easy postponement options not been available, the subsequent crisis might well have been mitigated, if not contained.4
We certainly do not agree with the many commentators and scholars who argued that the global imbalances were an essentially benign phenomenon, a natural and inevitable corollary of backward financial development in emerging markets. These commentators, including Cooper (2007) and Dooley, Folkerts-Landau, and Garber (2005), as well as Caballero, Farhi, and Gourinchas (2008) and Mendoza, Quadrini, and Rios-Rull (2007), advanced frameworks in which the global imbalances were essentially a "win-win" phenomenon, with developing countries' residents (including governments) enjoying safety and liquidity for their savings, while rich countries (especially the dollarissuing United States) benefited from easier borrowing terms. The fundamental flaw in these analyses, of course, was the assumption that advanced-country capital markets, especially those of the United States, were fundamentally perfect, and so able to take on ever-increasing leverage risklessly. In our 2001 paper we ourselves underscored this point, identifying the rapid evolution of financial markets as posing new, untested hazards that might be triggered by a rapid change in the underlying equilibrium.5
Bini Smaghi's (2008) assessment thus seems exactly right to us:
[E]xternal imbalances are often a reflection, and even a prediction, of internal imbalances. [E]conomic policies … should not ignore external imbalances and just assume that they will sort themselves out.6
In this paper we describe our view of how the global imbalances of the 2000s both reflected and magnified the ultimate causal factors behind the recent financial crisis. At the end, we identify policy lessons learned. In effect, the global imbalances posed stress tests for weaknesses in the United States, British, and other advanced-country financial and political systems – tests that those countries did not pass. ...

See also: Why are we in a recession? The Financial Crisis is the Symptom not the Disease! [open link]. The paper argues that the huge increase in the labor supply available to developed countries is the primary force behind our current troubles. Here are parts of the introduction and conclusion:

The impact of globalization is a sharp increase in the developed world's labor supply. Labor in developing countries – countries with vast pool of grossly underemployed people – can now compete with labor in the developed world without having to relocate in ways not possible earlier. ... [W]e argue that this huge and rapid increase in developed world's labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today.2 The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom. ...

10 The Way Forward The common wisdom is that cheap money and lax supervision of financial institutions led to this financial crisis, and solving that crisis will take us out of the recession. In our view, the financial crisis is just the symptom. The fundamental cause of the crisis is the huge labor supply shock the world has experienced, not the glut in liquidity in money supply.

Recovery will only occur when structural imbalances in global capital flows are corrected, in part through higher saving in developed nations and in part through greater capital flows into developing nations. ...

It may be tempting for those in power to close the door to outsourcing of manufacturing and other activities. While that may provide some immediate relief, it will accentuate other problems...

When millions of World War II soldiers returned home that increased the US labor force of about 60 million workers by almost 25% within a very short period of time. At that time the Department of labor, which certainly had no cause to accentuate the negative, predicted that 12 to 15 million workers would be unemployed.28 That did not happen! We managed that problem well leading to prosperity instead of doom, thanks in no small part to the GI Bill and other governmental fiscal intervention. We can manage this one as well. For that to happen, the first step is to recognize the problem for what it is. A solution may well require actions similar in scope to the GI Bill and require a national debate.

While there is plenty of blame to go around for mistakes, the macro forces triggered by the labor shock is like a tidal wave that needed to wash ashore no matter what. History might have taken an entirely different path with better risk management controls in place in the US but then again, financial innovation might just have found a different way of getting highly leveraged deals done off-shore or through creative accounting.29 The root cause of the excess liquidity in the global financial system must be addressed, otherwise we are just squeezing the proverbial balloon only to see it bulge out somewhere else. However, this does not negate the need for the development of improved risk management in the broadest sense in order to ensure financial stability and prosperity going forward.

China and India will continue to need to bring tens of millions of rural laborers into the productive workforce in the coming decades and the world economy must find a sustainable way of dealing with this influx. Clearly China's export led growth strategy of the past cannot continue indefinitely and domestic consumption must be allowed to grow as a share of GDP. At the same time, Western economies must adjust to a new equilibrium in which commodities are scarcer and households will face stiffer competition for jobs.

links for 2009-10-09

"Optimism Amid Uncertainty"

Max Lichtenstein and Jessica Renier of the Dallas Fed give their view of the outlook for the national economy:

Optimism Amid Uncertainty, by Max Lichtenstein and Jessica Renier, FRB Dallas: As we enter the final quarter of 2009, a number of important indicators are beginning to show expansion, suggesting that the trough of the current contraction may have come in the second quarter of this year. However, not all incoming information has been positive. Some data suggest that any optimism should be tempered, that this fledgling recovery has a long way to go before the economy achieves stability, and that the key word moving forward is "uncertainty."

Manufacturing Up, but Job Losses Give Reason for Pause An example of recent growth is the Institute for Supply Management's Purchasing Managers Index for Manufacturing. In August, this indicator crossed the critical threshold of 50 for the first time since January 2008. And it remained above 50 during September with a value of 52.6. This typically signals expansion in the manufacturing sector. The ISM's nonmanufacturing indicator also rose into expansion territory for the first time in a year, to a value of 50.9 (Chart 1).

Chart 1 ISM manufacturing and nonmanufacturing indexes in expansion territory

Conversely, the job picture in September is no cause for excitement. During the month, the economy shed 263,000 jobs, and the unemployment rate rose to 9.8 percent (Chart 2). The story becomes somewhat more worrisome when looking at only private-sector jobs. As of September, the number of nongovernment jobs was just below that seen in June 1999, leaving the impression that 10 years of private sector progress has been lost through 21 months of labor market downturn.

Chart 2 Job losses still give reason for worry

There is some optimism to be found in the job market, however. Job losses in housing-related industries are now tapering off at about the same pace as in nonhousing-related activities, suggesting that the structural adjustment that this sector has been undergoing since roughly 2005 may be coming to an end.

Housing Market Hints at Steps Toward Normalcy Taken together, existing-home sales and new housing starts give the impression that the housing market may have finally bottomed out (Chart 3). It's possible that the apparent stabilization has been artificially induced, in part, by the temporary tax credit for first-time homebuyers, something that will become clearer when the tax credit expires in December. Even so, the improvement in housing market conditions is apparent in the flattening of home prices during the three months of second quarter 2009—the first time in six quarters that prices have declined by less than 3 percent. Unfortunately, this too could give way to additional price declines once the large foreclosure inventory on banks' balance sheets hits the market.

Chart 3: Sales and starts consistent with housing market bottoming out

Perhaps the most persuasive evidence that the housing downturn has halted comes from the indicator of five-month-moving-average, single-family housing permits, which we use in gauging the housing cycle. According to this indicator, the housing downturn that started in December 2005 may have ended in April of this year, making it the deepest in magnitude and the third-longest on record (Chart 4).

Chart 4: Duration and depth of downturns in single-family building permits since 1964

Consumer Fears Ease and Prices Remain Subdued The pervading unease that has typified consumer spending seems to be gradually lifting as well. Headline retail sales climbed 2.7 percent in August, the biggest monthly advance since January 2006. The monthly gain remained solid—1.1 percent—even after excluding products benefiting from the cash-for-clunkers program. In addition, the University of Michigan's indexed consumer confidence indicator has risen 15 points since the end of last year, when it hit low levels comparable with those seen in the first- to third-quarter 1980 downturn.

Finally, changes in prices have remained relatively subdued. In both July and August, year-over-year CPI inflation was between –1.4 and –1.9 percent, while core CPI inflation remained about one point below its average over the past decade. Long-term inflation expectations, as implied by forward rates, similarly remain close to historical levels.

Financial Indicators Provide Market Optimism On the financial side, a host of indicators used to assess the stress of credit and securities markets are returning to historical levels, reinforcing the view that markets are beginning to heal. That is certainly the message coming from the three-month LIBOR–OIS spread. After a period of uncharacteristic elevation, the spread is quickly approaching levels seen well before the current downturn started (Chart 5).

Chart 5: three-month libor-OIS spread returning to normal level

Judging from the lower fraction of banks tightening credit standards on consumer and mortgage loans—on average, 20 percent fewer banks report tightening—financial intermediaries are feeling more comfortable about their current level of scrutiny toward borrowers (Chart 6).

Chart 6: fewer banks tighten consumer and mortgage loan standards

Unfortunately, troubles in the financial intermediation industry seem to have shifted from nonconventional credit markets to the traditional banking sector. However, the number of bank failures is still moderate by historical standards. In fact, the number of recently failed banks is comparable with the number coming out of the 1980–81 recession (Chart 7). A similar message comes from the size of failed banks, which, measured by the sum of their nominal assets as a percentage of gross domestic product (GDP), is still within the range observed in the mid-1980s when the U.S. economy was expanding.

Chart 7: Number of U.S. bank failures withing historical range

Uncharted Waters All in all, an examination of the usual indicators seems to suggest that the worst of the recession is over and that sufficient conditions for growth may finally be in place.

However, the speed of an eventual recovery is the subject of a wide range of opinions. The disparity in views can be traced in part to an unusual feature of this contraction: Despite sharp declines in employment and GDP, the overall efficiency of the economy (based on total factor productivity) appears to have remained intact throughout the downturn.

Deep contractions, both in the U.S. and internationally, are typically accompanied by large declines in the efficiency of the economy. The departure from this standard makes it particularly difficult to assess the characteristics of an eventual recovery.

Typically, more-severe-than-average contractions are followed by stronger-than-average recoveries. But the very presence of this productivity anomaly suggests that the U.S. economy is not living through normal times. As a result, policymakers will still be navigating uncharted waters in the months to come.

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