Fixing Global Finance Martin Wolf, Associate Editor

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Fixing Global FinanceMartin Wolf, Associate
Editor Chief Economics Commentator, Financial
Times

• Global Interdependence Center
• Philadelphia 9th March 2009

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Fixing Global Finance
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Fixing Global Finance

• Simply stated, the bright new financial
  system for all its talented participants, for
  all its rich rewards failed the test of the
  market place. Paul Volcker, April 8th 2008

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Fixing Global Finance

• Things that cant go on forever, dont
  Herbert Stein

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Fixing Global Finance

• Destination disaster
• Crisis and response
• Scenarios for the future
• Roads to reform
• Assessment

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1. Destination disaster

• It is usual, especially in the US, to point to
  either failures of regulation or failures of
  monetary policy as the root causes of the
  disaster
• This is right, but too limited
• I see both as consequences of three deeper
  forces global imbalances credit boom and
  financial innovation

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1. Destination disaster the imbalances

• In the 1980s and 1990s, emerging market economies
  suffered a series of shattering foreign currency
  and banking crises
• These culminated in the Asian crises of 1997-98,
  the Russian and Brazilian crises of 1998-99 and
  the Argentine crisis
• A central feature of many of these crises was
  current account deficits, financed by short-term
  foreign currency borrowing
• When the crises hit, the currencies collapsed and
  the currency mismatches created mass bankruptcies

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1. Destination disaster the imbalances
ECONOMIC COLLAPSES IN THE ASIAN CRISIS
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1. Destination disaster the imbalances
AND HUGE FISCAL LOSSES FOR BAIL-OUTS
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1. Destination disaster the imbalances
RISE OF FOREIGN CURRENCY RESERVES
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1. Destination disaster the imbalances
THE GREAT IMBALANCES
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1. Destination disaster the imbalances
HOUSEHOLDS SPENT
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1. Destination disaster the imbalances
HOUSEHOLDS SPENT
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1. Destination disaster credit boom

• We have seen an extraordinary increase in credit
  and debt in the US and global economies over the
  past three decades
• These developments accelerated in the 2000s
• The latter was an era of low nominal and real
  interest rates and housing bubbles

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1. Destination disaster credit boom
GREAT DEBT BOOM
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1. Destination disaster credit boom
PRIVATE DEBT BOOM
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2. Path to a disaster innovation

• Meanwhile, clever people invented
• The originate and distribute model
• Securitisation and
• 64,000 synthetic triple-A rated securities!
• These were then placed in
• Conduits and special investment vehicles
• In the US shadow banking system and
• Across the western world.

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3. Crisis and response

• These were the background conditions for the
  financial euphoria of the mid-2000s
• What happened in 2008 is partly the result of a
  panic
• But that panic is rooted in the twin realities of
  a mountain of bad debt, plus a reversal in the
  previous excesses of consumer spending in the US
  and elsewhere
• Success bred excess and excess bred collapse

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3. Crisis and response

• The crisis has had three stages
• Incipient, from 2006 to August 2007
• Chronic, from August 9th 2007 to September 15th
  2008
• Critical, from September 15th 2008, when Lehman
  was allowed to fail
• The last event destroyed trust and undermined the
  functioning of the financial system
• It then led to the recapitalisation of banking
  systems, extension of government guarantees and
  gigantic expansions in central bank liquidity
  operations.

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3. Crisis and response
RISK AVERSION SPREAD, AS BANKS DREW BACK
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3. Crisis and response
DEATH OF THE MORTGAGE-BACKED SECURITIES
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3. Crisis and response
PANIC AND RECOVERY
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3. Crisis and response

• Actions of G7 governments in October saved core
  banking institutions
• Confidence is slowly returning
• But recessionary forces in the real economy are
  overwhelming
• Asset price collapses in housing and equities are
  ongoing across the globe and, not least,
• IMF estimates mark-to-market losses on US assets
  at 2.2trn.
• Credit markets remain dysfunctional and the
  shadow banking system has imploded
• Consumers are cutting back spending dramatically

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3. Crisis and response
THE GREAT BEAR MARKET
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3. Crisis and response
OUTPUT GOES OVER A CLIFF
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4. Scenarios for the future

• Globally, the idea of decoupling is dead, as
  emerging economies are hit hard - directly, the
  by loss of external demand, and indirectly, by
  the loss of external finance
• Deep recessions are now certain in the US and
  Europe
• No significant spending offsets will occur in the
  rest of the world
• So a prolonged global slow-down seems highly
  likely

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4. Scenarios for the future
THE GRIM FUTURE BUT IS IT GRIM ENOUGH?
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4. Scenarios for the future

• Scenario 1 Swift recovery
• Lower oil prices
• Lower interest rates and aggressive monetary
  expansion
• Massive fiscal boosts across the globe,
  particularly in the US
• Lower risk spreads across the globe and
• Quick restoration of demand in deficit countries
  and return to business as usual.
• Objection structural imbalances and debt
  overhang make a relapse likely
• This is a low probability outcome, but not
  impossible

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4. Scenarios for the future

• Scenario 2 Global breakdown
• Continued rapid rise in desired savings in
  high-income countries
• Ineffective fiscal stimulus
• Mass bankruptcy and soaring unemployment
• Friction between deficit and surplus countries
• Sterling and then dollar crises
• Protectionism and an end to the open world
  economy.
• Objection fear of catastrophe should force
  co-operation
• This also is a low probability outcome, too, but
  not inconceivable

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4. Scenarios for the future

• Scenario 3 Muddling through
• Lower oil prices and monetary and fiscal easing
  restore a degree of confidence
• Fiscal stimulus in surplus countries
• Modest pick-up of private spending and
• Slow recovery in US and other deficit high-income
  countries in 2010 and 2011.
• Point This is a knife-edge path, given the
  imbalances
• Scenario 3 is much the most likely. But it would
  leave fundamental challenges ahead

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4. Roads to reform

• This big US adjustment that I believe must lie
  ahead is compatible with global growth only if
  other countries have smaller surpluses or bigger
  deficits
• Oil exporters have a good reason to run big
  surpluses in the long run, because they are
  shifting one asset into another, though this is
  not a problem at the moment
• Non-oil exporters also need to reduce current
  account surpluses or increase deficits
• This means they must spend more relative to
  incomes
• China is the most important case

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4. Roads to reform

• So how are emerging countries to run current
  account deficits safely?
• The answer is that the external finance must
  itself be relatively stable
• There are three solutions
• Equity investment (FDI and portfolio)
• Local currency bonds or
• More collective insurance e.g. via the IMF
• The development of local-currency bond markets
  shifts a potentially lethal risk onto foreign
  investors

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4. Roads to reform

• Of course, the development of local currency
  finance also depends on
• A sustainable fiscal position
• A sound currency
• A well-regulated financial system
• Openness to foreign investors
• Without these qualities local currency finance
  will fail, for both domestic residents and
  foreigners
• Countries that cannot generate such conditions
  need exchange controls

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4. Roads to reform
RISE OF DOMESTIC CURRENCY FINANCING
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4. Roads to reform

• Still more important is a much bigger global
  insurance system.
• The IMFs lending capacity is about 250bn. It is
  trying to double it now, but it needs to be an
  order of magnitude bigger
• That will also require a big re-engineering of
  voting shares
• Today Europe has a third of the votes. That
  cannot last, particularly since the Europeans do
  not use the resources of the Fund

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5. Assessment

• This is a turning point for the world economy
• We have reached the end of the US as borrower and
  spender of last resort
• We have reached the end of the Asian export-led
  mercantilist model of growth.
• The reduction in internal imbalances depends on
  reducing the external imbalances, while
  maintaining global economic growth
• This depends on big changes in the rest of the
  world and reforms in the global financial system