Fixing Global Finance Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

Fixing Global FinanceMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Global Interdependence Center Philadelphia 9th March 2009

Fixing Global Finance

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

Fixing Global Finance “Things that can’t go on forever, don’t” Herbert Stein

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

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

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

1. Destination disaster – the imbalances ECONOMIC COLLAPSES IN THE ASIAN CRISIS

1. Destination disaster – the imbalances AND HUGE FISCAL LOSSES FOR BAIL-OUTS

1. Destination disaster – the imbalances RISE OF FOREIGN CURRENCY RESERVES

1. Destination disaster – the imbalances THE GREAT IMBALANCES

1. Destination disaster – the imbalances HOUSEHOLDS SPENT

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

1. Destination disaster – credit boom GREAT DEBT BOOM

1. Destination disaster – credit boom PRIVATE DEBT BOOM

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.

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

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.

3. Crisis and response RISK AVERSION SPREAD, AS BANKS DREW BACK

3. Crisis and response DEATH OF THE MORTGAGE-BACKED SECURITIES

3. Crisis and response PANIC AND RECOVERY

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

3. Crisis and response THE GREAT BEAR MARKET

3. Crisis and response OUTPUT GOES OVER A CLIFF

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

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

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

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

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

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

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

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

4. Roads to reform RISE OF DOMESTIC CURRENCY FINANCING

4. Roads to reform • Still more important is a much bigger global insurance system. • The IMF’s 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

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

Fixing Global Finance Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times