I’m conscious of George Bernard Shaw’s comment that, “If all the economists were laid end to end, they would never reach a conclusion.” So I’ll try to be more of a one-handed economist and make 9 points on the global crisis.
We’ve seen this before. Guess the country.
The asset market boomed for 12 years before the collapse. Foreign buyers were active. Fraudulent practices developed. There were shady derivative trades, widespread default,and in the aftermath, a vigorous debate on regulation. The economy went into deep recession and bankruptcies doubled.
I’m referring to Amsterdam, Tulipmania, and the crash of 1636.
At the height of its activity, prices for the rarest bulbs ranged from 6 to 20 times the annual income of artisans, and twice the amount that Rembrandt received for painting “The Night Watch” in 1639.
Property prices on the Herengracht fell by 40 percent. (No doubt also due to the wave of bubonic plague which spread across northern Europe and killed 15 percent of Amsterdam’s population in 1636.)
We’re familiar how financial cycles begin.
Reductions in the cost of financing encourage credit creation, carry trades and leverage, and fuel asset prices. Investors take on greater risk in the search for higher yield and in doing so, significantly lower risk premia.
Dominant institutional investors placing similar bets, share similar benchmarks, and have similar pricing and risk management platforms.
All face the pressure of meeting short-term profit goals, and outperforming peers. We saw this pattern in the lead-up to the Argentinean crisis in the late 1990s. Investors continued to provide bond financing to Argentina –often at declining spreads – fearful of missing out on returns captured by those who preceded them.
Argentina came to represent nearly one quarter of the emerging market bond index. Rather than requiring higher risk premiums from an increasingly leveraged borrower, investment managers benchmarked to the emerging market bond index felt obliged to buy at the going price.
Economists should be modest about their forecasting ability.
Let me illustrate.
About 3 years ago, I was in a meeting with Alan Greenspan. Someone asked him the usual question “What did he see as the biggest systemic risk?” His answer, “The Chinese Banking system.”
About 15 months ago, I was at a G20 Deputies Meeting and shortly after, a meeting of the Financial Stability Forum. The US representatives were asked about the risk associated with the sub-prime problem. The meeting was assured that this was not something to be concerned about.
In March this year, I was at an IMFC Deputies Meeting. The Fund was forecasting GDP growth of 1.5 percent for OECD Europe this year and next. The European delegates were highly critical of what they considered the IMF’s pessimistic outlook.
Globalization is making economic and financial cycles more difficult to manage.
Most OECD countries have had low rates of underlying inflation for 25 years or more. Many had declining debt ratios for much of this period.
But governments have not been able to protect their economies from repeated asset price bubbles. We’ve seen several such bubbles since the Asia crisis in the late 1990s. Risk capital moves rapidly from one asset class to another as each cycle plays out. These bubbles have now demonstrated the power to generate macro instability at the global level.
International capital flows increasingly dominate our cycles of industrial production. These flows, and the complex financial engineering which accompanies them, are overpowering the traditional instruments of monetary policy and the regulatory architecture.
The current cycle still has a long way to go.
The crisis has demonstrated how all of the elements that will form the Basle II pillars, can fail in a G7 economy, including market discipline. Many factors contributed to the crisis, including a breakdown in underwriting standards, an erosion of market discipline and risk management weaknesses.
But two factors dominate others – the rapid growth in global liquidity and the permissive regulatory environment.
Real interest rates were very low in the first half of the decade, and there was little regulation around complex structured financial products. When the credit crisis intensified, policy mistakes were made. Bailout packages never got ahead of the markets, and the way in which the Lehman’s collapse was handled led to a complete breakdown in trust among financial intermediaries.
From that point onwards, the challenge became how to prevent a collapse of the global financial system and a deep global recession.
The speed with which the crisis is affecting economic activity around the world is staggering. Most OECD economies are already in recession (the numbers tomorrow are likely to confirm that the rest of Western Europe has joined Germany in recession).
The changes in household wealth taking place are unprecedented. Some estimates put the decline in household wealth in the US at around $9 trillion. Others put it much higher. About a quarter of US households with mortgages – about 12 million homes – currently have negative equity and in about half of these, the negative equity is above 20%.
Many analysts suggest that US real estate prices have another 10-15% to fall – assuming the market doesn’t overshoot. And we see commodity prices almost in freefall. Brent crude traded at $52 this morning, copper prices have fallen by 52% since 1 September, and wheat futures for December delivery are 62% below their peak in February. And global freight cost along key routes have declined by 80% since the collapse of Lehman.
Don’t put all your hopes on China in the short term.
In medieval times, China was the dominant economy in the world. It’s likely to recapture that standing in the next 30 years. But since August, China has been experiencing its sharpest slow-down since the early 1980s. The official data for October is very weak – industrial output and electricity generation are declining, and over 20% of China’s steel capacity is idle.
Taiwanese manufacturing data which captures companies with significant operations in China showed manufacturing revenue declining at a 40% annualized rate in the 3 months to October.
Japanese exports of machinery orders fell 26% month-on-month in October – China has been the key market for Japanese machinery companies in the last 5 years.
The fiscal policy package announced by the Chinese Authorities late last week implied a fiscal expansion of around 11.5% of GDP. But if one assumes that government spending – which has been rising by 23% annually over the last 3 years was to continue, the new spending component in the package is around 2.25% of GDP.
What’s positive is that the Chinese Authorities are signaling that as the economy slows, they’ll maintain the current momentum in government spending. The risks remain that the policy easing is more than offset by the decline in private sector investment in the least.
The poor will be the main victims.
Just over a year ago, we were talking about the strongest period of global economic growth in 40 years. The developing countries have been hit by food and energy shocks and now by the slow-down in remittances, trade, and banking flows.
The poorest countries are immensely vulnerable. Let me illustrate.
Contrary to what you may have read in the papers recently, Africa is not a country - Sub- Saharan Africa comprises 47 countries. But nearly all of them are small. For example, the GDP in USD term of all 47 countries, including South Africa, is less than that of the Netherlands. In PPP terms, the region is about the size of Canada or Mexico.
The median GDP is about the output of a town of 60,000 in a rich country.
It’s here, and in South Asia and Western China, that most of the world’s 1.4 billion people living on under $1.25 a day are found.
Even this number disguises the true extent of poverty – it disguises the infant mortality, malnutrition, lack of access to health care and education, and social exclusion. For these 1.4 billion people, poverty is so severe that life’s a struggle for survival. They’re politically, economically, and socially disenfranchised.
The challenges here are enormous.
Take the demographics of Sub-Saharan Africa’s 650 million people. 54% of the population is age under 20. It’s simply not possible to conceive of a realistic growth rate for these countries which will prevent tens of millions of youth unemployed for years to come.
Poverty will increase in the current crisis. Already a hundred million people have been driven into poverty as a result of high food and fuel prices. A 1% decline in developing country growth rates traps an additional 20 million people into poverty.
What’s the World Bank doing?
The World Bank is expanding its lending. In a typical year, we lend around USD13 billion to middle income countries. Over the next 12 months, we expect to triple this.
We’re also working to speed up grants and low interest loans to the poorest countries using the USD42 billion of pledges received from donor countries under IDA15.
Our focus will be on investments for the future, safety nets, infrastructure, and nutrition. The Bank Group’s also expanding its support to the private sector through the IFC - its private sector arm. It’s launching new facilities to expand trade finance, recapitalize distressed banks, finance infrastructure, and expand advisory services.
The Bank Group’s political risk insurance arm, MIGA is expanding its guarantees to foreign banks –particularly in Eastern Europe and Africa.
Let me turn very briefly to the future and 2 large political challenges that I think will emerge over the next 2 to 3 years.
Macro-economic management will become extremely difficult.
The global economy will pull out of this recession because the scale of the monetary and fiscal stimulus is unprecedented, and the structural forces that have driven productivitygrowth in recent years, haven’t disappeared.
But governments will be left with large fiscal deficits, high debt burdens, and sizable contingent liabilities. Within countries, there will be tensions between central banks and government debt management agencies over the interplay of debt management policy and monetary policy.
Central banks will also need to regain control over the enormous injections of liquidity into the financial systems. Governments will need to manage their vastly expanded and new ownership interests in the banking and corporate sectors. And some countries may be tempted to run higher rates of inflation to reduce their real debt burdens.
With governments facing macro-policy constraints and given the enormous industrial restructuring that’s taking place, it’s likely that the recovery will have characteristics of the jobless recoveries we saw in Europe and the US in the early 1990s.
The second threat is to globalization itself.
Globalization can only be sustainable if it creates opportunities and benefits for all.
Over the past 3 decades, income distribution and inequality in most countries has been increasing. A world where a large proportion of the population remains trapped in extreme poverty and unable to benefit from globalization, carries unacceptable costs in terms of human suffering, economic losses, political and security tensions.
In the past, while the global economy has been growing, these concerns have not disrupted the catalysts of trade, investment, labor mobility, and technology transfer.
But these dynamics will play differently in an environment of recession, huge wealth losses, rising insecurity, and, if I am right, a slow recovery with limited employment growth.
Governments learned from the Great Depression that pursuing self-interest through competitive devaluations and protection made everyone poorer.
But we see the pressures on governments to avoid compromise in the trade round, in discussions on climate change, and an unwillingness to meet Glen Eagles aid commitments.
Governments are likely to be much more activist in shaping regulatory policy – particularly in respect of the financial sector, taxation, and border protection.
Thanks very much.
