Even before the great unraveling of the global economy led to the collapse of housing and stock prices and double-digit unemployment in the United States, something clearly was awry with the architecture of global finance.
From the Latin American debt crisis of the 1970s through the Asian financial meltdown of 1997, the growing ease with which investors could lend and invest abroad, and their increased ability to instantly move money across borders and between currencies, contributed to wild swings of boom and bust. The gyrations in the flow of money led to greater vulnerability among poor and developing nations, who needed foreign investors to help fund their access to the global economy. The failure of the rich world to create a stable global financial system is what ultimately “blew back on us” and triggered the current fall, Martin Wolf argues in his new book, Fixing Global Finance [read an excerpt from the book here].
Especially after the Asian crisis of the late 1990s, which left nations like Thailand, South Korea and Indonesia begging for bailouts from the International Monetary Fund, many of the world’s emerging economies determined they would never again become vulnerable to the vicissitudes of international finance. Manufacturing bases like China, Taiwan and South Korea, though relatively poor, and petro-states like Saudi Arabia plowed their giant trade surpluses back into the rich world by buying U.S. government debt in a determined effort to insulate themselves from future crisis, says Wolf, associate editor and chief economics commentator for the London-based Financial Times.
As poorer nations continued to lend vast sums to the richest ones, especially Britain and the United States, there was an unintended consequence: American consumers found themselves rewarded by record-low interest rates at a time of war and rising debts. The Bush administration cut taxes. Easy money made it painless even for families with spotty credit to buy expensive new homes. Remarkably low interest rates helped fuel a real estate and construction bubble here and kept factories humming in China and South Korea to build the flat-panel TVs and kitchen appliances Americans needed to fill their new homes.
For a while, everybody won. But the rising imbalances between the savings of the East and the consumption of the West could not go on forever, says Wolf, who worked as an economist at the World Bank and as director of studies at the Trade Policy Research Centre in London before joining the Financial Times in 1987. What must emerge from this crisis, Wolf argues, is a new, more stable system in which capital can flow safely—not from the poor to the rich but from the wealthy to the poorest nations—without regular bouts of financial panic.
Q. Why did borrowing from the world’s poor countries get rich countries like the United States in trouble?
A. A number of very rich countries, of which the United States was the biggest and most important, absorbed this money, but not for investment. Their corporations didn’t want or need this money. Instead it went into a large fiscal deficit—which the United States ran ever since the Bush tax cuts in the early 2000s—and into massive household borrowing. The collapse of savings and the huge borrowings by British households and American households triggered a huge housing bubble.
We saw a huge increase in debt and indebtedness, and it also became associated with the creation of very sophisticated financial instruments that spread the bad mortgage debt across the world, which made the crisis much worse. It was quite clear to me there was going to be a correction, and when that correction occurred, there was likely to be a very significant recession in the United States that would inevitably become worldwide because the U.S. consumer had become such an important source of demand for the entire world.
Q. How do we rebalance a system that is clearly out of whack?
A. Well, this crisis is going to help. The crisis has taught the Chinese that they cannot rely to the extent they have on demand from the rest of the world, particularly from the United States, for the maintenance of their own growth. It’s made them very vulnerable. The whole East Asian system has been disrupted massively by this collapse in consumption. And the result is they’ve realized that they are very, very vulnerable.
Now if you’re very vulnerable, the sensible thing is to make yourself less vulnerable. And the obvious way to do that is to build up your domestic economy. The United States can’t be the borrower of last resort forever. So China must rebalance its economy.
Q. Let’s talk about the banks. Are we facing a crisis of confidence, or are the banks insolvent?
A. The honest truth is that I don’t know, because I’m not a bank examiner. But we know what the market believes, and the market believes they are bust, that’s absolutely clear.
There is a difference between having less capital than you would like in a big financial institution and actually being insolvent. Now that the government has provided substantial guarantees, true insolvency is very unlikely. So my sense is that a substantial number of the institutions are borderline insolvent and at the very least require a lot more capital if they are to extend their balance sheets, support credit in the economy.
Q. Does that mean nationalization?
A. You have basically only three options.
One is regulatory forbearance. You basically allow a bank to continue to operate in the hopes that over the years it will start making profits and rebuild its balance sheet. Given the extreme uncertainty about the economy now and the already weakened state of the balance sheets of these institutions, I’d suspect that this a strategy that just won’t work. It would take too long. But that is where we are, and the point of least resistance is to leave these banks in existence, not solve their problems, but not allow them to die either.
The second possibility, which is what some Republicans want, is to put banks through bankruptcy. Without the slightest doubt you would create a panic in the global corporate bond market. It would probably become a Lehman cubed. [Lehman Brothers, one of the world’s largest investment banks, filed for bankruptcy Sept. 15, 2008, touching off paralysis of credit markets.] It doesn’t look like a very attractive option at the moment, but it is a possibility. That would be the liquidation view.
And the third possibility is that you put money into them—you more or less nationalize them. If you wanted to put several hundred billion dollars into a big bank like, say, Citibank, the government would end up owning it. They would de facto, effectively own it because the market value is now so small. That would be a temporary nationalization. Once you own it, it’s easier to separate the bad assets out and put them into a special bank.
Q. What is your outlook for the next 18 months?
A. In terms of what is going to happen to the private sector, the overwhelming probability is that we are in a long recession. We’ve had a series of monstrous shocks. Asset prices, house prices, are still falling, there has been a big jump in unemployment, consumption is beginning to collapse: That creates its own cycle. I suspect that households all over the developed world and particularly the United States are saying, we can’t afford to consume anymore, we’ve got to start saving. The world is different. We can’t borrow anyway, no one is going to lend money to us, we’ve got to start saving. Once that happens you are in recession.
If we are lucky, we will stabilize the situation between this year and next after a shrinkage in many economies of maybe four or five percent of GDP. But I think we are in for a very long and very slow recovery at best. Some economists are talking about an “L” shape. You go down and are just stuck. It is going to be very difficult to get this world economy going again because the great engines of growth are more or less cut off at the moment.
Q. What do you tell those whose 401(k)s are now 201(k)s?
A. I tell them not to hold stocks. I’ve been telling them that for a long time. We’re in a bear market for stocks, I’m afraid. We’ve been so since 2000. The recovery in stock values was a bit illusory, fueled by easy money. And it depends ultimately on your time horizon and how desperate you are, but if you’ve suffered very, very large losses and you are desperate for income, it’s very difficult to be optimistic because you have a world of low interest rates and poor stock prices.
The best values, without a doubt, are in selected, investment grade bonds. You have to be prepared to take some risk. But they look to me to be oversold, so I’ve bought a few myself. But there are some risky assets out there: The most obvious are corporate bonds, which are now yielding relatively attractive sums. You have to recognize they are doing this because there are risks, so you have accept this and be diversified.
If you look at past collapses, sometimes the market bounces back in a few years. After the Great Depression it took about 20. So the question is, how much risk can you bear and how long is your time horizon?
Q. OK, Larry Summers, the director of the White House’s National Economic Council, brings you into a room and says, I am the smartest man here, but you, Martin, are the world’s second smartest man. What advice do you give him?
A. The stimulus package was way short of the best possible package. It will do better than nothing, but if people think that this will be enough to turn around the economy, they are going to be very disappointed. So it’s a pity they couldn’t go for more–a trillion dollars, although there is a case for more, some would say $1.5 trillion in this situation.
Q. What about banks?
A. In the case of the bank restructuring, it was very disappointing that a year and a half after the subprime market began to collapse Treasury Secretary Tim Geithner could still not come forward and say how they were going to do the single most important part of it, namely buying the toxic assets, the public-private partnership and all the rest of it. It looks as though they just hadn’t thought it through. It also wasn’t clear what the so-called stress testing of the banks was supposed to lead to. Were they planning then to go to Congress and say well, actually we need more money to recapitalize them or not? It’s not at all clear to anyone how it will work and whether it will actually fix the problems of the banks.
So many of us have now concluded that de facto, the United States is moving toward a zombie banking situation, and that’s a disaster. Many months may have been lost on the bank rescue, and that will make it much more difficult to recover.
Q. And housing?
A. The housing market is still going to fall. There may a come point where the government might actually have to invest directly to support the housing market but now is not the time. The big issue is to get a clean system for renegotiating, restructuring loans—a lot of them at once. And that has to be government-subsidized because the banks obviously don’t have the money to afford it.
Q. Anything else?
A. The fourth thing that they haven’t really said that much about is how to fix this global demand problem. That’s the biggest. That’s the point of my book.
I don’t believe there is any way out of this for the United States that doesn’t involve a massive expansion of net exports. If you can’t get companies to spend on investment, you can’t get consumers to spend on consumption, that means monstrous government deficit to boost the economy, and that’s not a sustainable, long-run path. So they have to go out to the world and put forward a plan that says the world economy has to rebalance over the next five years. We can do it, we can support it for that period, but it has to rebalance.
This means big institutional changes, changes to the International Monetary Fund, changes to global exchange rate regimes, different structures in terms of how we deal with China and other emerging economies. This is a global thing, because the United States is part of the global system, and this is a very big difference from the 1930s.
The path to Main Street isn’t just through Wall Street: It’s also through Shanghai and London and Paris, and I don’t know if they have fully grasped that yet at the political level in Washington.
Michael Zielenziger writes on business and the economy.