Martin Wolf Column

8/9/2019 Martin Wolf Column

http://slidepdf.com/reader/full/martin-wolf-column 1/6

Three years and new fault lines threatenBy Martin Wolf

Published: July 13 2010 22:45 | Last updated: July 13 2010 23:04

It is nearly three years since the world became aware of the coming financial tremors. Since then we haveexperienced a financial sector earthquake, a collapse in economic activity and an unprecedented monetary and fiscal

response. The world economy has now recovered. But this crisis is far from over.

As Raghuram Rajan of the University of Chicago Booth School of Business and former chief economist of the

International Monetary Fund notes in a thought-provoking new book, the underlying ³fault lines´ are still with us.*

More trouble may lie ahead. His voice is worth listening to: in 2005, he presented a controversial, yet now acclaimed,

paper at the annual Jackson Hole monetary conference entitled ³Has Financial Development Made the World

Riskier?´ His answer? Yes.

We already know that the earthquake of the past few years has damaged western economies, while leaving those of

emerging countries, particularly Asia, standing. It has also destroyed western prestige. The west has dominated the

world economically and intellectually for at least two centuries. That epoch is over (see charts). Hitherto, the rulers of emerging countries disliked the west¶s pretensions, but respected its competence. This is true no longer. Never again

will the west have the sole word. The rise of the Group of 20 leading economies reflects new realities of power and

authority.

Yet this is far from the only change in the global landscape. The crisis has revealed deep faults within western

economies and the global economy as a whole. We may be unable to avoid further earthquakes.

Martin Wolf¶s Exchange

Martin Wolf elicits readers¶ views on current economic issues

In his book, Prof Rajan points to domestic political stresses within the US. Related stresses are emerging in western

Europe. I think of it as the end of ³the deal´. What was that deal? It was the post-second-world-war settlement: in the

US, the deal centred on full employment and high individual consumption. In Europe, it centred on state-provided

welfare.





those inside the domestic economies of western countries, particularly the US, helped trigger the crisis and now

make it hard to rebuild after it.

As Prof Rajan notes, a number of significant countries have built their economies around exports. The resultant

dependence on foreign demand means the credit-dependence they proudly avoid at home emerges abroad. The

constraint upon them is what Prof Rajan describes as a ³politically strong, but very inefficient domestic-oriented

sector´. The problem is that the countries that used to provide the demand ± the US, at world level, or Spain, in theeurozone ± have over-indebted private sectors. So we see a zero-sum battle over shares of structurally deficient

global demand. This is a threat to survival of the eurozone and even the open world economy.

Similarly, it has proved extremely hard to manage the integration of market-based financial systems with ones based

on personal and even political relationships. Episodes of large-scale capital inflows from the former to the latter

ended up in crises. This then led to the huge accumulations of foreign currency reserves that helped to drive the

current crisis. Today, the risks of large-scale capital flows across frontiers are all too disturbingly evident. It may even

be hard to sustain financial integration.

The crisis, then, can be seen as the product of fault lines inside advanced western economies ± above all, the US ±

and in the relationships between advanced countries and the rest of the world. The challenge of returning to some

form of reasonable stability, while maintaining an open global economy, is enormous. Anybody who thinks that thepresent fragile recovery represents success with these tasks is myopic, at best.

We can see two huge threats in front of us. The first is the failure to recognise the strength of the deflationary

pressures (see chart). The danger that premature fiscal and monetary tightening will end up tipping the world

economy back into recession is not small, even if the largest emerging countries should be well able to protect

themselves. The second threat is failure to secure the medium-term structural shifts in fiscal positions, in

management of the financial sector and in export-dependency that are needed if a sustained and healthy global

recovery is to occur.

The west is not the power it was; its debt-fuelled consumers are not the source of demand they were; the west¶s

financial system is not the source of credit it was; and the integration of economies is not the driving force it proved to

be over the past three decades. Leaders of the world¶s principal economies ± both advanced and emerging ± will

need to reform co-operatively and deeply if the world economy is not to suffer further earthquakes in years ahead.

* Fault Lines, Princeton, 2010





In practice, however, this is not going to happen. Far from running a current account deficit of $3,000bn, emergingcountries are forecast to run a surplus: the latest from the Washington-based Institute for International Finance is for an aggregate surplus of about $300bn, two-thirds of which will be generated by China. This is smaller than two yearsbefore. But it still means that the emerging world will be a net provider of capital to advanced countries, not the other way around.

That is not all. According to the IIF, the net flow of private funds from advanced countries to emerging countries will

be close to $700bn this year. But that will be almost entirely offset by an official outflow, in the form of foreigncurrency reserves, of close to $600bn. These huge official interventions prevent the emergence of large net capitalinflows into emerging countries. Instead, the private sectors of the advanced countries accumulate net claims on theprivate sectors of emerging countries, while the governments of emerging countries accumulate offsetting claims onthe governments of advanced countries (see charts).

The bottom line is clear: there exists, at present, a gigantic net flow of funds into the liabilities of the governments of advanced countries. Of course, some countries can still get into difficulties. But it is quite wrong to argue that thedifficulties of a Greece or a Spain entail difficulties ahead for the US, or even the UK. The opposite is far more likely:flight from risk entails flight into something less risky. What is the least perilous asset for the investment of gigantic

private financial surpluses? The only answer is the public debt of the big advanced countries.

These flows of funds consist only of identities. So what are the causal factors? Maybe, the collapse in privatespending in the wake of the financial crisis was caused by terror of the fiscal deficits to come. Maybe, the moon ismade of green cheese, too. There is also next to no sign of crowding out in capital markets. The plausible hypothesis,then, is that the fiscal deficits were a response to the collapsing desire to spend of the crisis-hit private sector. Fiscalpolicy could have been tighter. But the result would have been a depression.



What then of the future? Suppose there is no significant change in policy in emerging economies. Then if a fiscalcontraction in advanced countries is not to cause a slowdown, even a second recession, it must be accompanied byan upsurge in private spending.

The argument must be that improved confidence in the long-run sustainability of public finances would lead to greater private consumption and investment spending now, even if there is no significant effects on interest rates or theexchange rate. I am highly sceptical of this argument (see ³Why it is right for central banks to keep printing´, FinancialTimes, June 22, 2010). But grant that this is true. Then the best policy is to slow the long-term growth in spending onage-related programmes. This comes out clearly from the discussion of long-term fiscal trends in the excellent newannual report from the Bank for International Settlements.

The arguments for a dramatic short-term fiscal contraction, however, are weak. Yes, we are enjoying a recovery. Buteconomies are still far below peak levels of activity and also below almost any plausible estimate of the long-termtrend (see chart). This is particularly true in the US, where unemployment rates have shot up by far more than inother advanced countries. Unless the US has suddenly become continental European, why should equilibriumunemployment have jumped by as much as that?

My conclusion, then, is that the advanced countries remain highly short of demand. In this environment, rapid cuts in

fiscal support make sense if, and only if, monetary policy can be effective on its own and expanding the interest-elastic parts of the economy is the best way to climb out of the hole. There is reason to doubt both ideas.

At the summit of the Group of 20 countries in Canada, leaders pledged to ³halve fiscal deficits by 2013 and stabiliseor reduce government debt-to-GDP ratios by 2016´. It would make far better sense for governments to focus their efforts on altering the long-term trajectory of spending. They may hope that retrenchment now will spur on privatespending. But what is their plan if it turns out that it does not?

Martin Wolf Column

Documents