Why the Sub-Prime Crisis is a Turning Point for the World Economy Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Nottingham.

Why the Sub-Prime Crisis is a Turning Point for the World Economy Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

Nottingham

March 5th 2008The Globalisation and Economic Policy Centre, Nottingham University

2

Why the Crisis is a Turning Point

“Things that can’t go on forever, don’t.” Herbert Stein.

3

Why the Crisis is a Turning Point

• Crisis of credibility for Anglo-Saxon financial capitalism

• Crisis for securitised lending

• Crisis for central banks and regulators

• Crisis for belief in free markets

• Crisis for global asset markets

• Crisis for global macroeconomic balances

• Crisis for US and global economic activity

• Crisis for game of “pass-the-external-deficits”

4

1. Crisis of Anglo-Saxon financial capitalism

• First, a mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London:

– From “ninja” (no-income, no-job, no-asset) sub-prime lending,

– To the placing (and favourable rating) of assets that turn out to be almost impossible to understand, value or sell,

– These activities have been riddled with conflicts of interest and incompetence.

– Huge risks have been taken. In the subsequent era of financial “revulsion”, core financial markets have seized up

5


HIGH REWARD MEANS HIGH RISK

6


SPREAD BETWEEN COMMERCIAL PAPER AND TREASURY BILL RATES

0.00

0.50

1.00

1.50

2.00

2.50

3.00

01

/01

/20

07

01

/02

/20

07

01

/03

/20

07

01

/04

/20

07

01

/05

/20

07

01

/06

/20

07

01

/07

/20

07

01

/08

/20

07

01

/09

/20

07

01

/10

/20

07

01

/11

/20

07

01

/12

/20

07

01

/01

/20

08

01

/02

/20

08

CREDIT SHOCK IN THE US

7


SPREADS BETWEEN INTERVENTION RATES AND THREE-MONTH LIBOR

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

01

/01

/20

07

15

/01

/20

07

29

/01

/20

07

12

/02

/20

07

26

/02

/20

07

12

/03

/20

07

26

/03

/20

07

09

/04

/20

07

23

/04

/20

07

07

/05

/20

07

21

/05

/20

07

04

/06

/20

07

18

/06

/20

07

02

/07

/20

07

16

/07

/20

07

30

/07

/20

07

13

/08

/20

07

27

/08

/20

07

10

/09

/20

07

24

/09

/20

07

08

/10

/20

07

22

/10

/20

07

05

/11

/20

07

19

/11

/20

07

03

/12

/20

07

17

/12

/20

07

31

/12

/20

07

14

/01

/20

08

US Eurozone UK

8

2. Crisis for securitised lending

• These events have called into question the workability of securitised lending:

– The argument for this change was that it would shift the risk of term-transformation (borrowing short to lend long) out of the banking system onto those best able to bear it;

– What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it;

– What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”; and

– What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper.

9

2. Crisis for securitised lending

EXCESS DEBT LEADS TO CREDIT IMPLOSION

10

3. Crisis for central banks and regulators

• Third, the crisis has opened up big questions about the roles of central banks:

– How far, for example, do the responsibilities of central banks as “lender-of-last-resort” during crises stretch?

– Should they, as some argue, be market-makers-of-last resort in credit markets?

– What, more precisely, should a central bank do when liquidity dries up in important markets?

11


• Equally, the crisis suggests that liquidity has been significantly underpriced:

– Does this mean that the regulatory framework for banks is fundamentally flawed?

– What is left of the idea that we can rely on financial institutions to manage risk through their own models?

– What, moreover, can reasonably be expected of the rating agencies?

– A market in US mortgages is hardly terra incognita. If banks and rating agencies got this wrong, what else must be brought into question?

12


NOTE HOW THINLY CAPITALISED BANKS ARE

13

4. Crisis for belief in free markets

• US officials used to lecture, not least the Japanese, about letting asset prices reach equilibrium and transparency enter markets. That was then:

– Now we see Hank Paulson, US Treasury secretary, a cartel of holders of toxic securitised assets in his “superSIV”;

– We see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market.

– We see increasing talk of a bail out of over-indebted households

– Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face.

14

4. Crisis for belief in free markets

REAL HOUSE PRICES(Case-Shiller 10-City)

020406080

100120140160180200

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

HO

US

E P

RIC

ES

IN R

EA

L

TE

RM

S

-15

-10

-5

0

5

10

15

20

RA

TE

OF

CH

AN

GE

OF

H

OU

SE

PR

ICE

S

Composite-10 annual per cent change

THIS TIME, IT’S PERSONAL

15

5. Crisis for global asset markets

• Fifth, the crisis signals a re-rating of risk.

• It also represents a move towards holding more transparent and liquid assets.

• This correction has been selective, however.

• It is a striking feature of what has happened that emerging markets have emerged as a safe haven.

• For emerging economies, this must be sweet revenge.

16


REDUCTION IN EMERGING MARKET RISK SPREADS(percentage points over US Treasuries)

0

200

400

600

800

1000

1200

1400

1600

1800

06

/01

/19

97

06

/07

/19

97

06

/01

/19

98

06

/07

/19

98

06

/01

/19

99

06

/07

/19

99

06

/01

/20

00

06

/07

/20

00

06

/01

/20

01

06

/07

/20

01

06

/01

/20

02

06

/07

/20

02

06

/01

/20

03

06

/07

/20

03

06

/01

/20

04

06

/07

/20

04

06

/01

/20

05

06

/07

/20

05

06

/01

/20

06

06

/07

/20

06

06

/01

/20

07

06

/07

/20

07

06

/01

/20

08

COMPOSITE MEXICO TURKEY CHINA

DISAPPEARING EMERGING ECONOMY RISK

17


EXPLOSIVE GROWTH OF FOREIGN CURRENCY RESERVES ($m)

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

7,000,000

Jan-

99

May

-99

Sep-9

9

Jan-

00

May

-00

Sep-0

0

Jan-

01

May

-01

Sep-0

1

Jan-

02

May

-02

Sep-0

2

Jan-

03

May

-03

Sep-0

3

Jan-

04

May

-04

Sep-0

4

Jan-

05

May

-05

Sep-0

5

Jan-

06

May

-06

Sep-0

6

Jan-

07

May

-07

Sep-0

7

Other developing

Mexico

Brazil

Russia

Oil exporters

Other industrial

Australia

UK

Eurozone

US

Other Asia

Thailand

Malaysia

Hong Kong

Singapore

Korea

India

Taiwan

Japan

China

Source: IMF

DISAPPEARING EMERGING ECONOMY RISK

18

6. Crisis for global macroeconomic balances

• Sixth, this event marks the limits to the US role as consumer of last resort in the world economy.

• The US is re-importing the stimulus it exported to the rest of the world in previous years.

• The credit crunch is accelerating this process.

• For this reason, US policymakers are relaxed about the dollar’s fall, provided it does not awaken fears of rapidly rising inflation.

19


CURRENT ACCOUNT BALANCES (as per cent of GDP)

-2

-1.5

-1

-0.5

0

0.5

1

1.5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

United States Euro area Japan Emerging Asia Oil exporters

Source: IMF, World Economic Outlook , October 2007

UNBALANCED WORLD ECONOMY

20


GLOBAL CURRENT ACCOUNT 2006 ($bn)

-$857

-$68

$131

$170

$239

$102

$511

$396

-$131

$19

-$1,000 -$800 -$600 -$400 -$200 $0 $200 $400 $600

US

UK

Western Europe, excluding UK

Japan

China

Rest of Asia

Total Asia

Fuel exporters

Rest of World

Discrepancy

Source: IMF, World Economic Outlook, April 2004, April 2007 and April 2007

Database.

US AS BORROWER OF LAST RESORT

21


CURRENT ACCOUNT BALANCE (per cent of GDP)

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

Q1 80

Q2 81

Q3 82

Q4 83

Q1 85

Q2 86

Q3 87

Q4 88

Q1 90

Q2 91

Q3 92

Q4 93

Q1 95

Q2 96

Q3 97

Q4 98

Q1 00

Q2 01

Q3 02

Q4 03

Q1 05

Q2 06

Q3 07

Source: BEA

SHRINKING CURRENT ACCOUNT DEFICIT

22


US REAL EXCHANGE RATE (JP Morgan)

60

70

80

90

100

110

120

130

Jan

-70

Jan

-72

Jan

-74

Jan

-76

Jan

-78

Jan

-80

Jan

-82

Jan

-84

Jan

-86

Jan

-88

Jan

-90

Jan

-92

Jan

-94

Jan

-96

Jan

-98

Jan

-00

Jan

-02

Jan

-04

Jan

-06

FALLING DOLLAR

23

7. Crisis for US and global economic activity

• Seventh, a deep US recession is possible. Whether it happens depends overwhelmingly on consumers:

– The principal counterpart of the external deficits has been the excess of spending over income by households.

– That has meant negligible savings and a big jump in household debt: mortgage debt jumped from 63 per cent of disposable incomes in 1995 to 98 per cent in 2005.

– This rising trend will not continue in a falling housing market.

– Unwillingness (or inability) to borrow on such a scale willhamper the effectiveness of US monetary policy.

– That, in turn, makes a weak dollar and strong export growth yet more important.

24


US DOMESTIC IMBALANCES

FINANCIAL BALANCES IN THE US ECONOMY, SINCE 1990(per cent of GDP)

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

199

0-I

199

0-III

199

1-I

199

1-III

199

2-I

199

2-III

199

3-I

199

3-III

199

4-I

199

4-III

199

5-I

199

5-III

199

6-I

199

6-III

199

7-I

199

7-III

199

8-I

199

8-III

199

9-I

199

9-III

200

0-I

200

0-III

200

1-I

200

1-III

200

2-I

200

2-III

200

3-I

200

3-III

200

4-I

200

4-III

200

5-I

200

5-III

200

6-I

200

6-III

200

7-I

200

7-III

Private Financial Balance Government Financial Balance Foreign Financial Balance

25


HOUSEHOLDS SPENT; COMPANIES DID NOT

US HOUSEHOLD AND BUSINESS FINANCIAL BALANCES(as per cent of GDP)

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

199

0-I

199

0-IV

199

1-III

199

2-II

199

3-I

199

3-IV

199

4-III

199

5-II

199

6-I

199

6-IV

199

7-III

199

8-II

199

9-I

199

9-IV

200

0-III

200

1-II

200

2-I

200

2-IV

200

3-III

200

4-II

200

5-I

200

5-IV

200

6-III

200

7-II

Business Financial Balance Household Financial Balance

26


CONSENSUS FORECASTS OF GROWTH FOR 2008

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Jan-07

Feb-07

Mar-07

Apr-07

May-07

Jun-07

Jul-07 Aug-07

Sep-07

Oct-07

Nov-07

Dec-07

Jan-08

Feb-08

USA 2008 UK 2008 Japan 2008 Eurozone 2008

Source: Consensus Forecasts

US LEADS THE ECONOMIC SLOWDOWN

27


CENTRAL BANK INTERVENTION RATES

0

1

2

3

4

5

6

7

01

/01

/20

07

15

/01

/20

07

29

/01

/20

07

12

/02

/20

07

26

/02

/20

07

12

/03

/20

07

26

/03

/20

07

09

/04

/20

07

23

/04

/20

07

07

/05

/20

07

21

/05

/20

07

04

/06

/20

07

18

/06

/20

07

02

/07

/20

07

16

/07

/20

07

30

/07

/20

07

13

/08

/20

07

27

/08

/20

07

10

/09

/20

07

24

/09

/20

07

08

/10

/20

07

22

/10

/20

07

05

/11

/20

07

19

/11

/20

07

03

/12

/20

07

17

/12

/20

07

31

/12

/20

07

14

/01

/20

08

28

/01

/20

08

11

/02

/20

08

25

/02

/20

08

US FEDERAL FUNDS EURO SHORT TERM REPO UK BASE RATE

THE FED DULY PANICS AS NEWS GETS BAD

28


• A very long and deep US recession is possible

• This depends on how far house prices fall

• If they fall a further 30-40 per cent, losses in the financial system could be anywhere between $1,000bn and $3,000bn. The latter would decapitalise the US banking system

• Similar points of weakness can be seen in housing markets and financial systems elsewhere

• Particularly the UK

29


REAL UK HOUSE PRICES(FT price index)

0

20

40

60

80

100

120

140

160

180

200

Jan

-87

Jan

-88

Jan

-89

Jan

-90

Jan

-91

Jan

-92

Jan

-93

Jan

-94

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

30

8. Crisis for game of “pass-the-external-deficits”

• This event also has big significance for the game of “pass-the-external-deficits” that has characterised the world economy for several decades.

– It has proved virtually impossible for emerging market economies to run large deficits, without running into crises;

– Over the past decade, the US filled the (growing) gap

– But surpluses being run by China and Japan, by oil exporters and, within the European Union, by Germany continue to grow.

– If we are to enjoy global macro-economic stability, a creditworthy set of countervailing borrowers must emerge.

31


SAVINGS, INVESTMENT AND CURRENT ACCOUNTS OF EMERGING MARKET AND OIL-PRODUCING COUNTRIES

(per cent of GDP)

-2

-1

0

1

2

3

4

5

6

7

8

9

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Current Account Saving Investment

Source: IMF, World Economic Outlook, April 2007

EMERGING ECONOMIES SHIFT INTO SURPLUS

32


-500

-400

-300

-200

-100

0

100

200

300

400

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

CA Balance Net FDI Other Capital Inflows Reserves Accumulation

CHINA’S EXPLOSIVE CURRENT ACCOUNT

33


COMPOSITION OF SAVINGS(per cent of GDP)

18.7 16.7 14.8 14.2 16.3 15.8 15.4 14.6 15.3

15.615.8

15.3 14.214.4 16.2

19.825.0

28.3

4.54.8

6.87.9

6.98.6

7.8

7.6

7.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

1998 1999 2000 2001 2002 2003 2004 2005 2006

Households Enterprises Government Gross capital formation

Source: World Bank

WHO DOES THE SAVING IN CHINA

34


THE PEGGED EXCHANGE RATE

$0.000

$0.050

$0.100

$0.150

$0.200

$0.250

02

/01

/19

90

02

/01

/19

91

02

/01

/19

92

02

/01

/19

93

02

/01

/19

94

02

/01

/19

95

02

/01

/19

96

02

/01

/19

97

02

/01

/19

98

02

/01

/19

99

02

/01

/20

00

02

/01

/20

01

02

/01

/20

02

02

/01

/20

03

02

/01

/20

04

02

/01

/20

05

02

/01

/20

06

02

/01

/20

07

02

/01

/20

08

35


THE FIXED CHINESE REAL EXCHANGE RATE

TRADE-WEIGHTED REAL EXCHANGE RATE

60

70

80

90

100

110

120

130

Jan

-90

Jan

-91

Jan

-92

Jan

-93

Jan

-94

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Source: JP Morgan

36

9. Conclusion

• So we have some huge tasks ahead:

– Managing the present crisis;

– Rethinking financial regulation;

– Rethinking central banking;

– Rethinking the management of global imbalances; and

– Rethinking exchange-rate and macroeconomic policies in developing countries

Why the Sub-Prime Crisis is a Turning Point for the World Economy Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Nottingham.

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