Martin Wolf on the Credit Crisis as a Turning Point

Martin Wolf, the Financial Times’ lead economics writer, is often most interesting when he is agitated. In his current offering, “Why the credit squeeze is a turning point for the world,” he is sufficiently charged up that he has dashed off a piece that in some way is more impressionistic than his usual offering, but no less insightful.

But one oddity surfaces in the disconnect between the headline, which makes this current episode of debt turmoil sound terribly important, and the first paragraph, which somewhat breathlessly compared it to the 1997-1998 emerging markets crisis and the dot com bust. Although the emerging markets upheaval focused the mind at the time, it had little in the way of systemic consequences (save perhaps that it ushered the decision by Asian nations to maintain currency pegs so as to always have large currency reserves and never suffer that sort of turbulence again). And while the dot-com crash destroyed a lot of value, it did not threaten the stability of the financial system.

Nevertheless, Wolf goes on to itemize why he thinks the current mess is a Big Deal. The points are all interesting, but I found the first four, in which he discusses how the wreckage of the last few months points out the failings of the workings and regulation of modern finance, noteworthy. It’s intriguing to see how sharp his criticisms are, and how that perspective is not yet widely shared on this side of the Atlantic.

From the Financial Times:

These are historic moments for the world economy. I felt the same during the emerging market financial crises of 1997 and 1998 and the bubble in technology stocks that burst in 2000. This “credit crunch” may, I believe, be an equally important turning point for financial markets and the world economy. Why do I believe this? Let me count the ways.

First and most important, what is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-orientated financial capitalism. A mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London. From the “ninja” (no-income, no-job, no-asset) subprime 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. In the subsequent era of “revulsion”, core financial markets have seized up (see charts).

Second, these events have called into question the workability of securitised lending, at least in its current form. The argument for this change – one, I admit, I accepted – was that it would shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of 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”, which proved to be only notionally off balance sheet. What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper (see chart).

Third, the crisis has opened up big questions about the roles of both central banks and regulators. 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? 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?

Fourth, do you remember the lecturing by US officials, not least to the Japanese, about the importance of letting asset prices reach equilibrium and transparency enter markets as soon as possible? That, however, was in a far-off country. Now we see Hank Paulson, US Treasury secretary, trying to organise a cartel of holders of toxic securitised assets in the “superSIV”. More importantly, we see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market. Either, or both, of these ideas might be good ones (though I strongly doubt it). But they are at odds with what the US has historically recommended to other countries in a similar plight. Not for a long time will people listen to US officials lecture on the virtues of free financial markets with a straight face.

Fifth (and here we start to move from the questions about the workings of the financial system to global macro-economic implications), the crisis signals a necessary re-rating of risk. It turns out that it also represents a move towards holding more transparent and liquid assets, as one would expect. This correction is altogether desirable. It has, moreover, been selective. It is a striking feature of what has happened that emerging markets have emerged as a safe haven as investors run away from US households. For those in emerging economies, this must be sweet revenge. They should not cheer too soon. Today’s favourites may be brutally discarded tomorrow.

Sixth, this event may well mark the limits to the US role as consumer of last resort in the world economy. As the Organisation for Economic Co-operation and Development notes in its latest Economic Outlook, the correction is well under way. In 2007, it forecasts, US final domestic demand will grow by just 1.9 per cent, down from 2.9 per cent in 2006. It forecasts a further decline, to growth of 1.4 per cent, next year. In both years, net exports will make a positive contribution to growth: 0.5 percentage points in 2007 and 0.4 percentage points in 2008, as the trade deficit shrinks in real terms. In this way, the US is re-importing the stimulus it exported to the rest of the world in previous years. The credit crunch is quite likely to accelerate this process. So the US needs strong growth of net exports. For this reason, policymakers are relaxed about the dollar’s fall, provided it does not awaken fears of rapidly rising inflation.

Seventh, a 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 is unlikely to continue in a falling housing market. Unwillingness (or inability) to borrow on such a scale will, in turn, hamper the effectiveness of US monetary policy. That, in turn, makes a weak dollar and strong export growth yet more important.

Last but not least, 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 as ever-larger borrower of last resort. This epoch has probably now ended. But the 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. If the US ceases to increase its absorption of the growing savings surpluses being generated elsewhere, which countries will be able and willing to do so?

Experience teaches that big financial shocks affect patterns of lending and spending across the world. Originating, as it does, at the core of the world economy, this one will do so, too. The question is how stable and dynamic the world economy that emerges will be.

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  1. a

    Self-flagellation can be useful, but it also means one may not be providing a correct analysis of the situation.

    IMHO the problem the U.S. is facing has been brought on by housing prices which went up too much. You’ll see an increase in prices not only in the U.S. and the U.K., but in Spain, France, China, India, Singapore – i.e. pretty much everywhere. I’d claim that no financial system can withstand that amount of increase, since at some point things will go in reverse. Every other country who has experienced similar increases will, I think, see problems in their financial sector (unless they were lucky and foreign banks did most of the lending). So I’m not sure the problem is so much with the new-fangled instruments everyone is pointing their finger at. I think they really did spread the risk and the losses (look, apparently, at Goldman Sachs); it’s just that the losses are so enormous that the financial system has to be impacted.

    (There should be a law which says when prices go up, people need to make larger deposits. If prices went up 10% last year, then people should have to put down 30% rather than 20% of the house’s value. This would go a long way to stop housing asset bubbles. Instead the system works in reverse; when prices go up, banks tend to lend their money more easily.)

  2. Yves Smith


    Yes, but if you have excesses in the banking system (which banks seem to create every decade or so) unless as they get as out of control as they did in Japan, the authorities can ameliorate the situation. When they occur outside the banking system, their hands are largely tied.

    In Australia, Ian Macfarlane was able to take a lot of air out of the housing bubble there mainly by talking it down (can you imagine anyone in the officialdom, much the less a Fed chairman saying housing was overpriced?) plus a couple of rate increases. Banks are still the big players in credit intermediation, so raising rates also had a more direct impact. By contrast, the Fed’s 17 rate increases didn’t do much to slow down mortgage lending.

  3. blueskies

    Not sure about Australia, but in New Zealand the vast majority of mortgages are adjustable rates (a fixed rate there means fixed at most for a couple years), with rates that closely track central bank. So, not only are the central bank statements far more informative, interesting and proactive, they are also a very credible immediate threat to the housing market. When they talk it down you have to take them seriously since they can slow it down by raising rates.

  4. Anonymous

    ‘ If the US ceases to increase its absorption of the growing savings surpluses being generated elsewhere, which countries will be able and willing to do so? “

    If the US ceases to increase its absorption of surpluses elsewhere, then it also ceases to be the trade counterparty to those surpluses via its own deficit – i.e. bilateral surpluses with the US must fall rather than be replaced elsewhere.

  5. s

    China full employmwnt vs. DC consensus (the new washington consensus) that everything “free” trade is good for the US. These two trains are running mock speed at each other and the inflation/wage/price controls the world over are mearly signs of things to come. Everyone talks about the housing market coming back? I awonder if we apply the historical appreication rate going forward even with a 20-30% decline, there is simply no way prices can continue to go up sans outsized wage inflation which isn;t going to happen. This malignant invective that assets prices can only go up becasue they always have is the modern day version of the medicine man and his secret positon. That Americans have had to subsidize their stadnard of living expansion with paper house gains is telling of just how great our comparitive advantage really is. In the face of all this, you still have to liten to the cheerleaders tell us that the foundations are strong. Thew foundation has been rotting from the inside out and this recent siezure is just the beginning of a long convulsion with the US consumer at the epicenter. I used to hear from the grandparents about saving sugur packets; it is now confirmed the greatest generation really is dying off (this while Brokow(n) celebrates the 60s – go figure)

  6. Peter Principle

    “If the US ceases to increase its absorption of the growing savings surpluses being generated elsewhere, which countries will be able and willing to do so?”

    This really is the $12 trillion question — and the shadow of a much bigger crisis hiding behind all the lesser ones popping off now. The development of the BRICs — well, mainly the ICs — into export powerhouses is a deflationary supply side shock the likes of which the world hasn’t seen since the late 19th and early 20th centuries. The incredible contortions and distortions in the U.S. financial system over the past few years only shows what it takes to create a consumption boom big enough to absorb those current account surpluses (the wellspring of Bernanke’s “global savings glut.”)

    The accounting identity says savings have to equal investment, but it doesn’t say HOW they have to equal. If the U.S. can’t absorb the glut, and the countries that DO need them are too risky and/or disfunctional to attract them, the books will have to balanced in some other way. And it won’t be pleasant. In fact the current follies could start to look downright entertaining by comparison.

  7. foesskewered

    Peter Principle

    Gather you’re worried about deflationary pressures, perhaps Japan on a larger scale? Theoretically that’s the case, but a more realistic more realistic view may be : we see a “bets are off” period for a couple of months but a combination of the threat of asset bubbles and inflation might drive the IC s in BRICET to release those pent up investment funds faster than they would like to and no matter how dodgy the investment destination is, they’ll probably heading there in droves. Never underestimate the power of greed or the lure of the gambling dice. They are the most effective amnesia-inducing drug ever! The irrationality of stock markets in I and C are just small signs of wholesale approval of Gekko’s mantra “Greed is good”

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