Wolfgang Munchau has a good piece in todays’ Financial Times delineating his economic policy wish list for 2009. It has the merit of being to the point and pragmatic.
His preamble contains some some striking tidbits. Munchau considers himself relatively optimistic about US housing, despite anticipating a 40 to 50% peak to trough decline, and far more worried about financial firms.
While I agree with his three objectives, forestal deflation, ratoinalize the financial sector, and improve coordination, Munchau fails to acknowledge that the Federal Reserve and Treasury’s actions suggest that they view keeping deflation at bay and reducing the size of the financial services industry to be in conflict. As this blog and others have noted repeatedly, the authorities instead appear to be taking a page from the Japanese playbook, of trying to shore up the value of impaired assets rather than allow price discovery to occur (and a huge number of bottom fishers would wade in once they had confidence that was indeed taking place) and contain the damage via firm-specific liquidity measures and recapitalizations for ones that appeared viable, liquidation for the rest.
From the Financial Times:
It is easy and difficult at the same time to predict the economy in 2009. It is easy to predict it will be an awful year for the US, Europe and large parts of Asia…
The difficult part of the forecast is to predict whether policymakers will succeed in preventing the recession turning into a depression and lay the foundations for a sustainable recovery in 2010. What I can predict with near certainty is that policy will matter a great deal next year.
We know that the current driving force behind this downturn is “deleveraging”…There is no chance of a sustained economic recovery until that process is almost complete.
We are still some way from that point. For example, on my calculations it will take a total peak-to-trough decline in real US house prices of some 40-50 per cent to get back towards long-term price trends and for price-rent ratios to return to more sustainable levels. We are about half-way through this process. The good news is that most of the nominal adjustment will have taken place by the end of 2009 or early 2010.
I am a lot less optimistic about the financial sector. While it is also reducing its leverage, it will not achieve a sustainable position quickly without a lot more government capital. But this would require deep restructuring and would take time.
On the basis of this admittedly brief sketch, I arrive at three policy priorities for 2009. The first is for central banks to avoid deflation. If ever there has been a need for a central bank to target price stability, it is now. I mean this in the European sense of the term, meaning a small but distinctly positive rate of inflation, say 2 or 3 per cent annually. I assume that central banks will succeed in this endeavour, given the full power of policies deployed. I worry, though, that the US will try to raise inflation afterwards, which would reduce the real level of US debt but create massive distortions in exchange rates and financial flows and produce another global financial and economic crisis.
The second priority is to shrink the financial sector. A disorderly collapse would be catastrophic, but it is neither desirable, nor possible, to maintain the financial sector at its current excessive size. Take the market for credit default swaps, an unregulated $50,000-$60,000bn casino that serves no economic purpose except to enrich its participants at massive risk to global financial stability. I would be in favour, as a matter of principle, of regulating any financial activity on the basis of its economic purpose. Since a CDS constitutes insurance from an economic point of view, we should treat it as such and subject it to insurance regulation (which would kill it of course).
In particular, we should try to avoid the temptation to regulate too much in detail. This is a game regulators will lose. The financial sector is good at deploying existing instruments, and creating new ones, to circumvent any inflexible rule set. We should instead focus on breaking up too-large-to-fail banks and reducing the size of the financial sector in relation to a country’s GDP. In particular, we should not try to guarantee the obligations of a banking sector several times the size of our economies.
Third, and perhaps most important, we need to co-ordinate the policy response at global level, since this is a global crisis with many global spillovers. What I would like to hear from US President-elect Barack Obama’s economic team is not a narrow-minded discussion about whether the stimulus will be $700bn or $850bn, or which programmes it will be spent on. What I want to know is how they intend to co-opt the Europeans and the Chinese into a joint strategy.
What national governments should not do is blow even more money on infrastructure investments and on education. Whatever problem this is supposed to solve, it is a different problem from the one we need to solve right now.
Nor do I see any real policy co-ordination, in which governments commit to policies they would otherwise not have considered. At present, in Europe at least, the co-ordination process works the other way round. Each government decides unilaterally what it wants to do. And then, at European Union level, they dress it up as policy co-ordination.
It is not difficult to construct a plausible scenario of an economic catastrophe. Pick some of the following and you could end up with a depression that beats every modern record: a rise in global protectionism; competitive currency devaluations; a sterling crisis; social unrest in China, leading to political instability; a well-timed terrorist attack; continued refusal by eurozone leaders to co-ordinate; a payment default by a large sovereign in the eurozone; an acute emerging market crisis; continued lack of synchronisation of monetary policies, or a collapse of the CDS market. Obviously, the insolvency of a large global bank or the annihilation of the hedge fund industry would not go unnoticed either.
Alternatively, we can try to keep the lid on the 2009 recession and lay the foundations for a sustainable but unspectacular recovery. This would be the best outcome. But for that we would have to recognise that the global economy is more than the sum of its parts. It implies that policymakers will have to smarten up, work together and start thinking outside the box. The trouble is this is not what they usually do.