"World Economy in 2009: Three priorities for recovery"

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.

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  1. bg

    “The trouble is this is not what they usually do”

    This is not what they ever do, and it is wildly enthusiastic to assume coordination is in the cards.

    It was in China’s interest to sell us heroin, and in our interests to consume it. Of course it was eventually going to blow up. So how can we expect the leopard to grow spots now? I am betting the next truly idiodic thing will come from Europe. They are the furthest in denial (except UK and Iceland, of course.)

  2. Yves Smith


    One could read Munchau’s piece as being coded (FT op ed writers need to sound statesman-like rather than alarmist) particularly given his comment that US real estate being half-way-60% through its expected fall is not too bad, all things considered.

    Thus, if you consider his list of three, the only one being worked on in a serious way is number one. That does not bode well, and that (along with the item you picked up) as signs that he is really very pessimistic, but will allow for the (slim) possibility that things might work out.

  3. Anonymous

    Doesn’t de-leveraging (which he says is inevitable, and I agree) go hand in hand with deflation (which he says must be stopped)?

    I just don’t see what’s so bad about prices getting lower.

    Those who conserved capital and saw this meltdown coming should be rewarded for their competence.

  4. Anonymous

    That’s a great article. And while deflation will probably be averted, the approach being taking will leave the financial system mostly paralyzed for a couple of years.

    Those who conserved capital and saw this meltdown coming should be rewarded for their competence.

    The problem with this fantasy is that the waves of economic destruction resulting from significant deflation would most likely swamp you, along with less fiscally prudent folks.

  5. John Christian Falkenberg

    A very good piece, although he gets the (minor) point on CDS market wrong: the figures he’s giving are about gross, not net exposure – and even that has been greatly reduced in the last few months through netting procedures. IMHO it’s one thing to worry a bit less about while focusing on other, most deeply-rooted problems. I think Munchau’s right to the point when he urges not to put blind faith on regulation and government spending as a cure-all, especially when aimed to an industry that specializes in capturing regulators and to a bureaucracy and political class that doen’t know where and how to stop spending.

  6. Anonymous

    Semantics. Everyone has their own definitions. Many variables.

    Is housing deflating or de-levering or correcting to an affordable wage ratio?

    Does it cost more or less to visit the grocery store lately?

    If you park your funds in T-Bills, in six months did you really save your wealth?

    Does the Government under report inflation to keep cost of living adjustments to a minimum?

    Can the working class support the unemployed?

  7. bg

    “One could read Munchau’s piece as being coded”

    Thanks for this explanation. As I reread his piece with this perspective I do see that he is saying:

    1. Yeah, helicopter away. Anti-depressants are needed.

    2. Rein in the I-banks. (yeah right).

    3. Coordinate currency, trade, taxes, and capital flows with china, russia, france, germany, england, US, (laughing out loud).

    What I think is underreported is a detailed analysis of likely trouble ahead. Germany, UK, US, Russia, China have all telegraphed their policy intentions, and there will be fisticuffs flying before too long. The only viable deterrent for their opponents is the plausable threat of retaliation. Therefore it is inevitable that there will be a LEH level rupture due to beggar-thy-neighbor policy choices. Even though the specifics of the falling dominoes is unknowable, isn’t it obvious there will be even greater stress on the just-in-time/no border globalized manufacturing system? I am not knowledgable enough to think this through beyond ‘uh-oh’.

  8. Anonymous

    The problem with this fantasy is that the waves of economic destruction resulting from significant deflation would most likely swamp you, along with less fiscally prudent folks.

    I don’t think you know what you are talking about. How exactly would it swamp prudent folks? There are many families with enough savings for 50 years of food.

  9. Anonymous

    While Wolfgang’s views are interesting I cannot help but feeling that his views are a little blinkered and sometimes text book. Assuming house prices will revert to affordable price norms with a 40 to 50 percent drop is not unreasonable if there is some stability in the economy. Adding forced selling due to job losses may take housing prices below affordable prices. We may be looking at a correction with a recession fall on top.

    Expecting a further 700 billion stimulus to achieve what is hoped may be a little unrealistic. The National Governors Association and the National Association of State Budget Officers mid year report shows 36 states will be in deficit and mid way through the year deficits were expected to be in the region of 200 billion for next year. The automakers will probably need further cash through next year along with AIG and the banks.

    What concerns me is that there is no mention of unemployment. A dramatic rise by half a million in unemployed sets up a feed back loop which needs to be broken. Even assuming that policy actions work then the steepness of the curve implies unemployment rates could soar before policy begins to work. Tackling this usually involves reducing interest rates and providing stimulus so that those employed spend more. Unfortunately those arrows have already been used tackling credit difficulties and the quiver is empty of arrows which can be directed at unemployment. Options for the US look like being limited to massive printing of currency.

    Wolfgang’s doomsday scenarios really show some blinkered thinking and we see no mention of a yen crisis, social unrest in the US, Chinese currency collapse, Multiple shipping industry failures, Utility industry failures. It’s the unexpected that does the damage not those concerns which are on everybody’s lips.

  10. Anonymous

    “I don’t think you know what you are talking about. How exactly would it swamp prudent folks? There are many families with enough savings for 50 years of food.”

    Few families have enough money to protect themselves against the punitive taxation the masses would impose if unemployment hit, say 20 or 30%. For example, how about annual wealth tax on all marketable securities, with look-through if they are held through non-public entities? How about eliminating the exception for foreign persons that allows them to trade securities in the US without US tax? How about eliminating the capital gains preference?

    I could go on…

  11. nanute

    I am just wondering: If China decides to export their way out of trouble, and the U.S. decides to spend their way out of trouble, could the end result be a caneling out of deflation/inflationary concerns?

  12. fresno dan

    “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.”
    I agree. The Japanese are pretty smart – why did they have such a tough time? The same reason we will – the inability to take short term pain for long term benefit. Also, I like the FT for noting “regulatory capture.”

  13. Lim

    I am just not convinced that the solution to the current crisis could be derived from framing the problems in terms of inflation and deflation. A drastic change in perspectives and assumptions by the regulators is needed.

  14. S

    Talk of nominal adjustments putting us close to the end of housing is fantasy. Inflation is not happening in wages. Period. It is quite the opposite. So this myth that inflation is going to help house prices is bordering on retarded. Why is it so hard to understand that printing money that doesn’t seep into a wage price spiral does nothing for debt service ratios? The current course assures destitution for middle class as things you need explode at some point. Please help me understand how the word “nominal” is remotely part of the housing discussion?

    Bloomberg has a thought experiment regarding the $9T in cash and short term investment sitting on the sidelines (See Mish re sideline Cash). What if the appetite for paper assets fails to reignite and that cash says no to equity / bonds and starts chasing things. Just a thought, but it is one that sends a shiver down the spine.

    Deleveraging and shrinking the financial complex are diametrical forces. The Fed and the likes of Krugman and his Keynesian sheeple seriously intellectually believe the size of the US economy (and their bizarre potential constructs) was/is real. Why they can be cold blooded realists about the housing bubble but not the one in GDP is intellectual gimmickry fit only for academia. And when the argument is distilled down to the fundamental truths, the examiner is attacked with The Hoover moniker (see Krugman today, threats of collapse, emergency law, expropriations, etc.

    Russia devalued again today -12th time in past few weeks. The idea that the rest of the world will be so bad that they have to run to support the US is too cute by half. Real conflict is coming in response to the economic warfare the Fed is conducting. It is the height of irony that the pious Fed judges itself world savior in driving rates to zero and printing money under the guise of we had to destroy you to save you.

    Do we really believe the rest of the world – far more accustomed to sacrifice – will be so quick to grant absolution? Call me skeptical.

  15. Anonymous

    “A drastic change in perspectives and assumptions by the regulators is needed.”

    Yes. They could try, you know, regulating.

    I’m not anonymous. I’m zak822, incognito.

  16. groucho

    There’s a new kid in town. His name is China. Today, all roads lead to China. Manchau, apparently is not aware of this development.

    China’s leverage will be put into play in 2009. Reinstalling export subsidies(with t-bill leverage)will drive deflation in the west. At the same time they will rapidly expand the social system to drive chinese consumption.
    2009 starts the beginning of the “Chinese century”

  17. ciccocicco

    I have a different perspective.

    Unintentionally the deleveraging has created a huge gain for the USA.

    Some of the large amount of money destroyed was in foreign hands, let’s say 1 TR out of 5 TR lost.

    If the FED creates again the 5 TR, most of it goes in US hands, almost none of it abroad.

    At the end if (IF) the FED manages to recreate the same money supply conditions that existed before, we would have the same amount of dollars, but 1 TR more in the US and 1 TR less abroad.

    A huge wealth transfer.

    I know this is a simplification, but it may be a way of seeing it.

    Another effect, contrary to all dominating views, is that the resulting 5 TR would be more evenly distributed among social classes than the inicial 5 TR.

    To further improve the situation the US will find itself with a much lower trade deficit do to lower financing from abroad, lower price of oil, and shift in consumer demand from good to services.

    At the end the problem countries will not be the US, but the export countries, China, Japan and Germany.

    They have a big problem, reducing production is more difficult then reducing consumption.

    Trying to be positive.

  18. donna

    “Those who conserved capital and saw this meltdown coming should be rewarded for their competence.”

    Damn skippy. I would be buying now, if I thought anything was reasonably priced.

    But it isn’t yet. And by the time it is, my money will be gone or worth a lot less. Sucks.

  19. S

    ciccocicco said…

    all assums the ROW hasn’t already decided to move beyond the USD. Just becuase it hasn;t happened in scale you can be assured that it will. The US financial engineering trickery is past its prime. Energy better spent focusing on doing something productive.

  20. ciccocicco


    The ROW has non better place to go. And even if it did, I still think that reducing by 400 BN the US current Account (by reducing consumption by 3 – 4 %) is much easier then being left with 10 – 15% of GDO of eccess production as in the case of Japan and Germany.

  21. Anonymous

    The world economy needs a large helping of fiscal stimulus targeted both at repairing the financial system and boosting demand, the International Monetary Fund said in a research paper released on Monday.

    The IMF said the current crisis will last for several more quarters and countries need to act aggressively to reduce the “perceived probability of another ‘Great Depression.'”


    Well isn’t that special the maria arm of the US government pleading for countries around the world to bailout the sad ass greedy bankers who caused the problem by saddling their citizens under a mountain of debt. Screw’em

  22. Glen

    groucho, China is the new kid in town but will be many years before this kid grows up to be anything of a force outside the commodity countries. China’s propensity to save has seen returns and principle savaged by big declines in all asset classes leaving those with what they have to be weary of any additional spending. Also, many of the goods produced for the west are beyond the purchasing capacity of most Chinese wage earners. As Ed Harrison over at Credit Writedowns said; “I look at China like one might see a 1970s Korea or a 1960s Japan” so it’ll be many years before this kid is all grown up.

  23. Anonymous

    @BG 2:07……..If you speak historically, heroin was the commodity of the East Indian Company, hence England and not China.

    I think China will evolve faster than many think. They have the benefit of a looking glass into the history of the Western/Eastern Markets and now are making real progress with Taiwan. Imagine those two healing old wounds and coming together, if only in economic partnership. Now plop Russia on top as they are in bad need of friends and China and them go way back.

    Consumer spending is a dry lake and the Governments attempts at rain making will require clouds to form first, no cloud, no seeding it. All I see is people trying to survive or pay off large debit, before they spend on any thing but the necessity’s. Case in point. Just got back from Noosa Bch Qld for family holiday, out of the 20 people their. All lost 40% to 60% of their net worth/retirement portfolios, for half it was a large amount of money. All are down sizing by 3/4, selling hard assets and stocks except the blue chips. One who is in the mining equipment business is selling their historically listed massive house, located intercity (rarity/established long term value) and looking for a average home to live in.

    So try as they may (Governments/Markets). I see no return to significant consumer spending till individual debit is paid off, not just down. This may take awhile as wages will go down and job losses mount.

    skippy, the happy one.

  24. S

    ciccocicco said…

    consumption will fall but let’s not forget that the current account hasd two sides importans and exports. You assume one will fall disproportionately to the other. Not a safe assumption. Also, by definition the current account deficit has to be offset by a capital account surplus. Your statement that the ROW has o where else to go is arrogant and shortsided. One only has to go back to early 20th century Britian to read similiar sentiments. While the GS designated BRICs are sure to dissapoint the lofty expectations – China is probably already in the low singles – the US has arguably the bigger challenge: to try and preserve a hollowed out economy at a totally unusustainable level. While Krugman andhis ilk belive that subsitution is the approach (and inflation) it papers over the reality that the US economy is realisticlly a shadow of itself. Count on it that the rest of the world has done the math and arrived at the same conclusion. Making relative arguments is the last bastion of the scoundrel. Ironic isn’t it: wall street jettisoned as insufficient relative arguments with the growth of absolute return alternative investing. Now the economic scoundrels drag out the discarded laundry to to bolster their flimsy arguments. I do not argue that the US is without options, but exercising those options will haveequally draconian ramifications. At this point, it is not beyond the realm of of possibilities that the governement is activily wishing and working toward a “market driven” devaluation. The outcome here ois fortold, it is just a question of how we get there.

  25. GloomBoom

    Munchau is a dreamer. Would that results were so easy to achieve.

    “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.”

    His most important policy suggestion is the most unrealistic. The three or four largest European economies can’t even agree and we are to believe that we can co-ordinate the policy response at a global level? This is the kind of hubris that got us into this crisis.

  26. GreenspanPutExpired

    “The second priority is to shrink the financial sector. “

    Agreed, as long as we don’t forget to include the Fed and treasury in the financial sector!

  27. groucho

    “China is the new kid in town but will be many years before this kid grows up to be anything of a force outside the commodity countries.”

    Glen, I believe this crisis and soft or hard depression will pass the baton to China. China has enormous domestic potential that has been kept back by China’s “Global Power” strategic initiatives that have been in play for well over a decade.
    Unlike Japan, who caved in to US pressure (Plaza Accord)(which then created the asian boom/bust of the 90’s and subsequent dollar pegging), China is planning to be #1 and is constantly juggling it’s policies to reach its objectives.

    The commodity collapse supplies the energy for their domestic expansion.

  28. Glen

    For sure groucho, China will be No. 1 at some point in the future but not as soon as many believe. I reckon there are too many deep structural changes (both economic and mindset) required before China takes the mantel. I’m not sure that China will want to follow the great western tradition of having a consumption based economy with the results of which are on show at the moment. China will develop a more even mix of consumption and investment economy but the downside will risk losing capital inflows as wage demands rise to meet consumption expectations and subsequently foreign investors will look to other low wage countries for cheap production to keep their cost advantage. It’ll be a fine balancing act but one where China may have painted themselves into a corner.

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