This blog was early to draw a comparison between the US financial crisis and emerging markets crises. As we wrote in March 2008:
Although the Journal does not draw this comparison, the US is in very much the same boat as Thailand and Indonesia in 1997, during the emerging markets crisis. And although the US arguably has a more diverse economy, the main things that differentiate us from them is the dollar’s reserve currency status (which means if we implode we do a great deal of collateral damage) and our nukes. We also like to think that because the US has been the biggest buyer of global exports, we are effectively too big for our cash rich trading partners to allow us to fail. Even if they accept that proposition (not clear, BTW), it’s not obvious in practical terms how they might act on it.
The “banana republic with nukes” meme has since gone mainstream.
Willem Buiter, who has some expertise in dodgy debtor nations, has a typically insightful post today, “Fiscal expansions in submerging markets; the case of the USA and the UK.“
Despite the dry title, what is noteworthy is that Buiter discusses in some detail how corruption, both in the government and society, limits policy choices. Put simply, diseased leadership has trouble pulling a country out of a debt crisis because no one trusts that they will do the right thing (and frankly, why should they?).
Buiter makes a compelling case that lack of credibility has real costs, and uses it to bolster his argument that the US and UK should not go on the kind of whole hog spending spree that most orthodox ecconomists are demanding right now. He thinks a currency collapse, a scenario that most would dismiss as impossible for the dollar, is in fact probable at higher deficit levels in part because creditors and investors know the US and UK lack the discipline to trim the sails soon enough.
While Buiter does not frame it this way, in effect he is saying that the downside of doing too little (deep recession and/or very sluggish growth) is preferable to doing too much (high inflation and the risk of collapses in major currencies.
But the most important aspect of the post is not the policy implications, but the fact that a Serious Economist has finally said that the lack of scruples in America and Britain has gone beyond the tipping point, and is going to exact high societal costs. The parasites are eating the host. I hope someone out there is taking notice.
Increasingly, I find it helpful to analyse the crises afflicting the US and the UK as emerging market crises – perhaps they could be called submerging markets crises.
During the decade leading up to the crisis, current account deficits increased steadily and became unsustainable. Strong domestic investment (much of it in unproductive residential construction) outstripped domestic saving. Government budget discipline dissipated; fiscal policy became pro-cyclical. Financial regulation and supervision was weak to non-existent, encouraging credit and asset price booms and bubbles. Corporate governance, especially but not only in the banking sector, became increasingly subservient to the interests of the CEOs and the other top managers.
There was a steady erosion in business ethics and moral standards in commerce and trade. Regulatory capture and corruption, from petty corruption to grand corruption to state capture, became common place. Truth-telling and trust became increasingly scarce commodities in politics and in business life. The choice between telling the truth (the whole truth and nothing but the truth) and telling a deliberate lie or half-truth became a tactical option. Combined with increasing myopia, this meant that even reputational considerations no longer acted as a constraint on deliberate deception and the use of lies as a policy instrument.
As part of this widespread erosion of social capital, both citizens and markets lost faith in the ability of governments to commit themselves to any future course of action that was not validated, at each future point in time, as the most opportunistic course of action at that future point in time – what macroeconomists call time-consistent policies and game theorists call ’subgame-perfect’ strategies.
This morality tale has important consequences for a government’s ability to conduct effective countercyclical policy. For a fiscal stimulus (current tax cut or public spending increase) to boost demand, it is necessary that the markets and the public at large believe that sooner or later, measures will be taken to reverse the tax cut or spending increase in present value terms. If markets and the public at large no longer believe that the authorities will assure fiscal sustainability by raising future taxes or cutting future public expenditure by the necessary amounts, they will conclude that the government plans either to permanently monetise the increased amounts of public debt resulting from the fiscal stimulus, or that it will default on its debt obligations. Permanent monetisation of the kind of government deficits anticipated for the next few years in the US and the UK would, sooner or later be highly inflationary. This would raise long-term nominal interest rates and probably give risk to inflation risk premia on public and private debt instruments as well. Default would build default risk premia into sovereign interest rates, and act as a break on demand.
Beacause I believe that neither the US nor the UK authorities have the political credibility to commit themselves to future tax increases and public spending cuts commensurate with the up-front tax cuts and spending increases they are contemplating, I believe that neither the US nor the UK should engage in any significant discretionary cyclical fiscal stimulus, whether through higher public spending (consumption or investment) or through tax cuts or increased transfer payments….
It is true that, despite the increase in longer-term Treasury yields from the extreme lows of early December 2008, recent observations on government bond yields don’t indicate any major US Treasury debt aversion…But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expeted inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.
The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency. But this elastic cannot be stretched indefinitely. While it is hard to be scientifically precise about this, I believe that the anticipated future US Federal deficits and the growing contingent exposure of the US sovereign to its financial system (and to a growing list of other more or less deserving domestic industries and other good causes) will cause the dollar in a couple of years to look more like an emerging market currency than like the US dollar of old. The UK is already closer to that position than the US, because of the minor-league legacy reserve currency status of sterling.
Under conditions of high international capital mobility, non-monetised fiscal expansion strengthens the currency if the government has fiscal-financial credibility, that is, if the markets believe the expansion will in due cause be reversed and will not undermine the sustainability of the government’s fiscal-financial-monetary programme. If the deficits are monetised, the effect on the currency is ambiguous in the short run (it is more likely to weaken the currency if markets are forward-looking), but negative in the medium and long term. If the increased deficits undermine the credibility of the sustainability of the fiscal programme, then the effect on the currency could be be negative immediately.
The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors. There has been a partial sudden stop of financial flows, both domestic and external, to the banking sector and the rest of the private sector, but the external capital accounts are still functioning for the sovereigns and for the remaining creditworthy borrowers. But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.
So just don’t do it. Focus fiscal resources on getting the credit mechanism and other key parts of the financial intermediation process going again. Effective Keynesian fiscal policy requires a virtuous policy maker, capable of credible commitment – that is, commitment capable of resisting the future the siren calls of opportunistic reneging on past commitments. The Obama administration is new and has had but limited opportunity to abuse the trust placed in its promises and commitments. That puts it in a better position that the UK government, which has been in office since May 1997. But many of the top players in Obama’s economic team are strongly identified with the failed policies, regulations and laws that brought us the disaster we are facing. So the amount of credibility capital is severely limited even for Obama. Use it to get credit flowing again. Tax cuts for friends and favoured constituencies, replacing clapped-out infrastructure and even the fight against global warming will have to wait until trust – public credit – is restored.