As Bernanke is about to take leave of office, attacks on his policies are becoming louder, thanks to financial markets turmoil resulting from the Bernanke/Geithner approach to the crisis: do whatever it takes to restore as much of status quo ante as possible. The problem, of course, is that status quo ante is what got us in this mess in the first place.
Another element of the resolution of the crisis that is simply not acknowledged in the American or European media all that much is the degree to which emerging economies engaged in stimulus programs which helped keep the global boat afloat, while advanced economies fixated on saving the banks and did far too little in the way of shoring up demand.
India central bank governor Raghuram Rajan took to Bloomberg to criticize the Fed for its failure to coordinate policies with the rest of the world. And Rajan can’t be dismissed as a partisan defending his country’s policies. Rajan is a Serious Economist, former IMF chief economist, and best known in popular circles for presenting a badly-received paper at Greenspan’s last Jackson Hole session that said that financial innovation was making the world riskier and could well cause a full blown financial crisis. And he assumed office only last September, so he’s also not defending policies he implemented.
Rajan is blunt by the standards of official discourse. I suggest you watch the interview starting at 9:10.
Some of his key points:
Emerging markets were hurt both by the easy money which flowed into their economies and made it easier to forget about the necessary reforms, the necessary fiscal actions that had to be taken, on top of the fact that emerging markets tried to support global growth by huge fiscal and monetary stimulus across the emerging markets. This easy money, which overlaid already strong fiscal stimulus from these countries. The reason emerging markets were unhappy with this easy money is “This is going to make it difficult for us to do the necessary adjustment.” And the industrial countries at this point said, “What do you want us to do, we have weak economies, we’ll do whatever we need to do. Let the money flow.”
Now when they are withdrawing that money, they are saying, “You complained when it went in. Why should you complain when it went out?” And we complain for the same reason when it goes out as when it goes in: it distorts our economies, and the money coming in made it more difficult for us to do the adjustment we need for the sustainable growth and to prepare for the money going out
International monetary cooperation has broken down. Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say we’ll do what we need to and you do the adjustment. ….Fortunately the IMF has stopped giving this as its mantra, but you hear from the industrial countries: We’ll do what we have to do, the markets will adjust and you can decide what you want to do…. We need better cooperation and unfortunately that’s not been forthcoming so far.
Narrowly, Rajan is correct, but the underlying problem is much bigger and most orthodox economists are unwilling to confront it because it conflicts with their free markets religion. Carmen Reinhart and Ken Rogoff, in an analysis that got much less attention that their work on debt levels and growth, looked at 800 years of history of crises and found a strong correlation between the level of international capital flows and the frequency and severity of financial crises. That’s implicit in his discussion of the impact of hot money flowing in and out. The Reinhart/Rogoff finding was confirmed by a 2010 paper by Claudio Borio and Piti Disyatat of the BIS that argued that what drives financial crises is not net capital flows (“global imbalances”) but gross capital flows (too much financial “elasticity” as they called it, or what most of us would describe as too much speculation). But Rajan may in fact be referring to remedies like capital controls when he says, basically, that the industrial economies may not like the remedies that emerging economies implement.
Advanced economies may choose to pretend, as the central bankers that Rajan calls out do, that the emerging markets live in a separate universe and their pains are of little importance to advanced economies. That’s true only if distress stays at a low level. As Scott points out by e-mail, the Asian crisis took place when the emerging market share of GDP was in the low 30%. Lehman nearly failed then (although it was a less important firm) and had LTCM not been rescued, its collapse might well have kicked off a crisis. Emerging markets now represent over 50% of global GDP, advanced economies are much weaker than in the 1990s, with more fragile financial institutions and much frothier asset valuations. And you also have the potential for real economy disruption too: global supply chains are much longer, and economic stress can quickly morph into political dislocation. In 1997, the rapid fall of currencies led to food-related riots in Thailand and Indonesia. Energy and agricultural commodity prices are higher now than then, so in many countries, a mere moderate decline in the currency will put a large chunk of the populace in serious distress.
Paul Krugman, without mentioning Rajan, took a broadly similar line in his new column, that advanced economies were making their emerging brethren bear the costs of the failure to clean house (notice how regularly that is projected on to the emerging economies). Key points:
You may or may not have heard that there’s a big debate among economists about whether we face “secular stagnation.” What’s that? Well, one way to describe it is as a situation in which the amount people want to save exceeds the volume of investments worth making.
When that’s true, you have one of two outcomes. If investors are being cautious and prudent, we are collectively, in effect, trying to spend less than our income, and since my spending is your income and your spending is my income, the result is a persistent slump.
Alternatively, flailing investors — frustrated by low returns and desperate for yield — can delude themselves, pouring money into ill-conceived projects, be they subprime lending or capital flows to emerging markets. This can boost the economy for a while, but eventually investors face reality, the money dries up and pain follows.
If this is a good description of our situation, and I believe it is, we now have a world economy destined to seesaw between bubbles and depression.
The larger point is that Turkey isn’t really the problem; neither are South Africa, Russia, Hungary, India, and whoever else is getting hit right now. The real problem is that the world’s wealthy economies — the United States, the euro area, and smaller players, too — have failed to deal with their own underlying weaknesses. Most obviously, faced with a private sector that wants to save too much and invest too little, we have pursued austerity policies that deepen the forces of depression. Worse yet, all indications are that, by allowing unemployment to fester, we’re depressing our long-run as well as short-run growth prospects, which will depress private investment even more.
Oh, and much of Europe is already at risk of a Japanese-style deflationary trap. An emerging-markets crisis could, all too plausibly, turn that risk into reality.
As readers know, NC is not taken with the “secular stagnation” thesis; it’s based on what John Quiggin calls zombie economics, ideas that have been debunked but still soldier on (see here, here, and here). Notice how it leads Krugman to characterize the problem (following Bernanke) as too much savings, as opposed to too little investment. As we’ve written repeatedly, large businesses, which do the bulk of investment spending, have become so fixated on short-term earning that they underinvest. That behavior was evident before the crisis, in 2006. It’s been confirmed by Andrew Haldane of the Bank of England via ascertaining that corporations use too high a required rate of return when evaluating investments, which leads them to invest less than is optimal for them or the economy as a whole (their executives’ pay packages are another matter).
But independent of Krugman’s assessment of why we are in the flagging growth mess we are in now, his description of responses is generally valid. But it’s not “either/or”. The resolution of the crisis has made the top wealthy even richer, while leaving everyone else a smidge worse off. And how much capital chases opportunities is a function not just of gross savings but how much leverage on leverage the financial system creates. As we discussed long-form in ECONNED, the shadow banking system, particularly CDOs, created a tremendous amount of gearing and was the main cause of the “wall of liquidity” of early 2007.
As a result of only superficially addressing the causes of the crisis just past, we are guaranteed to have more, likely even bigger ones, and were hardly alone in espousing that view. Whether this crisis can be contained remains to be seen, but Rajan’s assessment that the major central banks are in “every man for himself” mode does not bode well for dampening down the dislocation.