Thursday, April 16, 2009

double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

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