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The Deep Roots of the Financial Crisis

Interviewee: Martin Wolf, Associate Editor and Chief Economics Commentator, Financial Times
Interviewer: Lee Hudson Teslik, Associate Editor, CFR.org
October 21, 2008

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The narrative of the financial crisis of 2008 typically begins with the U.S. housing market. Overeager lending and borrowing led to a large housing bubble, and the bad debt from these loans was then securitized and spread throughout the financial system. But Martin Wolf, associate editor and chief economics commentator at the Financial Times and the author of a new book on financial crises, says the roots of the crisis in fact stretch back much further. In the late 1990s, Wolf says, as Asia recovered from a string of financial crises, governments endeavored to accumulate large currency reserves so as to never again have to borrow from the International Monetary Fund. This buildup accelerated as rising commodity prices led to foreign exchange gluts in oil-exporting countries. The result, Wolf says, was a fundamentally skewed system--as countries with large surpluses sought to invest their foreign exchange holdings, they poured money into developed countries, making money cheap and facilitating the emergence of housing bubbles. Now, Wolf says, that dynamic is rapidly unwinding. In the long term, he says, rebalancing the world economy will require strengthening capital market infrastructure in developing countries to allow them to invest in their own communities in their own currencies. More immediately, he suggests countries like China should encourage greater domestic consumption to provide an outlet for excess capital reserves.

You've written about the broader, long-term factors that led to the current financial crisis, beyond the immediate problems with subprime mortgages and the fallout from that. Can you explain?

The background to the so-called subprime crisis in my view should be seen in the context of the whole global financial system and global macroeconomics over the last three decades. In essence, after a long series of massive emerging market financial crises, the biggest and most important of which occurred in Asia in the late 1990s, a very large number of emerging economies, certainly the bigger ones, decided that running very large current account deficits, financed by foreign currency borrowing, predominantly in dollars, was very dangerous. When some shock occurred which created doubts among creditors on their ability to repay, there tended to be massive financial collapses, massive currency declines, mass bankruptcy, and terrible depressions. So they didn't want to do this anymore. There was a really fundamental shift in the emerging world that was reinforced by the entry of China as an enormous exporter with an undervalued exchange rate, and also the higher oil prices. All this together led to the emergence of enormous savings surpluses, which are current account surpluses by definition, in the emerging world. It was quite a novel phenomenon that the relatively poor countries of the world should be exporting so much capital. Currently, in aggregate, they're exporting about a trillion dollars a year. These are very, very large sums. And as a result of these policies, they accumulated enormous foreign currency reserves. The foreign currency reserves of the world have risen from about one and a half trillion to seven trillion over the last eight years, nearly all in emerging economies. China alone holds nearly two trillion.

Now, the simple truth is the world economy has to balance. Aggregate savings and investment have to balance, current account surpluses must be offset by deficits. As it turned out--and I think it's not an accident in this context of savings surpluses in the emerging world and very low real interest rates--the environment was established in which very significant housing bubbles began to emerge in a number of developed countries. Low real interest rates made it very attractive to borrow; [there were] low normal interest rates because it was low inflation in the world; and in countries with highly elastic credit systems--notably the United States, English-speaking countries like the UK and Australia, also Spain--there began to unfold enormous housing bubbles. This was associated quite naturally with a self-reinforcing binge of household borrowing, much of it securitized in the English-speaking world. As house prices rose, it seemed perfectly sensible to borrow more, spend more on bigger houses, or just borrow and spend more. This then led to huge current account deficits, with these countries absorbing most of the surpluses. That then created the conditions, in my view, for the financial crisis at the macroeconomic level. It was a consequence of this overall environment. And I think this remains the backdrop to any thoughts we have over how we're going to escape from this crisis.

Globalization already faces some very serious challenges, but this has emerged as potentially a death knell. Do you think it is?

I think not, and I hope not because it's difficult for me to imagine a really sensible alternative. But there clearly are two huge challenges posed by the crisis that we're now living through. First, there is likely to be, if not a true global recession in the sense of falling GDP [gross domestic product] across the world--that's very unlikely because emerging economies will continue to grow quite fast--still an enormous decline in global growth. The IMF [International Monetary Fund] has most recently forecast growth next year at below 2 percent, which is really very, very low. And that means, to translate into things that people feel, it means lost jobs; it means rising joblessness; it means collapsing companies; and with collapsing companies that means collapsing pension systems and so forth. You can see that happening all over.

When that happens, people are very strongly tempted to elect populist politicians of the left or right, many of them protectionist. That danger is clearly there just because of the economic slowdown. In addition, of course, it's obvious that this financial crisis has called into question the legitimacy of the free market, the credibility of financial capitalism, and people don't make subtle distinctions between† financial capitalism and free trade; they seem sort of the same. So there's a danger of contamination from this to the idea of markets all together. And, again, the globalization process is only the global market economy, so there's an intellectual challenge as well. If you add the economic challenge to the intellectual challenge, we're going to have to do a very credible job of explaining that we're going to do better in the future, managing the global adjustment on macroeconomics and the balance of payments that I've discussed, and getting back to growth. It's going to be very hard.

Clearly there's much more capital flowing around financial markets than there has been ever in the past. Can you talk about this dynamic and the challenges it poses?

There are huge stocks of capital now being owned by oil producers, governments, particularly in the emerging world in the form of foreign currency reserves and so-called sovereign wealth funds. There is this huge annual flow of surpluses being accumulated, again much of it in the oil-exporting world. And the question is, where is it going to go? How is it going to be used? If you look at it, a large part, actually, went directly or indirectly into household borrowing in rich countries. That's not a sustainable process, and it's sort of come to an end. What you want to see is these countries investing in places which really need additional capital. And on the whole, the developed world doesn't. Their companies don't want to invest a great deal in countries which are rich and have slow-growing populations--[that's] not the logical place to invest. They want to invest in emerging economies. But at the same time many emerging economies, particularly big ones like China, have more savings than they themselves can use. They also have very limited and inflexible capital markets. So the problem for many of the smaller rich countries around the world, emerging economies particularly, is that they've got all these savings, and they've got this stock of capital which they would like to invest in emerging economies, but the opportunities really aren't there (on this scale, when we're talking about trillions). To give an example, the inflow of foreign direct investment into China in recent years has been running--I haven't seen the most recent figures--about $60 billion a year. That's trivial in this context. So they end up continuing to try to invest in the developed world, the big capital markets. And this is a really fundamental problem. There is a great desire across the world to accumulate foreign assets-and particularly in these countries, these oil-exporting countries and countries of that kind-but there isn't the supply of good assets for them to buy. That makes one worry that we may have repeated crises of the sort that we've recently seen.

How long will it take to develop capital markets, to fix that situation?

That's going to be years. I don't see that being solved easily. We can get somewhere in the right direction through more macroeconomic policy changes. In particular, countries with surplus savings which are relatively poor, like China, should be encouraging higher levels of household and government consumption at home, instead of saving and accumulating foreign currency reserves, which have a negative real return. By doing so, they will expand domestic demand, they will shift production away from exports at the margin towards domestic consumption. As long as China continues to have a current account balance or surplus, there's not much risk in this given the reserves, and I think China could easily run a moderate current account deficit. India, certainly, should be able to run a bigger current account deficit financed by foreign direct investment. India, in fact, is a country which really does have potential, if it does continue with its reforms, to be a place which might more quickly be a good one for the Gulf states to invest in. There's a natural economic complementarity between the two. They're close together, they're comfortable with one another. That's really quite encouraging. But this is going to be a slow process. A combination of microeconomic reforms with macroeconomic policy changes are going to be needed to bring about better balance in the world economy.

Many analysts have compared the current U.S. crisis to Japan's of the 1990s. Could you compare and contrast the policy responses in the two situations?

The situation has similarities. It's a massive price bubble that's collapsing and has a lot of bad lending associated with it. So in that sense it's similar. And it's related to credit expansion and property, which was a very important element of the Japanese crisis. But there are some important differences both in what's happening and in the response. First, the Japanese had an absolutely enormous asset price collapse. If you include stocks, equities, land, housing, and commercial real estate, price falls were in the neighborhood of 70 percent from their peak. It was an absolutely gigantic destruction of collateral in the system, and obviously inevitably that created a huge amount of bad debt. It was a very long-run decline-the decline continued for about a decade in the case of housing.

It's very difficult for me to believe, looking at the figures, that the prospective declines in prices of housing in the United States are of that scale. More likely [the] peak to trough [will be] 40 percent or so. Equity prices in fact already are pretty well at reasonable values. They could of course overshoot downwards, but they're not unreasonably high anymore; on the contrary. So we should assume that the asset price collapse will be much smaller. Second, partly because of the securitization process--because it wasn't bank debt, unlike the Japanese case, and it wasn't a stable oligopoly like the Japanese banking system--the financial problem has become much bigger much quicker, with the financial collapse having occurred roughly two years after the house prices peaked. In Japan it was eight or nine years and, correspondingly, the interventions now taking place are the ones the Japanese introduced about eight or nine years after the crisis began. So we're almost seven years ahead. And nobody's thinking anything other than, "We've got to rescue it, we've got to make the economy recover." So in that sense, we're further ahead in the adjustment process, much further ahead. And I think there really will be absolute determination to try and get a recovery going, whatever it costs.

Japan had the great advantage that it was a creditor of itself. The Japanese are very large net creditors. The government was borrowing from the Japanese household sector, which was willing to finance the government to an enormous scale. One of the interesting questions is whether that will be true for the United States, which is much more reliant on foreign savings. So there is a bit of a concern perhaps of a loss of confidence in the dollar, which was a much less real danger for the Japanese. On the other hand, the U.S. dollar is still the global currency; it's very difficult to think of an alternative currency for the world. Even the euro isn't really an obvious alternative. So that may net out on balance as not being a very big difference between the two. Maybe a problem of some other countries, like the United Kingdom, which don't have those advantages. So I think the United States will probably get through that.

But overall, I think we are going to go through a similar sort of process as the Japanese in the United States and in some other developed countries. But I expect it to be quicker and possibly more brutal. The Japanese didn't have a really big recession; they essentially had a decade of stagnation, or semi-stagnation, very low growth, about 1 percent a year. I think what we're going to see in the United States, being more of a boom/bust economy, is a big recession. Might last a couple of years, and then probably quite a strong recovery. So it will be short and sharp and painful, rather than long and lingering, but I feel at the moment that we might see a recovery a couple of years from now, which is a more vigorous capitalist system than in the Japanese case.

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