The Shifts and the Shocks Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

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1 The Shifts and the Shocks Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Peterson Institute for International Economics 9 th October 2014 Washington DC

2 The Shifts and the Shocks What happened: the shifts and shocks? What is to be done: the solutions? 2

3 1. What happened? This was a gross failure of institutions and also of economic understanding The errors of the old orthodoxy : Inflation targeting; Financial deregulation. It is the second shock to macroeconomics since World War II. Economists have not responded adequately. 3

4 1. What happened? Two causes: macroeconomic shocks and financial shocks. These are intimately interconnected. Macroeconomic trigger - savings glut, fall in real interest rates; imbalances and endogenous monetary policy; Financial trigger - credit creation, endogenous fragility, the Minsky cycle ( stability destabilises ), innovation and liberalisation. The eurozone is the world in miniature. 4

5 1. What happened? SLIDE INTO DEPRESSION RATES OF INTEREST Real House Prices (index number) REAL HOUSE PRICES AND REAL INDEX-LINKED YIELDS US real (S&P Case Shiller National) Spain real UK real Nationwide UK 10-year IL gilts Index-linked Yield

6 1. What happened WHERE EXCESS SAVINGS CAME FROM 4 GLOBAL IMBALANCES (as per cent of world GDP) US Oil exporters Germany and Japan Peripheral Europe China and Emerging Asia Rest of world Discrepancy 6

7 1. What happened THE ROLE OF GOVERNMENTS $14,000 FOREIGN CURRENCY RESERVES ($bn) $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 China Other developing countries Other Asian developing countries Industrial countries 7

8 1. What happened? THE TRAP OF LEVERAGE 350.0% US CUMULATIVE PRIVATE SECTOR DEBT OVER GDP 300.0% 250.0% 200.0% 150.0% 100.0% 50.0% 0.0% Households Non-financial Business Financial Sectors 8

9 1. What happened? RATES AS LOW AS THEY WILL GO 8 CENTRAL BANK INTERVENTION RATES (per cent) Fed BoE Buba/ECB BoJ 9

10 1. What happened? CENTRAL BANK BALANCE-SHEET EXPANSION CENTRAL BANK ASSETS OVER GDP Federal Reserve BoE BoJ ECB 10

11 1. What happened? IN THE US IT IS NOW LOOKING LIKE A NEW ERA GDP (bn) $25,000 $20,000 $15,000 $10,000 $5,000 US GDP (Actual, trend and deviation from trend) 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% Deviation from trend (per cent) 11 $ % Gross domestic product Trend Deviation from trend (per cent)

12 1. What happened IMBALANCES AND REBALANCING 4.0% EUROZONE IMBALANCES ON CURRENT ACCOUNT (as per cent of Eurozone GDP) 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% Germany Other creditors Vulnerable countries France Others Eurozone 12

13 1. What happened? THE EUROZON LEHMANS SPREADS ON TEN-YEAR GOVERNMENT BONDS OVER BUNDS (percentage points) -2 1/1/07 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 1/1/13 1/1/14 Portugal Ireland Italy Spain LTRO OMT TLTRO 13

14 1. What happened ADJUSTMENT WITH ULTRA-LOW INFLATION 5.0 CORE CONSUMER PRICE INFLATION /1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 7/1/12 1/1/13 7/1/13 1/1/14 7/1/14 Germany Italy Portugal Ireland Greece Spain 14

15 1. What happened? OUTPUT IS VASTLY BELOW THE PRE-CRISIS TREND Quarterly GDP (bn) 3,000 2,500 2,000 1,500 1, EUROZONE GDP (Actual, trend and deviation from trend) 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% -12.0% -14.0% -16.0% Deviation from trend (per cent) Actual trend Deviation 15

16 1. What happened? THE BAD AND THE UGLY 110 GDP AND DEMAND IN THE CRISIS Eurozone domestic demand Eurozone GDP US domestic demand US GDP 16

17 2. What are the solutions? Inadequacies of the new orthodoxy : Basically, we have an updated version of the old policy orthodoxy, with the same reliance on monetary policy: Inflation targeting; Same old inflation target; No large-scale policies of debt restructuring; and No co-ordination with fiscal policy. Challenges: finance; and global demand. 17

18 2. What are the solutions? Finance We have basically, the same financial system: Yes, tighter regulation; Hoping for speedy resolution in cases of difficulty; But that regulation is complex and tortuous; Yet greater concentration in banking; Still very highly leveraged; Still relies on risk-weighting of assets; and is also Still global. This all reflects a profound break-down in trust, not matched by radical restructuring. 18

19 2. What are the solutions? Finance Ratio of risk-weighted to unweighted assets declines in four largest UK headquartered banks falls, as leverage increases 19

20 2. What are the solutions? Finance As of July this year, two years after the enactment of Dodd-Frank, a third of the required rules had been finalised. Those completed have added a further 8,843 pages to the rulebook. At this rate, once completed, Dodd-Frank could comprise 30,000 pages of rulemaking. That is roughly a thousand times larger than its closest legislative cousin, Glass- Steagall. Dodd-Frank makes Glass-Steagall look like throat-clearing. Andrew Haldane and Vasileios Madouros, Bank of England 20

21 2. What are the solutions? Finance The key to managing this is expected to be macroprudential policy: A way of protecting the financial sector from the cycle and the cycle from the financial sector; But this will raise difficult challenges: The interventions will be difficult to judge; They will be politically unpopular; They may conflict with monetary policy; and They may have unintended consequences. 21

22 2. What are the solutions? Demand Also macroeconomic policies have failed to generate an adequate recovery. Losses in economic welfare have been enormous. They also, alas, appear permanent. Why are losses so large? Unsustainable pre-crisis trends; Impact of crisis; Debt overhang; and Mistaken post-crisis policies, especially in eurozone? 22

23 2. What are the solutions? Demand Solutions in the medium run: Stronger demand: Ideally via higher public investment. That would be the best response to secular stagnation: Stronger demand in the eurozone. The greater Germany strategy is failing. Eurozone needs to be an adjustment union. Inflation in Germany should be 4 per cent, or so. 23

24 2. What are the solutions? Demand Faster debt restructuring, especially in the eurozone. Possibly better co-operation between monetary and fiscal policy, including helicopter money. 24

25 2. What are the solutions? Demand Solutions in the long run: Global: better insurance for developing country deficits; Domestic: Much more capital in banks; Radical deleveraging of economies; New equity-sharing contracts; and Experiments with 100 per cent reserve banking. 25

26 3. Conclusion This has been a major disaster, by any standards It was caused by the interaction between macroeconomic forces and financial fragility. The new orthodoxy is a big improvement But it is also likely to fail again We need to make the macro-economy more balanced And finance much less fragile 26

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