“We told you so.” The Bank for International Settlements has long warned of the dangers of unrestrained credit growth and asset price inflation. In this year’s annual report, the last to be prepared under the direction of William White, its long-serving Canadian economic adviser, it felt free to point out how right it had been. But it did so with restraint: “Rather than seeking to apportion blame,” it says, “thoughtful reactions must be the first priority.”

The report provides just such reactions. But it also describes the mess created by those who ignored its earlier warnings. “The current market turmoil in the world’s main financial centres is,” it claims, “without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless.”

As readers of BIS annual reports would expect, this one gives good answers to four big questions.

First, why did it happen? The report states that “loans of increasingly poor quality have been made and then sold to the gullible and greedy, the latter often relying on leverage and short-term funding to further increase their profits. This alone is a serious source of vulnerability. Worse, the opacity of the process implies that the ultimate location of the exposures is not always evident.”

Obviously, internal governance and external oversight were deficient. “How,” asks the report, “could a huge shadow banking system emerge without provoking clear statements of official concern?” How, indeed? Moreover, one of the features of the crisis is how widely distributed securitised loans turned out to be. The resulting uncertainty about who owns them, along with parallel uncertainty about what they are worth, has blighted money markets for almost a year (see charts).

Yet, insists the report, the drivers were not so much new inventions as old errors: a long period of easy money, asset price inflation and rapid credit growth. I have much sympathy with this view, along with its corollary, that central bankers bear part of the blame, with a caveat. As I argued in a speech* at a BIS conference last week, the “savings glut” and reserve accumulations by exchange-rate-targeting countries also explain the low long-term real interest rates and monetary easing of the US in the early 2000s.

This then brings us to a second question: how big are the risks now?

The answer is: very large. This is partly because the world economy is poised between deflationary financial and house-price collapses in several high-income countries and an inflationary global commodity price boom. Just as striking are the many huge uncertainties. Will the recent surge in commodity prices prove to be a short-term bubble or long-lasting? Will US households cut back sharply on consumption, which ran at 70 per cent of gross domestic product between 2003 and 2007? Can the deleveraging of the US and other high-income countries occur smoothly, without high inflation? How much more bad debt is still to emerge? Will emerging economies suffer such big inflationary surges that they will be forced to abandon intervention in currency markets? If so, will long-term interest rates jump in the US? Are emerging economies more vulnerable to the slowdown in US imports than many now believe? When will financial markets recover? Are equity markets adequately assessing the risks ahead?

The divergence in possible outcomes is so large that nobody can credibly claim to know what lies ahead. The combination of a massive re-rating of risk with global inflationary pressure is unprecedented and still quite scary.

The third big question is what policies we need right now. The BIS view is that the right bias in monetary policy is towards being “much less accommodating”. Better, it suggests, a sharp global slowdown than a big inflationary upsurge. I agree. But, as it also stresses, in today’s varying circumstances, one monetary policy cannot fit all. Each central bank must assess domestic conditions. This is itself a good reason for larger emerging countries to abandon exchange-rate pegs.

Yet the report does dare to raise a telling question about the US Federal Reserve’s policy of judging what to do in terms of “insurance” against unpleasant outcomes. The danger with this approach is that, if the extreme outcomes are unlikely, Fed monetary policy is likely to be seriously wrong much of the time. The BIS also stresses the need for policymakers and private actors to recognise reality: “If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off.”

The fourth and biggest question concerns the lessons we need to learn. Some instability is a normal part of a capitalist economy. But I do not accept that the huge bubbles in equities and housing over the past decade are normal. Moreover, even if normal, they cannot fall within any definition of desirability.

The most interesting part of the BIS analysis of the lessons is that it focuses not on what is new – the paraphernalia of the modern financial system – but on what is old – “the inherent procyclicality of the financial system and excessive credit growth”. The important point here is that fiddling with details of the regulatory regime or tightening supervision of individual institutions is not the heart of the matter. What matters is the operation of the system as a whole.

This is why the BIS takes such a strong stance on the need to tighten monetary policy when credit growth soars and asset prices explode, even if that temporarily reduces inflation below target levels. This, argues the BIS, would be a more symmetrical use of policy instruments. It is also why the report stresses “macroprudential” policies. These would focus not on the misbehaviour of specific institutions but rather on systemic risks, such as their shared exposure to common shocks and possible adverse interactions among and between institutions and markets.

The aim is clear: it is neither to prevent institutions from going bust nor to eliminate the cycle of boom and bust. The former is undesirable and the latter impossible. The aim is to reduce the frequency and severity of crises. It is not enough to say that we can clear up afterwards. That is too complacent and too one-sided.

We do not have all the answers. But, to its great credit, the BIS has at least defined the right questions.

martin.wolf@ft.com

Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one. Last week I argued that exchange-rate regimes were a link between these distinct events. This week, let us look at how to sail on these storm-tossed seas.

The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way. So what have we learnt about the world economy as a whole? The answer is that it is running into limits on resources, at least in the short term.

Our civilisation is based on fossil fuel. But since the end of 2001, the real price of oil has risen some six-fold. Today, the real price is higher than since the beginning of the previous century. As the World Bank notes in its Global Development Finance 2008, global oil supply stagnated in 2007. This, argues the report, “contributed to the large decline in stocks in the second half of 2007 and to sharply higher prices”*. These increases may prove temporary, as happened after the spikes of the 1970s, or permanent. We do not yet know.

Jumps in energy prices have at least three effects on the economy.

First, they increase headline inflation. In emerging economies, above all, bad inflationary surprises have become the norm (see chart).

Second, they lower potential supply, by squeezing profits in energy-consuming activities, forcing businesses to scrap energy-intensive capacity, and making it necessary to invest in new and more energy-efficient capacity.

In its latest Economic Outlook, the Organisation for Economic Co-operation and Development discusses the consequences of such a negative supply shock on member countries**. It makes two large points: first, uncertainty about current levels and future growth of potential output has risen; and, second, the adverse effects of this may be sizeable.

The OECD estimates that the recent rise in the relative real price of oil has lowered steady-state output by 4 per cent in the US and 2 per cent in the eurozone and lowered potential growth, in the medium term, by 0.2 percentage points and 0.1 percentage points, respectively. This is not trivial: in the case of the US, the decline in the growth of potential output must be at least 10 per cent of potential growth in output per head. In the more advanced emerging economies – and particularly a fast-growing industrialising economy like China – the reduction in the potential rate of growth may well be greater still.

Third, energy price jumps alter the level and distribution of global demand. The move from a price of close to $53 a barrel at the beginning of 2007 to $136 now, increases the annual cost to consumers by around $2,600bn annually, which is a tax of about 4.5 per cent on global non-oil output. Some two-thirds of this transfer is from oil-importing to oil-exporting countries. It is also from those who spend to those inclined to save, at least in the short term.

This shift itself will curb the rise in global demand. So, too, will the financial crises in the US and other high-income countries and the closely related collapse of several huge house-price bubbles. In the high-income countries, growth is forecast by the OECD to slow to a little below trend this year and next. As one would expect, the biggest decline is in the US, with gross domestic product growth of 1.2 per cent this year, almost all of which is expected to be contributed by the rise in net exports. From being a locomotive of growth, the US has become dependent on growth elsewhere.

Yet will this decline in the rate of growth in the high-income countries cool an overheated world economy sufficiently? Perhaps not. The OECD expects a decline in growth outside the OECD, but to levels still above (a hard to measure) potential (see chart). The World Bank’s Global Development Finance does expect a marked decline in developing country growth, though to still high levels, from 7.8 per cent in 2007 to 6.5 per cent this year and 6.4 per cent in 2009. Chinese growth is forecast to slow from 11.9 per cent in 2007 to 9.4 per cent in 2008 and India’s from 8.7 per cent to 7.0 per cent.

Yet, as I argued last week, global monetary policy is probably too loose, despite the adverse impact of the credit crisis on high-income countries. In many emerging countries output is growing quickly, with inflation rising strongly. If, as seems likely, the world economy cannot grow as fast as people hoped only a year or two ago, emerging economies have to be part of the adjustment. This will become still more obvious when, at last, the high-income countries recover fully.

Against this difficult background, what are the right responses and how should they be distributed, across the globe? These need to be divided into the short term and the longer term.

In the short term, the biggest monetary policy requirement is a tightening in emerging economies, many of which now have strongly negative real interest rates. A precondition for such a tightening is a relaxation of exchange rate targeting. Monetary tightening is less obviously necessary in high-income countries, though the US Federal Reserve may have cut too far.

As important is letting the jumps in energy prices pass through, so forcing the needed adjustments in energy use. The beneficiaries of the subsidies offered by many emerging countries are overwhelmingly in upper-income groups. In India, the cost of fuel subsidies is now almost as large as public spending on education: this is scandalous. No less important, however, is abandonment of the silly idea that price jumps in oil or food are the result of wicked “speculation” – a fantasy promoted by dangerous populists across the globe.

Finally, it is essential for the rich countries to cushion the poorest people and countries against such shocks. The aim should be to reduce the pain and to finance necessary adjustment, but not prevent it.

In the medium to long term, the biggest priority is to release energy constraints on growth. This means increased public and private investment in energy research, particularly in renewables. The challenge is huge, but must be met.

The shocks are large. But the more significant one is the high price of energy. The financial crisis was an avoidable stupidity. Rising prices of energy are a bitter reality. The world must adjust to this unpleasant new threat. Ideally, countries would act together. But whether they act together or not, they must act. Otherwise, greater danger – even a bad dose of stagflation – lies ahead.

*www.worldbank.org

**www.oecd.org

martin.wolf@ft.com

Inflation is always and everywhere a monetary phenomenon. Milton Friedman.

What explains the combination of a “credit crunch” in the US with soaring commodity prices and rising inflation across the globe? Are these unrelated events or part of a bigger picture? The answer is the latter. So far this is not a return to the 1970s. But action is needed to keep this true.

Inflation is a sustained rise in the price level: the result of too much money (or purchasing power) chasing too few goods and services. A one-off jump in commodity prices is not inflation. Nor need such a jump cause inflation. But a continuous rise in the relative price of commodities is a symptom of an inflationary process.

Whenever excess demand hits, the goods whose prices rise first are ones with flexible prices, of which commodities are the prime example. Commodity prices then are a pressure gauge. If we look at what has been happening in recent years, the gauge is showing red. The Goldman Sachs index of commodity prices has doubled since early 2007. Nominal prices of oil have increased by 150 per cent over the same period. The upward movement in commodity prices has persisted for 6½ years. It looks as though too much extra demand is pressing on too little ability to increase global supply.

The result is unexpectedly big increases in overall inflation: the consensus for world consumer price inflation in 2008 has jumped from the 2.4 per cent forecast in February 2007 to the 4.3 per cent forecast in June 2008. These jumps are modest, but not that modest. Nor is the forecast level. If people get used to the idea that inflation can jump like this, the notion may well become embedded in expectations, with dire consequences.

Yet how can we have an incipient global inflationary process when the US economy and those of other significant high-income countries are slowing down? The proximate reason is that they matter far less than they used to. The underlying explanation lies in the forces driving both global demand and supply.

On demand, two big things are happening: convergence and the imbalances. Under convergence comes the accelerated growth of emerging economies, above all of China and India. Under imbalances come the interventions in currency markets aimed at supporting competitiveness.

Charles Dumas of London-based Lombard Street Research notes that, at purchasing power parity, China now generates a little over a quarter of world economic growth in a normal year, while emerging and developing countries together generate 70 per cent. Even at market exchange rates, the growth of China’s gross domestic product is as big as that of the US in normal years for both countries.

The emerging countries are also in a good position to keep on growing, largely because they have such strong external positions. Many emerging economies have intervened in currency markets on a huge scale, principally in order to keep export competitiveness up and current account deficits down. Over the seven years to March 2008, global foreign currency reserves jumped by $4,900bn (€3,175bn, £2,505bn), with China’s reserves alone up by $1,500bn. Indeed, as much as 70 per cent of today’s reserves have been accumulated over this period. “Never again,” said the emerging countries hit by crises in the 1980s and 1990s; “not even once,” said China.

Interventionist policies aimed at sustaining export competitiveness expand economies. The results normally include rapid rises in net exports, low interest rates, aimed at curbing the capital inflow, and expansion in the monetary base, despite attempts at sterilisation. The Chinese economy is overheating as a direct result of this trio of effects.

Most of these reserves were accumulated by countries more or less explicitly targeting the US dollar and accumulating US liabilities. The resulting capital flow financed the US trade and current account deficits. But a trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes. The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today’s “credit crunch” is a direct result of the global imbalances.

Today, the hapless Federal Reserve is trying to re-expand demand in a post-bubble US economy. The principal impact of its monetary policy comes, however, via a weakening of the US dollar and an expansion of those overheating economies linked to it. To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

Meanwhile, on the supply side of the world economy, almost every piece of news has been bad. Whatever optimism one might feel about long-run possibilities for increased supply of energy, it is impossible to be optimistic about the short run.

What we see then is an incipient global inflation. Yet the central bank with the greatest influence on global monetary policy is the one confronting the post-bubble credit crunch. Its post-bubble predicament is made worse by the soaring energy prices that result from the strong growth of the world economy.

This then is a global challenge. The advanced countries are no longer the global driving force: they are importing inflation. If the world had a single central bank and a single currency, the former would surely tighten its monetary policy, in light of the evidence on the constraints on the rate of growth of potential global supply. In the absence of such a central bank, the right alternative has to be greater exchange rate flexibility and targeting of domestic inflation.

The world as a whole cannot import inflation: if every central bank assumes that the rise in commodity prices is the product of policies made elsewhere, general overheating must be the result. Worse, if that feeds into expectations the world will be depressingly similar to the 1970s. We are not there. Policymakers must ensure we never do get there.

martin.wolf@ft.com

　

“A full decade after Europe’s leaders took the decision to launch the euro, we have good reason to be proud of our single currency. The Economic and Monetary Union and the euro are a major success.” Self-congratulation is in order at birthday parties. So nobody should be surprised at the effusive remarks in the foreword by Joaquín Almunia, commissioner for economic and monetary affairs, to an excellent study of “Emu@10” (sic).*

How could anybody dare to question the achievements of the single currency? It is considered a credible rival to the US dollar. Jeffrey Frankel of Harvard even predicted in March that the “euro could replace the dollar within 10 years”.** This is a far cry from the scepticism, particularly in English-speaking circles, that greeted both its launch and the subsequent period of declining value against the US dollar. This is a credible currency.

Video: The ECB at 10

Ralph Atkins assesses the European Central Bank’s journey to credibility. Plus interviews with Otmar Issing and José González-Páramo

The successes are indeed obvious: the European Central Bank has established itself as a credible central bank and plausible rival to the Federal Reserve; annual inflation in the eurozone’s member countries averaged 2.2 per cent a year between 1999 and early 2008, against 3.3 per cent between 1989 and 1998; the fiscal deficit fell to 0.6 per cent of gross domestic product last year, compared with an average of 4 per cent in the 1980s and 1990s; nominal and real interest rates have both been lower than for several decades; intra-area trade flows now account for a third of the eurozone’s GDP, up from a quarter 10 years ago; and financial integration has proceeded apace, with the 16 largest banking groups holding more than 25 per cent of their assets outside their home countries.

It is little wonder, then, that the euro has recovered so strongly against the dollar and that in real terms a (synthetic) euro is at its highest since 1970, according to JPMorgan. It is little wonder that the euro’s share of disclosed foreign currency reserves rose from 18 per cent in 1999 to more than 25 per cent in 2007. It is little wonder, too, that the membership of the eurozone has risen to 15 from the initial 11, with more in the wings.

Yet all is not rosy. According to the Commission, real GDP per head grew at only 1.6 per cent a year between 1999 and 2008, down from 1.9 per cent between 1989 and 1998 and well below the 2.2 per cent in Denmark, Sweden and the UK, the three established members of the European Union to remain outside. Labour productivity grew at only 0.8 per cent a year, down from 1.6 per cent between 1989 and 1998 and well below the 1.6 per cent in the US between 1999 and 2008. The unemployment rate fell, but is still far above levels in the other three member states and the US.

The conclusion, then, is that the eurozone is a triumph as a monetary union. Yet it is much less so as an economic union. At the very least, its creation has not caused the acceleration in dynamism that proponents hoped for. If anything, structural reforms have slowed.

Moreover, as the euro soars, the pressures of adjustment to internal divergence are likely to grow to enormous levels. The report is honest about these challenges. Between 1999 and 2007, huge divergences in inflation, relative unit labour costs and current account positions emerged (see charts). These tendencies were exacerbated by the divergence in real interest rates, with the lowest rates in the countries with the highest inflation and – perversely, but inevitably – the strongest economies.

The stories here are two: the divergence in relative unit labour costs between Germany, on the one hand, and Ireland, Portugal, Greece, Spain and Italy, on the other; and the scale of the credit-fuelled property booms in Spain and Ireland. Spain is the most important example: it has had an enormous property boom, with residential investment reaching 9 per cent of GDP, and huge current account deficits, which peaked at 10 per cent of GDP. Yet Italy, which has suffered from chronically weak growth, instead, also has significant competitiveness problems.

How might these adjustments play out? The answer partly depends on what happens in the eurozone as a whole. The probabilities are that growth will slow sharply in the short term, under the pressures of a high exchange rate, the transfers of income abroad generated by high commodity prices and the ECB’s efforts to keep inflation under control.

Meanwhile, the peripheral countries will confront closely related structural and cyclical challenges. The cyclical one, particularly relevant to Spain, is to find new sources of demand, now that the credit boom has run its course; the structural one is to recover lost competitiveness. The two objectives tend to merge in the case of members of a currency union, since these have no monetary policy of their own and limited room for fiscal manoeuvre. So durable recovery will also need big improvements in external competitiveness.

When the euro itself is so strong, this is going to be hard to achieve. Assume, for argument’s sake, that trend productivity growth in the production of tradable goods and services is the same in Spain or Italy as in Germany. Then any improvements in competitiveness demand lower wage increases. A 10 per cent improvement in relative unit labour costs would demand a 10 per cent decline in relative wages. If that were to happen over, say, five years, nominal wage increases would probably have to be in the 0–1 per cent range. Little short of a recession is likely to generate that result.

The optimist would argue that the periphery has only to do what Germany itself did in the early years of Emu. The pessimist would note that Germany’s growth averaged only 0.6 per cent between 2001 and 2005 (inclusive). The pessimist might add that Germany’s self-discipline is legendary and the underlying strength of its manufacturing sector second to none. The pessimist might conclude by noting the behaviour of Europe’s national politicians. Many seem to have believed, or at least hoped, that Emu entry was the end of a tough process, rather than the beginning of one. This is not to argue that the adjustment ahead is impossible, but to stress the scale of the challenge.

Emu has been managed as successfully as such a union could be. For this those involved deserve plaudits. If this success were to continue in the decades ahead, the euro would surely become an ever more important global currency. But the success of the eurozone is not a technical matter. It will demand very tough choices. It will only be assured if overall performance improves and internal adjustment works smoothly. So can we conclude that Emu is a triumph? It is still too soon to tell.

*http://ec.europa.eu/economy_finance; **www.voxeu.org

martin.wolf@ft.com

Silliness is abroad in the UK. Some are arguing in favour of a looser monetary regime. I responded to this two weeks ago (“Britain must not cut loose its anchor”, May 15). Others are even muttering in favour of joining the eurozone, now celebrating its 10th birthday. Even my colleagues on the Lex column argued last week that the UK was close to meeting the economic tests for joining. The only obstacle to entry Lex could find was political.

Lex is wrong. Whether the UK meets arbitrary tests at a particular moment is irrelevant. What is right today may be wrong tomorrow. If a country is to join the eurozone, its people must be willing to cope with the consequences forever, however unpleasant they may sometimes be.

True, at present exchange rates, entry looks more plausible than for the past 12 years. The implied rate of the old D-Mark against the pound was 2.46 on May 23, well below the rate at which sterling was put in the old exchange rate mechanism in 1990. The real effective exchange rate measured by JPMorgan is 7 per cent below its average since the beginning of the 1980s. At present rates, adoption of the euro looks reasonable.

Moreover, add proponents, the UK pays a high price for being outside the zone. The real central bank intervention rate has averaged 3.2 per cent in the UK since 1999, against just 1.4 per cent in Germany or even negative levels in Ireland and Spain. These relatively high short-term rates have also pushed longer-term rates above levels in the eurozone.

Yet none of these points is compelling.

First, not long ago, some argued that the fact that sterling had been so stable against the euro from early 2003 to late 2007 was a reason for joining. Now people argue that sterling should join the eurozone because it is weak. All this shows is that the equilibrium exchange rate varies. The rate that made sense when the world was willing to finance the UK’s property-related borrowing spree no longer does so today.

Second, high short-term real interest rates were needed to contain the growth of credit. If the UK had been a member of the eurozone, with lower interest rates, both credit growth and the economy would have been stronger, domestic inflation higher and real short-term interest rates possibly even negative.

Not only would the inflation and credit overshoot have been even bigger, but now that the domestic spending boom is over, there would be no offsetting stimulus from the fall in the exchange rate. Sterling has fallen by about 14 per cent against the euro since last August. To achieve the same gain, Spain, now struggling with the end of a far bigger property-related boom, would need an annual rate of increase in unit labour costs a percentage point lower than in its eurozone competitors, for a good 15 years. That is quite a challenge.

Third, the advantages of exchange-rate flexibility need not go with worse price stability. Between 1998 and 2008, consumer prices will have risen by just 18 per cent in the UK, the same amount as in Germany and below the 20 per cent rise in France and 26 per cent in Italy, according to the International Monetary Fund.

Now that sterling has fallen against the euro, the domestic price level will rise in the UK relative to the eurozone. But, provided the Bank of England is determined to prevent pass-through to domestically determined prices, this should not endanger low inflation to any significant extent.

Finally, there is no evidence that being outside the eurozone has imposed a performance penalty upon the UK economy. Between the first quarter of 1999 and the first quarter of 2008, its economy expanded by 28 per cent, against 21 per cent in the eurozone as a whole and 16 per cent in Germany. As I noted this week (“Emu’s second 10 years may be tougher”, May 28), there is no evidence that Emu has improved the economic dynamism of its members. If anything, membership seems to have reduced the pressures for reform.

The proposition then is fundamentally an economic one: remaining outside the euro preserves the safety valve of currency flexibility, while losing nothing in aggregate economic performance. Being outside has not even hurt London’s position as a financial centre.

The big proviso is that the Bank of England continues to fulfil its mandate. That might now require a period of much slower growth, or even a recession. But long-lasting slowdowns in particular economies are just as likely (probably even more likely) inside the eurozone.

Yet the proposition is also political. Inside a currency union, years of slow growth will occasionally be needed if relative costs are to come back into line. There are countries in which it is possible for politicians to sell this proposition. Spain and Italy may be among them. The UK is not. That is the beginning and the end of this story.

martin.wolf@ft.com