the global
economic crisis hits its one year
anniversary, it is time to re-examine not
just the strategies for dealing with it, but
also the diagnosis underlying those
strategies. Is it not now clear that the
main macroeconomic challenges facing the
world today are an excess demand for
commodities and an excess supply of
financial services? If so, then it is time
to stop pump-priming aggregate demand while
blocking consolidation and restructuring of
the financial system.
The huge spike in
global commodity price inflation is
prima facie evidence that the
global economy is still growing too fast.
There is nothing sinister in this. The world
has just experienced perhaps the most
remarkable growth boom in modern history.
Given the huge cumulative rise in global
growth during the 2000s it is little wonder
that commodity suppliers have found it
increasingly difficult to keep up, even with
sharply rising prices.
For many
commodities, particularly energy and metals,
new supply requires long lead times of five
to 10 years. In principle, the demand
response is more nimble, but it has been
greatly dulled by a wide variety of
subsidies and distortions in fast-growing
emerging markets.
Absent a
significant global recession (which will
almost certainly lead to a commodity price
crash), it will probably take a couple years
of sub-trend growth to rebalance commodity
supply and demand at trend price levels
(perhaps $75 per barrel in the case of oil,
down from the current $124.) In the
meantime, if all regions attempt to maintain
high growth through macroeconomic stimulus,
the main result is going to be higher
commodity prices and ultimately a bigger
crash in the not-too-distant future.
In the light
of the experience of the 1970s, it is
surprising how many leading policymakers and
economic pundits believe that policy should
aim to keep pushing demand up. In the US,
the growth imperative has rationalised
aggressive tax rebates, steep interest rate
cuts and an ever-widening bail-out net for
financial institutions. The Chinese
leadership, after having briefly flirted
with prioritising inflation (expressed
mainly through a temporary acceleration in
renminbi appreciation), has resumed putting
growth as the clear number one priority.
Most other emerging markets have followed a
broadly similar approach.
Dollar bloc
countries have slavishly mimicked
expansionary US monetary policy, even in
regions such as the Middle East, where rapid
growth is putting huge upward pressure on
inflation. Of the major regions, only
Europe, led by the European Central Bank,
has resisted joining the stimulus party so
far. But even the ECB is coming under
increasing domestic and international
political pressure as Europe's growth
decelerates.
Individual
countries may see some short-term growth
benefit to US-style macroeconomic stimulus,
albeit at the expense of loosening inflation
expectations and possibly paying a steep
price to re-anchor them later on. But if all
regions try expanding demand, even the
short-term benefit will be minimal.
Commodity constraints will limit the real
output response globally, and most of the
excess demand will spill over into higher
inflation.
Some central
bankers argue that there is nothing to worry
about as long as wage growth remains tame.
True, globalisation continues to shrink
unskilled labour's share of global income.
But as goods prices rise, wage pressures
will eventually follow. As Carmen Reinhart
and I have shown in our research on the
history of international financial crises,
governments in every corner of the world
showed themselves perfectly capable of
achieving very high rates of inflation long
before they had the assistance of modern
unions*.
What of the
ever deepening financial crisis as a
rationale for expansionary global
macroeconomic policy? It is hard to see the
argument in emerging markets where inflation
is raging, but even in epicentre countries
it is becoming increasingly dubious.
Inflation stabilisation cannot be
indefinitely compromised to support bail-out
activities. However convenient it may be to
have several years of elevated inflation to
help bail out homeowners and financial
institutions, the gain has to be weighed
against the long-run cost of re-anchoring
inflation expectations later on. Nor is it
obvious that the taxpayer should absorb
continually rising contingent liabilities
(such as increased backing for Fannie Mae
and Freddie Mac, the giant US mortgage
agencies).
Indeed, if
financial firms are not going to be allowed
to go out of business, how exactly do
central banks and regulators intend to
effect the shrinkage of the financial
industry commensurate with the sharp fall in
key lines of business related to mortgage
securitisation and derivatives? Perhaps
regulators hope firms will shrink 10-15 per
cent across the board. But this is seldom
how consolidation works in any industry.
Rather, the weakest firms go out of
business, with their healthy parts being
taken over, or pushed aside by better run
institutions. Is every failure evidence of a
crisis?
The airline
industry often goes through periods of
excess capacity, with giant companies going
out of business or merging. Yet, we have
grown accustomed to these traumas and
learned to live with them, as in many other
industries. Is it right to let the banking
industry hold nations hostage each time they
experience consolidation? As major central
banks extend their discount windows to
complex investment banks whose business
lines are evolving and churning constantly,
“crises” of consolidation are surely going
to become more frequent.
For a myriad
reasons, both technical and political,
financial market regulation is never going
to be stringent enough in booms. That is why
it is important to be tougher in busts, so
that investors and company executives have
cause to pay serious attention to risks. If
poorly run financial institutions are not
allowed to close their doors during
recessions, when exactly are they going to
be allowed to fail?
Of course,
today's mess was many years in the making
and there is no easy, painless exit
strategy. But the need to introduce more
banking discipline is yet another reason why
the policymakers must refrain from
excessively expansionary macroeconomic
policy at this juncture and accept the
slowdown that must inevitably come at the
end of such an incredible boom. For most
central banks, this means significantly
raising interest rates to combat inflation.
For Treasuries, this means maintaining
fiscal discipline rather than giving in to
the temptation of tax rebates and fuel
subsidies. In policymaker's zealous attempts
to avoid a plain vanilla supply shock
recession, they are taking excessive risks
with inflation and budget discipline that
may ultimately lead to a much greater and
more protracted downturn.
*The Time is
Different: A Panoramic View of Eight
Centuries of Financial Crises, NBER Working
Paper 13882, March 2008
The writer is
professor of economics at Harvard University
and former chief economist at the
International Monetary Fund
