The crisis, global imbalances and the role of emerging markets

Shanghai conferenceGilles Saint-Paul

A. The Context: Global Imbalances

An unsustainable boom

• Very large trade deficits of the US• These deficits were due to a very low savings

rate (= high consumption)• They were financed by excess savings in China,

Japan, and producers of primary materials• This was further fueled by

– BofC exchange rate policy– Low FED interest rates

What should the adjustment look like?

• A large, permanent fall in US private consumption expenditure (by 5 % of US GDP)

• A reallocation of economic activity to the export sector (by 5 % of US GDP)

• A depreciation of the US real exchange rate (by 20 % to 40 %)

A crisis difficult to avoid

• US consumption has to fall by 2 % of World GDP• US export increase has to be sustained by a rise

in demand outside the US, i.e. in China• But this conflicts with the Chinese mercantilist

policies as well as their inadequate internal market

• Furthermore, US fall in aggregate demand as well as depreciation will have massive effects on the Eurozone

B. The Housing Bubble

Fig. 2.2Case-Shiller House price index

Source: Standard & Poor Case-Shiller, composite index.

40

60

80

100

120

140

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200

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240

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

January 2000=100

What is a bubble?

• Loosely, « prices are too high »• However, too high prices can be rational• Price deviates from the fundamental because

prices high in the future• Asset held even though bubble may rationally

be expected to burst• In this case, it rises even more quickly

Are bubbles sustainable in general equilibrium?

• In the long-run, the bubble cannot grow faster than the economy

• A bubble is more likely,– The higher the growth prospects– The lower the interest rate

• These conditions were satisfied during the relevant period

Fig. 1.1Economic growth and Ifo economic climate

for the world

Sources: IMF, World Economic Outlook Database October 2008, Update January 2009 (GDP 2008, 2009 and

2010, EEAG forecast); Ifo World Economic Survey (WES) I/2009.

2.9

1.52.0 2.0

3.4 3.3 3.7 4.0

2.53.5

4.7

2.22.8

3.6

4.94.5

5.1 5.2

3.4

1.42.3

0.0

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90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 1040

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140

Real GDP growth

Ifo World Economic Climate

% 1995=100

(left-hand scale)

(right-hand scale)

a) Arithmetic mean of judgements of the present and expected economic situation.

a)

Fig. 1.15

Sources: European Central Bank; Federal Reserve Bank of St. Louis; Bank of England; Bank of Japan.

Central bank interest rates

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Federal funds rate (US)

2.0 %

0.25 %

%

Main refinancing bid rate (ECB)

1.5 %

Bank rate (UK)

0.1 %Average target rate (BoJ)

The consequences of bubbles

• A wealth effect consumption goes up– Ex: consumption loan taken out of a loan against

appreciation in the value of the house

• Most houses owned by US residents US trade deficit goes up

• Foreigners may want to join the bubble rise in demand for US assets US trade deficit goes up

The consequences of bubbles (II)

• Corporations and entrepreneurs make capital gains

• They can use their assets as collateral• Borrowing easier• The cost of capital falls• Investment goes up• This is called the financial accelerator

Fig. 1.12

Sources: European Central Bank; Ifo Institute calculations.

Credit growtha) in the euro area

0

2

4

6

8

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16

2001 2002 2003 2004 2005 2006 2007 2008

Lending for house purchases

Corporate credit

Consumer credit

%

a) Annual percentage chnage; corporate credit = credit to non-financial corporations; lending to house purchases = credit to private households and Non Profit Institutions Serving Households.

Fig. 1.18

Spread between corporate and government bonds

Sources: Deutsche Bundesbank; EcoWin; Ifo Institute calculations.

0.0

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6.0

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1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

USA Baa long term (left-hand scale) Euro area BBB 10 years (left-hand scale)

Bank bonds Germany 9-10 years (right-hand scale) Euro area AAA 10 years (right-hand scale)

%%

Fig. 2.5

Source: Federal Reserve Bank.

Commercial paper outstanding in the United States

600

700

800

900

1000

1100

1200

2004 2005 2006 2007 2008

Non-asset backed CP

Asset-backed CP

Billions of dollars

The consequences of bubbles (III)

• If asset is accumulable, greater incentives to produce it

• Excess investment in the bubbble-ridden sector

• Ex: construction boom in US, Spain

C. The crisis

A 3-dimensional crisis:

• A solvency problem• A liquidity problem• A demand problem

The solvency problem

• Lenders assumed house prices would not fall– Bank made whole by seizing the house– Everybody can get a loan– Add deregulation and the loan can be 100% of the

purchase price

• But prices did fall– Giving back the house cheaper than reimbursing– This would have happened anyway as repossessions

would have taken place and depressed the price

The spreading of insolvency

• Securitization diluted ownership of mortgages throughout the financial system

• In principle, this is good, BUT– Systemic price risk ignored– Institutions highly leveraged all ended

vulnerable– Moral hazard problem in monitoring the loans

How to deal with insolvency?

• Insolvency is taken care of by bankruptcy• What is bankruptcy?• Shareholders lose their shares• Creditors take over and the losses are

allocated between them• The firm starts again

Why not?

• It is a lengthy process• Some assets may be inefficiently liquidated• But it could have been doable with

coordination by the government• One simple way of doing it is

– Computing the true value of the assets– Do a debt/equity swap

A debt-equity swap:

Assets Debt Equity

Before the crisis 120 100 20

During the crisis 60 100 -40

Conversion 1 $ of Debt 0.45 $ of Debt + 0.15 $ of equity

After the crisis 60 45 15

Why a bailout instead?

• Policymakers feared a run on the financial system• Runs exist because assets are less liquid than

liabilities• Example:

– 100 $ of deposits == 100 $ of a house– If all withdraw their deposits, all houses have to be

sold– But the equilibrium price will fall, not all can be paid– It is then rational for me to withdraw before the

others Bank run is one equilibrium

Two aspects of liquidity

• A (real) asset is worth less if liquidated now than allowed to continue to run– Deposit insurance will eliminate the « run »

equilibrium, since everybody will be served

• A (financial) market may be too thin for absorbing a large supply shock– Government purcha ses may render the

market liquid

The transmission mechanism

• The bursting bubble reduces aggregate demand through two mechanisms:– Wealth effect on consumers– Financial accelerator on firm

• Furthermore, this is exacerbated by debt-deflation:– Which increases the default rate– And reduces the (net) collateral of borrowers

The policy response

• Replace the bubble by the same nominal amount of public debt (Bail out)

• Replace private consumption by public consumption (Stimulus)

• Print money

D. The response to the crisis

Bail out

• Bailout prevents technical bankruptcy of bailed out institutions

• Bail-out can be win-win if value of assets < true value because of liquidity (ex. Sweden)

• Unlikely in the present situation: cost to tax payer is real

• Furthermore:– Opacity on the withdrawal of toxic assets– Sets the stage for another round of excessive risk-

taking (Moral hazard)

“The TARP was originally conceived to purchase troubled assets directly from banks. However, as quickly became apparent, properly valuing these assets was extremely difficult as a result of ongoing home mortgage foreclosures, defaults, and falling house prices. The financial turmoil intensified in the weeks following the bill’s passage, and to move quickly, the U.S. Treasury established the Capital Purchase Program (CPP), which became the centerpiece of TARP. The goal of the CPP was to recapitalize healthy banks by purchasing preferred shares of stock in banks instead of purchasing their troubled assets”

Stimulus

• Governments apply standard Keynesian analysis

• But the required US fall in consumption is permanent, not temporary

• Stimulus postpones the adjustment by preventing real exchange rate depreciation and price falls– G instead of X replaces C

Perverse effects of stimulus

• If future taxes highly distortionary, adverse response of consumption and stimulus contractionary (Cf japanese experience)

• Furthermore, expectations of stimulus make recession worse in the short run by maintaining high prices

• Finally, one may exit in a worse situation, with impoverished consumers and deteriorated public accounts

Money

• The liquidity injected replaces internal money with external one

• This may prove highly inflationary when the internal money creation process resumes

• Furthermore, a chunk of the money is backed by poor assets

• Withdrawing the money when exiting the crisis may prove a delicate task

Fig. 2.7 Central bank balance sheets

Source: European Central Bank; Federal Reserve Bank.

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2400

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J F M A M J J2007

A S O N D J F M A M J J2008

A S O N D J

Billions of euros Billions of dollars

FED b)

ECB a)

a) Total assets/liabilities. b) Total factors supplying reserve funds.2009

E. The near future and the role of China and emerging markets

Implications for China: consumption

• Consumption must rise in China– Because US aggregate demand cannot continue

at that rate– Because Chinese growth rates are high and

consumption should be smoothed– Because China has accumulated a large – stock of foreign assets

Implications for China: real exchange rate

• To sustain higher consumption, the Chinese real exchange rate must appreciate

• Pegging the renmibi to the US dollar does not prevent it

• It postpones it and makes it happen through inflation

• Dangerous because of inflation inertia• Better to let the renmibi float, albeit in a

managed way

Where should the money go?

• US assets have low return– Recession– Uncertainty about the dollar– Uncertainty about inflation– Potential high future taxes, including on capital

• In similar circumstances, many countries have experienced massive depreciation and BoP crisis

• This is not happening (yet). Why?

The investors lack alternatives

• Eurozone suffer from similar problems• Other zones suffer from insecure property

rights and/or undeveloped markets• Consequently US assets remain paradoxically

a good deal

The Euro option:

• Inherited stock of public debt typically higher than in the US

• Monetary policy more conservative lower LT inflation risk

• Euro may be over-valued• Some countries with fiscal/competitiveness

problems may jeopardize the Euro

The emerging market options

• No country among B,R,I,C has an established reputation of securing property rights (I ?)

• Return on investment also depends on development of internal markets:– Access to customers– Existence of a mass consumption sector– Financial development– Lack of financial repression

Conclusion• It is illusory to stimulate by perpetuating the

diseases of the boom, i.e.– Overconsumption– Overindebtedness and bad loans– Misallocation of activity

• Aggregate demand must move where the money is (China, etc.)

• The US Real exchange rate must depreciate (this process has started)

• The US is lucky to have avoided sharp capital flight so far.