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|Boom, bust, boom, bust...|
|Thursday, 19 March 2009 23:40|
Larry Summers, Director of President Obama's National Economic Council, has been perhaps the most powerful economist of his generation. A distinguised academic career, World Bank Chief Economist, Treasury Secretary under Clinton, President of Harvard and now back again under Obama.
So when Summers speaks, it is worth listening. On Friday March 13 of all days, Summers gave a very interesting presentation on the economic crisis at the Brookings Institution in Washington DC.
Summers first reminded us that there are two types of economic downturn. Usually we get a downturn as a result of central banks efforts to control inflation -- like in the early 1980s after the second oil price shock.
Another type of economic downturn "comes from the spontaneous correction of financial excess, the bursting of bubbles, deleveraging in the financial sector, declining assets values, reduced demand and reduced employment". This is the situation that we are in today as $50 trillion of global wealth has been wiped out over the last 18 months, including $7 trillion in the US stock market and $6 trillion in housing wealth. What Summers does not mention is that a lot of that was phony wealth generated in the asset bubble.
To understand the genesis of the crisis, it is important to go back to Economics 101. In that world of undergraduates, markets are self-stabilising. When there is too much supply, prices fall, producers produce less, consumers consume more, and the market comes back to equilibrium. This is Adam Smith's invisible hand.
However, we learnt from John Maynard Keynes that this does not always work. (Keynes was much maligned for a long time, but he comes back into favour each time that his theories suit our circumstances.) According to Keynes General Theory, two or three times each century, the self-equilibrating properties of markets break down, as they are overwhelmed by vicious cycles.
"Consider the vicious cycles. Declining asset prices lead to margin calls and deleveraging which leads to selling, further declines in asset prices, perpectuating the cycle. Lower asset prices mean banks hold less capital. Less capital means less lending. Less lending means lower asset prices, and the cycle perpetuates. Falling home prices lead to foreclosures which lead home prices to fall even further, forcing more foreclosures, forcing losses in the mortgage sector, forcing reductions in lending, forcing housing prices further down. A weakened financial sector leads to less borrowing and spending, which leads to a weakened economy, which leads to a weakened financial system. Lower incomes lead to less spending, which leads to less employment, which leads to lower incomes. And I could go on. These are not processes that are self-correcting."
In this context, the role for policy is to break and reverse this cycle produced by an abundance of greed and an absence of fear. "The risks of overreaction are dwarfed by the risks of inaction." So the Obama administration has launched a massive fiscal stimulus, is working to restore financial sector stability and is trying to break the vicious cycle of foreclosures and declining prices in the home market. Beyond that, the US administration will be overhauling the financial regulatory system.
I am sure that Summers and his team are doing the best they can, and that the dynamic US economy will recover as it always has in the past. The risk is that the powerful stimulus will, like last time, plant the seeds of the next bubble.
I am however somewhat puzzled looking closely at Summers' remarks. He starts by noting Keynes insight that markets have vicious cycles two or three times every century. And then later on he notes that "in little more than two decades, we have seen the stock market crash of 1987, the savings and loan scandals, the decline of the real estate market, the Mexican crisis, the Asian crisis, Long Term Capital Management, Enron. That works out to one big crisis every 2 1/2 years...".
Surely this suggests that there is something more fundamentally wrong with the functioning of financial markets. They are bubble-prone. Each successive bubble or crisis is a different one from the previous one, which makes them hard to identify in advance. And you can only be sure of bubbles after they burst.
Financial and commodity markets are often driven by herds. And once the herd gets started, it is almost impossible to stop it -- especially in the US, the land of excessive dynamism, enthusiasm and optimism.
"Responding to an Historic Economic Crisis: the Obama Program", Lawrence Summers, Director. White House National Economic Council. Friday, March 13, 2009. The Brookings Institution. www.brookings.edu/