Still something to look up to? (AFP)
Martin Wolf, chief economics commentator at the "Financial Times," discusses the origins of the current financial crisis and its potential implications for the United States and the world. In an interview with RFE/RL correspondent Jeremy Bransten, he outlines the different scenarios of how the crisis may play out -- from the most optimistic, to the most pessimistic.
RFE/RL: American economist Paul Krugman says we're in the midst of "an epic financial crisis." Former U.S. Federal Reserve Chairman Alan Greenspan recently said the current financial crisis in the U.S. is likely to be judged in retrospect as "the most wrenching since the end of the Second World War." And you wrote in the "Financial Times" this week that March 14, when the Bear Stearns bailout was announced, is "the day that the dream of global free market capitalism died." That's a strong pronouncement. Are we seeing a crisis in the Anglo-Saxon model of capitalism?
Martin Wolf: Yes, I think we are in fact, in very important ways. If you think that what we've been embarked on for the last 30 years -- and this is a very "rough and ready" reading of history, but I think it's not entirely wrong -- is a journey across the world toward ever more liberal economies, with the U.S. being in some ways the model toward which everybody was moving, more flexible, more dynamic, with a highly deregulated financial system. Then, I think that journey has stopped.
RFE/RL: Why was so much of the world following the U.S. model?
Wolf: The reason that model was so credible is not only that the U.S. was the richest country in the world, but because the evolution of the U.S. financial system -- which is the core, after all, of a capitalist economy -- seemed to offer a combination of flexibility with robustness that we weren't seeing elsewhere in the world.
The dominant feature of this system, as it emerged, was a shift from bank-based relationship lending to transaction-oriented activities, in which the financial system itself was engaged in arranging lending, arranging funds for borrowers, then packaging those funds into securities and selling them on to third parties, who would hold them for long periods: investment funds, pension funds, insurance companies, institutions like that.
This was the vision of the sort of model we had been moving toward worldwide. And this is quite clearly the model that is now breaking down. And it's broken down in really quite a spectacular manner, because many of the markets on which this model relies have basically been frozen for six or seven months. They've just disappeared. People can't transact in these activities.
No Consensus
RFE/RL: What seems most alarming is that economists, financial traders, and politicians still can't seem to agree on where we are. Are we at the start of a massive unraveling of the financial system as we know it? Economist Nouriel Roubini, who is a famous pessimist, recently wrote an analysis entitled "The 12 Steps To Financial Meltdown" that got a lot of attention. He says we're now at Step 9 and heading toward catastrophe. Other economists claim the end of the crisis is in sight. One day stock markets are way up. The next day they plummet. Commodity prices in recent days have also been gyrating wildly. Why can't the experts agree on what is happening and why? Is it because the financial products were so complex and they were repackaged in so many ways that we still don't know the extent to which the global financial system has been infected?
Wolf: I think you're asking the most important question, which is why do we all disagree about what might happen? I think the short answer comes in two words. One is "complexity" and the second is "novelty."
It's an incredibly complicated crisis, which involves the interconnection of macroeconomic conditions -- in particular the global imbalances, which played a very large part in this and monetary policy, with a lot of criticism of the Fed's monetary policy in particular. So there are macroeconomic conditions here. Then there's a very large asset bubble in housing, not just in the U.S., but in much of the developed world. So that's a big relative price change. There are important shifts in background conditions, particularly associated with inflation.
And finally, there's the mess in the financial system itself. These are all interrelated. And this makes it incredibly difficult to unravel the complexity of what's going on. And it's very, very easy to focus on just one aspect of this, while ignoring all the others.
And as I said, the other aspect of this is novelty. In important ways, the financial system we have today is different from any financial system that has existed in the past. The decline in house prices we're now seeing in the U.S., across the country, is unprecedented for the U.S. The interconnectedness of the world economy is itself also unprecedented. So there are very important elements of novelty here. And because it's new, we don't really have that much experience to go on.
RFE/RL: Can you elaborate on the main factors underpinning all this uncertainty?
Wolf: Let me just say what I think are the things on which the uncertainty hangs. The first thing we don't know -- and it's of incredibly large importance -- is how far house prices in the United States are going to fall. The reason we don't know that is because we've never seen something like this. Obviously, the further house prices fall, the more borrowers will find themselves with negative equity, so that has an enormous direct effect on the scale of the danger.
The second thing we don't know, and it's a very importance difference between Nouriel Roubini and some others, is what proportion of these homeowners who find that they owe more on their house than the value of the house, will default. That's simply something we have to guess, because there is, again, no experience for a situation in which possibly up to 9 or 10 million people might be in this situation. It is at least conceivable. And because we don't know how many people will default, we don't know what proportion of the losses suffered by homeowners will be borne by the financial system, which is where the financial crisis arises.
The third thing we don't know is how effective the various government policies to prevent mass defaults are going to turn out to be. At the moment they look pretty ineffective. There is a large fiscal stimulus going on. It's going to put money in the hands of people that at least might be an offset to some of the depressing factors here.
A fourth thing we don't know -- the list is long -- is how American households in general will respond to a reduction in their housing wealth and an increase in the likelihood of default by many Americans. The reason this matters so much is that American consumer demand is the dominant source of demand in the U.S. economy -- it's about 70 percent of GDP.
American households have not been saving, in aggregate, for many years. And in fact they've been spending more than their incomes for basically the last 10 years. If they should stop doing that in the situation and simply say: "We must start saving as we used to in the past," that would immediately have the effect of tipping the economy into a recession.
There's nothing big enough to offset that decision. And if the economy went into recession, there would be lots of unemployment, corporations would cut back their investment, households would find their financial positions worse. And that would clearly aggravate. You'd have a downward spiral. And we don't know whether that's going to happen.
Then we can turn to the financial system itself. The difficulty here is we don't know where the losses are. We don't know when or if ever people will be able to trade in this securitized paper again. And if they can't trade in it, it's stuck on their books. And if nobody knows how to value it, they might be stuck on their books for 20-30 years, unless the government takes it all over, which it might do.
Because we don't know these things, it's quite clear that many financial institutions are very unwilling to trade with other financial institutions and they are also very keen to hoard cash to meet any obligations they may have in the future, because they're not sure they can borrow from other financial institutions. So that's frozen the interbank market and money markets. And we don't know how long that will last either. The central banks have made really quite extraordinarily aggressive moves in the last six months to get those markets unfrozen. And they have actually not been fully successful. That itself has been very extraordinary.
If you just focus on these factors, and I've just listed a few of them [it's a lot to deal with]. There are other very important uncertainties, among them how strong will demand be in the rest of the world? Will it keep the world economy growing and offset a big U.S. slowdown or not?
The uncertainties are so huge because of the complexity and the novelty of this situation that it really is impossible, it's simply impossible to say what's going to happen. I have my own guess that we're going to have a pretty deep recession and it's going to be a long process of recovery in the financial system and in the American economy. But that is a guess and I might well turn out to be wrong.
RFE/RL: What you're saying is that the only way to keep the United States from a massive recession is to ensure that U.S. consumers keep spending and keep borrowing. So the government is basically hoping that Americans will take out more loans and use the $600 checks they will soon receive from the Treasury, to shop. Won't this -- at most -- just delay the crisis until later?
Wolf: The hope is that the adjustment will be slow. If you're optimistic, what you would hope would happen would be something like this: U.S. households will slowly save a higher proportion of their income, as indeed they almost certainly should. And the U.S., in aggregate, will save a higher portion of its income, as it should. This will be offset by an improvement in the U.S. external account, a reduction in the current account deficit and therefore reduced borrowing abroad, which will be replaced by household savings at home. Because the dollar is very weak, exports are doing rather well, so indeed net exports are improving. That is offsetting the increase in savings, but it can't do it very quickly. The U.S. is a very large economy in which trade is a relatively small portion of GDP. You can't offset a big weakness in the domestic economy with improved net trade, if the weakness in the domestic economy comes very quickly and is very severe.
The net trade is just not big enough to do it. But over five years or so it might be possible. So you would imagine four or five years of relatively weak demand growth, probably a weak economy -- not a disastrous one but an economy in which growth tends to be below potential and unemployment tends to be rising -- the current account improves and the U.S. emerges much better balanced and stronger.
Essentially, this is the offset to the long period since the mid 1990s in which domestic demand was extraordinarily strong, the current account deficit exploded and the U.S. had pretty good times in terms of consumption growing significantly faster than income over a long period.
So that would be the optimistic picture: a slow adjustment over several years and I think that would be manageable. But if that adjustment were to be [shrunk] into a year or two, you would certainly have a very, very deep recession.
The Fed's Actions
RFE/RL: Could the Fed get into trouble? So far, it's basically pledged to swap half of its available funds in exchange for potential bad debt from investment banks. Could the Fed run out of money or go bankrupt?
Wolf: The answer to this comes in two parts. The Fed can never run out of money. Essentially, the Fed can print as many dollars as it wants. But, of course, that could create two problems.
First, the Fed can create a hell of a lot of inflation by printing money without limit and that would create huge problems for Fed monetary policy, because basically, if its operations are too aggressive, there may be a general flight from the dollar by dollar holders both domestic and foreign. And that would be of course a nightmare. Interest rates would go up and the economy would be on the path to a really big rise in inflation. Everything achieved in the early 1980s in eliminating inflation would go. So that would be one nightmare. And it is clearly one of the Fed's real nightmares.
The other possibility is that the Fed sustains very large losses on its portfolio -- simply that the value of what it takes on its books turns out to be less than what it paid for [those assets], or the price at which it received them. And those losses can only be made up by the Treasury, which means a direct burden on taxpayers, or by the Fed printing more money. And that brings you back to the inflation story.
So the Fed won't run out of money. But there is a real danger, if this gets big enough, that the long-term consequences will be higher inflation. And of course that would solve a lot of the house prices problems, because it would raise incomes to justify these very high house prices.
Or, and I believe this is very likely, the U.S. federal government will have to raise its borrowing -- issue debt -- in order to refinance the Fed and/or bail out some other part of the financial system or the mortgage system directly. In other words, there would be an increased fiscal cost. And in the past, if you look at countries around the world, the fiscal costs have often been really quite large. And of course they would be enduring. There would be a need to service that debt for the indefinite future.
Global Impact
RFE/RL: Let me ask about the impact on the rest of the world. How badly will banks in Europe and other parts the world be touched by this crisis? Many local banks in our broadcast region have been bought out by leading Western banks. Could they be affected?
Wolf: I think there is a real danger for those emerging economies that are dependent particularly on a net flow of funds from the developed world. It's pretty clear that we are in the midst of a big re-rating of risk and a concern to hoard liquidity among potential lenders and not lend it in risky ways, as they were doing in previous years. So those countries that are dependent on a large capital inflow for the sustainability of their economy, that are running large current account deficits, particularly current account deficits financed by lending rather than foreign direct investment, are clearly vulnerable to a reversal of sentiment, which will lead either to a collapse in their currencies or if they have pegged exchange rates, to a big contraction in outstanding credit in the economy and so a recession -- a very deep recession -- while the current account deficit is eliminated. That's very much what happened in the Asian financial crisis 10 years ago.
And it could well happen to those countries in Central and Eastern Europe, including Turkey, which are vulnerable in that way. Secondly, there's obviously a chance that the banking sectors may themselves be weakened if they are directly or indirectly affected by losses of this kind. We don't know, at the moment, where these bodies are buried within the financial systems of the world. It's slowly emerging and my guess at the moment -- but it is only a guess and lots of people disagree with this -- is that most of the European banking system, with a few very well-known exceptions, UBS in Switzerland is one, is not going to be so damaged by the bad debts that it will significantly affect their activities. So most of the core Western European banks seem to be sound and therefore their activities in Europe as a whole should also continue reasonably well. But there are dangers.
Finally, of course, it must be stressed that if there is a significant U.S. slowdown, a really significant U.S. slowdown, it will affect the European economy, of course. It will affect the Asian economy, of course. And it will affect all small, open economies that are reliant on world trade. And it will have a direct effect via levels of demand for exports and tourism and all the other things on which these economies depend.
RFE/RL: Do some countries, especially oil and gas exporters like Russia, Azerbaijan, Turkmenistan, and Kazakhstan -- or major grain suppliers like Ukraine -- stand to benefit long-term from skyrocketing commodity prices? Or is there a danger that we're seeing another "bubble" that will soon burst?
Wolf: This is a very big question. A very, very big question. I've taken the view that there may well be bubble elements, particularly in recent months in commodities, with the recent surge. But part of it, of course, is simply a reflection of the fall in the dollar. It doesn't look quite the same in the euro as it does in the dollar. That's just the currency effect.
But I have tended to the view that if you look at the rise in commodity prices over the last four-five years or so, most of this is structural, not bubble-like. It reflects the demand for commodities from emerging powers, particularly China. It's a real phenomenon because essentially the emergence of these new very resource intensive economies -- and China is astonishingly resource intensive -- has imposed tremendous pressure on the supply of these commodities around the world. The supply is not very elastic, certainly not in the short to medium term, and this is driving up prices.
In the long run, it may be -- and I stress may be -- the case that supply will increase and demand will be curtailed and prices will fall back. I wouldn't be surprised at all if prices did fall back. But that's a medium to long-term effect. The reason I think that the bubble factor is limited, is that if it were the case and most of this were speculation, we would expect to see prices above equilibrium levels and very rapid increases in inventories of these commodities. Now we're seeing this for some, but for many. So I tend to assume that this is not a bubble and that there are good reasons why commodity prices should remain relatively high -- at least higher than they were for most of the 1990s. But that doesn't mean they will necessarily be sustained at the most recent levels.
RFE/RL: Is it conceivable that Russian sovereign funds will take the place of Western investments in the postcommunist sphere?
Wolf: That's not at all impossible. The funds could be very large. It's not clear to me precisely how they're going to be used by the Russians. And of course they have to recognize the political risks themselves. They need to buy things they know they can keep a hold of. But I would have thought it is plausible -- to take Russia as an example -- that its private business and government and semigovernment business will naturally seek to invest in the countries that they know. And that obviously includes the countries in the broadly defined former Russian sphere. So, as I understand it, it's already happening. There's been quite a lot of investment by Russians in the region. And I would be very surprised, since Russia at the moment has a big cash surplus, if we don't see that continuing.
The Dollar Question
RFE/RL: A big question is the fate of the dollar. Every time the Fed lowers interest rates, it hurts the dollar because outside investors get a lower return on their investment. China, Japan, the Gulf countries and others are sitting on trillions of dollars in reserves. What would happen if they lost confidence and decided to switch the bulk of their reserves into other currencies?
Wolf: Nobody knows precisely how large the foreign governments' holdings of dollars are. But my guess, from the figures we know, is that it's about $4 trillion, which is a pretty large sum -- though it's only a little less than a quarter of the gross liabilities of the United States to foreigners. If, of course, these governments all wish to get out of dollars together, then the dollar would certainly be very, very seriously weakened. And confidence would be further eroded, particularly if the private sector realized that that's what was happening. So far we're not seeing that happen, except at the margin. And it is difficult for the big holders -- particularly Japan and China, which hold between them about 40 percent of the world's foreign currency reserves. If they start shifting out, that's going to damage the price for them directly. It's not a very attractive thing to do. For both countries, too, it would be a pretty major foreign policy crisis because they would basically be seen by the Americans as attacking America. And neither China nor Japan, I think, would like to be in that position. So I have tended to assume that the diversification by the foreign official wealth holders of dollars will occur, but it will be very slow. And there won't be a comprehensive flight from the currency.
And finally, in the case of China, it still has a loose peg to the dollar. And as long as that's the case, there's a limit to how much it can sell in the way of dollars because it risks just pushing up the renminbi, which is not what it wants to do. So, there are clearly risks here. There's no doubt there are risks here. And it's something the Fed has to be concerned about, particularly in relationship to the private sector at home and abroad. But I tend to think that the dumping by foreign governments of the dollar is a rather unlikely development.
Nightmare Scenario
RFE/RL: But if it were to happen, what would the implications be for the U.S. economy?
Wolf: Catastrophic, I think. Basically, the ultimate nightmare for the United States is a dollar collapse. I don't know what the figures will be, but suppose the trade-weighted dollar were to fall 20 or 30 percent in a few months, this would bring the dollar to real levels never seen before. It's almost inconceivable, given how low interest rates are in the U.S., that you wouldn't have a big further rise in headline inflation in that situation. And these are guesses, but we might see inflation running at 6 or 7 percent (annually) for a while. Now the long bond rate in the U.S. has been running at 3.6 percent -- it's incredibly low, mainly because of the flight to safety. It's very difficult to see what justifies such low, long-term interest rates. In this situation I described, I think there would almost certainly be a sell-off of long bonds, bringing long-term interest rates up in the United States to -- again I'm guessing -- 5, 6, 7 percent.
Most of the loans that matter in America, including mortgages, are tied to these longer-term rates, not shorter-term rates. And if the Fed had a short rate of, say, two percent, and the long-term rate goes up in the way I described, the Fed's monetary policy would clearly be seen as grotesquely expansionary. In this situation, you get the contractionary effect of the higher long-term interest rates on the solvency of all these highly-indebted people in the United States, and you get the fear of inflation leading normally to a hoarding of cash -- almost forced hoarding.
This combination would be essentially stagflation in extreme form. It would bring us, I think, straight back to the 1970s and possibly worse. So it would be a complete nightmare for the U.S. It would be a combination of high inflation and almost certainly a very deep recession in the short to medium run, a loss of credibility of the dollar, and U.S. policymakers could do nothing about this because it would be about foreign confidence in the dollar. And there's nothing the government of the United States can do to mandate foreign confidence in the dollar.
So you would have to go through another wrenching elimination of inflation. Interest rates would probably have to be pushed back up, there would be mass defaults, mass defaults. It would be a monumental crisis. So nothing is more important -- and I've written about this many times -- than for the United States to maintain credibility of the dollar in the medium to long term. And the Fed does understand this very well. And it is a potential constraint on what they are now doing. They cannot risk, by their monetary policy, undermining the credibility of the dollar as a store of value for all the many millions of people around the world who hold it.
RFE/RL: You say the Fed understands the importance of maintaining confidence in the dollar. But there seems to be a general feeling that keeping the dollar strong is definitely a secondary priority right now. After all, the Fed keeps slashing interest rates and there is no talk of intervention to prop up the U.S. currency.
Wolf: So far, they've got away with it. There's been a reduction in the dollar, yes. But it hasn't been a collapse. And inflation has not soared. And above all, long-term interest rates -- as I've said -- have been falling, not rising, for U.S. Treasuries -- the safest of all securities. There's no sign of an explosive rise in inflationary expectations in the United States, and there's no sign yet of a gathering collapse, a real flight from the dollar. So the Fed's got away with it. For that reason, the Fed is able to do what it's doing. It is taking advantage of the fact that it's borrowing in its own currency and that people continue to have confidence in the currency. You asked me what would happen if it became obvious that actually nobody important still had confidence in the currency.
Once that happens, the Fed is in a nightmare situation, as I described. But that is not the situation now. The really important question is how close are we to that situation -- i.e., if the Fed keeps going in the way it is, will it possibly go over a tipping point? And suddenly the Fed would find itself in this nightmare world I described. The honest answer, again, is we don't know how close we are to such a crisis, such a tipping point. The Fed has certainly not confronted that now. My own guess -- and I stress it is a guess -- is that if the Fed keeps on pushing rates down below where they are now at 2 1/4 percent to 1 percent or lower, as the Japanese did, then I think it would run a real risk of such a crisis.
RFE/RL: And is the Fed's scope for further bailouts also limited, because it would further undermine confidence in the dollar?
Wolf: I think the bailouts are OK -- I mean I don't like them -- but if they are for specific institutions in trouble. But the Fed cannot bail out the mortgage market, for example. If the government were to make a decision -- and indeed it clearly is happening -- to try to support the mortgage market through [mortgage guarantors] Fannie Mae and Freddie Mac and other [government-linked] institutions, then this would have to be done by the U.S. Treasury.
If the U.S. Treasury is prepared to borrow money by issuing bonds to do that, at the moment there is no sign of a general flight from U.S. government liabilities in dollars. It seems that the rest of the world is willing to hold government bonds. So that is something where there is plenty of freedom to maneuver. But at the limit, you could imagine a situation in which worry about the dollar would actually make it very difficult for the U.S. Treasury to issue many more bonds, at least without paying a much higher interest rate. And then you get into the same mess that I talked about earlier. But the Fed can do bailouts for specific institutions, although I don't like it. It can provide liquidity to the market in the normal way, while minimizing its risk -- that's okay.
But if we're talking about the actual bailout of markets as a whole and particularly the mortgage market, the Fed cannot do that safely. It has to be done by the U.S. government, on its books, by basically swapping good government debt for bad, impaired debt. I think this is a very bad way to run a capitalist economy, but if worse comes to worst, I suspect that's what's going to happen.
Different World
RFE/RL: Do you think when we do emerge from this crisis, that we'll enter a new era of financial regulation on a global scale? Could the securities brokers end up as tightly regulated as conventional banks?
Wolf: I think at the end of all this, we're going to live in a different world and of course, how different depends on how severe it all turns out to be. And as I said earlier, we really don't know how severe this is going to be. The possibilities are so wide.
There are two points, specifically, about the financial sector. First of all, obviously, a pretty painful lesson is being learned. And I would be surprised if we saw a mania similar to the mania of the last 10 years -- the dot-com bubble and then the housing bubble -- return to the financial sector anytime soon. So in that sense, we will be locking the stable doors after the horses have bolted. The financial sector is going through a pretty difficult time and I suspect it will continue for a long time further. And that will itself change behavior. But yes, I do think it is going to be true, particularly if the losses in the financial sector are large and the rescues required continue to be sizeable. We'll see over the next few months. But some people think there will be many more bailouts.
Then, I would expect regulation to emerge in very different ways. And among other things, because the investment banks have turned out to be central to the securitized markets, because the securitized markets have proved to be a real source of vulnerability -- what's going on in these markets is very similar to a bank run and the central banks have had to get involved -- I do think the logic of regulating more like banks will seem very strong.
What that will mean in practice, I don't know because they aren't like banks. And it's not quite clear what you would ask of them. And I think there are lots of interesting ideas out there. But if this is as bad as it seems quite likely to be, I believe that governments are not going to be willing to let this happen again in the near future -- to put it mildly. So there will be changes in regulation, probably across the board.
And that's why I argued in the column I wrote this week that this is a turning point. The tacit assumption that the right way to move was toward ever greater deregulation of financial markets -- that assumption will just not be sustainable after this crisis is over, at least not for another generation. And we will have tighter regulation. Not as much as we did after the Great Depression in the 1930s, but there will be a tightening, because the mess has frightened everybody so much.
Martin Wolf: Yes, I think we are in fact, in very important ways. If you think that what we've been embarked on for the last 30 years -- and this is a very "rough and ready" reading of history, but I think it's not entirely wrong -- is a journey across the world toward ever more liberal economies, with the U.S. being in some ways the model toward which everybody was moving, more flexible, more dynamic, with a highly deregulated financial system. Then, I think that journey has stopped.
RFE/RL: Why was so much of the world following the U.S. model?
Wolf: The reason that model was so credible is not only that the U.S. was the richest country in the world, but because the evolution of the U.S. financial system -- which is the core, after all, of a capitalist economy -- seemed to offer a combination of flexibility with robustness that we weren't seeing elsewhere in the world.
The dominant feature of this system, as it emerged, was a shift from bank-based relationship lending to transaction-oriented activities, in which the financial system itself was engaged in arranging lending, arranging funds for borrowers, then packaging those funds into securities and selling them on to third parties, who would hold them for long periods: investment funds, pension funds, insurance companies, institutions like that.
This was the vision of the sort of model we had been moving toward worldwide. And this is quite clearly the model that is now breaking down. And it's broken down in really quite a spectacular manner, because many of the markets on which this model relies have basically been frozen for six or seven months. They've just disappeared. People can't transact in these activities.
No Consensus
RFE/RL: What seems most alarming is that economists, financial traders, and politicians still can't seem to agree on where we are. Are we at the start of a massive unraveling of the financial system as we know it? Economist Nouriel Roubini, who is a famous pessimist, recently wrote an analysis entitled "The 12 Steps To Financial Meltdown" that got a lot of attention. He says we're now at Step 9 and heading toward catastrophe. Other economists claim the end of the crisis is in sight. One day stock markets are way up. The next day they plummet. Commodity prices in recent days have also been gyrating wildly. Why can't the experts agree on what is happening and why? Is it because the financial products were so complex and they were repackaged in so many ways that we still don't know the extent to which the global financial system has been infected?
Wolf: I think you're asking the most important question, which is why do we all disagree about what might happen? I think the short answer comes in two words. One is "complexity" and the second is "novelty."
It's an incredibly complicated crisis, which involves the interconnection of macroeconomic conditions -- in particular the global imbalances, which played a very large part in this and monetary policy, with a lot of criticism of the Fed's monetary policy in particular. So there are macroeconomic conditions here. Then there's a very large asset bubble in housing, not just in the U.S., but in much of the developed world. So that's a big relative price change. There are important shifts in background conditions, particularly associated with inflation.
And finally, there's the mess in the financial system itself. These are all interrelated. And this makes it incredibly difficult to unravel the complexity of what's going on. And it's very, very easy to focus on just one aspect of this, while ignoring all the others.
And as I said, the other aspect of this is novelty. In important ways, the financial system we have today is different from any financial system that has existed in the past. The decline in house prices we're now seeing in the U.S., across the country, is unprecedented for the U.S. The interconnectedness of the world economy is itself also unprecedented. So there are very important elements of novelty here. And because it's new, we don't really have that much experience to go on.
RFE/RL: Can you elaborate on the main factors underpinning all this uncertainty?
Wolf: Let me just say what I think are the things on which the uncertainty hangs. The first thing we don't know -- and it's of incredibly large importance -- is how far house prices in the United States are going to fall. The reason we don't know that is because we've never seen something like this. Obviously, the further house prices fall, the more borrowers will find themselves with negative equity, so that has an enormous direct effect on the scale of the danger.
The second thing we don't know, and it's a very importance difference between Nouriel Roubini and some others, is what proportion of these homeowners who find that they owe more on their house than the value of the house, will default. That's simply something we have to guess, because there is, again, no experience for a situation in which possibly up to 9 or 10 million people might be in this situation. It is at least conceivable. And because we don't know how many people will default, we don't know what proportion of the losses suffered by homeowners will be borne by the financial system, which is where the financial crisis arises.
The third thing we don't know is how effective the various government policies to prevent mass defaults are going to turn out to be. At the moment they look pretty ineffective. There is a large fiscal stimulus going on. It's going to put money in the hands of people that at least might be an offset to some of the depressing factors here.
A fourth thing we don't know -- the list is long -- is how American households in general will respond to a reduction in their housing wealth and an increase in the likelihood of default by many Americans. The reason this matters so much is that American consumer demand is the dominant source of demand in the U.S. economy -- it's about 70 percent of GDP.
American households have not been saving, in aggregate, for many years. And in fact they've been spending more than their incomes for basically the last 10 years. If they should stop doing that in the situation and simply say: "We must start saving as we used to in the past," that would immediately have the effect of tipping the economy into a recession.
There's nothing big enough to offset that decision. And if the economy went into recession, there would be lots of unemployment, corporations would cut back their investment, households would find their financial positions worse. And that would clearly aggravate. You'd have a downward spiral. And we don't know whether that's going to happen.
Then we can turn to the financial system itself. The difficulty here is we don't know where the losses are. We don't know when or if ever people will be able to trade in this securitized paper again. And if they can't trade in it, it's stuck on their books. And if nobody knows how to value it, they might be stuck on their books for 20-30 years, unless the government takes it all over, which it might do.
Because we don't know these things, it's quite clear that many financial institutions are very unwilling to trade with other financial institutions and they are also very keen to hoard cash to meet any obligations they may have in the future, because they're not sure they can borrow from other financial institutions. So that's frozen the interbank market and money markets. And we don't know how long that will last either. The central banks have made really quite extraordinarily aggressive moves in the last six months to get those markets unfrozen. And they have actually not been fully successful. That itself has been very extraordinary.
If you just focus on these factors, and I've just listed a few of them [it's a lot to deal with]. There are other very important uncertainties, among them how strong will demand be in the rest of the world? Will it keep the world economy growing and offset a big U.S. slowdown or not?
The uncertainties are so huge because of the complexity and the novelty of this situation that it really is impossible, it's simply impossible to say what's going to happen. I have my own guess that we're going to have a pretty deep recession and it's going to be a long process of recovery in the financial system and in the American economy. But that is a guess and I might well turn out to be wrong.
RFE/RL: What you're saying is that the only way to keep the United States from a massive recession is to ensure that U.S. consumers keep spending and keep borrowing. So the government is basically hoping that Americans will take out more loans and use the $600 checks they will soon receive from the Treasury, to shop. Won't this -- at most -- just delay the crisis until later?
Wolf: The hope is that the adjustment will be slow. If you're optimistic, what you would hope would happen would be something like this: U.S. households will slowly save a higher proportion of their income, as indeed they almost certainly should. And the U.S., in aggregate, will save a higher portion of its income, as it should. This will be offset by an improvement in the U.S. external account, a reduction in the current account deficit and therefore reduced borrowing abroad, which will be replaced by household savings at home. Because the dollar is very weak, exports are doing rather well, so indeed net exports are improving. That is offsetting the increase in savings, but it can't do it very quickly. The U.S. is a very large economy in which trade is a relatively small portion of GDP. You can't offset a big weakness in the domestic economy with improved net trade, if the weakness in the domestic economy comes very quickly and is very severe.
"The Fed won't run out of money. But there is a real danger, if this gets big enough, that the long-term consequences will be higher inflation."
The net trade is just not big enough to do it. But over five years or so it might be possible. So you would imagine four or five years of relatively weak demand growth, probably a weak economy -- not a disastrous one but an economy in which growth tends to be below potential and unemployment tends to be rising -- the current account improves and the U.S. emerges much better balanced and stronger.
Essentially, this is the offset to the long period since the mid 1990s in which domestic demand was extraordinarily strong, the current account deficit exploded and the U.S. had pretty good times in terms of consumption growing significantly faster than income over a long period.
So that would be the optimistic picture: a slow adjustment over several years and I think that would be manageable. But if that adjustment were to be [shrunk] into a year or two, you would certainly have a very, very deep recession.
The Fed's Actions
RFE/RL: Could the Fed get into trouble? So far, it's basically pledged to swap half of its available funds in exchange for potential bad debt from investment banks. Could the Fed run out of money or go bankrupt?
Wolf: The answer to this comes in two parts. The Fed can never run out of money. Essentially, the Fed can print as many dollars as it wants. But, of course, that could create two problems.
First, the Fed can create a hell of a lot of inflation by printing money without limit and that would create huge problems for Fed monetary policy, because basically, if its operations are too aggressive, there may be a general flight from the dollar by dollar holders both domestic and foreign. And that would be of course a nightmare. Interest rates would go up and the economy would be on the path to a really big rise in inflation. Everything achieved in the early 1980s in eliminating inflation would go. So that would be one nightmare. And it is clearly one of the Fed's real nightmares.
The other possibility is that the Fed sustains very large losses on its portfolio -- simply that the value of what it takes on its books turns out to be less than what it paid for [those assets], or the price at which it received them. And those losses can only be made up by the Treasury, which means a direct burden on taxpayers, or by the Fed printing more money. And that brings you back to the inflation story.
So the Fed won't run out of money. But there is a real danger, if this gets big enough, that the long-term consequences will be higher inflation. And of course that would solve a lot of the house prices problems, because it would raise incomes to justify these very high house prices.
Or, and I believe this is very likely, the U.S. federal government will have to raise its borrowing -- issue debt -- in order to refinance the Fed and/or bail out some other part of the financial system or the mortgage system directly. In other words, there would be an increased fiscal cost. And in the past, if you look at countries around the world, the fiscal costs have often been really quite large. And of course they would be enduring. There would be a need to service that debt for the indefinite future.
Global Impact
RFE/RL: Let me ask about the impact on the rest of the world. How badly will banks in Europe and other parts the world be touched by this crisis? Many local banks in our broadcast region have been bought out by leading Western banks. Could they be affected?
Wolf: I think there is a real danger for those emerging economies that are dependent particularly on a net flow of funds from the developed world. It's pretty clear that we are in the midst of a big re-rating of risk and a concern to hoard liquidity among potential lenders and not lend it in risky ways, as they were doing in previous years. So those countries that are dependent on a large capital inflow for the sustainability of their economy, that are running large current account deficits, particularly current account deficits financed by lending rather than foreign direct investment, are clearly vulnerable to a reversal of sentiment, which will lead either to a collapse in their currencies or if they have pegged exchange rates, to a big contraction in outstanding credit in the economy and so a recession -- a very deep recession -- while the current account deficit is eliminated. That's very much what happened in the Asian financial crisis 10 years ago.
And it could well happen to those countries in Central and Eastern Europe, including Turkey, which are vulnerable in that way. Secondly, there's obviously a chance that the banking sectors may themselves be weakened if they are directly or indirectly affected by losses of this kind. We don't know, at the moment, where these bodies are buried within the financial systems of the world. It's slowly emerging and my guess at the moment -- but it is only a guess and lots of people disagree with this -- is that most of the European banking system, with a few very well-known exceptions, UBS in Switzerland is one, is not going to be so damaged by the bad debts that it will significantly affect their activities. So most of the core Western European banks seem to be sound and therefore their activities in Europe as a whole should also continue reasonably well. But there are dangers.
Finally, of course, it must be stressed that if there is a significant U.S. slowdown, a really significant U.S. slowdown, it will affect the European economy, of course. It will affect the Asian economy, of course. And it will affect all small, open economies that are reliant on world trade. And it will have a direct effect via levels of demand for exports and tourism and all the other things on which these economies depend.
RFE/RL: Do some countries, especially oil and gas exporters like Russia, Azerbaijan, Turkmenistan, and Kazakhstan -- or major grain suppliers like Ukraine -- stand to benefit long-term from skyrocketing commodity prices? Or is there a danger that we're seeing another "bubble" that will soon burst?
Wolf: This is a very big question. A very, very big question. I've taken the view that there may well be bubble elements, particularly in recent months in commodities, with the recent surge. But part of it, of course, is simply a reflection of the fall in the dollar. It doesn't look quite the same in the euro as it does in the dollar. That's just the currency effect.
But I have tended to the view that if you look at the rise in commodity prices over the last four-five years or so, most of this is structural, not bubble-like. It reflects the demand for commodities from emerging powers, particularly China. It's a real phenomenon because essentially the emergence of these new very resource intensive economies -- and China is astonishingly resource intensive -- has imposed tremendous pressure on the supply of these commodities around the world. The supply is not very elastic, certainly not in the short to medium term, and this is driving up prices.
In the long run, it may be -- and I stress may be -- the case that supply will increase and demand will be curtailed and prices will fall back. I wouldn't be surprised at all if prices did fall back. But that's a medium to long-term effect. The reason I think that the bubble factor is limited, is that if it were the case and most of this were speculation, we would expect to see prices above equilibrium levels and very rapid increases in inventories of these commodities. Now we're seeing this for some, but for many. So I tend to assume that this is not a bubble and that there are good reasons why commodity prices should remain relatively high -- at least higher than they were for most of the 1990s. But that doesn't mean they will necessarily be sustained at the most recent levels.
RFE/RL: Is it conceivable that Russian sovereign funds will take the place of Western investments in the postcommunist sphere?
Wolf: That's not at all impossible. The funds could be very large. It's not clear to me precisely how they're going to be used by the Russians. And of course they have to recognize the political risks themselves. They need to buy things they know they can keep a hold of. But I would have thought it is plausible -- to take Russia as an example -- that its private business and government and semigovernment business will naturally seek to invest in the countries that they know. And that obviously includes the countries in the broadly defined former Russian sphere. So, as I understand it, it's already happening. There's been quite a lot of investment by Russians in the region. And I would be very surprised, since Russia at the moment has a big cash surplus, if we don't see that continuing.
The Dollar Question
RFE/RL: A big question is the fate of the dollar. Every time the Fed lowers interest rates, it hurts the dollar because outside investors get a lower return on their investment. China, Japan, the Gulf countries and others are sitting on trillions of dollars in reserves. What would happen if they lost confidence and decided to switch the bulk of their reserves into other currencies?
Wolf: Nobody knows precisely how large the foreign governments' holdings of dollars are. But my guess, from the figures we know, is that it's about $4 trillion, which is a pretty large sum -- though it's only a little less than a quarter of the gross liabilities of the United States to foreigners. If, of course, these governments all wish to get out of dollars together, then the dollar would certainly be very, very seriously weakened. And confidence would be further eroded, particularly if the private sector realized that that's what was happening. So far we're not seeing that happen, except at the margin. And it is difficult for the big holders -- particularly Japan and China, which hold between them about 40 percent of the world's foreign currency reserves. If they start shifting out, that's going to damage the price for them directly. It's not a very attractive thing to do. For both countries, too, it would be a pretty major foreign policy crisis because they would basically be seen by the Americans as attacking America. And neither China nor Japan, I think, would like to be in that position. So I have tended to assume that the diversification by the foreign official wealth holders of dollars will occur, but it will be very slow. And there won't be a comprehensive flight from the currency.
And finally, in the case of China, it still has a loose peg to the dollar. And as long as that's the case, there's a limit to how much it can sell in the way of dollars because it risks just pushing up the renminbi, which is not what it wants to do. So, there are clearly risks here. There's no doubt there are risks here. And it's something the Fed has to be concerned about, particularly in relationship to the private sector at home and abroad. But I tend to think that the dumping by foreign governments of the dollar is a rather unlikely development.
Nightmare Scenario
RFE/RL: But if it were to happen, what would the implications be for the U.S. economy?
Wolf: Catastrophic, I think. Basically, the ultimate nightmare for the United States is a dollar collapse. I don't know what the figures will be, but suppose the trade-weighted dollar were to fall 20 or 30 percent in a few months, this would bring the dollar to real levels never seen before. It's almost inconceivable, given how low interest rates are in the U.S., that you wouldn't have a big further rise in headline inflation in that situation. And these are guesses, but we might see inflation running at 6 or 7 percent (annually) for a while. Now the long bond rate in the U.S. has been running at 3.6 percent -- it's incredibly low, mainly because of the flight to safety. It's very difficult to see what justifies such low, long-term interest rates. In this situation I described, I think there would almost certainly be a sell-off of long bonds, bringing long-term interest rates up in the United States to -- again I'm guessing -- 5, 6, 7 percent.
Most of the loans that matter in America, including mortgages, are tied to these longer-term rates, not shorter-term rates. And if the Fed had a short rate of, say, two percent, and the long-term rate goes up in the way I described, the Fed's monetary policy would clearly be seen as grotesquely expansionary. In this situation, you get the contractionary effect of the higher long-term interest rates on the solvency of all these highly-indebted people in the United States, and you get the fear of inflation leading normally to a hoarding of cash -- almost forced hoarding.
This combination would be essentially stagflation in extreme form. It would bring us, I think, straight back to the 1970s and possibly worse. So it would be a complete nightmare for the U.S. It would be a combination of high inflation and almost certainly a very deep recession in the short to medium run, a loss of credibility of the dollar, and U.S. policymakers could do nothing about this because it would be about foreign confidence in the dollar. And there's nothing the government of the United States can do to mandate foreign confidence in the dollar.
So you would have to go through another wrenching elimination of inflation. Interest rates would probably have to be pushed back up, there would be mass defaults, mass defaults. It would be a monumental crisis. So nothing is more important -- and I've written about this many times -- than for the United States to maintain credibility of the dollar in the medium to long term. And the Fed does understand this very well. And it is a potential constraint on what they are now doing. They cannot risk, by their monetary policy, undermining the credibility of the dollar as a store of value for all the many millions of people around the world who hold it.
RFE/RL: You say the Fed understands the importance of maintaining confidence in the dollar. But there seems to be a general feeling that keeping the dollar strong is definitely a secondary priority right now. After all, the Fed keeps slashing interest rates and there is no talk of intervention to prop up the U.S. currency.
Wolf: So far, they've got away with it. There's been a reduction in the dollar, yes. But it hasn't been a collapse. And inflation has not soared. And above all, long-term interest rates -- as I've said -- have been falling, not rising, for U.S. Treasuries -- the safest of all securities. There's no sign of an explosive rise in inflationary expectations in the United States, and there's no sign yet of a gathering collapse, a real flight from the dollar. So the Fed's got away with it. For that reason, the Fed is able to do what it's doing. It is taking advantage of the fact that it's borrowing in its own currency and that people continue to have confidence in the currency. You asked me what would happen if it became obvious that actually nobody important still had confidence in the currency.
Once that happens, the Fed is in a nightmare situation, as I described. But that is not the situation now. The really important question is how close are we to that situation -- i.e., if the Fed keeps going in the way it is, will it possibly go over a tipping point? And suddenly the Fed would find itself in this nightmare world I described. The honest answer, again, is we don't know how close we are to such a crisis, such a tipping point. The Fed has certainly not confronted that now. My own guess -- and I stress it is a guess -- is that if the Fed keeps on pushing rates down below where they are now at 2 1/4 percent to 1 percent or lower, as the Japanese did, then I think it would run a real risk of such a crisis.
RFE/RL: And is the Fed's scope for further bailouts also limited, because it would further undermine confidence in the dollar?
Wolf: I think the bailouts are OK -- I mean I don't like them -- but if they are for specific institutions in trouble. But the Fed cannot bail out the mortgage market, for example. If the government were to make a decision -- and indeed it clearly is happening -- to try to support the mortgage market through [mortgage guarantors] Fannie Mae and Freddie Mac and other [government-linked] institutions, then this would have to be done by the U.S. Treasury.
"If you look at the rise in commodity prices over the last four-five years or so, most of this is structural, not bubble-like. It reflects the demand for commodities from emerging powers."
If the U.S. Treasury is prepared to borrow money by issuing bonds to do that, at the moment there is no sign of a general flight from U.S. government liabilities in dollars. It seems that the rest of the world is willing to hold government bonds. So that is something where there is plenty of freedom to maneuver. But at the limit, you could imagine a situation in which worry about the dollar would actually make it very difficult for the U.S. Treasury to issue many more bonds, at least without paying a much higher interest rate. And then you get into the same mess that I talked about earlier. But the Fed can do bailouts for specific institutions, although I don't like it. It can provide liquidity to the market in the normal way, while minimizing its risk -- that's okay.
But if we're talking about the actual bailout of markets as a whole and particularly the mortgage market, the Fed cannot do that safely. It has to be done by the U.S. government, on its books, by basically swapping good government debt for bad, impaired debt. I think this is a very bad way to run a capitalist economy, but if worse comes to worst, I suspect that's what's going to happen.
Different World
RFE/RL: Do you think when we do emerge from this crisis, that we'll enter a new era of financial regulation on a global scale? Could the securities brokers end up as tightly regulated as conventional banks?
Wolf: I think at the end of all this, we're going to live in a different world and of course, how different depends on how severe it all turns out to be. And as I said earlier, we really don't know how severe this is going to be. The possibilities are so wide.
There are two points, specifically, about the financial sector. First of all, obviously, a pretty painful lesson is being learned. And I would be surprised if we saw a mania similar to the mania of the last 10 years -- the dot-com bubble and then the housing bubble -- return to the financial sector anytime soon. So in that sense, we will be locking the stable doors after the horses have bolted. The financial sector is going through a pretty difficult time and I suspect it will continue for a long time further. And that will itself change behavior. But yes, I do think it is going to be true, particularly if the losses in the financial sector are large and the rescues required continue to be sizeable. We'll see over the next few months. But some people think there will be many more bailouts.
Then, I would expect regulation to emerge in very different ways. And among other things, because the investment banks have turned out to be central to the securitized markets, because the securitized markets have proved to be a real source of vulnerability -- what's going on in these markets is very similar to a bank run and the central banks have had to get involved -- I do think the logic of regulating more like banks will seem very strong.
What that will mean in practice, I don't know because they aren't like banks. And it's not quite clear what you would ask of them. And I think there are lots of interesting ideas out there. But if this is as bad as it seems quite likely to be, I believe that governments are not going to be willing to let this happen again in the near future -- to put it mildly. So there will be changes in regulation, probably across the board.
And that's why I argued in the column I wrote this week that this is a turning point. The tacit assumption that the right way to move was toward ever greater deregulation of financial markets -- that assumption will just not be sustainable after this crisis is over, at least not for another generation. And we will have tighter regulation. Not as much as we did after the Great Depression in the 1930s, but there will be a tightening, because the mess has frightened everybody so much.
The Post-Soviet Petrostate
The Post-Soviet Petrostate
WEALTH AND POWER. At an RFE/RL briefing in Washington on January 24, Freedom House Director of Studies Christopher Walker and RFE/RL regional analyst Daniel Kimmage argued that energy-sector wealth is preventing many former Soviet countries -- Azerbaijan, Kazakhstan, Russia, and Turkmenistan -- from developing strong democratic institutions.
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