From Crisis to Contraction and Recovery

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From Crisis to Contraction and Recovery

• Willem H. Buiter CBE, FBA
• Professor of European Political Economy
• London School of Economics and Political Science

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These are extraordinary times

• The financial crisis of the north-Atlantic region
  that started in August 2007 is, by most metrics,
  the biggest financial crisis ever
• The global contraction of real economic activity
  that followed it will undoubtedly be the deepest
  and longest downturn since the Great Depression
• If policy makers screw up, it could still become
  worse than the Great Depression
• I dont consider that likely

3
Global economic prospects

• This will be the deepest global downturn since
  WWII
• It will not be the Great Depression revisited
• We are, globally, just past the inflection point
• We are, globally, not yet at a turning point
• Recovery will be, in most of the world, be slow

4
European economic prospects

• Europe will have a recession at least as deep as
  that of the US
• There will be marked differences between
  countries (France vs. Spain)
• Europe will emerge from the recession after the
  US, in part because it went into recession after
  the US
• CEE will be hard hit through a variety of
  channels (trade, remittances, capital markets,
  banks)

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House price bubbles and construction booms played
a significant part

• In a number of countries, house price booms
  and/or construction booms (residential and/or
  commercial) were the defining feature of the
  pre-crisis period USA, UK, Ireland, Spain,
  Netherlands, France, Baltics, Poland, Hungary,
  other CEE and SEE, Russia.
• Other countries had no or minor house price
  construction booms/bubbles Germany, Greece

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Why a long and deep downturn?

• History....
• and a bit of common sense
• aka economic theory

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Financial crises they happen...

• A lot....
• 20th century
• Panic of 1907, a U.S. economic recession with
  bank failures
• Great Depression, the worst systemic banking
  crisis of the 20th century
• Secondary banking crisis of 19731975 in the UK
• Japanese asset price bubble (19862003)
• Savings and loan crisis of the 1980s and 1990s in
  the U.S.
• Finnish banking crisis of 1990s
• Swedish banking crisis (1990s)
• 1997 Asian financial crisis
• 1998 collapse of Long-Term Capital Management
• 1998 Russian financial crisis
• Argentine economic crisis (19992002)
• 21st century
• 2002 Uruguay banking crisis
• US UK Financial crisis of 20072009, including
  
• Subprime mortgage crisis in the U.S. starting in
  2007
• Global financial crisis of 20082009

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• Financial crises are protracted affairs
• First, asset market collapses are deep and
  prolonged.
• Real housing price declines average 35 percent
  over six years
• equity price collapses average 55 percent over
  about 3.5 years.
• Second, aftermath of banking crises associated
  with profound declines in output and employment.
• unemployment rate rises an average of 7
  percentage points over down phase of cycle,
  which lasts on average over four years.
• Output falls (from peak to trough) an average of
  over 9 percent duration of downturn averages
  around 2 years.
• Third, real value of government debt tends to
  explode, rising an average of 86 percent in major
  postWorld War II episodes. Main cause is not
  costs of bailing out and recapitalizing banking
  system, but collapse in tax revenues with output
  contractions and discretionary countercyclical
  fiscal policies

Reinhart Rogoff (2008) Banking Crises An
Equal Opportunity Menace Data set 1800 -2008.
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Deeper recession follow financial stress
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Antecedents of current financial crisis and real
economy contraction familiar from past EM crises
downturns

• Systemic banking/financial crises are typically
  preceded by
• asset price bubbles
• credit booms
• large capital inflows rising current account
  deficits
• Rising leverage in financial sector, household
  corporate sectors
• Slowing growth
• This holds in rich and poor countries alike.
• (see Reinhart Rogoff)

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Other lessons from development economics and
study of EMs

• Todays advance industrial country financial
  crisis are rather like the EM crises of the
  1970s, 1980s and 1990s.
• Dysfunctional banking and financial systems
• Frozen impaired financial markets
• Lack of fiscal spare capacity
• Convergence of public sector banking sector
  credit ratings (in a crisis, all debt is public)
• risk of sudden stop
• Double crisis banks and sovereign debt
• Triple crisis banks, sovereign debt currency
• Main difference from EMs global reserve currency
  status of US Eurozone

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Lessons

• Pay special attention to the inconsistent quartet
• Small country
• Large internationally exposed banking sector
• Own non-global reserve currency
• Limited fiscal spare capacity
• Iceland, Switzerland, Sweden, UK, Ireland (3 out
  of 4)

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Now vs. then
Source Eichengreen ORourke (2009)
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Now vs. then
Source Eichengreen ORourke (2009)
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Now vs. then
Source Eichengreen ORourke (2009)
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Now vs. then
Source Eichengreen ORourke (2009)
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Now vs. then world money supplies (19
countries)
Source Eichengreen ORourke (2009)
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Now vs. then world government surpluses
Source Eichengreen ORourke (2009)
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Now vs. then industrial output 4 large European
countries
Source Eichengreen ORourke (2009)
20
Now vs. then industrial output 4 non-European
countries
Source Eichengreen and ORourke
21
Then Now 4 small European Countries.
Source Eichengreen ORourke
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What happens after we cross the desert?

• We will have a contraction in Eurozone most of
  the rest of Europe until middle of 2010 early
  2011.
• UK may exit contraction a bit earlier (sterling)
• US is likely to exit contraction a bit earlier
• Some favoured EMs (China, India, Brazil) may exit
  even earlier
• After the contraction, US likely to have a bout
  of inflation UK may too, although this is less
  likely than inflation in the US inflation
  unlikely in Euro Area

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The size and scope of the public sector

• More regulation state more intrusive, but not
  necessarily larger (spending as share of GDP).
• More state ownership, not necessarily controlling
  shares
• Where state ownership persists, state board
  member(2) with special fiduciary duties ((1)
  systemic stability (2) tax payer)

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Europe at the crossroads

• We have either too much or too little Europe
• Single market for financial services requires
  single regulator-supervisor for crossborder
  financial institutions
• Single supervisor-regulator requires a minimal
  fiscal Europe (recapitaliser of last resort)
• ECB requires fiscal backing to engage in
  unconvetional monetary policies (QE CE)
• Central bank independence will have to be
  rethought.

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American capitalism

• The partial Europeanization of American
  capitalism (flexicurity variant of social
  democracy)
• In the US the size of the public sector will rise
  to European levels (spending in mid-40s as of
  GDP)
• Universal health insurance
• Infrastructure investment catch-up
• Pre-school, primary and secondary education
• Stronger regulation and more intrusive
  supervision of financial sector
• Labour markets will remain flexible
• The national saving rate will rise sustainably,
  but slowly

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Acceleration of shift of financial, economic and
political power to Asia

• Since the industrial revolution in the 19th
  century, the rich countries of the first world
  have dominated the global economy. That era may
  be over
• The Economist (2006)
• It is now (Buiter, 2009).

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Key challenges for the new Asian Giants

• China restructure production and demand towards
  domestic consumption and away from export
  dependency and investment in heavy industry
• India education, infrastructure and more
  openness to FDI
• India and China avoiding domestic environmental
  disasters (fresh water, air, soil) and reducing
  their exploding contribution to global warming

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Green growth

• The crisis and the Great Contraction will not
  lastingly weaken the drive for environmental
  sustainability. In the short run, it will hurt
  Green projects requiring higher taxes it will
  help green projects requiring higher public
  spending
• As soon as the global recovery starts, energy and
  commodity prices will go through the roof
• Water will be the most dangerous scarce resource

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Final ruminations

• Crisis highlights blurred boundaries between
  private and public finance
• Anything private but systemically important ends
  up in the public accounts
• Crisis highlights importance of information and
  understanding as opposed to data
• Accounting should focus on economic essence of
  cash flows and contingent claims, not their legal
  or formal nature
• Accountability information consequences