博鳌亚洲论坛年会讲话

My assignment today is to give an overview of global financial markets. Well, the situation is very complicated with many cross currents and cross purposes. In order to explain what is happening let me put the current situation into historical context.

After the bankruptcy of Lehman Brothers in 2008 financial markets in the United States actually started to melt down and had to be put on artificial life support. They have been in what I call far-from-equilibrium territory ever since.

The bankruptcy of Lehman was also the bankruptcy of prevailing economic theory, notably the theory of rational expectations and the efficient market hypothesis. The authorities succeeded in holding financial markets together and the estate of Lehman has been liquidated but the bankruptcy of economic theory has not been resolved.

I come here from Hong Kong where I attended the conference of INET, the Institute of New Economic Thinking, whose objective is to rebuild economic theory from the ground up. Mainstream economic theory has tried to imitate natural science but that is an impossible task. Social phenomena have thinking participants, whose view of the world never fully corresponds to the actual state of affairs. The divergence between the two introduces an element of uncertainty into human behavior that is absent in the behavior of physical objects like billiard balls or planets. I call that the human uncertainty principle.

As you may know I have developed a conceptual framework based on that principle, but I would be the first to admit that it is not fully developed and far from generally accepted. INET is making good progress in developing new approaches and I believe Chinese economists will be able to make valuable contributions because they are less firmly rooted in the dogma that has enjoyed a monopolistic position in American universities.

The task INET set itself is far from accomplished. Neither the financial authorities nor market participants have a clear understanding of how markets really work. That is the reality but few people are willing to admit it. As a result, misinterpretations, misconceptions and a sheer lack of understanding play more important role than usual in shaping the course of events. The current situation cannot be understood without recognizing this fact.

One of the highlights of the INET conference was a lecture by Lord Adair Turner, who has just retired from the Financial Services Authority of the United Kingdom and became the senior research fellow of INET. He made an interesting point about economics, namely that the main task of macro-economic theory is to prevent avoidable mistakes. The need for better macro-economic theories has never been greater. As we look around the world we find that avoidable mistakes are causing immense human pain and suffering. This is particularly true of the EU.

Perhaps the best way to approach the current situation is to compare the situation in the Eurozone with what’s happening in Japan. Japan is abandoning orthodox monetary policy and switching to quantitative easing after twenty-five years of stagnation. By contrast, the Eurozone is committed to orthodox monetary policy and fiscal austerity. In other words, the Eurozone is heading into a situation from which Japan is desperate to escape. By engaging in quantitative easing on an unprecedented scale, the Japanese government is embarking on a risky experiment. If the experiment is successful and the economy accelerates there is a risk that interest rates will rise, making the cost of servicing the debt unsustainable. That is why the Bank of Japan resisted quantitative easing and perpetuated stagnation. Prime Minister Abe prefers to take the risk rather than condemn Japan to a slow death and his bold adventure has been enthusiastically received by the Japanese public.

I do not believe that the European public will put up with a slow death either. But Japan and Europe are not strictly comparable. Japan is a country while the European Union is an incomplete federation and there is a real danger that the austerity policy inflicted on the Eurozone may destroy the European Union. That would be a tragedy of historic proportions.

EUROPE

The Eurozone is the main trouble spot in the global financial system today. The euro has many deficiencies in its design. Its major defect is that it has created a monetary union without a political union; it has a central bank but it doesn’t have a common fiscal authority. The architects of the euro knew this but they had reason to believe that when the need for a political union arose, the political will necessary to create it could be generated. After all that is how the European Union was brought into existence, by what Karl Popper called “piecemeal social engineering”: Taking small steps at a time, knowing full well that they are inadequate and will create the need for further steps.

But the euro also had other shortcomings of which the architects were not aware. What turned out to be a fatal defect was that, by establishing an independent central bank, the government bonds of member countries became denominated in a currency they did not control. This raised the risk of default. Normally developed countries never default because they can always print money. Their currency may depreciate but the risk of default does not arise. The risk of default is characteristic of third world countries that borrow in a foreign currency, like dollars. In effect, the heavily indebted Eurozone countries were relegated to the status of third world countries without either the authorities or the financial markets fully understanding the implications of this fact.

When the euro was introduced the authorities treated government bonds as if they were riskless and regulators allowed commercial banks to buy them in unlimited amounts without setting aside any equity capital. The European Central Bank accepted all government bonds at its discount window on equal terms. This created a perverse incentive for commercial banks to accumulate the bonds of the weaker member countries, which paid higher rates, in order to earn a few extra basis points. As a result interest rate differentials between the various government bonds practically disappeared.

The convergence of interest rates caused a divergence in economic performance. The so-called periphery countries, Spain and Ireland foremost among them, enjoyed real estate, investment and consumption booms that made them less competitive, while Germany, weighed down by the cost of reunification, engaged in far-reaching labor market and other structural reforms that made it morecompetitive.

After the crash of 2008 the authorities had to substitute sovereign credit- in the form of central bank guarantees and budget deficits- for the credit of the financial institutions whose credit was impaired. That was when the need for a political union arose but the political will was lacking. Chancellor Merkel declared that each country should look after its financial institutions individually instead of the European Union doing it collectively. In retrospect that was the inception of the euro crisis.

It was only at the end of 2009, when Greece revealed the true size of its deficit did financial markets realize that a European country could actually default. But then the markets raised the risk premiums on all the weaker Eurozone countries with a vengeance. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent and that created both a sovereign debt and a banking crisis. The two are linked together like Siamese twins.

Once this is realized a solution of the euro crisis practically suggests itself. I shall spell it out in a lecture in Frankfurt on Tuesday because the solution cannot be implemented without German support so you’ll have to wait for it until Wednesday.

Let me now turn to other parts of the world.

THE UNITED STATES

Surprisingly, the U.S. is emerging as the strongest economy in the developed world and the dollar as the strongest currency. Shale gas and shale oil have given the U.S. an important competitive advantage in manufacturing. Both the banking and the household sectors have made some progress in deleveraging. Quantitative easing has boosted asset values. The housing market has improved and a pick-up in construction is helping employment numbers.

All these factors combined are strong enough to outweigh the fiscal drag exerted by sequestration. This is a fortunate combination that slows down the recovery and prolongs QE.

Even more surprisingly, I am also optimistic about the political outlook. The two-party system used to work by the two-parties competing for the middle ground in order to win elections. This kept both of them moderate. Legislation usually involved bi-partisan cooperation.

Then the Republican Party became dominated by extremists. The Democrats tried to follow them in order to regain the middle ground. That is how policies became one sided, and the checks and balances that worked well for two hundred years ceased to function properly.

As you may know, I was very critical of the Bush administration and, later on, of the way the Republicans were obstructing the Obama administration. Now I think the Republicans have over stepped the limits with sequestration. One way or another, the Tea Party will find itself isolated and the two main parties will revert to competing for the middle ground.

CHINA

As regards China, I am not as well informed as I would like to be. China has been the main motor of growth for the global economy ever since the financial crisis. It is a smaller motor than the U.S. consumer had been during the boom years; that is one of the reasons why global growth has been so anemic.

China must now change its growth model. It cannot rely on export and investment-led growth any longer, partly because the rest of the world cannot continue absorbing a chronic Chinese export surplus and partly because the rapid growth of investments has reduced profitability. Without profits it is difficult to finance further investments. The investment boom has been financed partly by the household sector that was earning negative real interest rates on its savings and partly by the state owned banks that accumulated bad debts. That cannot continue forever. The current growth model can be maintained for another year or two but not for another decade. The household sector has now shrunk to 34 percent of GDP and its savings are no longer sufficient to subsidize the other two-thirds of the economy. The banking system is also in trouble.

The obvious solution is to build a new growth model based on household spending. By improving the social safety net and making it more dependable the propensity to save can be reduced. But the transition will not be easy. Less investment in industrial capacity and infrastructure will slow down the improvement in productivity and the overall growth rate is bound to fall below 8%. The slower growth rate will also delay the breakeven point of infrastructure investments and that will aggravate the bad debts of state owned banks. Moreover, the initial impact of an overall slowdown is to increase the propensity to save because consumers become more cautious. This increases the chances of a hard landing.

One could see the beginnings of a hard landing last year when the authorities ordered the banks to cut back on lending. Some of the problems I mentioned began to surface and lead to a rapid expansion of the shadow banking system. Some borrowers, particularly in the housing industry, were willing to pay much higher interest rates even as their profits were under pressure. This raised the risk that the loans would eventually default. Most of these loans came from the wealth management and other subsidiaries of commercial banks. Wealth management products are not legally guaranteed by the parent but so far the parent company always paid up on the few occasions when there was a shortfall. To an American observer the situation is reminiscent of money market funds where one fund that “breaks the buck” could cause widespread panic. Altogether the rapid growth of shadow banking has some disturbing similarities with the subprime mortgage market in the US that caused the financial crisis of 2007-8.

I am sure the authorities are aware of the dangers. They have both the skills and the resources to deflate an incipient bubble gradually. China has been able to successfully change its growth model several times in recent history. So there is every reason to believe that they will be able to do it again – except for one factor: vested interests are much stronger today than they were on previous occasions. The rapid expansion of shadow banking indicates that the vested interests were able to exert considerable influence over state owned banks.

If the American experience is any guide, the authorities have a couple of years to bring shadow banking under control because it took two or three years of exponential growth in the subprime mortgage market to lead to the financial crisis of 2007-8. I think it is of the utmost importance that the authorities should succeed, not only for China but for the world.

CURRENCY MARKETS

Let me conclude by assessing the implications of all these influences for currency markets. Exchange rates had been remarkably stable since the disturbances caused by the financial crisis. They became unhinged towards the end of last year when Japan changed sides and adopted QE. The UK also became more aggressive with QE. This left the ECB as odd man out. Both the Yen and Sterling started falling against the euro and the dollar. After the Italian elections the euro also came under pressure, leaving the dollar as the strongest major currency in the world. Nevertheless, the decline of the Yen and Sterling is likely to aggravate the recession in the Eurozone.

Practically the entire developed world is engaged in quantitative easing with the notable exception of the European Central Bank. This is giving financial assets an upward momentum but creating greater volatility in currency and bond markets.

Quantitative easing is just another word for currency depreciation. It is not the optimum policy. Lord Adair Turner proposed some other alternatives at the INET conference in Hong Kong that would combine fiscal and monetary stimulus. But the euro crisis has colored the discussion about the perils of too much government debt and it has distorted the political debate by overstating the risk of default. Consequently, there has been strong political resistance to using fiscal stimulus not only in the Eurozone but also in the US and UK. So QE is probably the best policy attainable in the prevailing conditions.

But QE needs to be better coordinated because competitive devaluation is liable to create havoc. The lack of international cooperation in currency markets and the lack of agreement on the fundamentals of macro-economic policy is reminiscent of the 1930s. This is very dangerous. I expect the next year or so to be very turbulent, with the euro at the center of the storm.

I have focused on the financial situation because that is my expertise. But I have the same concern about the political situation. We have too many conflicts and not enough international cooperation. I think China, which has escaped many of the financial strains that affect the developed world, could play a very positive role in promoting greater international cooperation. That would be an appropriate continuation of China’s peaceful rise.