Martin Wolf: Post-crunch paradigm
John Walsh interviews Martin Wolf about the causes of the subprime credit crisis and what needs to be done to avoid another similar meltdown in the future. Wolf also analyses the prospects for the Irish economy against the post credit crunch economic landscape
There are very few journalists who command the attention of the world's leading central bankers and economic policymakers. Associate editor and chief economics commentator with the Financial Times Martin Wolf is one of the few exceptions. Every week, 50 top economists debate his articles online in Wolfforum.com. And in view of the current financial market turmoil, there has probably been no greater need for the balanced, insightful commentary with which Wolf has become synonymous.
They say a week is a long time in politics. These days a week on the financial markets seems like a lifetime. Ever since the subprime credit crisis first exploded last August, fresh pain has been visited on investors, financial institutions and practically every sector of the financial system with alarming regularity. Attempts to put this crisis in context have exercised even the most seasoned observer.
One view is that the current rupture exposes fundamental flaws in the financial system. Then there is the view that this is no more than a timely reminder that investors were developing too much of an appetite for risk, and the fallout from the subprime crisis - albeit a very drastic correction - is taking the froth out of the market.
Moreover, previous financial crises have flared up and been resolved almost in splendid isolation to the real economy. Not so on this occasion. There are very real consequences for global economic growth. Again, wildly disparate views are emerging on the extent and complexion of this slowdown. Some would argue that the US economy is on a precipice and, if it tips over, then the world economy will be plunged into a severe slump.
Wolf says that even though this subprime-triggered turbulence is still at an early stage, he is taking the view that this is a very significant crisis - possibly the most significant financial trauma since the second World War. And that is because the subprime meltdown quickly spread to the core of the financial system and the large financial institutions that dominate Wall Street and New York. But potentially much more damaging, the credit crisis has exposed serious flaws in the way the financial system operates.
"It concerns predominantly the securitisation of mortgages and derivative products thereof. And securitisation, the so-called originate and distribute model, of which securitisation was a central element - this was considered to be at the core of the new transactions-oriented financial system."
Over the past number of years, banks have increasingly offloaded loans from their balance sheets. They have been securitised and sold on. This process has been at the heart of the subprime crisis. "This securities-dominated financial system depended very heavily on the workability of this securitisation process. This has broken down. There is a long chain of agents between the original loans advanced to borrowers - particularly US mortgages - to the ultimate investors in the securities and it is clear that everybody concerned acted with the greatest possible irresponsibility."
One of the first consequences of the subprime crisis is that interbank lending dried up. Central banks waded in to pump liquidity into the system to stave off systemic risk and to prevent the collapse of any banks highly exposed to the liquidity crunch. The British bank Northern Rock was an early casualty. A number of hedge funds have succumbed to the unfavourable conditions. But the news that one of the major players on Wall Street, Bear Stearns, had to be bailed out and sold off at a bargain price to rival JP Morgan sent the markets into a tailspin. Uncertainty has always been the bete noire of financial markets. Because of the opaqueness of the credit market instruments at the centre of this crisis, it is impossible to say when a line will be drawn under the current turmoil.
"This crisis is clearly not over because the underlying asset against which all this leverage was created and these assets were created - US housing - is continuing to fall in price. And because it is continuing to fall in price - experts believe that it still has far to go - the likelihood is that losses are far bigger than have been revealed.
"At the end of all that, it is very possible that a very substantial part of the financial system will be decapitalised which could turn into the most significant crisis in the US since the war. I tend to believe that it will be a turning point and I think the excesses of the system will need a substantial rethink about how it operates in the future."
How the authorities respond to events over the past eight months is going to become a very political issue. And that is causing deep concern among senior bankers. They draw an analogy between what could happen now and what happened in the aftermath of the Enron scandal in the US in 2002. Because of high-level fraud, the energy firm Enron collapsed amid a pile of debt. Two US senators reacted to the scandal by introducing the Sarbanes-Oxley Act.
The consensus is that the regulatory response was completely disproportionate to the original crime and that all it has succeeded in doing is introduce another layer of bureaucracy without addressing the underlying causes of the problem. The financial community has been almost una voce that any regulatory response in this case could have the same consequences and choke off the lifeblood of the western economy. The flipside of this argument is that financial market deregulation has gone too far and that is the root cause of the subprime crisis.
Wolf says that it is naive to think that this crisis is going to be anything other than intensely political for three interlocking reasons. "It is an election year and a very bitter one in which the Democrats hope to unseat and reverse what has now been three decades of growing Republican ascendancy. It is a crisis that is seen by most people as having something to do with corrupt practises encouraged by Wall Street - the core of the financial system. There is no doubt that this story is riddled with financial corruption in terms of loans created and packaged. Hatred of bankers is a permanent theme of American history. That is the reason it took so long to create a central bank and there is nothing new in this constant recycling of fear by the moneyed power in America. The third reason that it is very political is that it is about housing and millions of people are going to lose their houses. And nearly all of them are natural Democrats. Anything that involves the large-scale repossession of the homes of ordinary people in a democracy is politically explosive. If this were to happen in the UK then there is no doubt that the government would have fallen."
Wolf highlights specific areas he says need to be addressed as part of a regulatory response to what has happened. Central bankers, finance ministries and regulators all have to push forward the relevant part of the current regulatory framework, particularly Basel II and the Bank of International Settlement agreement on banking regulation.
"My own view is that the biggest single thing is to greatly increase the capital requirements by the financial institutions that are effectively insured by the state - the big commercial banks. They need far more capital than they have. They get decapitalised far too soon and because they have very little capital and they get high returns on that capital, there is a big incentive to take very large risks. But I do think there are other bigger issues. And that is whether to merge commercial banking and investment banking has turned out to be a sensible thing to do because you are essentially merging a utility that provides services to a wide range of customers with an investment bank, which is essentially a hedge fund operation. There are some very big questions that you cannot avoid."
The financial sector is almost unrecognisable from the model that existed before market deregulation first took hold in the late 1980s. Coinciding with this process of deregulation has been an almost exponential increase in capital flows around the world. Since the late 1990s, one of the dominant trends has been the huge ramp up in capital accumulation in Asian countries in both private and public spheres. Most of that money has found its way into the US. And even though this "wall of money" coming from Asia created plentiful liquidity and cheap access to capital, it has precipitated two massive bubbles since 2000: first the dot.com frenzy and now the credit market crash.
On a macro level, insatiable Asian demand for US assets has helped inflate the US current account deficit and trade deficits to record levels. When the low interest rate environment boom was in full swing, there were plenty of commentators lining up to claim that this was a new paradigm. Inflation was a thing of the past and property - the asset class driving much of the boom - was the safest place for investors to put their money. Now that the party is over, the blame game has started. Former chairman of the US Federal Reserve Alan Greenspan has come into the firing line.
"There has been a tremendous amount of criticism of Alan Greenspan, saying that his monetary policy was too loose and this generated the credit bubble in the financial markets, of which we are now seeing the results. I think criticism of Greenspan is exaggerated but there is something in it. I think he should have tightened interest rates much quicker but, given the excess savings going into the US from Asia, boosting domestic demand was essential to avoid a permanent slump after 2000. The financial system part of the problem is that they did not lend the money responsibly. And if we don't fix the macro economic imbalances one way or another, then we are going to be back in the same problem as we were before we got into this crisis."
The US economy, the engine of global growth for the past few decades, is key to how smoothly the current downturn pans out. Wolf says that even though the size of the US trade deficit has caused deep problems in the tradeable goods sector, there are positive underlying trends in productivity and innovation. In other words, the supply side of the US economy is in no worse shape than any other western country. The problem lies with US consumers. Even though the US economy has been growing at 2.5-3% over the past number of years, the current account deficit has been running at 7% to 8% of GDP. Household debt in the US has soared to record levels over this time frame. The country's position as spender of last resort looks to be over. If this turns out to be the case, then there could be a rocky road ahead, says Wolf.
"It is indeed possible that if the Fed is successful in re-igniting US demand - and that is going to be some challenge - three years from now, we could be in the same mess as before, possibly even worse. I don't think the Fed will be interested in doing that and if the Asians don't start spending more, then we are going to have a pretty significant global slowdown. And it could be long lasting because the Europeans will not offset the excess savings in Asia and the oil exporting countries, and there will be chronic insufficient global demand."
Wolf gets teeth into Ireland
To use a horrible cliché, the story of the Celtic Tiger has been a game of two halves. The first half was productivity-led growth. Despite international scepticism that Ireland's economic success story was a slight of hand based on transfer pricing by multinationals, the OECD named Ireland as the most attractive location in the world for foreign direct investment in 1998 on the basis of productivity and profitability.
The second leg of the boom followed the US model of growth. Ireland availed of cheap money at the start of the decade, which triggered a construction frenzy. Much of the investment in the economy went into residential housing which, in economic parlance, is not a productive use of capital. Now the construction boom has come to an end and the country is at a crossroads. The Irish Stock Exchange (ISE) is dominated by banks and construction stocks, which means it is very sensitive to the current environment. In effect, is it wise to be closer to Boston than Berlin?
"In a sense, the question is how robust is the supply transformation of Ireland into a highly competitive, flexible, dynamic and innovative economy, obviously very closely linked to the US on one hand and Europe on the other - how much has it been a credit bubble over the past few years? The honest truth is that it has been a mixture of both. It does seem the effects inside the euro zone of very loose monetary policy from the European Central Bank [ECB] for much of the past five or six years, largely because of the period of very long weakness in Germany and to a similar degree in France and Italy, has had its effects on those parts of the euro zone where demand was very interest-rate sensitive. Therefore it has generated property booms in Ireland and on an even bigger scale in Spain. In both these cases, there is a real reason why this happened but it was greatly exacerbated by low interest rates. One of the reasons I was concerned about the UK joining the euro zone is that we would have interest rates far below what is needed because of the UK housing sector's tendency to overshoot. I must say I shudder to think what the UK would look like now if we had ECB rates instead of Bank of England rates," says Wolf.
"That is clearly part of the Irish story. The question is, if domestic demand deflates because the property boom is over, will the supply side be able to generate exports to make up for it? Ireland has a great advantage in that it is a small open economy, so shifting output into the external sector should not in principle be very difficult. It would be a lot easier than for a country like the US. The question is how responsive would the trade/export oriented activity be to change in demand at home. The difficulty it seems to me is that Ireland is now a fully caught-up economy.
"Obviously the potential for very rapid growth must be limited and at the same time it is subject to competition from a lot of other locations that would like to eat Ireland's lunch. I'd expect that after a very successful 15 years there are going to be some pretty tough adjustments over the next four to five as the property bubble deflates and the economy has to increase international competitiveness to compensate."
European monetary union has always had its detractors. The argument is that it is impossible to set monetary policy that will be appropriate for all the member states. Moreover, given that the core euro zone economies have the greatest political clout, it is much more likely that when the ECB convenes to set interest rates, it does so with the economies of Germany, France and Italy in mind. But Ireland has been out of synch with the mainland economies since the inception of European monetary union. Low interest rates fuelled the boom period. But how the looming downturn is managed will be far more important. The country's hands are tied in two key areas: interest rate and exchange rate policy. The thorny political issue of fiscal policy will be the Government's key weapon in the near-to-medium term.
"You can use fiscal policy if domestic demand weakens. I don't know how much room for manoeuvre Ireland has before it starts running into Maastricht criteria... So provided you thought this was a temporary shock on the property side, the Government could run larger fiscal deficits from a demand point of view. And the debt position of Ireland is excellent so I wouldn't pay much attention to Maastricht for that. The second thing is that fiscal policy has to be used in a way that will strengthen future competitiveness. Since Ireland is an open economy that depends on highly skilled people for innovation, it seems to me that a high degree of public tax spending - rather than tax cuts - should go to support the innovation base, the human resource base of the economy.
"Because at the end of this, you want to come through it with a better supply side than you have today. Provided there isn't a huge slowdown in Europe - and at the moment I am moderately optimistic about Europe - that should be enough to get Ireland through this without an immense amount of pain. But, in essence, supply side policy to help generate the emergence of new profitable activities and classic fiscal responses to a temporary slowdown in demand are really the only responses you have."