Why the Sub-Prime Crisis is a
Turning Point for the World Economy
Martin Wolf, Associate Editor & Chief Economics
Commentator, Financial Times
Nottingham
March 5th 2008
The Globalisation and Economic Policy Centre, Nottingham
University
Why the Crisis is a Turning Point
“Things that can’t go on forever,
don’t.” Herbert Stein.
2
Why the Crisis is a Turning Point
• Crisis of credibility for Anglo-Saxon financial capitalism
• Crisis for securitised lending
• Crisis for central banks and regulators
• Crisis for belief in free markets
• Crisis for global asset markets
• Crisis for global macroeconomic balances
• Crisis for US and global economic activity
• Crisis for game of “pass-the-external-deficits”
3
1. Crisis of Anglo-Saxon financial capitalism
• First, a mixture of crony capitalism and gross
incompetence has been on display in the core financial
markets of New York and London:
– From “ninja” (no-income, no-job, no-asset) sub-prime lending,
– To the placing (and favourable rating) of assets that turn out to
be almost impossible to understand, value or sell,
– These activities have been riddled with conflicts of interest and
incompetence.
– Huge risks have been taken. In the subsequent era of financial
“revulsion”, core financial markets have seized up
4
1. Crisis of Anglo-Saxon financial capitalism
HIGH REWARD MEANS HIGH RISK
5
1. Crisis of Anglo-Saxon financial capitalism
CREDIT SHOCK IN THE US
SPREAD BETWEEN COMMERCIAL PAPER AND TREASURY BILL
RATES
3.00
2.50
2.00
1.50
1.00
0.50
6
01/02/2008
01/01/2008
01/12/2007
01/11/2007
01/10/2007
01/09/2007
01/08/2007
01/07/2007
01/06/2007
01/05/2007
01/04/2007
01/03/2007
01/02/2007
01/01/2007
0.00
7
US
Eurozone
UK
14/01/2008
31/12/2007
17/12/2007
03/12/2007
19/11/2007
05/11/2007
22/10/2007
08/10/2007
24/09/2007
10/09/2007
27/08/2007
13/08/2007
30/07/2007
16/07/2007
02/07/2007
18/06/2007
04/06/2007
21/05/2007
07/05/2007
23/04/2007
09/04/2007
26/03/2007
12/03/2007
26/02/2007
12/02/2007
29/01/2007
15/01/2007
01/01/2007
1. Crisis of Anglo-Saxon financial capitalism
SPREADS BETWEEN INTERVENTION RATES AND THREE-MONTH
LIBOR
1.4
1.2
1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
2. Crisis for securitised lending
• These events have called into question the workability
of securitised lending:
– The argument for this change was that it would shift the risk of
term-transformation (borrowing short to lend long) out of the
banking system onto those best able to bear it;
– What happened, instead, was the shifting of the risk on to the
shoulders of those least able to understand it;
– What also occurred was a multiplication of leverage and termtransformation, not least through the banks’ “special
investment vehicles”; and
– What we see today, as a result, is a rapid shrinkage of
markets in asset-backed paper.
8
2. Crisis for securitised lending
EXCESS DEBT LEADS TO CREDIT IMPLOSION
9
3. Crisis for central banks and regulators
• Third, the crisis has opened up big questions about the
roles of central banks:
– How far, for example, do the responsibilities of central banks
as “lender-of-last-resort” during crises stretch?
– Should they, as some argue, be market-makers-of-last resort
in credit markets?
– What, more precisely, should a central bank do when liquidity
dries up in important markets?
10
3. Crisis for central banks and regulators
• Equally, the crisis suggests that liquidity has been
significantly underpriced:
– Does this mean that the regulatory framework for banks is
fundamentally flawed?
– What is left of the idea that we can rely on financial institutions
to manage risk through their own models?
– What, moreover, can reasonably be expected of the rating
agencies?
– A market in US mortgages is hardly terra incognita. If banks
and rating agencies got this wrong, what else must be brought
into question?
11
3. Crisis for central banks and regulators
NOTE HOW THINLY CAPITALISED BANKS ARE
12
4. Crisis for belief in free markets
• US officials used to lecture, not least the Japanese,
about letting asset prices reach equilibrium and
transparency enter markets. That was then:
– Now we see Hank Paulson, US Treasury secretary, a cartel of
holders of toxic securitised assets in his “superSIV”;
– We see the US Treasury intervene directly in the rate-setting
process on mortgages, in an attempt to shore up the housing
market.
– We see increasing talk of a bail out of over-indebted
households
– Not for a long time will people listen to US officials lecture on
the virtues of free financial markets with a straight face.
13
Ja
Jan-8
7
Jan-8
8
Jan-8
9
Jan-9
0
Jan-9
1
Jan-9
2
Jan-9
3
Jan-9
4
Jan-9
5
Jan-9
6
Jan-9
7
Jan-9
8
Jan-9
9
Jan-0
0
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
n- 6
07
HOUSE PRICES IN REAL
TERMS
14
200
180
160
140
120
100
80
60
40
20
0
15
10
5
0
-5
-10
-15
Composite-10
annual per cent change
RATE OF CHANGE OF
HOUSE PRICES
4. Crisis for belief in free markets
THIS TIME, IT’S PERSONAL
REAL HOUSE PRICES
(Case-Shiller 10-City)
20
5. Crisis for global asset markets
• Fifth, the crisis signals a re-rating of risk.
• It also represents a move towards holding more
transparent and liquid assets.
• This correction has been selective, however.
• It is a striking feature of what has happened that
emerging markets have emerged as a safe haven.
• For emerging economies, this must be sweet revenge.
15
16
COMPOSITE
MEXICO
TURKEY
CHINA
06/01/2008
06/07/2007
06/01/2007
06/07/2006
06/01/2006
06/07/2005
06/01/2005
06/07/2004
06/01/2004
06/07/2003
06/01/2003
06/07/2002
06/01/2002
06/07/2001
06/01/2001
06/07/2000
06/01/2000
06/07/1999
06/01/1999
06/07/1998
06/01/1998
06/07/1997
06/01/1997
5. Crisis for global asset markets
DISAPPEARING EMERGING ECONOMY RISK
REDUCTION IN EMERGING MARKET RISK SPREADS
(percentage points over US Treasuries)
1800
1600
1400
1200
1000
800
600
400
200
0
4. Crisis for global asset markets
DISAPPEARING EMERGING ECONOMY RISK
EXPLOSIVE GROWTH OF FOREIGN CURRENCY RESERVES ($m)
7,000,000
Other developing
Mexico
Brazil
6,000,000
Russia
Oil exporters
5,000,000
Other industrial
Australia
UK
4,000,000
Source: IMF
Eurozone
US
3,000,000
Other Asia
Thailand
2,000,000
Malaysia
Hong Kong
Singapore
1,000,000
Korea
India
Ja
nM 99
ay
-9
Se 9
p9
Ja 9
nM 00
ay
-0
Se 0
p0
Ja 0
nM 01
ay
-0
Se 1
p0
Ja 1
nM 02
ay
-0
Se 2
p0
Ja 2
nM 03
ay
-0
Se 3
p0
Ja 3
nM 04
ay
-0
Se 4
p0
Ja 4
nM 05
ay
Se 05
p0
Ja 5
nM 06
ay
-0
Se 6
p0
Ja 6
nM 07
ay
Se 07
p07
0
17
Taiwan
Japan
China
6. Crisis for global macroeconomic balances
• Sixth, this event marks the limits to the US role as
consumer of last resort in the world economy.
• The US is re-importing the stimulus it exported to the
rest of the world in previous years.
• The credit crunch is accelerating this process.
• For this reason, US policymakers are relaxed about
the dollar’s fall, provided it does not awaken fears of
rapidly rising inflation.
18
6. Crisis for global macroeconomic balances
UNBALANCED WORLD ECONOMY
CURRENT ACCOUNT BALANCES (as per cent of GDP)
Source: IMF, World Economic Outlook , October 2007
1.5
1
0.5
0
-0.5
-1
-1.5
-2
1997
1998
1999
2000
2001
United States
19
2002
Euro area
2003
2004
Japan
2005
2006
Emerging Asia
2007
2008
Oil exporters
2009
2010
6. Crisis for global macroeconomic balances
US AS BORROWER OF LAST RESORT
GLOBAL CURRENT ACCOUNT 2006 ($bn)
-$1,000
US
-$800
-$600
-$400
-$200
$0
$200
-$68
Western Europe, excluding UK
$131
Source: IMF, World Economic Outlook,
April 2004, April 2007 and April 2007
Database.
$170
China
$239
Rest of Asia
$102
Total Asia
$511
$396
Fuel exporters
Rest of World
Discrepancy
20
$600
-$857
UK
Japan
$400
-$131
$19
6. Crisis for global macroeconomic balances
SHRINKING CURRENT ACCOUNT DEFICIT
CURRENT ACCOUNT BALANCE (per cent of GDP)
2
1
0
-1
-2
-3
-4
Source: BEA
-5
-6
-7
-8
80 81 82 83 85 86 87 88 90 91 92 93 95 96 97 98 00 01 02 03 05 06 07
1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3
Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
21
22
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Jan-84
Jan-82
Jan-80
Jan-78
Jan-76
Jan-74
Jan-72
Jan-70
6. Crisis for global macroeconomic balances
FALLING DOLLAR
US REAL EXCHANGE RATE (JP Morgan)
130
120
110
100
90
80
70
60
7. Crisis for US and global economic activity
• Seventh, a deep US recession is possible. Whether it
happens depends overwhelmingly on consumers:
– The principal counterpart of the external deficits has been the
excess of spending over income by households.
– That has meant negligible savings and a big jump in
household debt: mortgage debt jumped from 63 per cent of
disposable incomes in 1995 to 98 per cent in 2005.
– This rising trend will not continue in a falling housing market.
– Unwillingness (or inability) to borrow on such a scale
willhamper the effectiveness of US monetary policy.
– That, in turn, makes a weak dollar and strong export growth
yet more important.
23
7. Crisis for US and global economic activity
US DOMESTIC IMBALANCES
FINANCIAL BALANCES IN THE US ECONOMY, SINCE 1990
(per cent of GDP)
8.0%
6.0%
4.0%
2.0%
0.0%
-2.0%
-4.0%
-6.0%
Private Financial Balance
24
Government Financial Balance
Foreign Financial Balance
2007-III
2007-I
2006-III
2006-I
2005-III
2005-I
2004-III
2004-I
2003-III
2003-I
2002-I
2002-III
2001-III
2001-I
2000-III
2000-I
1999-III
1999-I
1998-III
1998-I
1997-III
1997-I
1996-III
1996-I
1995-III
1995-I
1994-III
1994-I
1993-III
1993-I
1992-III
1992-I
1991-III
1991-I
1990-III
1990-I
-8.0%
7. Crisis for US and global economic activity
HOUSEHOLDS SPENT; COMPANIES DID NOT
US HOUSEHOLD AND BUSINESS FINANCIAL BALANCES
(as per cent of GDP)
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
-4.0%
19
90
19 -I
90
-I
19 V
91
-I
19 II
92
-I
19 I
93
19 -I
93
-I
19 V
94
-I
19 II
95
-I
19 I
96
19 -I
96
-I
19 V
97
-I
19 II
98
-I
19 I
99
19 -I
99
-I
20 V
00
-I
20 II
01
-I
20 I
02
20 -I
02
-I
20 V
03
-I
20 II
04
-I
20 I
05
20 -I
05
-I
20 V
06
-I
20 II
07
-II
-5.0%
Business Financial Balance
25
Household Financial Balance
7. Crisis for US and global economic activity
US LEADS THE ECONOMIC SLOWDOWN
CONSENSUS FORECASTS OF GROWTH FOR 2008
3.5
3.0
2.5
2.0
1.5
1.0
Source: Consensus Forecasts
0.5
0.0
Jan07
Feb07
Mar07
Apr07
May07
USA 2008
26
Jun- Jul-07 Aug07
07
UK 2008
Sep07
Japan 2008
Oct07
Nov07
Dec07
Eurozone 2008
Jan08
Feb08
27
US FEDERAL FUNDS
EURO SHORT TERM REPO
UK BASE RATE
25/02/2008
11/02/2008
28/01/2008
14/01/2008
31/12/2007
17/12/2007
03/12/2007
19/11/2007
05/11/2007
22/10/2007
08/10/2007
24/09/2007
10/09/2007
27/08/2007
13/08/2007
30/07/2007
16/07/2007
02/07/2007
18/06/2007
04/06/2007
21/05/2007
07/05/2007
23/04/2007
09/04/2007
26/03/2007
12/03/2007
26/02/2007
12/02/2007
29/01/2007
15/01/2007
01/01/2007
7. Crisis for US and global economic activity
THE FED DULY PANICS AS NEWS GETS BAD
CENTRAL BANK INTERVENTION RATES
7
6
5
4
3
2
1
0
7. Crisis for US and global economic activity
• A very long and deep US recession is possible
• This depends on how far house prices fall
• If they fall a further 30-40 per cent, losses in the
financial system could be anywhere between $1,000bn
and $3,000bn. The latter would decapitalise the US
banking system
• Similar points of weakness can be seen in housing
markets and financial systems elsewhere
• Particularly the UK
28
29
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
7. Crisis for US and global economic activity
REAL UK HOUSE PRICES
(FT price index)
200
180
160
140
120
100
80
60
40
20
0
8. Crisis for game of “pass-the-external-deficits”
• This event also has big significance for the game of
“pass-the-external-deficits” that has characterised the
world economy for several decades.
– It has proved virtually impossible for emerging market
economies to run large deficits, without running into crises;
– Over the past decade, the US filled the (growing) gap
– But surpluses being run by China and Japan, by oil exporters
and, within the European Union, by Germany continue to
grow.
– If we are to enjoy global macro-economic stability, a
creditworthy set of countervailing borrowers must emerge.
30
8. Crisis for game of “pass-the-external-deficits”
EMERGING ECONOMIES SHIFT INTO SURPLUS
SAVINGS, INVESTMENT AND CURRENT ACCOUNTS OF EMERGING
MARKET AND OIL-PRODUCING COUNTRIES
(per cent of GDP)
9
Source: IMF, World Economic Outlook, April 2007
8
7
6
5
4
3
2
1
0
-1
-2
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20
Current Account
31
Saving
Investment
8. Crisis for game of “pass-the-external-deficits”
CHINA’S EXPLOSIVE CURRENT ACCOUNT
400
300
200
100
0
-100
-200
-300
-400
-500
1996
1997
1998
CA Balance
32
1999
2000
Net FDI
2001
2002
2003
Other Capital Inflows
2004
2005
2006
Reserves Accumulation
2007
8. Crisis for game of “pass-the-external-deficits”
WHO DOES THE SAVING IN CHINA
COMPOSITION OF SAVINGS
(per cent of GDP)
60.0
Source: World Bank
50.0
7.0
7.6
40.0
7.8
4.5
8.6
4.8
6.8
7.9
6.9
30.0
28.3
25.0
15.6
15.8
15.3
20.0
10.0
18.7
16.7
19.8
14.4
16.2
16.3
15.8
15.4
14.6
15.3
2002
2003
2004
2005
2006
14.2
14.8
14.2
2000
2001
0.0
1998
1999
Households
33
Enterprises
Government
Gross capital formation
34
02/01/2008
02/01/2007
02/01/2006
02/01/2005
02/01/2004
02/01/2003
02/01/2002
02/01/2001
02/01/2000
02/01/1999
02/01/1998
02/01/1997
02/01/1996
02/01/1995
02/01/1994
02/01/1993
02/01/1992
02/01/1991
02/01/1990
8. Crisis for game of “pass-the-external-deficits”
THE PEGGED EXCHANGE RATE
$0.250
$0.200
$0.150
$0.100
$0.050
$0.000
8. Crisis for game of “pass-the-external-deficits”
THE FIXED CHINESE REAL EXCHANGE RATE
TRADE-WEIGHTED REAL EXCHANGE RATE
130
120
110
100
90
Source: JP Morgan
80
70
35
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
60
9. Conclusion
• So we have some huge tasks ahead:
– Managing the present crisis;
– Rethinking financial regulation;
– Rethinking central banking;
– Rethinking the management of global imbalances; and
– Rethinking exchange-rate and macroeconomic policies in
developing countries
36