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A special report on the world economy October 11th 2008

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The Economist October 11th 2008 A special report on the world economy 1

stocks; and, most dramatic of all, pledgedto take up to $700 billion of toxic mortgagerelated assets on to its books. The Fedand the Treasury were determined to prevent the kind of banking catastrophe thatprecipitated the Depression. Shellshockedlawmakers cavilled, but Congress and theadministration eventually agreed.

The landscape of American �nance hasbeen radically changed. The independentinvestment bank�a quintessential WallStreet animal that relied on high leverageand wholesale funding�is now all but extinct. Lehman Brothers has gone bust; BearStearns and Merrill Lynch have been swallowed by commercial banks; and Goldman Sachs and Morgan Stanley have become commercial banks themselves. The�shadow banking system��the moneymarket funds, securities dealers, hedgefunds and the other nonbank �nancial institutions that de�ned deregulated American �nance�is metamorphosing at lightning speed. And in little more than threeweeks America’s government, all told, expanded its gross liabilities by more than $1trillion�almost twice as much as the costso far of the Iraq war.

Beyond that, few things are certain. Inlate September the turmoil spread and intensi�ed. Money markets seized up across

When fortune frowned

AFTER the stockmarket crash of October1929 it took over three years for Ameri

ca’s government to launch a series of dramatic e�orts to end the Depression, starting with Roosevelt’s declaration of afourday bank holiday in March 1933. Inbetween, America saw the worst economic collapse in its history. Thousands ofbanks failed, a devastating de�ation set in,output plunged by a third and unemployment rose to 25%. The Depression wreakedenormous damage across the globe, butmost of all on America’s economic psyche.In its aftermath the boundaries betweengovernment and markets were redrawn.

During the past month, little more thana year after the �nancial storm �rst struckin August 2007, America’s governmentmade its most dramatic interventions in �nancial markets since the 1930s. At the timeit was not even certain that the economywas in recession and unemploymentstood at 6.1%. In two tumultuous weeks theFederal Reserve and the Treasury betweenthem nationalised the country’s two mortgage giants, Fannie Mae and Freddie Mac;took over AIG, the world’s largest insurance company; in e�ect extended government deposit insurance to $3.4 trillion inmoneymarket funds; temporarily bannedshortselling in over 900 mostly �nancial

The worst �nancial crisis since the Depression is redrawing theboundaries between government and markets, says Zanny MintonBeddoes. Will they end up in the right place?

An audio interview with the author is at

www.economist.com/audiovideo

A list of sources is at

www.economist.com/specialreports

Taming the beastHow far should �nance be reregulated? Page 3

Of froth and fundamentalsThe real lessons from volatile commodityprices. Page 7

A monetary malaiseCentral bankers helped cause today’s mess.Will they be able to clean it up?Page 10

Charting a di�erent courseWill emerging economies change the shapeof global �nance? Page 13

Beyond DohaFreer trade is under threat�but not for theusual reasons. Page 15

Shifting the balanceMore than a new capitalism, the world needsa new multilateralism. Page 17

Also in this section

AcknowledgmentsThis survey has bene�ted from the help and advice ofmany economists, not all of them mentioned in the text.Particular thanks are due to Doug Elmendorf, ThomasHelbling, Subir Lall, Adam Posen, Eswar Prasad, KenRogo� and Arvind Subramanian.

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2 A special report on the world economy The Economist October 11th 2008

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the globe as banks refused to lend to eachother. Five European banks failed andEuropean governments fell over themselves to prop up their banking systemswith rescues and guarantees. As this special report went to press, it was too soon todeclare the crisis contained.

Anatomy of a collapseThat crisis has its roots in the biggest housing and credit bubble in history. America’shouse prices, on average, are down by almost a �fth. Many analysts expect another10% drop across the country, which wouldbring the cumulative decline in nominalhouse prices close to that during the Depression. Other countries may fare evenworse. In Britain, for instance, householdsare even more indebted than in America,house prices rose faster and have so far fallen by less. On a quarterly basis prices arenow falling in at least half the 20 countriesin The Economist’s houseprice index.

The credit losses on the mortgages that�nanced these houses and on the pyramids of complicated debt products builton top of them are still mounting. In its latest calculations the IMF reckons thatworldwide losses on debt originated inAmerica (primarily related to mortgages)will reach $1.4 trillion, up by almost halffrom its previous estimate of $945 billionin April. So far some $760 billion has beenwritten down by the banks, insurancecompanies, hedge funds and others thatown the debt.

Globally, banks alone have reportedjust under $600 billion of creditrelatedlosses and have raised some $430 billion innew capital. It is already clear that manymore writedowns lie ahead. The demiseof the investment banks, with their farhigher gearing, as well as deleveragingamong hedge funds and others in theshadowbanking system will add to a global credit contraction of many trillions ofdollars. The IMF’s �base case� is that American and European banks will shed some$10 trillion of assets, equivalent to 14.5% oftheir stock of bank credit in 2009. In America overall credit growth will slow to below 1%, down from a postwar annual average of 9%. That alone could drag Westerneconomies’ growth rates down by 1.5 percentage points. Without government action along the lines of America’s $700 billion plan, the IMF reckons credit couldshrink by 7.3% in America, 6.3% in Britainand 4.5% in the rest of Europe.

Much of the rich world is already in recession, partly because of tighter creditand partly because of the surge in oil prices

earlier this year. Output is falling in Britain,France, Germany and Japan. Judging bythe pace of job losses and the weakness ofconsumer spending, America’s economyis also shrinking.

The average downturn after recentbanking crises in rich countries lasted fouryears as banks retrenched and debtladenhouseholds and �rms were forced to savemore. This time �rms are in relatively goodshape, but households, particularly in Britain and America, have piled up unprecedented debts. And because the asset andcredit bubbles formed in many countriessimultaneously, the hangover this timemay well be worse.

But history teaches an important lesson: that big banking crises are ultimatelysolved by throwing in large dollops of public money, and that early and decisive government action, whether to recapitalisebanks or take on troubled debts, can minimise the cost to the taxpayer and the damage to the economy. For example, Swedenquickly took over its failed banks after aproperty bust in the early 1990s and recovered relatively fast. By contrast, Japan tooka decade to recover from a �nancial bust

that ultimately cost its taxpayers a sumequivalent to 24% of GDP.

All in all, America’s government hasput some 7% of GDP on the line, a vastamount of money but well below the 16%of GDP that the average systemic bankingcrisis (if there is such a thing) ultimatelycosts the public purse. Just how America’sproposed Troubled Asset Relief Programme (TARP) will work is still unclear.The Treasury plans to buy huge amountsof distressed debt using a reverse auctionprocess, where banks o�er to sell at a priceand the government buys from the lowestprice upwards. The complexities of thousands of di�erent mortgagebacked assetswill make this hard. If direct bank recapitalisation is still needed, the Treasury cando that too. The main point is that Americais prepared to act, and act decisively.

For the time being, that o�ers a reasonfor optimism. So, too, does the relativestrength of the biggest emerging markets,particularly China. These economies arenot as �decoupled� from the rich world’stravails as they once seemed. Their stockmarkets have plunged and many currencies have fallen sharply. Domestic demandin much of the emerging world is slowingbut not collapsing. The IMF expects emerging economies, led by China, to grow by6.9% in 2008 and 6.1% in 2009. That willcushion the world economy but may notsave it from recession.

Another shortterm �llip comes fromthe recent plunge in commodity prices,particularly oil. During the �rst year of the�nancial crisis the boom in commoditiesthat had been building up for �ve years became a headlong surge. In the year to Julythe price of oil almost doubled. The Economist’s foodprice index jumped by nearly55% (see chart 1). These enormous increases pushed up consumer prices acrossthe globe. In July average headline in�ation was over 4% in rich countries and almost 9% in emerging economies, far higherthan central bankers’ targets (see chart 2).

High and rising in�ation coupled with�nancial weakness left central bankerswith perplexing and poisonous tradeo�s.They could tighten monetary policy to prevent higher in�ation becoming entrenched (as the European Central Bankdid), or they could cut interest rates to cushion �nancial weakness (as the Fed did).That dilemma is now disappearing.Thanks to the sharp fall in commodityprices, headline consumer prices seem tohave peaked and the immediate in�ationrisk has abated, particularly in weak and �nancially stressed rich economies. If oil

2Danger signals

Source: IMF *August

Headline inflation rates, % increase on a year earlier

2002 03 04 05 06 07 08*0

2

4

6

8

10

Global

Industrial economies

Emerging economies

1Combustible material

Sources: The Economist;

Thomson Datastream

*West Texas Intermediate†September

The Economist commodity-price indices, $ termsJanuary 2000=100

2000 01 02 03 04 05 06 07 08†0

100

200

300

400

500

All itemsFoodOil*


2

1

prices stay at today’s levels, headline consumerprice in�ation in America may fallbelow 1% by the middle of next year. Rather than fretting about in�ation, policymakers may soon be worrying about de�ation.

The trouble is that because of its largecurrentaccount de�cit America is heavilyreliant on foreign funding. It has the advantage that the dollar is the world’s reservecurrency, and as the �nancial turmoil hasspread the dollar has strengthened. But today’s crisis is also testing many of the foundations on which foreigners’ faith in thedollar is based, such as limited government and stable capital markets. If foreigners ever �ee the dollar, America will facethe twin nightmares that haunt emergingcountries in a �nancial collapse: simultaneous banking and currency crises. America’s debts, unlike those in many emergingeconomies, are denominated in its owncurrency, but a collapse of the dollarwould still be a catastrophe.

Tipping pointWhat will be the longterm e�ect of thismess on the global economy? Predictingthe consequences of an un�nished crisis isperilous. But it is already clear that, even inthe absence of a calamity, the direction ofglobalisation will change. For the past twodecades the growing integration of theworld economy has coincided with the intellectual ascent of the AngloSaxon brandof freemarket capitalism, with America asits cheerleader. The freeing of trade andcapital �ows and the deregulation of domestic industry and �nance have bothspurred globalisation and come to symbolise it. Global integration, in large part,has been about the triumph of markets

over governments. That process is now being reversed in three important ways.

First, Western �nance will be reregulated. At a minimum, the most freewheelingareas of modern �nance, such as the $55trillion market for credit derivatives, willbe brought into the regulatory orbit. Ruleson capital will be overhauled to reduce leverage and enhance the system’s resilience. America’s labyrinth of overlappingregulators will be reordered. How muchcontrol will be imposed will depend lesson ideology (both of America’s presidential candidates have promised reform)than on the severity of the economicdownturn. The 1980s savingsandloan crisis amounted to a sizeable banking bust,but because it did not result in an economic catastrophe, the regulatory consequences were modest. The Depression, incontrast, not only refashioned the structure of American �nance but brought regulation to whole swathes of the economy.

That leads to the second point: the balance between state and market is changingin areas other than �nance. For manycountries a more momentous shock overthe past couple of years has been the soaring price of commodities, which politicians have also blamed on �nancial speculation. The foodprice spike in late 2007and early 2008 caused riots in some 30countries. In response, governmentsacross the emerging world extended theirreach, increasing subsidies, �xing prices,banning exports of key commodities and,in India’s case, restricting futures trading.Concern about food security, particularlyin India and China, was one of the mainreasons why the Doha round of trade negotiations collapsed this summer.

Third, America is losing economic cloutand intellectual authority. Just as emergingeconomies are shaping the direction ofglobal trade, so they will increasinglyshape the future of �nance. That is particularly true of capitalrich creditor countriessuch as China. Deleveraging in Westerneconomies will be less painful if savingsrich Asian countries and oilexporters inject more capital. In�uence will increasealong with economic heft. China’s vicepremier, Wang Qishan, reportedly told hisAmerican counterparts at a recent SinoAmerican summit that �the teachers nowhave some problems.�

The enduring attraction of marketsThe big question is what lessons theemerging students�and the disgracedteacher�should learn from recent events.How far should the balance between governments and markets shift? This specialreport will argue that although some rebalancing is needed, particularly in �nancialregulation, where innovation outpaced asclerotic supervisory regime, it would be amistake to blame today’s mess only, oreven mainly, on modern �nance and �freemarket fundamentalism�. Speculative excesses existed centuries before securitisation was invented, and governments beardirect responsibility for some of today’stroubles. Misguided subsidies, on everything from biofuels to mortgage interest,have distorted markets. Loose monetarypolicy helped to in�ate a global credit bubble. Provocative as it may sound in today’sfebrile and dangerous climate, freer andmore �exible markets will still do more forthe world economy than the heavy handof government. 7

�WALL STREET got drunk.� �Bankersdeserve D.� A few years ago those

phrases might have appeared on placardsheld by purplehaired protesters at antiglobalisation rallies. Now they come fromthe president of the United States and a former chairman of the Federal Reserve.Thinking the microphones were o�,George Bush told a group of Republicansin July that Wall Street needed to �soberup� and wean itself from �all these fancy �nancial instruments�. And long before

September’s events, Paul Volcker gave �nanciers their D grade along with a devastating critique. �For all its talented participants, for all its rich rewards,� he said inApril, the �bright new �nancial system�has �failed the test of the marketplace�.

In light of the events of recent weeks, itis hard to disagree. A �nancial system thatends up with the government taking oversome of its biggest institutions in serialweekend rescues and which requires thepromise of $700 billion in public money to

stave o� catastrophe is not an Agrade system. The disappearance of all �ve bigAmerican investment banks�either bybankruptcy or rebirth as commercialbanks�is powerful evidence that WallStreet failed �the test of the marketplace�.Something has gone awry.

But what exactly, and why? The fashionable answers come in sweeping indictments of speculators, greedy Wall Streetexecutives and freemarket ideologues.France’s president, Nicolas Sarkozy, recent

Taming the beast

How far should �nance be reregulated?


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ly said that the world needed to �bring ethics to �nancial capitalism�. Brazil’s president, Luiz Inácio Lula da Silva, wants tocombat the �anarchy of speculation�. Amore serious analysis, however, needs todistinguish between three separate questions. First, what is Mr Volcker’s �brightnew �nancial system�? Second, how farwas today’s mess created by instabilitiesthat are inseparable from modern �nance,and how far was it fuelled by other errorsand distortions? Third, to the extent thatmodern �nance does bear the blame, whatis the balance between its costs and itsbene�ts, and how can it be improved?

An AngloSaxon inventionPut crudely, the bright new �nance is thehighly leveraged, lightly regulated, marketbased system of allocating capital dominated by Wall Street. It is the spivvy successor to �traditional banking�, in which regulated commercial banks lent money totrusted clients and held the debt on theirbooks. The new system evolved over thepast three decades and saw explosivegrowth in the past few years thanks tothree simultaneous but distinct developments: deregulation, technological innovation and the growing international mobility of capital.

Its hallmark is securitisation. Banks thatonce made loans and held them on theirbooks now pool and sell the repackagedassets, from mortgages to car loans. In 2001the value of pooled securities in Americaovertook the value of outstanding bankloans. Thereafter, the scale and complexityof this repackaging (particularly of mortgagebacked assets) hugely increased as investment banks created an alphabet soupof new debt products. They pooled assetbacked securities, divided the pools intorisk tranches, added a dose of leverage,and then repeated the process severaltimes over.

Meanwhile, increasing computer wizardry made it possible to create a dizzyingarray of derivative instruments, allowingborrowers and savers to unpack and tradeall manner of �nancial risks. The derivatives markets have grown at a stunningpace. According to the Bank for International Settlements, the notional value ofall outstanding global contracts at the endof 2007 reached $600 trillion, some 11times world output. A decade earlier it hadbeen �only� $75 trillion, a mere 2.5 timesglobal GDP. In the past couple of years thefastestgrowing corner of these marketswas creditdefault swaps, which allowedpeople to insure against the failure of the

newfangled credit products. The heart of the new �nance is on Wall

Street and in London, but the growth ofcrossborder capital �ows vastly extendedits reach. Financial markets, particularly inthe rich world, have become increasinglyintegrated. Figures compiled by GianMaria MilesiFerretti, an economist at theIMF, show that the stock of foreign assetsand liabilities held by rich countries hasrisen �vefold relative to GDP in the past 30years and doubled in the past decade (seechart 3). The �nancial integration of emerging economies has been more modest, buthas also increased considerably in recentyears�though with a peculiar twist.Emerging economies, in net terms, haveexported capital to the rich world as theircentral banks have built up vast quantitiesof foreignexchange reserves.

The innovations of modern �nancegenerated great pro�ts for its participants.But were these innovations the root causeof today’s mess? That depends, in part, onwhether you begin from the premise that�nancial markets are e�cient, or that theyare inherently prone to irrational behaviour and speculative excess.

The rationale behind �nancial deregulation was that freer markets produced asuperior outcome. Unencumbered capitalwould �ow to its most productive use,boosting economic growth and improvingwelfare. Innovations that spread risk morewidely would reduce the cost of capital, allow more people access to credit and makethe system more resilient to shocks.

Today, however, a di�erent premise hasbecome popular: that �nancial markets areinherently unstable. Periods of stability always lead to excess and eventual crisis,and freer �nancial markets only lead togreater damage. This view was famouslyexpounded by Hyman Minsky, a 20thcentury American economist. Minsky argued

that economic stability encouraged evergreater leverage and ambitious debt structures. Stable �nance was an illusion.

The trouble is that �nancial innovationdid not occur in a vacuum but in responseto incentives created by governments.Many of the newfangled instruments became popular because they got around �nancial regulations, such as rules onbanks’ capital adequacy. Banks created o�balancesheet vehicles because that allowed them to carry less capital. The market for creditdefault swaps enabled themto convert risky assets, which demand a lotof capital, into supposedly safe ones,which do not.

Politicians also played a big part. America’s housing market�the source of thegreatest excesses�has the government’s�ngerprints all over it. Long before theywere formally taken over, the two mortgage giants, Fannie Mae and Freddie Mac,had an implicit government guarantee. AsCharles Calomiris of Columbia Universityand Peter Wallison of the American Enterprise Institute have pointed out, one reason why the market for subprime mortgages exploded after 2004 was that theseinstitutions began buying swathes of subprime mortgages because of a politicaledict to expand the �nancing of �a�ordable housing�.

History also shows that �nancialbooms tend to occur when money ischeap. And money, particularly in America, was extremely cheap in the past fewyears. That was partly because a long period of low in�ation and economic stabilityreduced investors’ perception of risk. But itwas also because America’s central bankkept interest rates too low for too long, anda �ood of capital swept into Western �nancial instruments from highsaving emerging economies.

So modern �nance should not be indicted in isolation. Its costs and bene�tsare, at least in part, the result of the incentives to which the money men were responding. But given those distortions, didthe newfangled �nance boost economicgrowth, welfare and stability?

Costs versus bene�tsCritics answer no on all three counts. MrVolcker, for instance, points out that theAmerican economy expanded as brisklyin the �nancially unsophisticated 1950sand 1960s as it has done in recent decades.But plenty of things other than �nancewere di�erent in the 1950s, so such a simplecomparison is hardly fair. And althougheconomists have long been divided on the

3Globalisation reigns

Source: Philip Lane and Gian Maria Milesi-Ferretti

Total foreign assets and liabilities as % of GDP

1970 80 90 2000 070

100

200

300

400

500

Advanced economies

Emerging anddeveloping economies

theoretical importance of �nance forgrowth, the balance of the evidence suggests that it does matter.

According to Ross Levine, an economistat Brown University who specialises inthis subject, numerous crosscountry studies show that countries with deeper �nancial systems tend to grow faster, particularly if they have liquid stockmarkets andlarge, privately owned banks. Growth isboosted not because savings rise but because capital is allocated more e�ciently,improving productivity.

Within America several studies haveshown that states which did most to deregulate their banking systems in the 1970sgrew faster than other states. In 2006 economists at the IMF compared deregulatedAngloSaxon �nancial systems with moretraditional bankdominated systems, suchas Germany’s or Japan’s, and found thatAngloSaxon systems were quicker to reallocate resources from declining sectors tonew, fastgrowing ones.

Many economists argue that �nancialinnovation, and the quick reallocation ofcapital that it promotes, was one reasonwhy America’s productivity growth accelerated in the mid1990s. Technology alonecannot explain that advance, because inventions such as the internet and wirelesscommunications were available to anycountry. What set America apart was thestrong incentives it o�ered for deployingthe new technology. Corporate managersknew that if they adapted fast, America’s�exible �nancial system would rewardthem with access to cheaper capital.

Just because �nancial innovation canboost growth does not mean it always will.Not every technological breakthrough im

proves productivity. The bonanza in mortgagebacked securities helped create a glutof new homes that did little to promotelongterm growth. But �nance’s recent focus on housing, rather than more productive forms of investment, may have hadmore to do with the government guarantees inherent in housing than �nance itself.

What about people’s lives? Even if �nancial innovation does not boost growth,it is a good thing if it improves welfare.Modern �nance improved people’s accessto credit. Computers enabled lenders touse standardised credit scores, and theriskspreading from securitisation made itsafer to lend to less creditworthy borrowers. This �democratisation of credit� letmore people own homes (and even now itis worth remembering that most subprimeborrowers are keeping up with their payments). It enabled more households tosmooth their consumption over time, reducing their �nancial hardship in leantimes. Studies show that consumers in An

gloSaxon economies cut their spendingby less when they su�er temporary shocksto their income than those in countrieswith less sophisticated �nancial systems.Smoother household consumption oftenmeans a smoother economic cycle, too.Many economists believe that �nancial innovation, including easier access to credit,is one reason for the �Great Moderation� inthe business cycle in the past few decades.

Still, in the light of today’s bust that welfare calculus needs revisiting, not least because broader access to credit plainly fuelled the housing bubble. Demand forcomplex mortgage securities led to a loosening of lending standards, which in turndrove house prices higher. Wall Street’sfancy computer models, based on recentprice histories, underestimated how muchthe innovation was pushing up houseprices, understated the odds of a nationalhouseprice decline in America and so encouraged an unsustainable explosion ofdebt. The country’s household debt rosesteadily, from just under 80% of disposableincome in 1986 to almost 100% in 2000. By2007 it had soared to 140%. Once assetprices started to come down and creditconditions tightened, this borrowing bingeleft households�and the broader economy�extremely vulnerable. Not surprisingly, the �wealth e�ect� (the extent towhich a change in asset prices a�ects people’s spending) is bigger in the indebtedAngloSaxon economies than elsewhere.If �nancial innovation fuelled the bubble,so it will exaggerate the bust.

That leads to the critics’ third point: thatfar from enhancing economies’ resilience,modern �nance has added to their instability. Mr Volcker, for instance, points to the

4Scary

Sources: Deutsche Bundesbank;

UK Statistics Authority; Federal Reserve *Latest

Household debt as a % of disposable income

1990 95 2000 05 08*

50

100

150

200

Britain

United StatesGermany


2

1


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1

absence of �nancial crises just after thesecond world war. At that time �nance wastamed by the rules and institutions introduced after the Depression. But the 1950swere unusual. In a forthcoming book,�This Time is Di�erent: Eight Centuries ofFinancial Folly�, Carmen Reinhart of theUniversity of Maryland and Ken Rogo� ofHarvard University survey eight centuriesof �nancial crises. Their numbers suggestthat, despite all that �nancial innovation,recent years have seen a surprising periodof quiet�at least until the current crash.

Sowing the stormThe incidence of crashes is only one measure of risk, however: their severity alsomatters. In theory, derivatives, securitisation and a choice of �nancing shouldspread risk, increase the �nancial sector’sresilience and reduce the economic damage from a shock. Before securitisation, thee�ect of a crash was intensely concentrated. A property bust in Texas meant mortgages held by Texan banks failed, starvingTexan companies of capital. The expectation was that today’s decentralised andglobal system would spread risk and reduce the economic impact of a �nancialshock. In his book, �The Age of Turbulence�, Alan Greenspan points to the aftermath of the telecoms bust in the late 1990s,when billions of dollars went up in smokebut no bank got into trouble.

At �rst that resilience seemed to be ondisplay during this crisis too. The fact thatmortgage defaults in Cleveland or Tampatriggered bank losses in Germany was asign of the system working. But that resilience proved ephemeral. One reason wasthat risk was more concentrated than anyone had realised. Many banks originatedmortgagebacked securities but then failedto distribute them, holding far too much ofthe risk on their own balancesheets. Thatwas a perversion of securitisation, ratherthan an indictment of it.

More troubling to proponents of modern �nance was the crippling impact onmarket liquidity of uncertainty about thescale of risks and who held them. To worke�ciently, markets must be liquid. Yet thepast year has shown that uncertaintybreeds illiquidity. High leverage ratios anda reliance on shortterm wholesale funding rather than retail deposits, two featuresof the new �nance, left the system acutelyvulnerable to such a panic. Forced toshrink their balancesheets faster than traditional banks, the investment banks,hedge funds and other creatures of thenew �nance may have made the economy

less resistant to a �nancial shock, not more. That is the conclusion of a new analysis

by Subir Lall, Roberto Cardarelli and SelimElekdag, published in the IMF’s latestWorld Economic Outlook, which arguesthat the economic impact of �nancialshocks may be bigger in countries withmore sophisticated �nancial markets. Thestudy looks at 113 episodes of �nancialstress in 17 countries over the past three decades and assesses the e�ect they had onthe broader economy. Financial crises, theauthors �nd, are as likely to cause downturns in countries with sophisticated �nancial systems as in those where traditional banklending dominates. But suchdownturns are more severe in countrieswith the AngloSaxon sort of �nancial system, because their lending is more procyclical. During a boom, highly leveraged investment banks encourage a credit bubble,whereas in a credit bust they have to deleverage faster.

Excessive and excessively procyclicalleverage is clearly dangerous, but was itcaused by the new �nancial instrumentsand deregulation? Again, not alone. Financial excesses often occur in the aftermathof innovation: think of the dotcom bubbleor the 19thcentury railways boom andbust. But throughout history, loose monetary conditions have fuelled the cycle:cheap money encourages leverage whichboosts asset prices, which in turn encourage further leverage. Sophisticated �nancemeant that havoc spread in a new way.

Tackling leverageGiven the past year’s calamity, how farmust AngloSaxon �nance be remade? Themarket itself has already asked for dramatic changes�away from highly geared investment banks towards the safety of lower leverage and more highly regulatedcommercial banks. Some sensible im

provements to the �nancial infrastructureare already in the works, such as the creation of a clearing house for trading creditdefault swaps, so that the collapse of a bigforce in the market, such as AIG, does notthreaten to leave its counterparties withbillions of dollars in worthless contracts.

The harder question is where�and byhow much��nancial regulation should beextended. Proposals for reform are pouring out from central banks, securities regulators, �nance ministries, bank and universities, much as securitised mortgage debtonce poured out from Wall Street. But justas �nancial innovation bears only part ofthe blame, so regulatory reforms will, atbest, yield only part of the solution.

Indeed, some popular suggestions willnot yield much. There is a lot of talk, for instance, of reforming creditrating agencies,which encouraged the creation of mortgage securities by publishing misleadingassessments of their quality. But the problem with creditrating agencies lies in thetension between their business model andtheir use as a regulatory tool. The marketsand regulators use ratings to determine theriskiness of an asset. Yet creditrating agencies are paid by the issuers of securitiesand so have an inbuilt incentive to tailortheir ratings to their clients’ needs.

Another popular suggestion is tochange the incentive structures within �nancial institutions to discourage recklessand shortterm behaviour. The Americangovernment’s bailout will include curbson the pay of the bosses of troubled banksthat bene�t from it. This is a poor route tofollow. Governments are ill placed to micromanage the incentive structure withinbanks. Besides, even �rms with compensation systems that encouraged their managers to lend carefully got into trouble. Inboth Bear Stearns and Lehman Brothers,for instance, employees owned a large partof the �rms’ shares.

Could tighter government oversightproduce better results? No one doubts thatAmerica’s complicated, decentralised andoverlapping system of federal and state �nancial supervisors could be improved.(AIG, for instance, is technically supervised by New York state.) Nor that theenormous new markets, such as the $55trillion global market in creditdefaultswaps, need more oversight. Nor that better disclosure and transparency are necessary in many of the newest �nancial instruments. But it would be unwise toexpect too much. An entire governmentagency was devoted to overseeing thehousing�nance giants, Fannie Mae and

5Been there, done that

Source: Carmen Reinhart

and Kenneth Rogoff *Based on 251 crises

Proportion of countries suffering a banking crisis*

0

5

10

15

20

25

1800 1850 1900 1950 2007

% of all countries

3-yearaverage


2

1

CLIMB a steep �ight of stairs down asmall side street in Fatehpuri, part of

the bustling commercial hub of Old Delhi,and you will come to a set of rooms overlooking an imposing internal courtyard. Inone of them, half a dozen men lounge onmats beneath a poster of Lakshmi, the Hindu goddess of wealth. Next to them is aclutch of telephone sets, each on a longwire cord. Outside hangs a blackboardwith prices scrawled in chalk. This is thetrading �oor of the Rajdhani Oils and Oilseeds Exchange, where futures contractsfor soyabean oil, mustard seed and jaggery(sugar) are bought and sold.

It seems a long way from the New YorkMercantile Exchange, but the political heaton both places has been much the same oflate. Over the past couple of years India’sgovernment has banned futures trading oncommodities that include rice, wheat andlentils to rein in prices and stop what it seesas dangerous speculation. And in recentmonths America’s Congress has beenmulling a series of measures to discouragesimilar speculation in oil markets. On September 18th the House of Representativespassed a bill that would limit how muchspeculative traders, such as hedge funds orpension funds, could invest in commodities, and closed the �Enron loophole�,which allows energy traders to escape government regulation when buying and selling over the counter or on electronic plat

forms. Japan’s government has tightenedcontrols on futures trading and China hasrestricted foreign trading in its commodities markets.

Speculators have long been a populartarget for politicians frustrated by volatilecommodity prices. In 1947, when wartimecontrols ended and food prices soared,Harry Truman raised margin requirements(the share of the value of a futures contract

that a trader must post upfront with an exchange) to 33%, vowing that food pricesshould not be a �football to be kickedabout by gamblers�. In 1958 America’sCongress banned futures trading in onionsfor much the same reason.

But this time politicians are not the onlyones who blame �nanciers for distortingprices. George Soros, a veteran investor, declared earlier this year that commodities

Of froth and fundamentals

The real lesson from volatile commodity prices

Freddie Mac, but that did not stop them behaving recklessly. So far, at least, a strikingfeature of the crisis has been that hedgefunds, the least regulated part of the �nance industry, have proved more stablethan more heavily supervised institutions.

Similarly, reregulation should proceedcautiously and with an eye to unintendedconsequences. Just as many of the innovations of modern �nance, such as creditdefault swaps, have been used to avoid thestrictures of today’s bank regulation, so tomorrow’s innovations will be designed toarbitrage tomorrow’s rules. Even after today’s bust, bankers will be better paid andmore highly motivated than �nancial regulators. The rulemakers are fated to be onestep behind.

Nonetheless, improvements are possi

ble. The most promising avenue of reformis to go directly after the chief villain: excessive and excessively procyclical leverage.That is why regulators are now rethinkingthe rules on banks’ capital ratios to encourage greater prudence during booms andcushion deleveraging during a bust. It alsomakes sense for �nancial supervisors tolook beyond individual �rms, to the stability of the �nancial system as a whole�andnot just at the national level.

Leverage can be tackled in other waystoo. For a start, governments should stopsubsidising it. America, for example,should no longer allow homeowners todeduct mortgage interest payments fromtheir taxable income. And governmentsshould stop giving preferential treatmentto corporate borrowing as well. Private

equity �rms and the like are encouraged toload up companies with debt because taxcodes favour debt over equity.

The bigger point is that governmentsshould not view �nancial reform in a vacuum. Modern �nance arose in an environment created by regulators and politicians.As Hank Paulson, the treasury secretary,told Congress during hearings about theAmerican government’s bailout plan:�You’re angry and I’m angry that taxpayersare on the hook. But guess what: they arealready on the hook for the system we alllet happen.� Whether that system is improved depends in part on whether politicians recognise their own role in shaping�and distorting��nancial markets. The example of another recent crisis�incommodities�does not bode well. 7


2

1

were a �bubble�. Michael Masters, ahedgefund manager, caused a stormwhen he told a congressional committee inJune that the price of oil (then $130 a barrel)might be halved were it not for �nancialspeculation. Even Shyam Aggarwal, thechief executive of the Rajdhani exchange,says futures trading in food productsshould be banned, at least temporarily.

Broadly, these men all make the sameargument: that the �ood of money frompension funds, hedge funds and the likethat has poured into commodity futures inrecent years is distorting spot markets forphysical commodities. Rather than helping producers and consumers to hedgetheir risks and set commodity prices moretransparently and e�ciently, futures markets have become dominated by hedgefunds, sovereignwealth funds and so onseeking to diversify their portfolios. Thespeculative tail is wagging the spot dog.

If that argument were true, the consequences would be profound. Commodityprices have a more immediate impact onpeople’s lives than do stock or bond prices,particularly in poorer countries, wheremany households spend much of theirbudgets on food. If speculators are distorting commodity prices rather than improving price discovery, there may be good reason to shift the balance betweengovernment and market.

Speculating about speculatorsAt �rst sight the �nger does seem to pointto the speculators. Commodities have become a popular alternative asset class forinvestors. According to Barclays Capital, institutional investors had around $270 billion in commoditylinked investments atthe end of June, up from only $10 billionsix years ago. The number of futures contracts on commodities exchanges has quadrupled since 2001. The notional value ofoverthecounter commodity derivativeshas risen 15fold, to $9 trillion (see chart 6).

The timing of this increase coincidesneatly with the long commodities boom.Prices since 2002 have soared by any yardstick. The climb has been most pronounced in dollars, the currency in whichmost globally traded commodities arepriced, because the dollar itself has weakened. But over the past six years commodity prices have also risen in euros or indeedany other currency.

Speculation might also explain the extraordinary volatility of prices since the �nancial turmoil struck last August. As largeswathes of debt instruments suddenly became illiquid and risky, investors�so the

argument goes�sought safety in commodities. As America’s Federal Reserve slashedinterest rates, so money managers, fearfulof in�ation, �ed to hard assets, particularlyoil. That surge of cash created a new bubble which has recently burst.

On closer inspection, however, thespeculation theory stands up less well.First, there is no consistent pattern between the scale of investors’ purchases ofa commodity and the behaviour of spotprices. For example, as investment fundspiled into hog futures the price fell sharply�even as prices of other commoditiesrose. Second, many of the commodities inwhich prices have soared over the past fewyears, from iron ore to molybdenum, arenot traded on exchanges and thus o�er lessopportunity for investors. Third, much ofthe surge of cash that has gone into commodities futures is due to rising prices. Asthe price of a commodity goes up, so doesthe value of a commoditylinked fund,even without any new money.

Lastly, stocks of most commoditieshave been low compared with their historical averages. This is important, becauserising stocks are the channel throughwhich speculation in futures markets affects the spot price. When speculatorspush up the futures prices of oil, for instance, they create an incentive for someone to buy oil in the spot market, sell a futures contract on it and store the oil untildelivery is due. This hoarding shouldshow up in higher stocks of unsold oil, buto�cial oil stocks are well below their average of the past �ve years. The same is truefor many other commodities.

The absence of hoarding is not conclusive proof of speculators’ innocence. AsRoger Bootle of Capital Economics haspointed out, arbitrageurs must simplywant to hold bigger stocks; they do nothave to succeed. In markets where supply

is constrained, their attempts to hoardcould push up spot prices without any increase in physical stocks, at least temporarily. Moreover, in some commodities, particularly those that are mined or pumped,producers can reduce supply simply byholding back production. Oil producers,for instance, can simply pump less. Butthere is scant evidence that this has happened. As prices soared in the �rst half ofthis year, oil experts reckoned that mostproducers were pumping at full capacity.Saudi Arabia is the only large producerwith spare capacity; if anything, it pushedup production this year.

All told, the case that speculators drovethe commodity boom is weak. To be sure,futures markets can overshoot, and investors may have added temporary fuel, particularly in the �rst half of 2008. But thelong rise in commodity prices�and theirrecent decline�can be explained muchmore easily by economic fundamentals.

Too much, too little, too lateOver the past 50 years commodity priceshave, on average, fallen relative to othergoods and services as their supply hasmore than kept up with demand. As population growth and greater a�uence increased the world’s demand for calories,for instance, agricultural productivitygrew, which in turn increased supply. Butthis broad downward trend included plenty of volatility and several big shocks, notably in the 1970s when commodity pricesof all sorts soared for several years.

One reason for those price swings wasthat neither the supply of nor the demandfor commodities can change quickly. People have to eat, even if a bad harvest temporarily reduces the world’s grain stocks. Ittakes years to develop an oil �eld. In economists’ jargon, the price elasticity of bothdemand and supply is low in the short

6Alternative attractions

Source: Bank for International Settlements

Turnover of exchange-traded commoditycontracts, m

Notional amounts outstanding of over-the-counter(OTC) commodity derivatives, $trn

1998 99 2000 01 02 03 04 05 06 070

2

4

8

10

6

Gold

Other precious metals

Other commodities

1993 95 2000 05 080

100

200

300

400

500


2

1

term. So any surprises on either side quickly translate into big price changes.

The 1970s commodity shocks weremostly set o� by unexpected shortfalls insupply. Culprits included the Arab oil embargo of 1973, catastrophic harvests in 1972and 1974 and the Iranian revolution in 1979.This decade’s boom, by contrast, was duelargely to unexpectedly strong demand.

The world economy grew faster for longer than anyone foresaw. In its forecasts ofApril 2003, for instance, the IMF expectedaverage global growth below 4% a yearover the following three years. In fact, theworld economy grew at an annual averageof 4.5% between 2003 and 2007. This boomwas driven by emerging economies, whichgrew at an average pace of 7.3% a year. In2003 the IMF expected China’s economy,for example, to grow by 7.5% a year, but infact it has grown at an average annual rateof 10.6% a year since then. Not only didemerging economies grow unexpectedlyfast, but at this stage of development theiruse of commodities becomes more intenseas they get richer. The result was a dramaticrise in demand, particularly for energy andindustrial commodities.

Take oil. In the four years from 1998 to2002 world oil demand grew at an averagerate of 1.1% a year. Between 2003 and 2007the pace almost doubled, to an average of2.1%, and almost all the increase came fromthe emerging world (oil demand in theOECD countries has been falling since2006). In 2007 China alone accounted foronethird of the increase in global oil demand. In products such as most metals itmade up an even bigger share.

Where governments have gone wrongRising prosperity, however, is not thewhole story behind stronger demand.Governmentinduced distortions havealso blunted price signals. In many emerging economies governments control theprices of important fuels, such as diesel,and keep them below worldmarket levels.Oilexporting countries are the worst offenders. Whereas the American price isclose to a dollar per litre, for instance, SaudiArabia sells petrol at 13 cents and Venezuela at 16 cents (see chart 7). Tellingly, the Middle Eastern oil exporters have seen a big increase in oil consumption. In 2007 theyaccounted for a quarter of the rise in globaloil demand even though they represent afar smaller share of the world economy.

As oil prices rose, some countries decided to start unwinding these distortions.Oilimporting countries such as Malaysia,Taiwan, Indonesia, China and India have

pushed up fuel prices in recent months.China has raised prices twice, in November 2007 and again in June this year. Its petrol prices are now not far o� America’s(though other energy prices in China arestill arti�cially low). But many other countries kept prices �xed and increased thesize of their subsidies. This has hurt theirgovernment �nances and, more importantly, has made price volatility worse byobstructing the route from higher prices toweaker demand.

The distortions that governments introduce are even more evident in foodstu�s,and this time the culprits are rich countries, particularly America and Europe. Ostensibly to reduce carbon emissions, governments in both places have introducedpolicies to encourage biofuels (cornbasedethanol in America and biodiesel in Europe). Thanks to these subsidies and regulations, demand for maize and vegetableoils (on which biodiesel is based) has exploded and these crops have displacedothers, such as wheat.

Analysts from the OECD to the WorldBank argue that biofuel demand is the biggest single reason why food prices havesoared in the past couple of years, accounting for as much as 70% of the rise in maizeprices and 40% of the rise in soyabeanprices. Higher energy prices have alsomade a di�erence as fertiliser and other input costs have risen.

Rather than recognise their own role increating the foodprice spike, many Western politicians (notably President GeorgeBush) have pointed to rising a�uence inemerging economies. Richer Indian andChinese consumers are indeed eatingmore meat than they did�though a lot less

than people do in the West�but that shifthas not been sudden enough to explain theprice surges since 2006. It is biofuels thathave made the di�erence.

Demand shocks and misguided government policies go a long way towardsexplaining the behaviour of commodityprices in recent years. But supply surpriseshave also played a role, particularly in oil,where the supply response to higher priceshas been sluggish even by its standards.

After years of low oil prices in the 1990sthe OPEC group of producers began the recent boom with plenty of spare capacity.That spare capacity has all but disappeared, largely because production outside OPEC has been disappointing. Again,government policy played a part. The vastmajority of the world’s oil reserves are inthe hands of governmentowned oil companies. Too often these �rms use their revenues for political purposes rather than invest it to raise output.

In agriculture emerging governmentsrestricted supply, aggravating the problemscaused by demand in the rich world. Panicked by rising food prices in 2007, morethan 30 governments, from Ukraine to China, introduced export restrictions for farmproduce. This cut the supply of food onworld markets, sending prices even higher.Rice was worst hit because only 4% of itsglobal crop is traded across borders, compared with 13% for maize and 19% forwheat. On news of bans in China, Vietnam, Cambodia, India and Egypt (whichbetween them grew 40% of world rice exports in 2007), the price tripled within afew weeks.

In this panicked environment, futuresprices for all food commodities shot up. Attimes investment funds may have exacerbated fears about scarcity. But for food, asfor fuel, the main reason for the price risesof recent years has been unexpected de

7Far too cheap

Sources: EIA; gasoline-germany.com

Petrol prices, end September 2008, $ per litre

0 0.2 0.4 0.6 0.8 1.0

United States

Vietnam

Russia

Indonesia

China

Mexico

Nigeria

Ecuador

UAE

Egypt

Libya

Kuwait

Venezuela

Saudi Arabia

Iran

8Where it hurts

Sources:IMF;

The Economist; BEA

*Break in series †August‡Including oil

IMF commodity-price indices, 1960=100, real terms

1960 70 80 90 2000 08†25

50

75

100

125

150

175Food-price index

All-commoditiesindex‡

*

*

*


2

1

FOUNDED in 1930, the Bank for International Settlements (BIS) is the oldest and

chummiest of the international �nancialinstitutions. Based in Basel (with its famously good food), the central bankers’ clubis the nerve centre for international cooperation on monetary technicalities. Howironic, then, that the BIS’s economists putmuch of the blame for the current mess oncentral bankers and �nancial supervisors.

For years, BIS reports have given warning about excess global liquidity, urgedcentral bankers to worry about asset bubbles even when consumerprice in�ationwas low, encouraged policymakers in aglobal economy to pay more attention toglobal measures of economic slack, and argued that banking supervisors needed tolook beyond individual �rms to the soundness of the �nancial system as a whole. Today’s calamity, in the BIS’s view, stemsfrom one fundamental source: a worldwhere creditdriven excesses went on fortoo long. �The unsustainable has run itscourse,� thundered the organisation’s annual report in June.

The case against central bankers comesin two parts. The �rst is that they, alongwith other �nancial regulators, wereasleep at the wheel, failing to appreciatethe scale of risks being built up in the�shadow� banking system that modern �nance had created. The second is that they

fuelled a credit bubble by keeping moneytoo cheap for too long.

The criticisms are most often directed atthe Fed. This is because America is theworld’s biggest economy; because its interestrate decisions a�ect prices across theworld; because the Fed has shown a penchant for cheap money in recent years; andbecause America’s mortgage mess fed the�nancial crisis. The Fed carries a disproportionately large weight among America’s patchwork of �nancial regulators.

Supervision cannot work miracles, butthe Fed clearly could have done better. Itdid not have direct jurisdiction over the independent mortgage brokers who weremaking the dodgiest loans during theheight of the housing boom (they were notionally supervised by their states). But ithad plenty of chances to sound the alarmand could have calmed the frenzy by tightening federal rules designed to protect consumers. However, Alan Greenspan, theFed’s chairman during the bubble years,saw little risk in the housing boom and followed his handso� instincts. His successors now admit that was a mistake. Supervision has been tightened.

What about monetary policy? Here theproblem is the Fed’s asymmetric approach. By ignoring bubbles when theywere in�ating, whether in share prices orhouse prices, but slashing interest rates

when those same bubbles burst, America’s central bankers have run a dangerously biased monetary policy�one that hasfuelled risktaking and credit excesses.

In the most recent episode the Fedstands accused of three main errors. Mistake number one was to loosen the monetary reins too much for too long in the aftermath of the 2001 recession. FearingJapanstyle de�ation in 2002 and 2003, theFed cut the federal funds rate to 1% and leftit there for a year. Mistake number two wasto tighten too timidly between 2004 and2006. Mistake number three was to lowerthe funds rate back to 2% earlier this year inan e�ort to use monetary policy to alleviate �nancial panic. The �rst two failures fuelled the housing bubble. The third aggravated the commodityprice surge.

With hindsight, there is merit to the �rsttwo charges. The Fed did worry undulyabout Japanesestyle de�ation in the earlypart of this decade, though it was a defensible decision at the time. The failure totighten policy more quickly from 2004 onwards was a bigger mistake. Low shortterm rates encouraged the boom in adjustablerate mortgages that added to thehousing bubble, and the predictability andgradualness of the Fed’s eventual tightening encouraged broader risktaking onWall Street.

From a narrowly American perspec

A monetary malaise

Central bankers helped cause today’s mess. Will they be able to clean it up?

mand growth, often compounded by government distortions.

Contrary to what the critics of speculation suppose, the main task of futures markets has been to signal these fundamentalsto �rms and households, speeding up theiradjustment to the changing balance ofsupply and demand for physical commodities. In the absence of such signals, itwould have taken even bigger and moreextended swings in the prices of physicalcommodities to bring supply and demandinto balance.

The same mix of fundamentals andgovernment action, but in reverse, helpsexplain the easing of prices in recentmonths. The drop in commodity prices indollar terms partly re�ected a strengthening of the greenback. Oil prices in euros, forinstance, have fallen by 25% less from their

peak than oil prices in dollars. A series ofsensible moves by governments, such asthe decision by some big exporters to liftexport controls, helped ease the panic infood markets. The prospect of bumper cereal crops has boosted con�dence aboutshortterm supply. The Economist’s foodprice index at endSeptember was down23% from its peak. Yet nobody is denouncing speculators for driving prices down.

The oil market is also adjusting. A newSaudi �eld has come on stream, improvingthe prospect of a supply boost. On the demand side, consumers have started to respond. Faced with petrol at $4 a gallon,American drivers changed their habitsfaster than expected, switching to smallercars, driving less and using public transport more.

Most important, the world economy

has suddenly slowed, and its prospectshave darkened dramatically. Thanks, inpart, to the shock of higher oil prices, output growth in Japan and Europe ground toa halt at the beginning of the summer. ByAugust even the big emerging economieswere showing signs of slowing from theirbreakneck pace. As the scale of the globalslowdown became clearer, so commodityprices weakened.

If persistent and unexpected demandfuelled much of the commodities boom,so surging prices may, at least in part, havebeen a symptom of a global economy thatwas overheating. That is now changingfast. But it suggests that the world’s politicians, rather than point the �nger at speculators, might look �rst at their own policies�and then at the mistakes of theircentral bankers. 7


2

1

tive, the case against the Fed’s rate cuts thisyear is weaker. Long before last month’scalamities, the turmoil on Wall Street keptoverall �nancial conditions tight even asthe Fed slashed the price of shorttermmoney. Because risk spreads have soared,borrowing costs for �rms and individualshave barely budged even as lending standards have tightened dramatically. Giventhe economy’s weakness, it is now hard toargue that the Fed was wrong to cut ratesso enthusiastically this year.

But should the Fed be judged just byAmerican criteria? Its actions�both duringthe bubble and the subsequent bust�tookplace against the backdrop of rapid �nancial globalisation and choices made bycentral bankers elsewhere. The most important of these was the emergence oflarge saving surpluses in many big emerging economies, especially China, and their(related) decision to link their currencies tothe dollar, in a system often called the Bretton Woods II regime. (Bretton Woods I wasthe global monetary system in force between 1944 and the early 1970s underwhich countries �xed their currencies tothe dollar, which in turn was tied to gold.)

Wall of moneyThe large saving surplus in emerging economies caused a �ood of capital to richones, largely America. That surplus hadseveral causes. Investment in many Asianeconomies collapsed after their �nancialcrises in the late 1990s. The rapid increasein the price of oil over the past few yearsshifted wealth to oil exporters, such as Saudi Arabia and Russia, faster than theycould spend it. But policy choices, especially emergingeconomies’ currency management, played a big role. The rapid rise inChina’s saving surplus between 2004 and2007 stemmed in part from an undervalued exchange rate. Emergingeconomycentral banks now hold over $5 trillion inreserves, a �vefold increase from 2000 (seechart 9).

This �ood of capital fuelled the �nancial boom by pushing longterm interestrates down. Long rates fell across the richworld and stayed perplexingly low even asthe Fed (and other richworld centralbanks) began raising shortterm rates in2004. Mr Greenspan famously dubbedthis a �conundrum� but did nothing tocounter it by increasing rates more quickly.

Eventually Bretton Woods II began tofuel credit booms and economic overheating in the emerging world. That is no surprise. When capital is mobile, countriesthat �x their currencies lose control over

their domestic monetary conditions.When foreign capital �ows in they mustbuy foreign currency and pay out theirown one, increasing the money supplyand stoking in�ation. Central banks cantry to keep foreign capital out, and can �sterilise� the e�ect of buying foreign currencyby selling bonds or forcing banks to holdhigher reserves. Some countries, particularly China, have been surprisingly successful at this. But none of these methodsworks perfectly: eventually domestic credit takes o� and in�ation accelerates.

That is particularly likely when there isa large divergence in economic conditionsbetween the anchor country (in this caseAmerica) and those that shadow its currency. The Fed’s interestrate cuts in late2007 and early 2008 may have been appropriate for a weak and �nanciallystressed American economy. But they sentthe dollar tumbling and left monetary conditions far too loose in many emergingmarkets whose economies had long beengrowing beyond their sustainable pace.

By 2008, according to the IMF’s estimates, emerging economies were growingabove their trend rate for the fourth year in

a row and had more than exhausted theirspare capacity. Underlying in�ation (excluding food and fuel) was beginning torise. Everything pointed to the need toraise interest rates. Yet by March of thisyear shortterm real interest rates in emerging economies (based on the weighted average of 26 centralbank policy rates) werenegative (see chart 10). That suggests risingin�ation was the consequence of a �decoupled� world economy in which emerging economies were booming even asAmerica stumbled, and a misguided monetary regime that linked the two.

The upshot was a commoditypricespike and a rise in in�ation the world overeven as the �nancial crisis was deepeningin rich countries. Ordinarily a banking crisis leads to disin�ation (or even de�ation)as asset prices fall, credit shrinks and economies slow. Yet in America, the centre ofthe storm, in�ation rose this summer tolevels not seen in almost two decades.

The role of commodity prices made thein�ation risk hard to interpret. Centralbankers had to decide whether the accelerating prices of food and fuel were a temporary surge in their price relative to othergoods (in which case economic damagewould be minimised by temporarily allowing overall in�ation to rise); or whetherthe rising prices were a symptom of generalised price pressure (which would arguefor higher interest rates).

Central bankers responded to this challenge in a variety of ways. Some emergingeconomies, particularly in Latin America,took an orthodox approach, raising interest rates quickly to get in�ation back towards its target. Others, especially in Asia,took longer to adjust, even though wageswere rising fast and demand was strong.Worried by doubledigit in�ation, somecountries, such as India, eventually beganto tighten sharply. Others, such as Malaysia, with in�ation at 8.5%, did not budge.

In the rich world, central bankers in Europe were more worried about in�ationthan the Fed, partly because many paydeals in Europe are set centrally and wageshave been more inclined to rise along withprices. The ECB raised interest rates in July,and Sweden’s Riksbank increased them asrecently as September. But everybody wasperplexed by the combination of �nancialcrisis and rising in�ation. �I don’t understand what the hell is going on,� said onehonest o�cial in June.

In recent weeks those tensions haveabated, though not in a comforting way.Global demand dropped sharply over thesummer and the outlook for the world

9Picking up

Source: IMF

Developing countries’ foreign-exchange reserves$trn

1999 2001 03 05 07 080

1

2

3

4

5

6

10Unsustainably lowEmerging-market real interest rates*, %

Source: Morgan Stanley;

The Economist

*Policy rate minus

inflation rate

2000 01 02 03 04 05 06 07 085

0

5

10

15

20

+

–


2 economy darkened. That slowdownhelped to bring commodity prices down,transforming the in�ation outlook in richcountries. Simple mathematics suggeststhat if oil prices stay around $100 a barrel,headline in�ation in the euro area couldfall towards 2% within a year; in America itcould be down to 1%. Since both these regions are in, or close to, recession, economic slack is increasing fast, which inturn will bring down in�ation further. Addin September’s �nancial calamities andthe risk of entrenched and outofcontrolin�ation seems slim. Suddenly the idea ofde�ation�a generalised drop in prices�nolonger seems farfetched.

From in�ation to de�ation?That is a worrying prospect. De�ation thatre�ects a slump in demand and excess capacity is always dangerous. Falling pricescan cause consumers to put o� purchases,leading to a downward spiral of weak demand and further price falls. That outcomeis particularly pernicious in economieswith high levels of debt, as Japan painfullydiscovered in the 1990s. The real value ofthe debt burden grows as prices fall�precisely the opposite of what a countryneeds when it is weighed down by excessive debts already.

The rich world’s economies are alreadysu�ering from a mild case of this �debtde�ation�. The combination of falling houseprices and credit contraction is forcingdebtors to cut spending and sell assets,

which in turn pushes house prices andother asset markets down further. IrvingFisher, an American economist, famouslypointed out in 1933 that such a viciousdownward spiral can drag the overalleconomy into a slump. A general fall inconsumer prices would make matterseven worse. Since central banks cannot cutnominal interest rates below zero, de�ation raises real interest rates, slowing theeconomy further and raising the real valueof debts. Privatesector debts are nowmuch larger than they were in the 1930s, soa modern depression could be even nastier. But there are four reasons why a de�ationary spiral should be still a remote risk�and a risk that policymakers can avoid.

First, although food and fuel prices arevolatile, most other prices do not drop soeasily. In most rich countries �core� in�ation is still a long way from zero. That willnot change quickly. In Japan de�ation didnot set in until four years after that country’s �nancial bubble burst.

Second, central bankers�at least outside America�have plenty of monetaryammunition left. At 4.25%, the ECB’s policyrate still leaves plenty of scope for downward adjustment.

Third, American policymakers, at least,have understood that public money is necessary to counter a spiral of debtde�ation.They are now spraying taxpayers’ moneyat the �nancial crisis like �remen with hoses. This will help slow the deleveraging.

Lastly, and less happily, several years of

rising oil prices may have slowed the richworld’s underlying economic speed lim

it, by reducing the productivity of energyguzzling machinery and raisingtransportation costs. Economic weakness may therefore be less disin�ation

ary than it used to be. All in all, then, the rich world’s policy

makers have plenty of tools with which tobeat o� de�ation. But just as the bubblewas in�ated by the interaction of monetary policy in the rich and the emergingworld, so today’s macroeconomic outlookwill be in�uenced by decisions made outside America, Japan and Europe.

So far, emerging economies havebeen playing a positive role. If, as still

seems likely, the biggest amongthem slow but do not slump,

then some sort of �oor will beput under commodity prices and ro

bust consumers in the emerging world willprop up exports from fragile debtladenrich countries.

But the emerging markets’ resiliencecannot be taken for granted. They su�eredtheir own version of the cycle that BrettonWoods II in�icted on the rich world: surplus savings �owed in, stoking asset prices.Now many stockmarkets and currencieshave plunged as the pendulum has swungback again. Investors worry about continuing high in�ation (in emerging Asia)and lower commodity prices (in LatinAmerica). Countries, especially in easternEurope, that built up currentaccount de�cits when cheap money made these easyto �nance now look vulnerable. But thebiggest economies, notably China’s, appear robust. And if the world economydarkens further, China will emerge as thelikeliest saviour.

China to the rescue?China’s government has already shownconcern about its economic slowdown,lowering reserve requirements for smallbanks and cutting interest rates. But from aglobal perspective it would be best for China to loosen �scal policy and allow thecurrency to strengthen. The country hasample room to boost spending. And by allowing its currency to rise faster, it wouldcounter the de�ationary risks in the richworld as both the dollar and the euroweaken against the yuan.

Misguided currency rigidity helpedcause today’s mess; enlightened �exibilitycould help solve it. And in the longer termthe lessons that emerging economies drawfrom today’s turmoil will help de�ne thedirection of global �nance. 7

have stood emerging economies in goodstead. They are one reason why thesecountries have proved so resilient in today’s global turmoil. But, as this special report has argued, these war chests introduced many distortions and rigidities thathelped to in�ate the global �nancial bubble and stoke domestic in�ation. The challenge for emerging economies is to create asystem of global �nance that is more �exible yet still safe.

The academic evidence is not reassuring. After the 1990s crisis economists beganto look closely at what poor countriesgained from integration with global capitalmarkets. The answer appeared to be notmuch. An in�uential study for the Brookings Institution in 2007 by Eswar Prasad ofCornell University, Raghu Rajan of theUniversity of Chicago and Arvind Subra

manian of the Peterson Institute showedthat poor countries that relied on domesticsavings to �nance their investment grewfaster than those that relied more on foreign money.

Nor did foreign capital seem to helpemerging economies to cope better withsudden income shocks. In another paperMr Prasad, together with Ayhan Kose andMarco Terrones of the IMF, showed thatthe volatility of consumption in emergingeconomies has increased in recent years.Poor countries with weak �nancial systems, it appears, cannot cope with �oodsof foreign capital. The money is oftenchannelled to unproductive areas such asproperty. Such in�ows seem to makeboombust cycles worse.

The news was not all bad. Studies alsoshowed that foreign direct investment andequity �ows brought in knowhow andimproved corporate governance. And theevidence also suggests that competitionfrom foreign banks and foreigners’ moneyin stockmarkets can improve emergingeconomies’ own �nancial systems. Butlong before Mr Volcker questioned thewisdom of globalised �nance in America,academics were having second thoughtsabout the wisdom of �nancial globalisation for the emerging world.

Ignore the ivory towerIronically, this intellectual backlash wastaking place even as emerging economieswere becoming �nancially ever more integrated with the rest of the world. All in all,the citizens of emerging countries nowhave some $1 trillion deposited in foreignbanks, a threefold increase since 2002. Byevery measure, the gross �ows of capitalinvolving emerging economies havegrown since the mid1990s and acceleratedin the past few years. The composition ofthose �ows has changed: foreign direct investment and equity �ows have risenmuch faster than debt. But the overall levelof �nancial integration is up signi�cantly.

Financial globalisation sped up partlybecause governments did not listen to theacademic sceptics. Most continued to openup, particularly to equity and foreign directinvestment. According to the IMF’s indexof capital controls, only two emerging

Charting a di�erent course

Will emerging economies change the shape of global �nance?

�THE United States has been a modelfor China,� says Yu Yongding, a

prominent economist in Beijing. �Nowthat it has created such a big mess, ofcourse we have to think twice.�

The future of global �nance dependson what kind of rethinking takes place inBeijing and the rest of the emerging world.So far the signals have been mixed, evenwithin the same country. In India, for instance, the central bank�long a reluctantliberaliser�recently changed its mindabout allowing creditdefault swaps, arguing that the subprime crisis showed thetime was not �opportune� for such innovations. But at the end of August Indialaunched exchangetraded currency derivatives, giving people a means to hedgeagainst �uctuations in the rupee.

Chinese o�cials have been unusuallyoutspoken about Wall Street’s failures. Butjust as several rich countries, from Britainto Australia, have banned or reined inshortselling (selling borrowed shares) in amisguided e�ort to stop share prices falling, China’s cabinet agreed to allow investors to buy shares on credit and sellshares short.

By and large, emerging economies’ attitude to AngloSaxon �nance is deeply pragmatic, de�nedmore by the lessons of their own �nancial crises in the 1990s than bytoday’s calamities on Wall Street.Those crises in�icted far greater economic pain than anything the richworld has seen so far. Mexico’s GDP,for instance, fell by 6% in 1995 and Indonesia’s by 13% in 1998.

Those collapses held powerfullessons: foreigncurrency debt wasdangerous, the IMF was to be avoidedat all costs and prudence demanded thebuildup of vast war chests of foreignexchange reserves. Rich countries typicallyhave foreigncurrency reserves worthabout 4% of their GDP. The level in emerging economies used to be much the same,but over the past decade that ratio has risen to an average of over 20% of GDP. Chinahas a whopping $1.8 trillion, and eight other emerging economies have more than$100 billion apiece.

At �rst sight, fat cushions of reserves


1


2 economies closed their capital accountsbetween 1995 and 2005, whereas 14 countries opened up fully. The rest came somewhere inbetween but were mostly moving towards greater openness.

At the same time foreign banks wereplaying an ever bigger role. By 2007 almost900 foreign banks had a presence in developing countries. On average they accounted for some 40% of bank lending, up from20% a decade earlier. In some places, particularly in eastern Europe and LatinAmerica, foreign banks dominate the domestic �nancial system. Even China andIndia, which have been slow to allow inforeign banks, have opened up more in thepast decade.

More important, �nancial integrationwas accelerating regardless of any deliberate policy choices. In a fastglobalisingworld even countries with strict capitalcontrols saw an increase in actual capital�ows. One explanation is that more tradeinevitably produces more capital integration. A �nancial infrastructure grows up tosupport global supply chains. Larger trade�ows make it easier for �rms to evade capital controls, by over or underinvoicingtheir transactions. And fast growth hasmade emerging economies an attractivetarget for foreign investors and their owncitizens living abroad, who can �nd waysto get around capital controls.

The distortions and costs associatedwith capital controls are rising as emergingeconomies become more globalised. Temporary taxes to discourage sudden surgesof capital may still have a role to play, eventhough they can sometimes prove counterproductive. Thailand, for example, imposed a tax on foreign capital in�ows intoits stockmarket in 2006 but saw the marketplunge and quickly reversed the decision.In the longer term the distortions causedby such measures become more burdensome. China, for instance, has some of thestrictest controls among large emergingeconomies, partly insulating itself fromglobal capital markets, but the controlsneeded to deter speculative capital are becoming ever more intrusive. Since July theState Administration of Foreign Exchange(SAFE) has demanded more informationon export earnings. For many smallscaleexporters that is a big burden. Globalised�nance, it turns out, is an inextricable partof global integration.

That means the right question foremerging economies to ask is not whetherglobal �nance is a good thing but how tomaximise the gains and minimise thecosts. The answer is to rely more on mar

kets, not less, but try to avoid the mistakesthat the rich world made.

At home that means adopting more ofthe new �nance. Emerging economies varyenormously in their domestic �nancial development, but some of the biggest are stillsurprisingly primitive. India, for instance,has highly sophisticated equity markets butits banking system is underdeveloped anddistorted by government edicts. Some 40%of India’s bank loans are directed to �priority sectors� such as agriculture, and the mainsource of credit for the typical citizen is theinformal moneylender.

The harder question is how to deal withforeign capital. Top of the list should begreater currency �exibility. The risk foremerging economies that open themselves up to global capital �ows is destabilisation. Money will slosh in and out, driving underdeveloped local asset markets upand down and a�ecting the level of demand in the real economy. Countries thatallow foreign banks to enter their marketswill be a�ected by these banks’ fortuneselsewhere in the world. Losses that European banks make on American mortgageproducts, for instance, may cause tightercredit in Hungary.

To deal with such volatility, emergingmarkets need to manage demand in theway that rich nations do: through more�exible interest rates and exchange rates.By allowing their exchange rates to riseand fall as capital �ows wax and wane,emerging economies should be able tokeep a measure of control over their domestic monetary conditions. Firms and investors in developing countries also needthe risksharing derivatives developed byAngloSaxon �nance. Some already havethem. Brazil’s market for foreignexchangederivatives, for instance, is one of the mostsophisticated and transparent in theworld. Others, particularly in Asia, have

much further to go, though India’s recentinnovations are encouraging.

By removing the need to accumulatevast foreignexchange reserves, greater currency �exibility would also create a morestable global monetary system. The warchests of reserves could be used to boostdomestic �nancial development. In thesummer 2008 issue of the Journal of Economic Perspectives, Messrs Prasad and Rajan o�er an intriguing proposal. Countrieswith plenty of reserves, such as China orIndia, could allow mutual funds (domesticor foreign) to issue shares in domestic currency with which they could buy foreignexchange from the central bank. These mutual funds would then invest abroad on behalf of domestic residents. The resultwould be a controlled liberalisation ofcapital out�ows, along with the creation ofnew �nancial institutions and instrumentsat home. Oilexporting countries couldachieve much the same e�ect by issuingtheir citizens with an oil dividend thatcould be invested abroad through similarmutual funds. Under both models themanagement of emerging economies’ foreign assets would be shifted increasinglyto the private sector. That would allowprivate investors from China or Saudi Arabia to pick over the carcass of Wall Street.

The heavy hand of the stateAt present, though, the trend is still in theopposite direction. Governments in Asiaand emerging oil exporters already controlsome $7 trillion of �nancial assets, most ofit in currency reserves, the rest in sovereignwealth funds. Analysts at the McKinsey Global Institute reckon that the totalcould reach $15 trillion by 2013. That wouldmake governmentcontrolled funds a largeforce in global capital markets, with theequivalent of 41% of the assets of global insurance companies, 25% of global mutualfunds and a third of the size of global pension funds (see chart 11).

There is an irony here. By and large,emerging economies shut their ears to theantimarket sceptics who argued that global capital �ows were dangerous. But in resisting one statist temptation they havesuccumbed to another: they have accumulated vast sums of capital in governmenthands, transforming the nature of global �nance long before Wall Street’s implosion.However professionally these funds aremanaged, such huge governmentcontrolled assets will change the balance between state and market. They will also addto the biggest risk for global integration: rising protectionism. 7

A rising forceAssets under management, 2013 forecast, $trn

0 10 20 30 40 50 60

Mutual funds

Pension funds

Insurance assets

Asian sovereign investors

Petrodollars

Hedge funds

Source: McKinsey Global Institute

11


1

DURING a summer when the economicshadows darkened so dramatically,

few paid attention to the collapse�yetagain�of the Doha round of global tradetalks. Champions of liberal trade, such asthis newspaper, wrung their hands, but noone else cared much. The failure in Geneva, where the World Trade Organisation(WTO) is based, seemed something of asideshow.

In a global survey of business executives, conducted for this special report bythe Economist Intelligence Unit, a sistercompany to The Economist, over half therespondents regarded the Doha round asminimally or not at all important, and only10% thought it very important. One in tensaw protectionism as the biggest threat tothe world economy, but far more wereworried about recession, in�ation and the�nancial crisis.

At �rst sight that seems a reasonablejudgment to make. With so many barriersalready removed, the immediate economic stakes in the Doha round are modest: gains of some $70 billion a year, according to one recent estimate, little morethan 0.1% of global GDP. Add in the likelyboost to productivity growth and the eventual impact will be higher, but it is still hardto argue that the Doha round, taken in isolation, could dramatically change theworld’s fortunes.

That is partly because the negotiationswere about �bound� tari� rates�the maximum permitted by global trade rules. Butmost countries have already slashed theirtari�s unilaterally to well below the boundrates�and it is actual trade barriers, not thehighest permissible ones, that businesspeople worry most about (see chart 12).Tellingly, the scale of corporate lobbyingaround the Doha negotiations has beenmuch lower than in previous global talks,such as the Uruguay Round.

Nor is it hard to see why many companies discount the risks of protectionism.Rich countries, particularly America, havegrumbled a lot about trade with China, butnothing much has happened to obstructthe spread of commerce. Congress hasthreatened to punish China’s currencypolicy with tari�s and to �get tough� withother supposedly unfair trade behaviour,

but no laws have emerged. Globally, theuse of antidumping duties, a popular protectionist tool, has fallen. With supplychains so integrated, it is tempting to conclude that multilateral negotiations are nolonger necessary and new trade barriershave become implausible.

Tempting but wrong. In an increasinglyintegrated world, multilateralism mattersmore than ever. The inability to get a Dohadeal done is a worry not because of themodest amount of freer trade forgone butbecause of the symbolic importance of thetalks and the reasons for the impasse. Thistrade round is the �rst international forumin which big emerging economies, such asIndia, Brazil and China, have played an in�uential role. Failure to reach agreementthus bodes ill for future multilateral cooperation of any sort.

If the talks continue to �ounder, negotiating momentum will shift to (far less desirable) regional and bilateral trade deals,of which there are already some 400 inplace or under negotiation. The WTO itselfmay be weakened. India signed a regionaltrade deal with the ASEAN group of Asiancountries less than a month after the Dohatalks fell. If countries lose faith in multilateral negotiations as a means to achievingbetter market access, they may turn to litigation to reach their trade goals.

Perhaps most worrying, the Doha impasse in part re�ects the intellectual shiftsthat this special report has described. TheJuly summit failed because of China’s andIndia’s insistence on maintaining the right

to impose �safeguard� tari�s to protecttheir own farms in case of a sudden surgein food imports. India, which has over200m farmers, has long been reluctant toexpose them to international competition.China, which had kept a low pro�lethroughout Doha’s six years of torturedtalks, swung behind India’s position at thelast minute, worried about food security inthe wake of the commodityprice surge.

SecurityconsciousThe centrepiece of the Doha trade round isfreer trade in farm goods, a shift that willbene�t poor countries disproportionately.But the round was launched in 2001, wellbefore the commodities boom, so its mainemphasis was on government policies thatkept prices arti�cially low, such as production and export subsidies in rich countries.Today, the main concern is policies thatpush prices up: unilateral export bans, subsidies for consumers and the pursuit ofbiofuels. The fear is about security of supply. Food selfsu�ciency has become a political rallying cry.

That instinct is plainly misguided. Thefood with the most volatile price over thepast year is rice, precisely because it is theleast traded. Freer trade in food is the bestway to ensure stable access and prices. Butan e�cient global market needs stricturesagainst unilateral barriers to exports asmuch as imports, and the WTO’s currentrules do little to control export restrictions.Nor are current trade rules much use forcontrolling the use of regulations to boostbiofuels. Fixing that requires multilateraltalks of a di�erent sort.

The irrelevance of the global negotiating agenda to today’s trade concerns goesbeyond agriculture. In a provocative newpaper, Aaditya Mattoo of the World Bankand Arvind Subramanian of the PetersonInstitute argue that global talks should concentrate on fears over �security��of food,energy, environment and income. Theypoint out that there are strikingly few rulesgoverning trade in oil, the world’s singlemost important commodity. The WTO

prohibits export quotas, but not the production quotas on which the OPEC oil cartel is based. More broadly, the WTO, atleast in its present form, is illequipped to

Beyond Doha

Freer trade is under threat�but not for the usual reasons

12Fewer fetters

Source: Arvind Subramanian

and Aaditya Mattoo

*Simple average of all countries

from WDI, IDB and TRAINS

databases †% of GDP

Global tariffs and trade*, %

0

20

40

60

80

1986 90 95 2000 06

Applied tariffs

Bound tariffs

Trade in goods†

deal with other potential �ashpoints, from�green tari�s� (barriers imposed againstcountries that do not take action on climate change) to complaintsabout undervalued currencies or investment protectionism, particularly the backlash against sovereignwealthfunds and other investors ownedby the state.

The risk of a wholesale retreat into beggarthyneighbour tari�s may be remote,but a proliferation of new kinds of barriersis all too plausible. Take green tari�s. Themost prominent climatechange bill inAmerica’s Congress makes reference totrade restrictions against countries that donot take equivalent actions to control carbon emissions. European leaders, too,have talked of trade sanctions to punishthe laggards in the �ght against globalwarming. As tools to promote global carbon reduction, such tari�s have a theoretical rationale. But in practice they would almost certainly set back the cause of globalcooperation on climate change.

Although capitalstarved Westernbanks are desperately seeking cash infusions from sovereignwealth funds andother stateowned investors, the threat ofinvestment protectionism is growing, withcontrol of natural resources being a primeworry. Many commodityrich countriesare becoming increasingly jittery aboutChina’s thirst for direct control of naturalresources. Faced with a surge in applications for foreign direct investment fromChina, most of them in the mining industry, Australia is now �closely examining�those that involve governmentcontrolledentities and natural resources.

A new study for the Council on ForeignRelations by Matthew Slaughter of Dartmouth College and David Marchick of theCarlyle Group points out that in the pasttwo years at least 11 big economies, whichtogether made up 40% of all FDI in�ows in2006, have approved or are consideringnew laws that would restrict certain typesof foreign investment or expand government oversight. A �protectionist drift�,they conclude, is already under way. Ifstatebased investors play an ever biggerrole in global capital markets, that protectionist drift may become irresistible.

Many of the politicians’ fears about foreign investors are surely misguided. Mostsovereignwealth funds are run by professional managers to maximise returns, andinternational codes to improve their transparency are in the process of being drawnup. Countries already have plenty of rules

to prevent foreign control of strategic assets. And provided that markets are competitive and well regulated, it does notmake much di�erence who owns the �rmsconcerned.

A question of leadershipAt a macroeconomic level, however, it isreasonable to fret about the growing cloutof statebased investors, not least becausemost of this money will be held by a smallgroup of (authoritarian) countries including China, Saudi Arabia and Russia. Chinais piling up foreignexchange reserves sofast that if it were to put them into American shares instead of bonds, it would already be buying more than all other foreigners put together. As Brad Setser of theCouncil on Foreign Relations points out ina new report, concentrated ownership byauthoritarian governments is a strategic aswell as an economic concern, particularlyfor America.

Both the risks of this new protectionism and the odds of it being countered depend heavily on the relationship betweenAmerica and the biggest emerging economies. As the Doha malaise has shown, active American leadership, although no lon

ger su�cient, is still necessary formultilateral progress. Yet the politics oftrade has become increasingly di�cult inAmerica, compromising the country’sability to take the lead. Support for moreopen markets is weaker than almost anywhere else in the world. According to thisyear’s Pew Global Attitudes Survey, only53% of Americans think trade is good fortheir country, down from 78% in 2002. Several other surveys in America suggest thatsupporters have become a minority. Inother countries support is far higher. Some87% of Chinese and 90% of Indians saytrade is good for their country, along with71% of Japanese, 77% of Britons, 82% ofFrench and 89% of Spaniards.

America’s popular disillusionment hasbeen accompanied by a growing intellectual one. Several wellknown Americaneconomists, including Paul Krugman, aprofessor at Princeton and prominent NewYork Times columnist, Alan Blinder ofPrinceton and Larry Summers, a Harvardeconomist and former treasury secretary,have begun to doubt whether increasedglobalisation is good for the Americanmiddle class. Rather than improving typical Americans’ living standards, they sug


2

1


2

1

gest, global integration may be causingwage stagnation, widening inequality andgreater insecurity.

Mr Blinder worries that o�shoring�theoutsourcing of services to countries suchas India�will pose problems for tens ofmillions of Americans over the coming decades. Mr Krugman, who pioneered research in the 1990s that found trade playedonly a small part in explaining wage inequality, now believes that the e�ect ismuch bigger, because America trades morewith poorer countries and more tasks canbe traded. Mr Summers has similar concerns, arguing that the increasing mobilityof global capital limits the government’sability to act as �rms move away fromAmerica in search of lowtax regimes.

These economists all eschew protectionism as a solution, arguing instead fordomestic changes, such as healthcare andeducation reform as well as greater redistribution through the tax system. But theyhave helped change the terms of the political debate in America�a shift that has notbeen lost on policymakers in the emergingworld, many of whom are irritated by

America’s double standards. One Indiano�cial talks of an �intellectual climatechange� and a �betrayal� by globalisation’s erstwhile champions.

Middleclass Americans’ living standards have stagnated over the past fewyears and income inequality has widened.Globalisation could be a culprit, becausethe integration of hundreds of millions ofworkers from emerging economies increases the global supply of labour andpresents less skilled American workerswith more competition. But academic analyses suggest that this e�ect is modest compared with other factors, such as the decline of trade unions and, particularly,technological innovation that has raisedthe demand for skilled workers.

Nor is there much evidence to supportthe revisionist view. In a recent Brookingspaper Mr Krugman searched for statisticsto show that trade now plays a bigger rolein wage inequality but failed to �nd them.Several other new studies point in the opposite direction. A paper by Runjuan Liu ofthe University of Alberta and Dan Tre�erof the University of Toronto shows that the

e�ect on American workers of outsourcingservice work to India and China has beentiny and, if anything, modestly positive.

In a recent book, �BlueCollar Blues�,Robert Lawrence of Harvard Universityshows that the chronology of America’swidening income inequality makes it hardto blame trade with poorer countries. Lowskilled workers lost out in the 1980s, longbefore trade with China surged. Most ofthe latest rise in inequality is due to thesoaring incomes of the very rich. A studyby Christian Broda and John Romalis ofthe University of Chicago argues that tradewith China has helped reduce inequalityin living standards, because poorer folkbene�t disproportionately from lowerprices for manufactured goods (thoughhigher commodity prices have recentlybeen pushing in the opposite direction).

But whether or not the evidence justi�es it, America’s intellectual climate hasshifted. Advocates of globalisation are onthe defensive, particularly in the Democratic party. That, alas, augurs badly for thenew kind of multilateralism that the worldeconomy urgently needs. 7

JUST under ten years ago, during theemergingmarket �nancial crises, Timemagazine ran a cover headlined �The

committee to save the world�. It showedAlan Greenspan, then chairman of theFederal Reserve; Robert Rubin, the treasurysecretary; and Larry Summers, his deputy.Inside was a breathless account of howthis trio of Americans had saved the worldeconomy from calamity by masterminding IMF rescue packages for cashstrappedAsian countries through weekend meetings and latenight conference calls.

Today the threats facing the globaleconomy are graver than they were a decade ago, yet it would be hard to knowwhom to put on such a cover. Wall Street isat the centre of the mess, so America’s stature and intellectual authority has plunged.Rather than staving o� defaults in Asia, MrPaulson, today’s treasury secretary, andBen Bernanke, chairman of the Federal Reserve, are battling to prevent the implosionof their own �nancial system. Instead ofdictating tough terms to Asian governments, they have been begging Congress

for public money to deal with Wall Street’smost toxic securities.

But even as the crisis spreads far beyond America, few others have so farshown much sign of leadership. Europe isrife with Schadenfreude at America’s travails but its politicians have been slow torecognise the scale of their own problems.China, the biggest, most resilient emergingeconomy and the one with the deepestpockets, has stood quietly on the sidelines.The IMF provides useful analysis but hasno political clout.

The only institutions that have cooperated, and creatively so, are the rich world’scentral banks. Even as many politicianshave grandstanded and pointed �ngers,the ECB, the Fed, the Bank of England andothers have tried to stem panic by �ooding�nancial markets with liquidity, lendingeyepopping sums of money against allmanner of collateral.

Unfortunately, central bankers�however creative�cannot sort out this messwith injections of liquidity alone. That isbecause it is a crisis of solvency as well as

liquidity. The bursting of the biggest housing and credit bubble in history has causeda banking bust that will probably turn outto be the biggest since the Depression, affecting many countries simultaneously.Across the rich world banks are short ofcapital; many are insolvent. As they deleverage, they will force down asset pricesand weaken economies that are alreadystumbling, so the mess will only worsen.Uncertainty and panic have already ampli�ed the problem as banks hoard cash.

The urgent task is to prevent a gravemulticountry banking crisis from becoming a global economic catastrophe. Thatought not to be too hard. Thanks to thegrowing importance of emerging markets,the world economy has become more resilient to trouble in its richer corners. Capital is plentiful outside Western �nance.Now that commodity prices have tumbled, the rich world’s central banks haveplenty of room to cushion their weakenedeconomies with lower interest rates. Andalthough publicdebt burdens are alreadyheavy, notably in Italy, Europe’s govern

Shifting the balance

More than a new capitalism, the world needs a new multilateralism

quidity and information, the very thingsthat they have lacked in this crisis. Even ifthe easy mistakes are avoided, improvingsupervision and regulation is hard. Financial regulators must look beyond the leverage within individual institutions to thestability of complex �nancial systems as awhole. Wherever the state has extended itsguarantee, as it did with moneymarketfunds, it will now have to extend its oversight too. As a rule, though, governmentswould do better to harness the power of

markets to boost stability, by demanding transparency, promoting standardisation and ex

changebased trading. Overreaction is a bigger risk than inaction.

Even if economic catastrophe is avoided,

the �nancial crisis willimpose great costs on con

sumers, workers and businesses. Anger and resentment di

rected at modern �nance is sure togrow. The danger is that policymakers will add to the damage, not only

by overregulating �nance butby attacking markets rightacross the economy.

That would be a bitter reverse after a generation in

which markets have beenfreed, economies have opened

up�and prospered. Hundreds of millions have escaped poverty and hundredsof millions more have joined the middleclass. As the world reconsiders the balancebetween markets and government, itwould be tragic if the ingredients of thatprosperity were lost along the way. 7

ish complexity. But the crisis is as much theresult of policy mistakes in a fastchangingand unbalanced world economy as ofWall Street’s greedy innovations. The rapidbuildup of reserves in the emerging worldfuelled the asset and credit bubbles, andrichworld central bankers failed to counter it. Misguided monetary rigidity caused�nancial instability. Much though peoplenow blame deregulation, �awed regulation was more of a problem. Banks set uptheir o�balance sheet vehicles in response to capital rules.

It is the same story with the spike infood and fuel prices over the past year. Tobe sure, commodities markets canovershoot�but rather than pointingthe �nger at speculators, governments should look in the mirror.Rich countries’ biofuel policiespushed up the cost of food. Poorcountries’ foodexport bansand fuel subsidies compounded the problems. Inmany ways today’smess is a consequenceof policymakers’ misguided reactions to globalisation and the increasing economic heftof the emerging world.

If markets are not always dangerous and governments not always wise,what policy lessons follow?In the aftermath of the crisis thebattle will be to ensure that �nance is reformed�and in the right way. The pitfallsare numerous. Banning the shortsellingof stocks, for instance, makes for a goodheadline; but it deprives markets of li


2

Previous special reports and a list offorthcoming ones can be found online

www.economist.com/specialreports

Future special reportsCountries and regionsSpain November 8thRussia November 29thIndia December 13th

Business, �nance, economics and ideasCorporate IT October 25thCars in the developing world November 15th The sea January 3rd 2009

www.economist.com/rights

ments, like America’s, have enough publicfunds to prevent a capitalstarved bankingsystem dragging their economies down.

This has already started to happen,most strikingly with the American government’s $700 billion plan to take over mortgagebacked securities. But other governments too are stepping in. Five Europeanbanks were nationalised or bailed outwith public funds in the last week of September. Several European governmentshave guaranteed the deposits and in somecases the debts of their banks.

Yet these disparate rescues are likely tobe more expensive and less e�ective than amore coordinated policy that reaches beyond the �nancial system alone. The panicin the markets would be stemmed if therich world’s governments agreed on acommon approach for stabilising and recapitalising banks. Equally, a coordinatedinterestrate cut would boost con�denceand make economic sense: the in�ationthreat is receding simultaneously acrossthe rich world.

Any such policy coordination must include the big emerging markets as well. Byboosting domestic spending and allowingits currency to appreciate faster, Chinacould counter de�ationary pressures inthe rest of the world economy and helpsupport growth in Europe and Americajust when this is needed most.

There are precedents for highpro�le international economic cooperation, notably the Plaza and Louvre Accords in the1980s. Designed, respectively, to push thedollar down and to prop it up, these agreements met with mixed success. Today’sproblems are deeper, and the number ofparties is larger. But if there were ever atime for a new multilateralism, this, thebiggest �nancial crisis since the 1930s, issurely it.

Learning the right lessonsA successful multilateral strategy tostaunch the crisis would also make it morelikely that the world will rise to the secondchallenge: learning the right lessons. Toomany people ascribe today’s mess solelyto the excesses of American �nance. Putting the blame on speculators and greedhas a powerful appeal but, as this specialreport has argued, it is too simplistic. Thebubble�and the bust�had many causes,including cheap money, outdated regulation, government distortions and poor supervision. Many of these failures were asevident outside America as within it.

Newfangled �nance has its �aws, fromthe procyclicality of its leverage to its �end

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