financial matters

Years back, when Raghuram Rajan was chief economist of the International Monetary Fund, I used to post about the fragility of the global economy.[1] I didn't write as an expert on the subject, but as a civilian struggling to understand a complicated situation that's too often discussed by economists and pretty much ignored by people like me.

Unlike almost all the others whose writings I attempted to master, Rajan wrote clearly and imparted a coherent and convincing point of view.[2] I was not the only one to feel this way and the blog posts I wrote gathered an unusually large number of hits. In 2007, when Rajan left the IMF, its press releases suddenly became much less useful from my point of view and, at about the same time, its influence was seen as waning. The world's economic condition was no less perilous, but I'd lost my primary source for understanding it.

Fortunately, I'd begun earmarking Steven Pearlstein's excellent columns in the Washington Post. The WaPo archive of his work, going back to July 5, 2006, can be found here.[3]

This week's column, The politics and economics of a falling dollar, is especially good.

He recognizes that people like me find it difficult to focus our attention on global financial matters, but, he says, "it turns out they are at the heart of most of the economic issues we're dealing with, from budget battles to the euro crisis to the rising price of gasoline." He explains how the US dollar became and continues to be the world's dominant currency, tells how this results in unimaginable quantities of dollars being held outside the United States, and predicts (as others have been doing) that America's debt problems are producing a devaluation of the dollar which will, in time, result in the decline of the dollar as dominant currency. He says "the global system is forced to rely on the currency of a once-dominant economy that has piled up too much debt and can't quite figure out how to deal with it."

He concludes:

There are two ways this dollar story can play out.

In the optimistic scenario, a credible budget deal is reached in Washington, the Fed manages to sop up all the excess liquidity it has created, and the long-term slide in the dollar remains gradual enough for the world to muddle through until a new order and a new architecture can emerge.

In the darker scenario, hinted at last week by the leading credit-rating agency, the failure to adopt a budget deal triggers a U.S. credit crisis that spawns a dollar crisis, which sets off another global financial crisis — one that makes the last one look like child’s play.

In the column, Pearlstein quotes Gordon Brown's speech at this year's Bretton Woods Conference. The speech is quite long, but admirably free of jargon and not difficult to understand. In it, Brown makes a persuasive call for a new set of international agreements for regulation of global finance. Here's a short summary of his talk by the New Yorker's John Cassidy.[4]

Gordon Brown, who was voted out of Downing Street last year, delivered a sweeping survey of global economic issues. Noting that he had recently enjoyed a “period of reflection, enforced reflection,” he argued that most of the problems facing the world—financial instability, recessions, trade disputes, environmental degradation — ”cannot be addressed on an individual basis and can only be resolved by global coördination.” In the area of financial regulation, Brown pointed out, coördination was sorely lacking, with some individual countries pursuing their own agendas and trying to cozy up to big financial institutions. “I believe we are going back to a race to the bottom,” Brown said.

Brown also pointed out that the old industrial nations of the North Atlantic would soon be surpassed in wealth by China and the other newer ones. It's virtually inevitable that the purchasing power of the Chinese population will dwarf that of the United States within the next two decades. Inhabitants of China will then be the world's greatest consumers; Americans may be able to export goods to feed this Chinese demand, but that's not a certainty. Careful oversight at the international level will be required to make likely a smooth transition from the past half century's American dominance to whatever is to follow it.

This graphic, from wikipedia, gives one economic projection for the next four decades. It estimates the ten largest economies in the world in 2050, measured in GDP nominal (millions of USD).


Here is the video of Gordon Brown's speech at this years Bretton Woods Conference.



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Notes:

[1] These posts, going back to 2006, are mostly on the global economy and are mostly drawn from the work of Rajan and the Washington Post's Steven Pearlstein.

• Travels of a T-Shirt
• kleptocratic cliques of looters and world trade
• China cuts back on financing US deficit
• something to think about (hard work & contentment)
• where does all the oil money go?
• a global monetary storm triggered by the Bank of Japan?
• a frightening prosperity
• the Japan carry trade, of all things
• sovereign wealth funds and US sovereignty
• whither China?
• economic inequality
• Rajan on resolving global imbalances
• a time for committed and credible American leadership
• Pearlstein on burst bubbles
• making nice to foreigners
• topsy-turvy economics
• credit and discredit, trust and mistrust
• who are we that this happened to us?
• I read the news today oh boy
• financial pundits of the FT
• easy living, not always easy to maintain
• a life that breathes its own breath

[2] The authors of the wikipedia article on Rajan say

In 2005, at a celebration honoring Alan Greenspan, who was about to retire as chairman of the U.S. Federal Reserve, Rajan delivered a controversial paper that was critical of the financial sector. In that paper, "Has Financial Development Made the World Riskier?", Rajan "argued that disaster might loom."Rajan argued that financial sector managers were encouraged to

(take) risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.[...] But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized.

Thus Rajan described the 2007-2008 collapse of the world's financial system.

The response to Rajan's paper at the time was negative. For example, former U.S. Treasury Secretary and former Harvard President Lawrence Summers called the warnings "misguided."

[3] Articles by Steven R. Pearlstein

[4] Cassidy is author of How Markets Fail: The Logic of Economic Calamities (which I recommend) and Dot.con: How America Lost Its Mind and Money in the Internet Era