[OPE] Kenneth Rogoff on the financial crisis

I didn't pick this up earlier, but Prof. Rogoff (FT September 17 2008) makes a good point:

"One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis."

He explains that:

"If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it. But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America's flagship financial sector, the public and private sector's massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold."

But surely the exchange rate is founded on "dollar hegemony" in world trade, i.e. its level doesn't just depend on what happens in the US? Most likely, Mr Obama will win the election, in which case the dollar will strengthen in response. Anyhow, the more the dollar devalues, the more attractive it becomes to buy stuff in or from the US, though it also generates inflationary pressures in foreign trade and new political problems. The recent past proves that dollar exchange rates can fluctuate up to about 25 percentage points without society disintegrating or anything like that. The real problem is not so much economic, but social and political - how will ordinary Americans respond to the economic crisis? What will be the level of socio-political instability? Given the conservatism of American society, it is difficult to see very serious socio-political instability happening in the short term, except possibly in a few limited areas. How will Americans respond to new socio-political instability overseas? The US crisis is more a rich people's problem, though poor people bear the brunt of it. That is the real source of anxiety about the electoral outcomes. Every four years, there is one day when a lot of poor people together can have a real political effect, but nobody really knows what the hell it will be.

He also says that:

"It is true that the US government has very deep pockets. Privately held US government debt was under $4,400bn at the end of 2007, representing less than 32 per cent of gross domestic product. This is roughly half the debt burden carried by most European countries, and an even smaller fraction of Japan's debt levels. It is also true that despite the increasingly tough stance of US regulators, the financial crisis has probably already added at most $200bn-$300bn to net debt... Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn. (...) A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending."

But he does not mention also that the US government has very large assets, against which the debts should be weighed. If the federal administration is restructured, with a certain amount of privatisation, a lot of the debts simply disappear. I used to live in New Zealand, an economically marginal country in the world economy which has a culture similar to California, and after Friedman-type shock therapy was applied, the public sector no longer had big debts, it was just that the private sector debt rose enormously and socio-economic inequality went off the scale. There was double digit inflation for some years prior to that, causing a wages, rents and price freeze. In a sense, the US is now socially where New Zealand was in 1984. Americans never had shock therapy, they still have a governmental system that went out of fashion in most of the rest of the world because it wasn't affordable. Again, the problem is not primarily economic - all the resources are there - but political. Dealing with the financial crisis means there are winners and losers, and whatever you do, some gain at the expense of others, it becomes a zero-sum game. People have to learn again not to live beyond their means. The question then is how the gains and losses are actually distributed - depending on how you do it, it becomes even more difficult to unite people around a program of reform. John McCain has some good ideas about reforming the state, but unfortunately qua technique he is living in the past.

Rogoff argues:

"It will certainly make it harder for the US to maintain its military dominance, which has been one of the lynchpins of the dollar. The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts. It is a very good thing that the rest of the world retains such confidence in America's ability to manage its problems, otherwise the financial crisis would be far worse. Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with."

But as regards US military dominance, funds and assets have already been committed for many years into the future, so this is more a longterm argument, not a shortterm argument. In reality, technically, military dominance is becoming cheaper, although there is a lot of wasteful spending in that area (prestige projects and so on). The US financial system can shrink, but not necessarily permanently, it's more like a sponge. Mathematically, I would say that a few extra percentage points of inflation don't make a very large, significant dent in debt levels, there's more effect really on the amount of new debt incurred. Obviously, if you have near-zero benchmark interest rates, there's plenty potential scope for increasing interest rates. All that means economically is that poor people with little discretionary income can, other things remaining equal, no longer buy or borrow much, and that a bit of fat is trimmed off the middle class. But politically it could mean a whole lot more.

On balance, I think Prof. Rogoff is mixing up short-term issues with long-term issues in his article, which a politician would not do. Sure, there is a severe economic problem, but the real problem is socio-political. American society doesn't have a lot of the redistributive buffers we have in Europe, and thus there's a lot of people in for a rude financial shock. What is critical is how they will respond to it. Germany, the strongman of the European economy, had five million unemployed with an employed labour force of 40 million, and they brought unemployment down to 3.4 million (the official count, real unemployment is another story). That wasn't simply a question of economic boom, but of a conscious political policy, it took basically a decade to achieve. But even if US unemployment rises to 10% or 12%, and inflation rises to 6-8%, that doesn't stop wealthy people from making a lot of money in the US. In 1973-74 and 1980-81 a lot of people thought capitalism was on the brink of collapse, but that obviously wasn't the case. Why think so now?

The specificity of the current recession is that it is clearly caused by rich people who lent out borrowed money on very dodgy terms, and that you can't blame the working class for it. You cannot even blame the Chinese or oil sheiks or terrorists. The question then is, "who pays for the crisis?". Somehow, although rich people caused the crisis, poor people should pay for it. That sort of argument obviously does not really work, and so the whole discussion shifts to the theme that the recession is an inevitable calamity that just has to wash over - we cannot blame anybody, but we cannot do anything about it either. But as the recession rumbles, you can bet your boots that there will be political repercussions, and landslides in public opinion.

Jurriaan

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Received on Thu Sep 18 19:49:50 2008