Friday, December 03, 2010
The Bath Taysom Lecture
Posted by David Smith at 06:00 PM
Category: David Smith's other articles

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On Thursday December 2, the University of Bath's Economics Society invited me to deliver the annual Taysom lecture, as part of its international economics week. It was a very enjoyable occasion in the splendid location of Bath's historic Assembly Rooms. My congratulations to the Economics Society for organising the event so well. This is the lecture.

I’m very grateful to John Taysom for sponsoring this lecture. It is a great thing when successful people put something back into their places of learning.

It is also a great pleasure to be here in these historic Assembly Rooms. Most people know them because of Jane Austen, who featured them in at least two of her novels. Or Charles Dickens, who lectured here more than 150 years ago. I think of them for a slightly different reason – an economic reason. In early September 1992, the British government hosted a meeting of European finance ministers and central bankers. It was intended to be a routine meeting, hence the location – the idea being to show the Europeans this magnificent city.

Unfortunately, by the time they assembled in these Assembly Rooms, the European economy was deep in crisis. We did not have a euro back then but we did have the exchange rate mechanism of the European Monetary System, which linked the currencies of Europe in a formal way. As you will recall, Margaret Thatcher had resisted joining the ERM as it was called, until the eve of her departure from office. So in September 1992 Britain had been part of it for less than two years. But Britain, along with Italy, was hanging on for dear life.

There was a threat to the entire system. So in these rooms we saw a titanic struggle. The easiest way to ease pressure on the system was for Germany to cut interest rates. Four times Norman Lamont, Britain’s chancellor, called on Helmut Schlesinger, president of the Bundesbank, to cut interest rates. Four times he refused, protesting that the decision was not for him but for his full Bundesbank council, finally threatening to walk out.

The meeting broke up without agreement and less than two weeks later we had Black Wednesday – or Golden Wednesday if you think it was a necessary liberation – when sterling was forced out of the ERM by pressure from speculators like George Soros.

It changed the course of British politics, paving the way for Tony Blair and new Labour, and it changed the course of Europe. In the following few months the ERM almost collapsed entirely. European leaders resolved to redouble their efforts to defeat the speculators and decided that the best way to do this was to speed the timetable for establishing the single currency. These very rooms played a part in giving us the euro just over six years later, at the start of 1999. As we’ve seen, the euro itself is in trouble, which I’ll return to, though I don’t think a meeting here in these Assembly Rooms is planned.

Anyway, in this your International Economics Week, I want to talk about where the global economy is after the biggest financial crisis in the post-war era. And I also want to talk about what kind of world economy we can look forward to in the coming decades.

The first thing to say is that this is a great time to be studying economics, and for those in the audience who are not, to be interested enough to attend an evening lecture on it. When I look back on the period when I was at university, I think back to a time when it was surprisingly easy to avoid the news events of the day, even the very big ones. My sense is that you are different. Apart from the fact that the repercussions of the crisis will live in the memory as the time a coalition government – itself very rare in Britain – introduced a huge hike in tuition fees, I think everybody got a sense of the drama we went through, perhaps are still going through, in the crisis.

The global financial crisis started more than three years ago, in the summer of 2007. That was when we moved from the easy credit-driven growth of the 1990s and 2000s into something very different. Funding markets froze, making it difficult for banks to fund their lending. Initially it was thought that this was just a liquidity crisis and that if the authorities, the central banks, could pump in enough liquidity into the markets for a couple of years everything would be fine.

Now we know it was much worse than that. The crisis faced by the banks was one of solvency – many did not have enough capital to survive. So two years ago, in the autumn of 2008, the Western banking system came very close to collapse – this was the time when at a practical level the cash machines almost didn’t get refilled, the supermarket shelves not restocked, the wages not paid. It was very close to a full state of economic emergency. You can see that by the exceptional actions that were taken, the partial nationalisation of Royal Bank of Scotland and the Lloyds Banking Group and Bank rate reduced to just 0.5%, comfortably its lowest level in the 316 years of the Bank’s existence. Exceptional circumstances required exceptional measures.

How did it happen? When I embarked on my book The Age of Instability I tended to think that the crisis was the product of relatively recent developments. There were those Ninja mortgages in America – people with no job, no income and no assets – all that subprime lending which was sliced, diced and packager into securities that were really junk but were rated Triple AAA. By the way, I thought that Ninja was a term of abuse when it came to the mortgage market. Far from it. Ninja mortgages were patented by one US lender, and they are still available. Had it been just this very recent phenomenon, I don’t think the crisis would have been as bad.

So I believe it was the product of a much longer development – a very long-running credit boom that went back perhaps decades. The so-called shadow banking system in America, which as its name suggests operates outside the public eye and away from the gaze of regulators, dates back to about 1980. By the time of the crisis, the shadow banking system was as big as the actual banking system in America. Some people say we shouldn’t be too hard on the banks. After all, they were simply providing the credit for businesses to invest and for consumers to spend and buy houses. There’s some truth in that and there’s no doubt that the majority benefited from the easy availability of credit. But the biggest increase in credit was in the financial sector itself. Two-thirds of the rise in debt in Britain between the early 1990s and 2008 was financial sector debt. Finance is supposed to finance industry, to finance economic growth. Mostly, finance financed itself, and generated large returns for the people who worked in it in the process. That can’t be allowed to happen again, though whether regulators get cleverer in preventing it than they were in the past is open to debate. People sometimes forget that we had crises even when bank lending was tightly controlled, though not on the scale of recent events.

Before getting on to where we go from here, every economist, and I suspect every economics student, has had to live with the accusation that economics fell down on the job when it came to predicting the crisis. What looks so obvious with hindsight was somehow missed by the mass of economists.

I think some of the criticism is justified. Certainly most economists did not think enough about the banking system. We assumed that the banks and their boards knew what they were doing. We assumed that the regulators would not allow them to do anything as risky and irresponsible as they did. We regarded them as the equivalent of financial utilities – a tap of credit to be turned on when it was needed. Having said that, economists are not particularly well qualified to assess the risks of individual banks, let alone the system as a whole. Those who were qualified, such as the banks’ auditors and specialist banking analysts, mainly failed to spot the problems too.

Second, we came to believe too much in the infallibility of policy. From 1997 to 2007, you could have believed that we had entered a period in which the economy could be controlled by tiny little touches on the tiller. Every month the nine members of the Bank of England’s monetary policy committee met and we all got very excited if it happened to nudge interest rates up or down by a quarter of a percentage point. Now we know that economies are more difficult to control than that. Maybe it was a bit of illusion. Maybe we just have these periods of stability, followed by instability, followed by stability again and it doesn’t matter as much as we thought what central banks do.

Third, people believed less in the infallibility of economic models, but it was the case that models were simply incapable of picking up on the developments that led to the crisis. Things are being remedied now but the majority of economic models had underdeveloped or non-existent monetary and financial sectors, and that’s where the crisis came from. Models are only as good as the assumptions that go into them. Nobody assumed a banking crisis and even if they had the models would have found it hard to accommodate them.

Having said all that let me speak up for economics and economists. We get all the jokes – lay every economist in the world end to end and you never reach a conclusion; economists are people who found accountancy too exciting – and so on, but the truth is that when it comes to predicting crises and catastrophes, a more valid criticism of economists is that they predict too many, not too few.

So, economists have been banging on about global imbalances since the mid-1980s. Global imbalances were an important factor in the crisis. But could anybody predict that it would take 25 years for the chickens to come home to roost?

Similarly, the idea that economists were sidetracked because they assumed that every economic actor was rational and every market efficient seem to me pretty wide of the mark. The efficient markets hypothesis, which to me simply says that markets reflect the information known at the time, has been given a prominence in the criticism that it did not deserve. I think the problem with economics is that in the public mind it is associated too much with forecasting. Economic forecasting has its uses. Economists are pretty good at predicting longer-term trends. What they are not are soothsayers or magicians. When we think about the crisis, it is easy to think that it was always going to pan out in the way it did. But on the contrary, it is better to view it as a whole series of crossroads, at each of which we could have gone in a different direction. There was no guarantee it would go in the way it did. The biggest crossroads of all was in September 2008, and the failure to rescue Lehman Brothers. It is quite possible that the global banking system would still have come close to collapse and the world economy fall off a cliff in the absence of the failure of Lehman Brothers. But it is also quite possible that things would have turned out very differently, and that the outcome would have been much less damaging than it was. In some senses, then, the crisis was literally unpredictable.

But it happened, where did it leave us? One of the interesting things is how quickly the global economy has bounced back. 2009 saw the first year in the post-war period when world GDP actually fell – previous world recessions had seen growth slow very sharply but not fall. World trade fell by 12% last year, compared with just 1% or 2% in previous post-war global recessions. Pretty well all of that happened in what I call the falling off a cliff moment, from October 2000 until May-June 2009, since which time we have had a good recovery. So this year we should see growth of between 4.5% and 5% for the global economy, similar to the rates of growth we were seeing before the crisis. World trade has almost made up the ground it lost last year, and should show a rise of about 10% this year. As far as the world is concerned, at least on the basis of the big numbers, things appear to be back to normal.

They are, however, very different. The central thought I want to leave you with this evening is that the effect of the financial crisis has been to significantly accelerate a trend that was there before it. That trend is the shifting axis of the global economy. Emerging economies, led by China, but also including India, Brazil, perhaps Russia, Indonesia, Vietnam, Nigeria and many other countries in Africa, are much less affected by the aftermath of the crisis. Their banking systems are much less damaged, their public finances much less in trouble and therefore not requiring substantial surgery. Asian economies, having had their rehearsal with the Asian financial crisis of 1997-98, made themselves more resilient, less vulnerable to the whims of the markets. Western economies, in contrast, are hobbled, in some cases very badly, by these twin hangovers, of broken banking systems and damaged public finances.

Two things arise from this. The first is the balance of global growth has shifted substantially. Not so long ago, the picture was fairly clear – two-thirds of world economic growth came from advanced economies and one-third came from emerging and developing economies. Now and for the foreseeable future it will be the other way around. Two-thirds of global growth will be from the emerging world; they are the engines of the world economy; its locomotives.

The other development relates to size and economic outlook. On the eve of the crisis, the trend seemed pretty clear. China would overtake Japan as the world’s second largest economy by about 2015 and become bigger than America in the 2030s. Many people, particularly Americans, had trouble believing such predictions. But now, as we know, China has already overtaken Japan, doing so this year, and is on course to overtake America by 2020. The crisis has had the effect of accelerating the global shift by 5-10 years, if not more. By the mid-2030s, the world’s big three will be China, India and America, in that order. That does not mean the people of China and India will be as rich or own as many cars as the Americans, even then. It does mean that their economies will be bigger, and with that goes increasing economic and political clout.

It is possible to see many of today’s developments via that way of looking at things. So the crisis of 2007-9 perhaps marked the end of the American century, the passing of the torch to Asia. You write off America at your peril, and I would not want to do this, but you can see in America a country that has lost its way economically and politically. Suddenly all the dynamism of America appears to have been diverted into the curious corruption of Wild West financial capitalism. America is the world’s only superpower, though not for very long, but the crisis has knocked the stuffing out of it. The hangover from the crisis in America seems that much worse. Unemployment is high and looks set to stay so. There’s an end of empire sense about America now. It will still be a formidable economic player, but the torch is clearly passing.

You can see it too in what has been happening to the euro-zone. This was Europe’s most confident statement of its own future. A zone of economic and financial stability even in an unstable world. Every new member of the EU is required to join the euro when it has met the rather loose financial conditions for entry. The euro was a monument to European integration. What the euro could not cope with, however, was the financial crisis. It has brought out all the contradictions inherent in the single currency. The eurozone is not an optimal currency area, in other words it does not have wage flexibility, geographical mobility of labour or a central Treasury. The idea that countries need not be too economically converged when they entered, because they would achieve such convergence once in, has proved to be false. The trouble-hit peripheral economies of the eurozone – Greece, Ireland, Portugal and Spain - have lost between 20% and 30% competitiveness since the euro came into being in 1999, or since they joined. This is not a tenable situation. Either they have to regain that competitiveness, which looks like a huge challenge, or they have to leave the euro. I have long believed that while the euro will survive, it will not do so with all its members. Some new member states in Eastern Europe, who are committed to entry, are thinking again about whether there interests are best served by joining.

The problems in America and eurozone are reflections of the fundamental shift that’s occurring. They don’t mean that there will be no growth in America and Europe, simply that most of the interesting action will be in Asia, and in South America and in Africa.

What do we have to do in the light of this shift? We saw in the case of the crisis in Ireland a lot of criticism of British industry for the fact that we export more to the Irish Republic than to China, India, Brazil and Russia put together. I think this is a misleading statistic. A lot of trade between Britain and Ireland is border trade between Northern Ireland and Ireland. Just as Lancashire trades a lot with Yorkshire, so there is a lot of local trade across the Irish border. There’s also a lot of criticism of British business for selling too much into Europe. Certainly it does not look that smart for more than half of Britain’s exports to be going to other EU countries. There is, however, a reason for that. If you think about much of the inward investment Britain has attracted over the past 20-30 years, for example the Japanese car assembly plants such as Nissan, Toyota and Honda. They did not come to Britain to supply the Asian market but to sell into the EU. They came to the UK because of our flexible labour market but even that does not mean they’ll sell much to China from the UK, particularly since they have their plants there. That would be like selling coals to Newcastle, as people used to say when the north-east still produced coal.

In general, Britain is pretty good at tapping into parts of the world that are growing well. The UK is an open economy that does well when the world economy is growing. Sectors like financial services, business services such as advertising, accountancy, law and architecture, all are internationally competitive. So is much of what is left of manufacturing. Of course we have to get better, for if there is one clear message it is that every country has more or less the same strategy. But we can get better. And there is no reason why we should not. It does not mean, very definitely, that we have to look forward to a grim future, or that everybody should uproot and get themselves off to Shanghai or Mumbai. I am very much of the view that the re-emergence of China, India and the rest will be a benefit – it is a sustained positive economic shock for the world. I say re-emergence because you only have to go back a couple of hundred years to a time when China and India, between them, accounted for between 50% and 60% of the world economy.

What if the world does not turn out quite like I think? Some of these big predictions come right but some go badly wrong. In the 1980s, when there were also serious doubts about the US economy and Japan appeared to have the answer to everything, it was common to come across predictions in which the all-mighty Japanese economy would overtake America and become the world’s number one. It did not happen, as we now know. In fact, Japan went into its long period of stagnation, America rediscovered the elixir of growth, and such predictions came to look very silly.

Could the same thing happen to China, India, and the rest of the fast-growing emerging economies? Let me focus on just one, China, and ask the question.

There are economic risks in China – partly from the outside world and, say, protectionism by America and other advanced economies. If China’s markets were cut off, China would grow much more slowly. There’s another economic risk, and it’s what happens when China tries to move towards more balanced growth. I wouldn’t pretend that it is easy for any economy to grow but economic growth based on heavy investment in infrastructure and exports is fine as far as it goes. Will China be able to adjust to something more like Western-style growth? And then there is the big political question. Can you have economic freedom without political freedom? How long will China be able to suppress democracy? There are already 100,000 officially admitted protests a year. China has embraced the world economically but is very different politically.

What’s the answer? We shouldn’t pretend any of this will be easy. I usually come back to a single statistic, which is that China has grown by an average of 9.5% a year for more than three decades, beginning in 1978. All through that period people have been predicting imminent disaster for the Chinese economy, that its growth will run into the sand. So far it has not happened. At some stage it might. But the West would be unwise to rely on China crashing and burning.

Its leaders are intelligent and its economic resilience impressive. It could go wrong but it seems to me that this is one of those shifts that happen from time to time in the global economy. And what goes for China goes for most of the other emerging economies too.