A year of living dangerously for the world
By Martin Wolf
Published: July 15 2008 20:18 | Last updated: July 15 2008 20:18
It is now almost a year since the US subprime crisis went global. Many then hoped that the repricing of risk would be no more than a brief interruption in the progress of the US and world economies. Such hopes have been disappointed. The woes of Fannie Mae and Freddie Mac, the tumbling stock markets and the climbing oil prices make clear how far the turmoil is from its end. It has, in all likelihood, not even passed the end of its beginning.
So where is the world economy now? And where might it go? Here are some preliminary answers to these questions.
The answer to the first comes in two main parts: continued financial distress and commodity price rises.
The performance of banking stocks tells one most of what one needs to know about the financial crisis. In the US, the epicentre of the distress, banks had lost half of their market value between a year ago and the end of last week, relative to the S&P composite index.
Equity investors are not the only people worried about the health of banks. The banks themselves are also worried. Spreads between rates of interest on inter-bank lending in dollars, euros and sterling and expected official rates over three and six months are now wider than they were in March. On six-month loans spreads are now as high as at the two previous peaks, in September and December of last year (see chart).
This is no mere liquidity crisis. The banks are expressing concern about the solvency of their peers. One good reason for them to worry is that the quality of the underlying collateral for much of the lending of previous years – housing – continues to deteriorate. The Case-Shiller 20-city index declined by 18 per cent in nominal terms and 22 per cent in real terms between its peak in mid-2006 and April of this year. This rate of decline is also accelerating.
It is little wonder, then, that the stock market has been showing something close to panic over prospects for the two government- sponsored enterprises, Fannie Mae and Freddie Mac, which have been financing about three-quarters of all US mortgages. A formal government takeover of these entities, whose total liabilities are close to 40 per cent of US gross domestic product, is not out of the question. In terms of gross government indebtedness, this would make the US look like Italy.
Meanwhile, the price of oil is close to $150 a barrel. While an important part of the world economy is worrying about the risks of financial collapse and ensuing deflation, the price of the world’s most important commodity has doubled over the past year. In real terms, the price of oil is now 25 per cent higher than in 1979, at the peak of the second oil shock.
The soaring prices of oil and other commodities are something of a puzzle, since global economic growth is slowing: consensus forecasts for June have world growth at 2.9 per cent this year (at market exchange rates), down from 3.8 per cent in 2007, largely because of the slowdown in the high-income countries, with US growth forecast at only 1.5 per cent this year, down from 2.2 per cent in 2007, and growth in western Europe at 1.8 per cent, down from 2.8 per cent in 2007.
So why are commodity prices soaring when the world economy is slowing? The popular explanation seems to be “speculation”. But, since speculation is always with us, this cannot explain why prices are soaring now. Another popular explanation is the aggressive easing of US monetary policy. But this hardly explains the fact that the price of oil is rising rapidly even in euros (see chart). Nor does speculation explain the rise in the prices of commodities that do not have active futures markets: iron ore, for example.
In the case of oil, as Daniel Gros of the Centre for European Policy Studies pointed out in the Financial Times last week (this page, July 10), speculation is inherent in deciding whether to produce. The producers are speculators on the future value of their resource – and rightly so, since it is finite.
Producers will leave oil in the ground if the rise in real oil prices is expected to be faster than the return on the alternative assets. What determines the current price then is the expected future price. The most important drivers have been the prospective growth in the demand of emerging countries, particularly China, and gloom about alternative sources of supply. China’s rapid and highly resource-intensive growth is the most important factor: growth there is still expected to be 10 per cent this year and more than 9 per cent in 2009.
So what happens to the world economy next? Here perhaps the most important point is the uncertainty. It is possible to tell stories of a return to rapid growth in the world economy. It is just as easy to tell stories of something close to a financial meltdown.
Yet the balance of economic forces is contractionary: financial crises and property price collapses in the US and a number of other high-income countries; soaring commodity prices; and inflationary pressures, particularly in emerging countries. It is hard to see any outcome other than a sustained slowdown in the world economy. It is even quite likely that the trend growth of the world economy is considerably slower than was hoped a few years ago.
Furthermore, some of the risks could combine in dangerous ways. An attack on Iran might push the price of oil above $200, for example. Moreover, the creditworthiness of the US government cannot be taken for granted. If the ongoing deleveraging of the US economy weakened US consumption, the economy might go into a deep recession. US fiscal deficits would then soar and long-term US interest rates might jump. This could make the debt dynamics of the US government look very unpleasant. A flight from the dollar and dollar bonds might even ensue. Who would then want to be running the Federal Reserve?
The good news is that the world economy has held up surprisingly well. The bad news is that the risks remain squarely on the downside. It will take some luck and much judgment to pass through the storms unscathed. It is time to take a break from the gloom. That is what I will now do. I will be back at the end of August.