1. Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth, Harvard University Global Macroeconomic Address: The Impact of Current Economic & Regulatory Policy on Economic Recovery -- Where Does the Financial Crisis Leave the U.S. Economy in Global Terms? Westin Boston Waterfront, Harbor Ball Room, June 3, 2010

2. RecessionRecession RecoveryRecovery OutlookOutlook The Impact of PolicyThe Impact of Policy Where Does The Financial Crisis Leave the U.S. Economy in Global Terms?Where Does The Financial Crisis Leave the U.S. Economy in Global Terms?

3. 3 The US Recession The US recession started in Dec. 2007 according to the NBER Business Cycle Dating Committee. The US recession started in Dec. 2007 according to the NBER Business Cycle Dating Committee. The earliest we might date the trough is June 2009. The earliest we might date the trough is June 2009. Even then, at 18 months, the recession’s length passed the postwar records: Even then, at 18 months, the recession’s length passed the postwar records: 16 months -- 1973-75 & 1981-82. 16 months -- 1973-75 & 1981-82. One has to go back to 1929-33 for a longer downturn. One has to go back to 1929-33 for a longer downturn. Also the most severe, by most measures: Also the most severe, by most measures: rise in unemployment rate, job loss, output loss…. rise in unemployment rate, job loss, output loss….

4. 4 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction Quarterly dates are in parentheses Peak to Trough August 1929 (III) May 1937 (II) February 1945 (I) November 1948 (IV) July 1953 (II) August 1957 (III) April 1960 (II) December 1969 (IV) November 1973 (IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV) March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 20011 (IV) 43 months 13 8 11 10 8 10 11 16 6 16 8 8 Average, all cycles: 1854-2001 (32 cycles) 1945-2001 (10 cycles) 17 10 June 2009 (II) or later > 18 months [not yet declared]

5. 5 US employment peaked in Dec. 2007, which is one reason why the NBER BCDC dated the peak from that month. 8 million jobs were lost over the next two years. Payroll employment series Source: Bureau of Labor Statistics Jobs peak Jobs trough Payroll employment series Source: Bureau of Labor Statistics, April 2010

6. The U.S. recession of 2007-09 differed from the usual, not just in its length and severity, but also in the extent of the loss of liquidity… Source: WEO, IMF, April 2010

7. …and in the extent of the loss of jobs. Source: WEO, IMF, April 2010

8. 8 Most indicators began to improve by mid or late 2009 Interbank spreads Interbank spreads GDP GDP Stock market Stock market Consumer confidence & spending Consumer confidence & spending The labor market has been terrible. The labor market has been terrible. But even it has responded, with lags no worse than usual. But even it has responded, with lags no worse than usual.

9. Interbank spreads came back down sharply in 2009 Source: OECD Economic Outlook May 2010

10. Source: Jeff Frankel’s blog, Nov. 2009 But the usual cyclical pattern of recovery began in 2009, Q II: 1. Leading indicators come first. 2. Output indicators come next. 3. Labor market indicators come last. The economic roller coaster went into free-fall in the 3 rd quarter of 2008.

11. Source: OECD Economic Outlook May 2010 Growth has been positive for the last 3 quarters

12. 12 Total hours worked in the US economy (an indicator that does not lag as far behind as unemployment) began to turn upward in October 2009 Source: New series from BLS covering the entire private economy. May 2010

13. Source: OECD Economic Outlook May 2010

14. 14 Demand growth in the 2 nd half of 2009 came in large part from: Demand growth in the 2 nd half of 2009 came in large part from: fiscal stimulus, & fiscal stimulus, & end of firms’ inventory disinvestment. end of firms’ inventory disinvestment. Both stimulus sources are running down in 2010. Both stimulus sources are running down in 2010. Fortunately consumption & investment seem to be catching fire in their place: Fortunately consumption & investment seem to be catching fire in their place: GDP reported by BEA (5/27/10). GDP reported by BEA (5/27/10). QIII: +2.2% QIV: +5.6% QI: +3.0 %, now led by consumption & business equipment. QIII: +2.2% QIV: +5.6% QI: +3.0 %, now led by consumption & business equipment. Danger of a W-shaped recession?

15. There could always be new shocks: There could always be new shocks: Contagion from Greece Contagion from Greece Hard landing for the $ Hard landing for the $ Geopolitical/oil shock… Geopolitical/oil shock… I now put the odds of a double dip recession as I now put the odds of a double dip recession as << 50%, but << 50%, but big enough to have persuaded the NBER BCDC in our April 8 meeting to wait longer before declaring the 2009 trough. big enough to have persuaded the NBER BCDC in our April 8 meeting to wait longer before declaring the 2009 trough. Danger of a W-shaped recession?

16. 16 Policy Response of 2007-09 -- How did we avoid another Great Depression? We learned important lessons from the 1930s and, for the most part, didn’t repeat the mistakes made then. We learned important lessons from the 1930s and, for the most part, didn’t repeat the mistakes made then.

17. 17 We learnt from the mistakes of the 1930s. We learnt from the mistakes of the 1930s. Trade policy: Trade policy: Some slippage, e.g., Chinese tires. Some slippage, e.g., Chinese tires. But we did not repeat 1981 auto quotas or 2001 steel tariffs But we did not repeat 1981 auto quotas or 2001 steel tariffs let alone Smoot-Hawley ! let alone Smoot-Hawley ! Monetary response: Monetary response: good this time. good this time. Fiscal response: Fiscal response: relatively good, but : relatively good, but : constrained by inherited debt constrained by inherited debt and congressional politics. and congressional politics. Financial regulation? Financial regulation? Clearly inadequate, going in. But now…? Clearly inadequate, going in. But now…?

18. 18 U.S. Policy Responses Monetary easing was unprecedented, appropriately avoiding the mistake of 1930s. (graph) Monetary easing was unprecedented, appropriately avoiding the mistake of 1930s. (graph) Policy interest rates ≈ 0. Policy interest rates ≈ 0. Then we had aggressive quantitative easing: Then we had aggressive quantitative easing: the Fed purchased assets not previously dreamt of. the Fed purchased assets not previously dreamt of.

19. 19 The Fed certainly did not repeated the mistake of 1930s: letting the money supply fall. Source: IMF, WEO, April 2009 Box 3.1 1930s 2008-09

20. 20 Federal Reserve Assets ($ billions) have more-than-doubled, through new facilities, rather than conventional T bill purchases Source: Federal Reserve H.4.1 report

21. 30 years of monetary theory say that if you double the monetary base, you will soon double the price level. So, should we fear that inflation will soon soar? In a word, “No.” So long as unemployment is high, & output below potential, inflation is not an immediate threat. This will hold (unfortunately) through 2011-2012. Of course the Fed must plan ahead a year or two.

22. 22 Soon we must return toward fiscal discipline. The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. The only way to do this is both reduce spending & raise tax revenue, as we did in the 1990s. Any solution requires: Any solution requires: Honest budgeting (e.g., Iraq war goes on-budget…) Honest budgeting (e.g., Iraq war goes on-budget…) PAYGO PAYGO Wise up to politicians who claim they will eliminate budget deficits entirely on the spending side (and even with lower taxes), but who raise spending when they get the chance. Wise up to politicians who claim they will eliminate budget deficits entirely on the spending side (and even with lower taxes), but who raise spending when they get the chance.

23. On the tax side… Tax revenue Tax revenue Let President Bush’s tax cuts expire in 2011. Let President Bush’s tax cuts expire in 2011. Introduce a Value Added Tax Introduce a Value Added Tax Or phase in carbon tax or auctioned tradable emission permits Or phase in carbon tax or auctioned tradable emission permits And curtail expensive and distorting tax expenditures And curtail expensive and distorting tax expenditures E.g., Tax-deductibility of mortgage interest E.g., Tax-deductibility of mortgage interest All politically very difficult, needless to say. All politically very difficult, needless to say.

24. 24 Spending Spending Cuts in farm subsidies for agribusiness & farmers Cuts in farm subsidies for agribusiness & farmers Cut unwanted weapons systems (a rare success: the F22 fighter) Cut unwanted weapons systems (a rare success: the F22 fighter) Cut manned space program… Cut manned space program… Social security Social security Raise retirement age – just a little Raise retirement age – just a little Progressively index future benefit growth to inflation (vs. wages) Progressively index future benefit growth to inflation (vs. wages) If necessary, raise the cap on social security taxes. If necessary, raise the cap on social security taxes. Health care Health care Encourage hospitals to standardize around best-practice medicine Encourage hospitals to standardize around best-practice medicine to pursue the checklist that minimizes patient infections and to pursue the checklist that minimizes patient infections and to avoid unnecessary medical tests & procedures. to avoid unnecessary medical tests & procedures. Lever: making Medicare payments conditional on these best practices. Lever: making Medicare payments conditional on these best practices. Curtail corporate tax-deductibility of health insurance, Curtail corporate tax-deductibility of health insurance, especially gold-plated health plans. especially gold-plated health plans.

25. When will US adopt the tough measures to get back to fiscal sustainability? Ideally, we would now adopt measures that would begin to go into effect by 2012 and over the coming decades – repeating the 1990s success. That is unlikely politically, due to partisan gridlock. Hopefully, then, after the 2012 presidential elections. Otherwise, in response to future crises, when it will be much more painful !

26. 26 Policy Responses, continued succeeded in getting the financial system going again, succeeded in getting the financial system going again, thereby precluding a new Great Depression, thereby precluding a new Great Depression, yet without “nationalization” of the banks. yet without “nationalization” of the banks. Contrary to almost all commentary at the time of TARP: Contrary to almost all commentary at the time of TARP: The conditions imposed on banks in early 2009 were strong enough to make them balk at keeping the funds. The conditions imposed on banks in early 2009 were strong enough to make them balk at keeping the funds. The banks have since paid back the taxpayer at a profit. The banks have since paid back the taxpayer at a profit. Geithner’s stress tests fulfilled their function of telling strong banks from weak. Geithner’s stress tests fulfilled their function of telling strong banks from weak. The policy of “financial repair”

27. 27 Financial reform. My own views on what is needed Lending Lending Mortgages Mortgages Consumer protection agency, including standards for mortgage brokers Consumer protection agency, including standards for mortgage brokers I would not have let the Fed have this one. I would not have let the Fed have this one. Fix “originate to distribute” model, so lenders stay on the hook. Fix “originate to distribute” model, so lenders stay on the hook. Remove policy bias toward housing debt. (Sadly, politicians won’t hear of it.) Remove policy bias toward housing debt. (Sadly, politicians won’t hear of it.) Banks: Banks: Regulators shouldn’t let banks use their own risk models ; Regulators shouldn’t let banks use their own risk models ; should make capital requirements higher & less pro-cyclical. should make capital requirements higher & less pro-cyclical. Is “too big to fail” inevitable? The worst is to say “no” and then do “yes.” Is “too big to fail” inevitable? The worst is to say “no” and then do “yes.” Tax banks. But I wouldn’t earmark the revenues for a bailout fund. Tax banks. But I wouldn’t earmark the revenues for a bailout fund. Extend bank-like regulation to “near banks.” Extend bank-like regulation to “near banks.” Regulators need resolution authority. Regulators need resolution authority. Segmentation of function: Segmentation of function: Volcker rule ? or all the way back to Glass-Steagall ? (I don’t think so.) Volcker rule ? or all the way back to Glass-Steagall ? (I don’t think so.)

28. 28 Financial reform continued Financial reform continued Executive compensation Executive compensation Compensation committee not under CEO. Compensation committee not under CEO. Maybe need Chairman of Board. Maybe need Chairman of Board. Discourage golden parachutes & options, Discourage golden parachutes & options, unless truly tied to performance. unless truly tied to performance. Securities Securities Derivatives: Derivatives: Create a central clearing house for CDSs. Create a central clearing house for CDSs. Don’t ban short sales, as the Germans are doing. Don’t ban short sales, as the Germans are doing. Credit ratings: Credit ratings: Reduce ratings agencies’ conflicts of interest. Reduce ratings agencies’ conflicts of interest. Reduce reliance on ratings: AAA does not mean no risk. Reduce reliance on ratings: AAA does not mean no risk. MSN Money & Forbes

29. 29 Policy Responses, continued $787 b fiscal stimulus passed Feb. 2009. $787 b fiscal stimulus passed Feb. 2009. Good old-fashioned Keynesian stimulus Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts has returned; Even the principle that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, e.g., not just from Larry Summers, e.g., but also from Martin Feldstein. but also from Martin Feldstein. Is $800 billion too small? Too large? Is $800 billion too small? Too large? Yes: Too small to knock out recession ; Yes: Too small to knock out recession ; too large to reassure global investors re US debt. too large to reassure global investors re US debt. Also Congress was not willing to vote for more, especially on the spending side. Also Congress was not willing to vote for more, especially on the spending side.

30. 30 Bottom line of macroeconomic policy response: The monetary and fiscal response was sufficient to halt the economic free-fall. The monetary and fiscal response was sufficient to halt the economic free-fall. It won’t be enough to return us rapidly to full employment and potential output. It won’t be enough to return us rapidly to full employment and potential output. Given the debt path that was inherited in 2009, it is unlikely that much more could be done. Given the debt path that was inherited in 2009, it is unlikely that much more could be done. Chinese officials already questioning our creditworthiness Chinese officials already questioning our creditworthiness

31. 31 The return of Keynes Keynesian truths abound today : Keynesian truths abound today : Origins of the crisis Origins of the crisis The Liquidity Trap The Liquidity Trap Fiscal response, including spending vs. tax cuts Fiscal response, including spending vs. tax cuts Motivation for macroeconomic intervention: to save market microeconomics Motivation for macroeconomic intervention: to save market microeconomics International transmission International transmission Need for coordinated expansion (now the G20) Need for coordinated expansion (now the G20)

32. 32 Motivation for macroeconomic intervention The view that Keynes stood for big government is not really right. The view that Keynes stood for big government is not really right. He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s, He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s, by using macroeconomic demand to return to equilibrium. by using macroeconomic demand to return to equilibrium. Some on the Left reacted to the 2008 crisis & election by hoping for fundamental overhaul of the economic system. Some on the Left reacted to the 2008 crisis & election by hoping for fundamental overhaul of the economic system. But the policy that prevails today is the same. But the policy that prevails today is the same.

33. 33 The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch…. The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch…. like Keynes’ animal spirits or beauty contest. like Keynes’ animal spirits or beauty contest. Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, Kindleberger 78 ’s “manias & panics” Kindleberger 78 ’s “manias & panics” the “Minsky moment,” the “Minsky moment,” & Fisher’s “debt deflation.” & Fisher’s “debt deflation.” The origin this time was not a monetary contraction in response to inflation as were 1980-82 or 1991. The origin this time was not a monetary contraction in response to inflation as were 1980-82 or 1991. But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices.

34. 34

35. Appendix: Origins of the 2007-09 financial crisis The U.S. Economy compared to others The Global Economy The Problem of Global Current Account Imbalances

36. 36 Who got pieces of it right, beforehand? Krugman: If a Depression can happen in Japan, it can happen in any modern economy. Krugman: If a Depression can happen in Japan, it can happen in any modern economy. Rajan: Failures of corporate governance. Rajan: Failures of corporate governance. BIS (Borio & White): Too-easy credit, via asset prices, leads to crises -- with no inflation in between. BIS (Borio & White): Too-easy credit, via asset prices, leads to crises -- with no inflation in between. Shiller: US housing price bubble. Shiller: US housing price bubble. Gramlich: Homeowners are being sold mortgages that they can’t repay. Gramlich: Homeowners are being sold mortgages that they can’t repay. Rogoff: “This Time Is Not Different.” Rogoff: “This Time Is Not Different.” Roubini: The recession will be severe. Roubini: The recession will be severe.

37. 37 Six root causes of the financial crisis 1. US corporate governance falls short E.g., rating agencies; E.g., rating agencies; executive compensation … executive compensation … options; options; golden parachutes… golden parachutes… 2. US households save too little, borrow too much. 3. Politicians slant excessively toward homeowner debt Tax-deductible mortgage interest; Tax-deductible mortgage interest; F annie M ae & Freddie Mac ; F annie M ae & Freddie Mac ; Allowing teasers, NINJA loans, liar loans… Allowing teasers, NINJA loans, liar loans… MSN Money & Forbes

38. 38 Six root causes of financial crisis, cont. 4. The federal budget has been on a reckless path since 2001, reminiscent of 1981-1990 reminiscent of 1981-1990 5. Monetary policy was too loose during 2004-05, accommodating fiscal expansion, reminiscent of the Vietnam era. accommodating fiscal expansion, reminiscent of the Vietnam era. 6. Financial market participants grossly underpriced risk 2005-07. Ignoring possible shocks such as: Ignoring possible shocks such as: housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics…. geopolitics….

39. 39 US real interest rate < 0, 2003-04 Real interest rates <0 Source: Benn Steil, CFR, March 2009

40. 40 In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted. So did spreads on US junk & emerging market bonds. In 2008, it all reversed. Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008 juanpablofernandez.wordpress.com/2008/05/juanpablofernandez.wordpress.com/2008/05/

41. 41 Monetary policy easy 2004-05 Federal budget deficits Underestimated risk in financial mkts Failures of corporate governance Households saving too little, borrowing too much Excessive leverage in financial institutions Stock market bubble Housin g bubble Stock market crash Housin g crash Financial crisis 2007-08 China’s growth Low national saving Lower long- term econ.growth Eventual loss of US hegemony Recession 2008-09 Oil price spike 2007-08 Gulf insta- bility Foreig n debt Origins of the financial/economic crises Excessive complexity CDSs MBS s CDO s Predatory lending Homeownership bias

42. 42 They did. Indices peaked in late 2006, and fell 1/3. The “black swan”: investors thought housing prices could never go down.

43. 43 Financial meltdown: bank spreads rose sharply when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008).

44. 44 My favorite monthly indicator: total hours worked in the economy It confirms: US recession began Dec. 07, turned severe in Sept. 08, when the worst of the financial crisis hit (Lehman bankruptcy…)

45. 45 National income has been more reliable than GDP, even though they are supposed to measure the same thing. Recession of July 1990 – March 91 Recession of Mar. 2001 – Nov. 2001 Recession of Dec. 2007 – ?

46. 46 OECD Econ.Outlook, April 2010 Evidence that the banking sector returned to normal by late 2009. Start of US sub-prime mortgage crisis Lehman failure

47. 47 OECD Economic Outlook, April 2010 Evidence that the banking sector returned to normal in late 2009.

48. % % Corporate bond rates have come back down too. OECD Economic Outlook, April 2010 Now < interest rates in the (mild) 2001 recession.

49. US employment fell fully in proportion to GDP, unlike the “labor hoarding” pattern of the past.

50. In Germany, by contrast, the recession has shown up only in GDP, not at all in employment.

51. 51 The global economy quickly followed the US into recession, Source: OECD Economic Outlook, April 2010 and now back out again (starting 2009, QIII)

52. 52 Unemployment is forecast to come down only slowly (typical of financial crashes) Source: OECD Economic Outlook, April 2010

53. The countries with the big housing bubbles suffered the most severe recessions measured by unemployment Source: IMF World Economic Outlook, April 2010

54. IMF World Economic Outlook, April 2010 Unlike the U.S. & Spain, where job loss > GDP loss, other countries like Germany & Japan had it the other way around.

55. Unlike the U.S. & Spain, where job loss > GDP loss, other countries like Germany & Japan had it the other way around.

56. Source: OECD Economic Outlook, April 2010 Unemployment in the US has risen above Europe for the first time in decades

57. 57 Employment Lags Behind GDP Although U.S. job loss has been especially bad in this recession, the recovery lag behind GDP has not been unusual. Recession of Mar. 2001 – Nov. 2001 Recession of Dec. 2007 – ?

58. De-coupling turned out to be real after all at least with respect to East Asia, which has rebounded very strongly over the last year, after a sharp loss of exports over the preceding year, from 2008 QI to 2009 Q I. China’s growth has not only returned to its blistering pace of > 10% but by now is a source of global growth because China is now a much larger share of the world economy than in the 1980s or 90s. India, Indonesia, & other Asian countries also weathered the global recession well, and are growing strongly.

59. 59

60. The worst post-war decline in global trade (2008-09) has now reversed

61. Source: IMF WEO, April 2010

62. Source: IMF WEO, April 2010

63. Source: IMF WEO, April 2010

64. Source: IMF WEO, April 2010

65. Source: IMF WEO, April 2010 So far, it doesn’t look like one of those recessions where “the deeper they fall, The faster they bounce back.”

66. Forecasts International Monetary Fund April 14, 2010 World Economic Outlook (%) Year over Year Q4 over Q4 (2010-2011 are projections) 2008 2009 2010 2011 2009 2010 2011 World Output3.0 –0.6 4.2 4.3 1.7 3.9 4.5 Advanced Economies 0.5 –3.2 2.3 2.4 –0.5 2.2 2.5 Japan –1.2 –5.2 1.9 2.0–1.4 1.6 2.3 United States 0.4 –2.4 3.1 2.6 0.1 2.8 2.4 Euro Area 0.6 –4.1 1.0 1.5 –2.2 1.2 1.8 Newly Industrialized Asian Economies 1.8 –0.9 5.2 4.9 6.1 3.4 5.9

67. Emerging & Devel- 6.1 2.4 6.3 6.5 5.2 6.3 7.3 oping Economies Central & E.Europe 3.0 –3.7 2.8 3.4 1.9 1.3 4.1 Russia 5.6 –7.9 4.0 3.3 –3.8 1.7 4.2 Developing Asia 7.9 6.6 8.7 8.7 8.6 8.9 9.1 China 9.6 8.7 10.0 9.9 10.7 9.4 10.1 India 7.3 5.7 8.8 8.4 6.0 10.9 8.2 ASEAN-54.7 1.7 5.4 5.6 5.0 4.2 6.2 Middle East & N.Africa 5.1 2.4 4.5 4.8......... Sub-Saharan Africa 5.5 2.1 4.7 5.9......... Western Hemisphere 4.3 –1.8 4.0 4.0......... Brazil 5.1 –0.2 5.5 4.1 4.3 4.2 4.2 Mexico 1.5 –6.5 4.2 4.5 –2.4 2.3 5.5 Year over Year Q4 over Q4 (2010-2011 are projections) 2008 2009 2010 2011 2009 2010 2011

68. RGE Global Economic Outlook Q2 2010 Draft, for release April 20 Roubini Global Economics Real GDP (% chg, y/y) Country 2009 2010 USA -2.4 2.8 Japan -5.2 2 Eurozone -4.1 0.9 UK-5 1.1 G7 -3.4 2.2 Advanced Economies 1 -3.4 2 Asia 2 3.6 6.9 Asia ex-Japan 5.8 8.2 Latin America 3 -2.1 4.3 EMEA 4-3.5 3.1 BRICs 4.9 8.3 BICs 5 7 9 World -0.8 3.7 1 Includes USA, Canada, Japan, UK, Eurozone, Sweden, Denmark, Australia & NZ. 2 Includes Japan, China, India, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, Vietnam, Korea, Taiwan & Thailand. 3 Brazil, Argentina, Mexico, Chile, Peru, Colombia & Venezuela. 4 Turkey, Russia, Kazakhstan, Ukraine, Czech Rep., Hungary, Slovakia, Poland, Romania, Bulgaria, Egypt, Saudi Arabia, UAE, Israel, Nigeria, S. Africa 5 Brazil, India & China; or BRICs excl. Russia. Global Growth Forecasts

69. 69 The problem of global current account imbalances, especially the US CA deficit & China’s surplus, especially the US CA deficit & China’s surplus, was the most salient global macroeconomic issue on the eve of the financial crisis. was the most salient global macroeconomic issue on the eve of the financial crisis. Imbalances narrowed sharply in 2009; Imbalances narrowed sharply in 2009; the US deficit fell by almost ½ ; the US deficit fell by almost ½ ; China’s CA fell by almost ½. China’s CA fell by almost ½. Its trade surplus actually dipped to 0 in March 2010. Its trade surplus actually dipped to 0 in March 2010. Problem solved? Problem solved? The imbalances will now resume widening. The imbalances will now resume widening.

70. 70 Global current account imbalances – China’s surplus and America’s deficit – narrowed ≈ ½ in the 2009 recession.

71. Global current account imbalances – China’s surplus and America’s deficit – are expected now to widen again some, with recent recovery in US income & the $.

72. 72 Economists were (are) split between Ken Rogoff * Ken Rogoff * Maury Obstfeld Maury Obstfeld Larry Summers Larry Summers Martin Feldstein Martin Feldstein Nouriel Roubini Nouriel Roubini Menzie Chinn Menzie Chinn Me Me Lots more Lots more Ben Bernanke Ben Bernanke Ricardo Caballero * Ricardo Caballero * Richard Cooper Richard Cooper Michael Dooley Michael Dooley Pierre-Olivier Gourinchas Pierre-Olivier Gourinchas Alan Greenspan Alan Greenspan Ricardo Hausmann Ricardo Hausmann Lots more Lots more those who saw the US deficit as unsustainable, requiring a $ fall, and those who saw (see) no problem. * Some claim that the financial crisis of 2007-09 fits their theories.

73. The events of 2007-09 struck major blows against both interpretations of CA. Most of us in the unsustainability camp would have predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $. Instead, the $ strengthened. Most of those in the sustainability camp had been arguing that the US has uniquely superior assets (corporate governance, securities markets, bank regulation…) Instead, the crisis showed the US system to suffer serious flaws of crony capitalism like other countries (Simon Johnson, Ragu Rajan) or – worse – excessive deregulation (Joe Stiglitz) The answer, for the moment: The $ and US Treasury bills still play unique roles in the world monetary system.

74. When will the day of reckoning come? It didn’t come in 2008: The financial crisis caused a flight to quality which evidently still means a flight to US $. Chinese warnings in 2009 may have augured a turning point: Premier Wen worried US T bills will lose value. He urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $ (Nov.). PBoC Gov. Zhou proposed replacing $ as international currency, with the SDR ( March 09).

75. The problem of Greece Implications for Europe: European leaders have handled the crisis poorly, boding ill for the long-term euro project. Implications for the US In the short term, possible contagion is the new source of risk for us well. In the longer term, it will be good if this gives political impetus to address the long-standing problems of our own fiscal path. Implications for the global financial system: The dividing line between advanced countries & developing countries has been erased.

77. The Greek crisis has begun to affect banks, especially in euroland. LIBOR went back above 50 basis points in late May Banking sector 5-year CDS rates Source: Datastream, OECD Ec. Outlook May 2010

78. By 2007, emerging & developing economies had achieved fiscal balance & debt/GDP ratios well below those of advanced economies.

79. The fruits of fiscal discipline: For the first time, Korea has a higher credit rating than Iceland or Greece Developing countries were able to respond to the 2008-09 recession with fiscal expansion to moderate the downturn.

80. Greece, Portugal & Iceland have lost creditworthiness, as a result of excessive debt: while East Asian NIEs have gained creditworthiness. All countries listed are described as "advanced” in WEO, 2010 economies" Ratings are issued by S&P for foreign currency long-term debt

81. 81 Not used, for now