Ethos Issue 6, Jul 2009

Thinking Beyond the Crisis
Conversation with Bradford DeLong

Noted economics historian and commentator Professor Bradford DeLong, traces the roots of the current crisis, and expresses confidence in the long-term resilience of the global economy.

The quantity of bad investments made in Thailand in 1993 to 1996 was quite small relative to the collapse in Asian financial values in 1997 and 1998. Similarly, the amount of bad subprime mortgage loans made in the US is at the most US$1 trillion, and yet we have a US$20- to US$30-trillion collapse in global financial asset values as a result.

In 1997 to 1998, you had a slight collapse of the financial market’s risk tolerance and a flight to the safety of the US dollar. This meant that domestic central banks could do little to calm the markets or diminish the amount of risk held by the private sector. It took the International Monetary Fund (IMF) six months before it recognised that it was faced with a crisis which didn’t originate in bad government policies, but instead, was due to the collapse of the private sector’s risk tolerance. But once that was acknowledged, and the US Treasury and Wall Street banks made their move, things turned around remarkably quickly.

In fact, this was the sort of nightmare crisis Nouriel Roubini predicted years ago—that the US housing sector would go bust and cause a panic flight from dollardenominated assets, leading to a collapse in the financial system. If the People’s Bank of China saw its dollar-denominated portfolio shrinking and decided to dump its assets, the US Federal Reserve would be powerless to respond. We’ve heard about organisations being too big to fail, but the US in a full financial crisis would be too big to rescue.

Fortunately, however, what we seem to have at the moment is a much smaller crisis: there is still a rush toward dollardenominated assets which are still seen as safe in the global economy, and that is much easier to handle. The People’s Bank of China knows that it would be very difficult to get out of dollardenominated assets fully; its best course is to postpone its paper losses into the future where they will no longer matter as much.

Economists believe that the world’s safe real interest ought to be around 2% per year in real terms—reflecting stable growth rates. And the global equity premium—the expected return you get by investing in riskier stock and corporate equities—is about 2.2%, if you do the sums.

Yet when you look at the real world, the safe interest rate is close to 0% per year and the risky rate is around 8%. We seem to be doing a really poor job of mobilising the collective risk-bearing capacity of the global economy.

In other words, we should be able to do a much better job of diversifying everyone’s financial portfolio, so that people would then be much more willing to hold risky assets and much more willing to invest. We ought to have more sophisticated financial systems and portfolio diversification, more confidence in safety and much higher investment.

While financial innovation that leads to profoundly foolish portfolios like those seen in the current crisis should be curbed, the market would not be able to do its job of spreading more of the collective risk-bearing capacity of the world—and a lot of it isn’t mobilised—if financial innovations were restrained.

Look at the Industrial Revolution: it introduced factories, canals, railroads and so on, all of which required the mobilisation of the savings of huge numbers of individuals to fuel different enterprises. There was also diversification, which assured individual savers that if any enterprise they didn’t control or didn’t understand went bankrupt, it wouldn’t carry all of their wealth down with it.

Page 1 I 2