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Can the IMF avert a global meltdown?

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF. His last piece on Webdiary was Did America really kill the trade talks?

by Kenneth Rogoff

When world financial leaders meet in Singapore this month for the joint World Bank/International Monetary Fund meetings, they must confront one singularly important question. Is there any way to coax the IMF’s largest members, especially the United States and China, to help diffuse the risks posed by the world’s massive trade imbalances?

This year, the US will borrow roughly $800 billion to finance its trade deficit. Incredibly, the US is now soaking up roughly two-thirds of all global net saving, a situation without historical precedent.

While this borrowing binge might end smoothly, as US Federal Reserve Chairman Ben Bernanke has speculated, most world financial leaders are rightly worried about a more precipitous realignment that would likely set off a massive dollar depreciation and possibly much worse. Indeed, if policymakers continue to sit on their hands, it is not hard to imagine a sharp global slowdown or even a devastating financial crisis.

Although Bernanke is right to view a soft landing as the most likely outcome, common sense would suggest agreeing on some prophylactic measures, even if this means that the US, China, and other large contributors to the global imbalances have to swallow some bitter medicine. Unfortunately, getting politicians in the big countries to focus on anything but their own domestic imperatives is far from easy.

Though the comparison is unfair, it is hard not to recall the old quip about the IMF’s relative, the United Nations: “When there is a dispute between two small nations, the UN steps in and the dispute disappears. When there is a dispute between a small nation and a large nation, the UN steps in and the small nation disappears. When there is a dispute between two large nations, the UN disappears.”

Fortunately, the IMF is not yet in hiding, even if some big players really don’t like what it has to say. The IMF’s head, the Spaniard Rodrigo Rato, rightly insists that China, the US, Japan, Europe, and the major oil exporters (now the world’s biggest source of new capital) all take concrete steps towards alleviating the risk of a crisis.

Though the exact details remain to be decided, such steps might include more exchange-rate flexibility in China, and perhaps a promise from the US to show greater commitment to fiscal restraint. Oil exporters could, in turn, promise to increase domestic consumption expenditure, which would boost imports.

Likewise, post-deflation Japan could promise never again to resort to massive intervention to stop its currency from appreciating. Europe, for its part, could agree not to shoot its recovery in the foot with ill-timed new taxes such as those that Germany is currently contemplating.

Will the IMF be successful in brokering a deal? The recent catastrophic collapse of global trade talks is not an encouraging harbinger. Europe, Japan, and (to a much lesser extent) the US, were simply unwilling to face down their small but influential farm lobbies. The tragic result is that some of the world’s poorest countries cannot export their agricultural goods, one of the few areas where they might realistically compete with the likes of China and India.

Fortunately for Rato, addressing the global imbalances can be a win-win situation. The same proposed policies for closing global trade imbalances also, by and large, help address each country’s domestic economic concerns.

For example, China needs a stronger exchange rate to help curb manic investment in its export sector, and thereby reduce the odds of a 1990’s style collapse. As for the US, a sharp hike in energy taxes on gasoline and other fossil fuels would not only help improve the government’s balance sheet, but it would also be a way to start addressing global warming. What better way for new US Treasury Secretary Hank Paulson, a card-carrying environmentalist, to make a dramatic entrance onto the world policy stage?

Similarly, the technocrats at the Bank of Japan surely realise that they could manage the economy far more effectively if they swore off anachronistic exchange-rate intervention techniques and switched whole-heartedly to modern interest-rate targeting rules such as those used by the US Federal Reserve and the European Central Bank.

With Europe in a cyclical upswing, tax revenues should start rising even without higher tax rates, so why risk strangling the continent’s nascent recovery in the cradle? Saudi Arabia, with its burgeoning oil revenues, could use a big deal to reinforce the country’s image as a major anchor of global financial stability.

If today’s epic US borrowing does end in tears, and if world leaders fail to help the IMF get the job done, history will not treat them kindly. Instead, they will be blamed for not seeing an impending catastrophe that was staring them in the face. Let’s hope that on this occasion in international diplomacy, the only thing that disappears are the massive global trade imbalances, and not the leaders and institutions that are supposed to deal with them.

Copyright: Project Syndicate, 2006.

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US outlook

Michael Coleman, re “I note that the denunciations of Roubini's prediction of recession in 2007 came without a single factual argument to explain his error. Perhaps, you would like to have a go?” I’m not sure why you’re asking me to explain arguments omitted from an article that you linked.

Re “what do you think are the factors that will enable the US to avoid a recession next year?” and “If they do go into recession, what are the factors that will keep the downturn from being deep and nasty?” To start with I’m going to rely on the standard textbook version of a recession here, namely two consecutive quarters of negative real GDP.

I can’t guarantee that the US economy won’t experience two negative quarters of growth next year (just like you can’t guarantee that it will). However, if had to bet one way or the other, I’d bet against a recession in 2007. I reckon the chances of the US economy experiencing a prolonged “deep and nasty” recession (e.g. real GDP sustains a fall of more than 5% over a period exceeding 12 months) are slim.

These are some factors that support a flat to positive outlook for the US economy in 2007.

- Unemployment continues to fall, now down to 4.7% with 249,000 new jobs created in the last two months. Nothing supports spending better than a job.

- Signs of a slowing economy would be met with a cut in interest rates by the Federal Reserve. Core inflation (the Fed’s preferred measure) is still under 3%, so there is room for a rate cut.

- Signs of a slowing US economy will likely cause energy prices to fall, freeing up funds for consumption. Consider it a form of natural hedge.

Hope For The Best, Prepare For The Worst

Gareth Eastwood, I don't see how lowering interest rates again will save the hugely endebted American consumer in the long term. It is possible that the looming correction will mirror the Japanese experience of the last fifteen years. There must come a point where low interest rates cannot lure consumers to take on any more debt. Zero interest was not low enough to entice the Japanese to resume spending.

There is some doubt that inflationary pressures are under control. The large increases in energy and commodity prices over the last few years are likely to feed into consumer prices. Any fall in the relative value of the USD required to rebalance the trade account will have a major inflationary impact too.

Given that much of the US employment growth in recent years has come from the construction, real estate sales and financial services sectors, a collapse in the housing market is likely to have a significant negative effect on overall employment.

As for energy prices, I think you are right that a recession in the US will see prices fall with demand. By the same argument, I would suggest that there will be a natural brake on any recovery from recession. If we are anywhere near peak oil production now, the capacity to ramp up production when demand picks up will be compromised and prices could really soar as a consequence.

Anyway, I hope I am wrong. My retirement will be much easier if the financial system does not melt down any time soon. History would suggest, however, that monumental credit explosions like the one we have seen since the late 1990s will end in tears for those who are not prepared.

Private money

Rob Wearne, how far would you like to see ‘free market money’ go? Would you do away with the RBA for example? If so, how would you prevent money producers from profiting from “printing money?”

Regarding backing a currency with gold, doesn’t this transfer monetary policy to gold producers? This gives gold producers an incentive to inflate (by limiting supply) the value of gold (and thus money) and cause massive deflation. How is different to your fears of massive inflation?

Economic doom

Michael Coleman, I note a few quotes from the ‘nasty and deep’ article you linked to, referring to views held by Nouriel Roubini.

While many economists share Roubini's concerns about imbalances in the global economy and in the U.S. housing sector, he stands nearly alone in predicting a recession next year.”

“Fed watcher Tim Duy called Roubini the ‘the current archetypical Eeyore,’ responding to a comment Dallas Fed President Richard Fisher made last week in referring to economic pessimists as "Eeyores," after Winnie the Pooh's grumpy friend.”

“He also sees many of the same warning signs in other economies, including some in Europe.”

There are plenty of pessimist economists going around Michael. If you get a chance, read some of Max Walsh’s work (The Bulletin’s economics editor), I think you’ll find it to your liking. In the 15 years I’ve been reading the Bulletin, I don’t think Max has written an article with a positive outlook.

Rob Wearne, are you advocating the return to some kind of gold standard?

Where's The Substance?

Hi Gareth. I note that the denunciations of Roubini's prediction of recession in 2007 came without a single factual argument to explain his error. Perhaps, you would like to have a go?

The large number of ARMs due to reset next year, combined with the downturn in the property markets, a negative savings rate, record levels of credit card debt, falling real incomes and high energy prices are all signs that consumers are in strife. Given that consumption is 70% of US GDP, what do you think are the factors that will enable the US to avoid a recession next year?

If they do go into recession, what are the factors that will keep the downturn from being deep and nasty? 

Free market money

Gareth, not necessarily the gold standard but free market money…..


Although I think that the characteristics of gold would make it one of the better instruments for this.

Too much statism?

Ian, one of the largest causes of the non-existent savings rates in the United States and Australia is exactly because of the irresponsible expansionist Keynesian policy that has been implemented by the Fed and to a lesser extent the RBA.

This expansionary monetary policy is now feeding into the commodity cycle – no its not just because of China...

Please see this prophetic (written about 50 years ago) article by one of the founders of modern Austrian theory.

The Virtues and Alleged Shortcomings of the Gold Standard

"First of all there is need to remember that the gold standard did not collapse. Governments abolished it in order to pave the way for inflation. The whole grim apparatus of oppression and coercion.”

by Ludwig von Mises

The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit's purchasing power independent of the policies of governments and political parties. Furthermore, it prevents rulers from eluding the financial and budgetary prerogatives of the representative assemblies. Parliamentary control of finances works only if the government is not in a position to provide for unauthorized expenditures by increasing the circulating amount of fiat money. Viewed in this light, the gold standard appears as an indispensable implement of the body of constitutional guarantees that make the system of representative government function.

When in the 'fifties of the nineteenth century gold production increased considerably in California and Australia, people attacked the gold standard as inflationary. In those days Michel Chevalier, in his book Probable Depreciation of Gold, recommended the abandonment of the gold standard, and Béranger dealt with the same subject in one of his poems. But later these criticisms subsided. The gold standard was no longer denounced as inflationary but on the contrary as deflationary. Even the most fanatical champions of inflation like to disguise their true intentions by declaring that they merely want to offset the contractionist pressure which the allegedly insufficient supply of gold tends to produce.

Yet it is clear that over the last generations there has prevailed a tendency of all commodity prices and wage rates to rise. We may neglect dealing with the economic effects of a general tendency of money prices and money wages to drop.[3] For there is no doubt that what we have experienced over the last hundred years was just the opposite, namely, a secular tendency toward a drop in the monetary unit's purchasing power, which was only temporarily interrupted by the aftermath of the breakdown of a boom intentionally created by credit expansion. Gold became cheaper in terms of commodities, not dearer. What the foes of the gold standard are asking for is not to reverse a prevailing tendency in the determination of prices, but to intensify very considerably the already prevailing upward trend of prices and wages. They simply want to lower the monetary unit's purchasing power at an accelerated pace.

Such a policy of radical inflationism is, of course, extremely popular. But its popularity is to a great extent due to a misapprehension of its effects. What people are really asking for is a rise in the prices of those commodities and services they are selling while the prices of those commodities and services which they are buying remain unchanged. The potato grower aims at higher prices for potatoes. He does not long for a rise in other prices. He is injured if these other prices rise sooner or in greater proportion than the price of potatoes. If a politician addressing a meeting declares that the government should adopt a policy which makes prices rise, his hearers are likely to applaud. Yet each of them is thinking of a different price rise.

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments."

From time immemorial inflation has been recommended as a means to alleviate the burdens of poor worthy debtors at the expense of rich harsh creditors. However, under capitalism the typical debtors are not the poor but the well-to-do owners of real estate, of firms, and of common stock, people who have borrowed from banks, savings banks, insurance companies, and bondholders. The typical creditors are not the rich but people of modest means who own bonds and savings accounts or have taken out insurance policies. If the common man supports anti-creditor measures, he does it because he ignores the fact that he himself is a creditor. The idea that millionaires are the victims of an easy-money policy is an atavistic remnant.

For the naive mind there is something miraculous in the issuance of fiat money. A magic word spoken by the government creates out of nothing a thing which can be exchanged against any merchandise a man would like to get. How pale is the art of sorcerers, witches, and conjurors when compared with that of the government's Treasury Department! The government, professors tell us, "can raise all the money it needs by printing it." Taxes for revenue, announced a chairman of the Federal Reserve Bank of New York, are "obsolete." How wonderful! And how malicious and misanthropic are those stubborn supporters of outdated economic orthodoxy who ask governments to balance their budgets by covering all expenditures out of tax revenue!

These enthusiasts do not see that the working of inflation is conditioned by the ignorance of the public and that inflation ceases to work as soon as the many become aware of its effects upon the monetary unit's purchasing power. In normal times, that is in periods in which the government does not tamper with the monetary standard, people do not bother about monetary problems. Quite naively they take it for granted that the monetary unit's purchasing power is "stable." They pay attention to changes occurring in the money prices of the various commodities. They know very well that the exchange ratios between different commodities vary. But they are not conscious of the fact that the exchange ratio between money on the one side and all commodities and services on the other side is variable too. When the inevitable consequences of inflation appear and prices soar, they think that commodities are becoming dearer and fail to see that money is getting cheaper. In the early stages of an inflation only a few people discern what is going on, manage their business affairs in accordance with this insight, and deliberately aim at reaping inflation gains. The overwhelming majority are too dull to grasp a correct interpretation of the situation. They go on in the routine they acquired in non-inflationary periods. Filled with indignation, they attack those who are quicker to apprehend the real causes of the agitation of the market as "profiteers" and lay the blame for their own plight on them. This ignorance of the public is the indispensable basis of the inflationary policy. Inflation works as long as the housewife thinks: "I need a new frying pan badly. But prices are too high today; I shall wait until they drop again." It comes to an abrupt end when people discover that the inflation will continue, that it causes the rise in prices, and that therefore prices will skyrocket infinitely. The critical stage begins when the housewife thinks: "I don't need a new frying pan today; I may need one in a year or two. But I'll buy it today because it will be much more expensive later." Then the catastrophic end of the inflation is close. In its last stage the housewife thinks: "I don't need another table; I shall never need one. But it's wiser to buy a table than keep these scraps of paper that the government calls money, one minute longer."

Let us leave the problem of whether or not it is advisable to base a system of government finance upon the intentional deception of the immense majority of the citizenry. It is enough to stress the point that such a policy of deceit is self-defeating. Here the famous dictum of Lincoln holds true: You can't fool all of the people all of the time. Eventually the masses come to understand the schemes of their rulers. Then the cleverly concocted plans of inflation collapse. Whatever compliant government economists may have said, inflationism is not a monetary policy that can be considered as an alternative to a sound-money policy. It is at best a temporary expedient. The main problem of an inflationary policy is how to stop it before the masses have seen through their rulers' artifices. It is a display of considerable naivete to recommend openly a monetary system that can work only if its essential features are ignored by the public.

"The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit's purchasing power independent of the policies of governments and political parties."

The index-number method is a very crude and imperfect means of "measuring" changes occurring in the monetary unit's purchasing power. As there are in the field of social affairs no constant relations between magnitudes, no measurement is possible and economics can never become quantitative. But the index-number method, notwithstanding its inadequacy, plays an important role in the process which in the course of an inflationary movement makes the people inflation-conscious. Once the use of index numbers becomes common, the government is forced to slow down the pace of the inflation and to make the people believe that the inflationary policy is merely a temporary expedient for the duration of a passing emergency, one that will be stopped before long. While government economists still praise the superiority of inflation as a lasting scheme of monetary management, governments are compelled to exercise restraint in its application.

It is permissible to call a policy of intentional inflation dishonest as the effects sought by its application can be attained only if the government succeeds in deceiving the greater part of the people about the consequences of its policy. Many of the champions of interventionist policies will not scruple greatly about such cheating; in their eyes what the government does can never be wrong. But their lofty moral indifference is at a loss to oppose an objection to the economist's argument against inflation. In the economist's eyes the main issue is not that inflation is morally reprehensible but that it cannot work except when resorted to with great restraint and even then only for a limited period. Hence resort to inflation cannot be considered seriously as an alternative to a permanent standard such as the gold standard is.

The pro-inflationist propaganda emphasizes nowadays the alleged fact that the gold standard collapsed and that it will never be tried again: nations are no longer willing to comply with the rules of the gold-standard game and to bear all the costs which the preservation of the gold standard requires.

First of all there is need to remember that the gold standard did not collapse. Governments abolished it in order to pave the way for inflation. The whole grim apparatus of oppression and coercion - policemen, customs guards, penal courts, prisons, in some countries even executioners - had to be put into action in order to destroy the gold standard. Solemn pledges were broken, retroactive laws were promulgated, provisions of constitutions and bills of rights were openly defied. And hosts of servile writers praised what the governments had done and hailed the dawn of the fiat-money millennium.

The most remarkable thing about this allegedly new monetary policy, however, is its complete failure. True, it substituted fiat money in the domestic markets for sound money and favored the material interests of some individuals and groups of individuals at the expense of others. It furthermore contributed considerably to the disintegration of the international division of labor. But it did not succeed in eliminating gold from its position as the international or world standard. If you glance at the financial page of any newspaper you discover at once that gold is still the world's money and not the variegated products of the diverse government printing offices. These scraps of paper are the more appreciated the more stable their price is in terms of an ounce of gold. Whoever today dares to hint at the possibility that nations may return to a domestic gold standard is cried down as a lunatic. This terrorism may still go on for some time. But the position of gold as the world's standard is impregnable. The policy of "going off the gold standard" did not relieve a country's monetary authorities from the necessity of taking into account the monetary unit's price in terms of gold.

"What people are really asking for is a rise in the prices of those commodities and services they are selling while the prices of those commodities and services which they are buying remain unchanged."

What those authors who speak about the rules of the gold-standard game have in mind is not clear. Of course, it is obvious that the gold standard cannot function satisfactorily if to buy or to sell or to hold gold is illegal, and hosts of judges, constables, and informers are busily enforcing the law. But the gold standard is not a game; it is a market phenomenon and as such a social institution. Its preservation does not depend on the observation of some specific rules. It requires nothing else than that the government abstain from deliberately sabotaging it. To refer to this condition as a rule of an alleged game is no more reasonable than to declare that the preservation of Paul's life depends on compliance with the rules of the Paul's-life game because Paul must die if somebody stabs him to death.

What all the enemies of the gold standard spurn as its main vice is precisely the same thing that in the eyes of the advocates of the gold standard is its main virtue, namely, its incompatibility with a policy of credit expansion. The nucleus of all the effusions of the anti-gold authors and politicians is the expansionist fallacy.

The expansionist doctrine does not realize that interest, that is, the discount of future goods as against present goods, is an originary category of human valuation, actual in any kind of human action and independent of any social institutions. The expansionists do not grasp the fact that there never were and there never can be human beings who attach to an apple available in a year or in a hundred years the same value they attach to an apple available now. In their opinion interest is an impediment to the expansion of production and consequently to human welfare that unjustified institutions have created in order to favor the selfish concerns of money lenders. Interest, they say, is the price people must pay for borrowing. Its height therefore depends on the magnitude of the supply of money. If laws did not artificially restrict the creation of additional money, the rate of interest would drop, ultimately even to zero. The "contractionist" pressure would disappear, there would no longer be a shortage of capital, and it would become possible to execute many business projects which the "restrictionism" of the gold standard obstructs. What is needed to make everyone prosperous is simply to defy "the rules of the gold-standard game," the observance of which is the main source of all our economic ills.

These absurd doctrines greatly impressed ignorant politicians and demagogues when they were blended with nationalist slogans. What prevents our country from fully enjoying the advantages of a low-interest-rate policy, says the economic isolationist, is its adherence to the gold standard. Our central bank is forced to keep its rate of discount at a height that corresponds to conditions on the international money market and to the discount rates of foreign central banks. Otherwise "speculators" would withdraw funds from our country for short-term investment abroad and the resulting outflow of gold would make the gold reserves of our central bank drop below the legal ratio. If our central bank were not obliged to redeem its banknotes in gold, no such withdrawal of gold could occur and there would be no necessity for it to adjust the height of the money rate to the situation of the international money market, dominated by the world-embracing gold monopoly.

The most amazing fact about this argument is that it was raised precisely in debtor countries for which the operation of the international money and capital market meant an inflow of foreign funds and consequently the appearance of a tendency toward a drop in interest rates. It was popular in Germany and still more in Austria in the 1870s and 80s, but it was hardly ever seriously mentioned in those years in England or in the Netherlands, whose banks and bankers lent amply to Germany and Austria. It was advanced in England only after World War I, when Great Britain's position as the world's banking center had been lost.

Of course, the argument itself is untenable. The inevitable eventual failure of any attempt at credit expansion is not caused by the international intertwinement of the lending business. It is the outcome of the fact that it is impossible to substitute fiat money and a bank's circulation credit for non-existing capital goods. Credit expansion initially can produce a boom. But such a boom is bound to end in a slump, in a depression. What bring about the recurrence of periods of economic crises are precisely the reiterated attempts of governments and banks supervised by them to expand credit in order to make business good by cheap interest rates.

Ludwig von Mises (1881-1973) was dean of the Austrian School. This article was excerpted from Chapter 21 of The Theory of Money and Credit.

Send out the search party

Michael Coleman, I am sure that if things were as bad as you suggest, Mr Costello would be warning us. In any case, if the Australian banks should run short of people willing to lend them money to lend to Australians to finance the current levels of expenditure on imports, shares, real estate etc, a significant number of us would be able to relocate to that country so despised by 'economic rationalists': Sweden. Sweden's current account when I last looked was heavily into the black, and its economic outlook is not bad at all. Not surprising, as they sell a lot of Volvos, Husqvarnas, Ikeas, Saabs etc in the US and Australia, despite the tyranny of distance.

Perhaps Howard and Bush should send out a search party for JM Keynes. He may be needed soon.

Not Bloody Likely

The die is cast, IMHO. I can't see anyone being able to do anything significant to prevent the consequences of rampant, global, monetary inflation, the unprecedented boom in real estate prices and consumption financed by record levels of debt.

The US is facing a perfect storm of nightmare mortgages, a housing market collapse and declining real incomes at its worst in the manufacturing states. Consequently, the recession will be nasty and deep.

As the saying goes, when the US economy sneezes, the whole world catches cold. Alas, the US economy isn't just going to sneeze. It has a nasty anuerism and is headed for a stroke.

Social Just-us

Making the money is economic growth but selling without making enough to buy back is one of the seven stupidities of the new world order.

Social justice is a-coming down the glorious road of salvation on a trajectory course that is unparalleled in the history of the world. Mexican, you do not have to run north of the border anymore. Whenever there is no wealth building in this nation or any other nations, there is nothing to spread around freely.

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