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A World Unprepared, Again, for Rising Interest Rates A World Unprepared, Again, for Rising Interest Rates
(about 2 hours later)
MEXICO CITY — I was living in São Paulo in 1997 when, out of the blue, an investment banker I knew in London called to ask about Brazilian cocktails. He didn’t want one. He needed a name for a potential economic crisis, in the vein of Mexico’s Tequila affair in 1994 and Thailand’s Tom Yum Kung debacle, which was unfolding at the time.MEXICO CITY — I was living in São Paulo in 1997 when, out of the blue, an investment banker I knew in London called to ask about Brazilian cocktails. He didn’t want one. He needed a name for a potential economic crisis, in the vein of Mexico’s Tequila affair in 1994 and Thailand’s Tom Yum Kung debacle, which was unfolding at the time.
As unlikely as it seemed to most Brazilians then, the crisis did arrive. A default by the Russian government in 1998 set off a run on Brazilian bonds, as investors rushed to pare their holdings in emerging markets by selling the most liquid among them.As unlikely as it seemed to most Brazilians then, the crisis did arrive. A default by the Russian government in 1998 set off a run on Brazilian bonds, as investors rushed to pare their holdings in emerging markets by selling the most liquid among them.
Suffering from large trade and budget deficits and a shrinking stock of foreign reserves, Brazil was forced a few months later to sever the real’s link to the dollar and let it sink.Suffering from large trade and budget deficits and a shrinking stock of foreign reserves, Brazil was forced a few months later to sever the real’s link to the dollar and let it sink.
That’s when it dawned on me that we weren’t living in my parent’s economy anymore.That’s when it dawned on me that we weren’t living in my parent’s economy anymore.
The stable American economic order lasted more than three decades from the end of World War II, when economic cycles were essentially driven by the Fed’s raising and lowering of interest rates to combat inflation. It started to crumble with the severing of the link between gold and the dollar and the twin oil crises of the 1970s. That ushered in an era of footloose capital, unshackled by three decades of increasing deregulation, that led to the global tides that, for better and worse, now drive economic ups and downs. The stable American economic order lasted more than three decades from the end of World War II, when economic cycles were essentially driven by the Federal Reserve’s raising and lowering of interest rates to combat inflation. It started to crumble with the severing of the link between gold and the dollar and the twin oil crises of the 1970s. That ushered in an era of footloose capital, unshackled by three decades of increasing deregulation, that led to the global tides that, for better and worse, now drive economic ups and downs.
That Brazilian morning 17 years ago has come to mind again as the Federal Reserve has started gradually reducing the amount of money it pumps into the economy. The move could hardly have been a surprise, because the Fed announced as early as last spring that it would begin doing so by the end of 2013. That Brazilian morning 17 years ago has come to mind again as the Fed has started gradually reducing the amount of money it pumps into the economy. The move could hardly have been a surprise, because the Fed announced as early as last spring that it would begin doing so by the end of 2013.
If anything, the Fed’s action has had an easing effect on domestic interest rates. While higher than in the spring, yields on Treasury bonds were lower last Friday than they were a month before.If anything, the Fed’s action has had an easing effect on domestic interest rates. While higher than in the spring, yields on Treasury bonds were lower last Friday than they were a month before.
And yet around the world, financial markets have swooned as if struck by lightning.And yet around the world, financial markets have swooned as if struck by lightning.
The reasoning behind investors’ abrupt change of heart makes a certain sense. China’s economic slowdown will blunt the exports of commodity producers, weakening their trade balances. Macroeconomic management in many developing countries has been poor. Budget and trade deficits in some are way too high.The reasoning behind investors’ abrupt change of heart makes a certain sense. China’s economic slowdown will blunt the exports of commodity producers, weakening their trade balances. Macroeconomic management in many developing countries has been poor. Budget and trade deficits in some are way too high.
Still, there is a deeper dynamic at play. The pullout of capital from developing countries around the world has an eerie resemblance to the seemingly unlikely financial wave that emerged from Asia, crossed through Russia and Eastern Europe and ended up walloping Brazil.Still, there is a deeper dynamic at play. The pullout of capital from developing countries around the world has an eerie resemblance to the seemingly unlikely financial wave that emerged from Asia, crossed through Russia and Eastern Europe and ended up walloping Brazil.
That’s hardly the only precedent. As Carmen M. Reinhart, a renowned international economist at Harvard’s Kennedy School, put it, capital bonanzas, inevitably followed by financial crises, are “older than the hills.”That’s hardly the only precedent. As Carmen M. Reinhart, a renowned international economist at Harvard’s Kennedy School, put it, capital bonanzas, inevitably followed by financial crises, are “older than the hills.”
Problem is, the cycles of boom and bust seem to keep getting worse. Whether the Fed continues removing monetary stimulus at the same pace or it pauses, perhaps worried by sluggish job growth, long-term interest rates eventually will rise. The world, evidently, is not prepared. And it’s even less prepared for the bigger crisis that we seem doomed to suffer after this one.Problem is, the cycles of boom and bust seem to keep getting worse. Whether the Fed continues removing monetary stimulus at the same pace or it pauses, perhaps worried by sluggish job growth, long-term interest rates eventually will rise. The world, evidently, is not prepared. And it’s even less prepared for the bigger crisis that we seem doomed to suffer after this one.
Lawrence Summers, President Obama’s former top economic adviser, recently articulated an idea that suggests booms and busts, each one bigger than the last, might be with us for a while.Lawrence Summers, President Obama’s former top economic adviser, recently articulated an idea that suggests booms and busts, each one bigger than the last, might be with us for a while.
At a speech at the International Monetary Fund last November, he said that the global economy was suffering from “secular stagnation,” persistent low growth caused by the fact that there are more savings around than profitable investments to be made.At a speech at the International Monetary Fund last November, he said that the global economy was suffering from “secular stagnation,” persistent low growth caused by the fact that there are more savings around than profitable investments to be made.
There could be several reasons, including slowing labor force growth or declining productivity. Cautious consumers and businesses burned by the crisis might be prone to save more and invest less. Income inequality might blunt consumption.There could be several reasons, including slowing labor force growth or declining productivity. Cautious consumers and businesses burned by the crisis might be prone to save more and invest less. Income inequality might blunt consumption.
Regardless of the cause, a persistent savings glut would make bubbles much more likely. “In an era of secular stagnation, when equilibrium interest rates are low, there will be more financial stability problems,” Mr. Summers told me.Regardless of the cause, a persistent savings glut would make bubbles much more likely. “In an era of secular stagnation, when equilibrium interest rates are low, there will be more financial stability problems,” Mr. Summers told me.
This rings a bell. Asian countries emerged from the 1990s intent on never suffering like that again. It’s debatable whether their primary motivation was to build trade surpluses or to amass financial war chests against future attacks. The fact is they bulked up on savings, held back on consumption and investment, and amassed huge caches of foreign reserves.This rings a bell. Asian countries emerged from the 1990s intent on never suffering like that again. It’s debatable whether their primary motivation was to build trade surpluses or to amass financial war chests against future attacks. The fact is they bulked up on savings, held back on consumption and investment, and amassed huge caches of foreign reserves.
Sunk into Treasury bonds, these reserves drove a speculative boom in the “emerging market” of the moment: American subprime mortgages.Sunk into Treasury bonds, these reserves drove a speculative boom in the “emerging market” of the moment: American subprime mortgages.
It was a wave of money that — to the confusion of Alan Greenspan, the Fed chairman at the time — the Fed seemed powerless to manage. When it did stop, as all such waves do, the housing bubble came to a cataclysmic end.It was a wave of money that — to the confusion of Alan Greenspan, the Fed chairman at the time — the Fed seemed powerless to manage. When it did stop, as all such waves do, the housing bubble came to a cataclysmic end.
Is there anything to be done about the new unstable order?Is there anything to be done about the new unstable order?
“International monetary cooperation has broken down,” said Raghuram G. Rajan, India’s central bank chief, a couple of days after he was forced to raise interest rates to keep the rupee from sinking. “Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say, ‘We’ll do what we need to and you do the adjustment.' ” “International monetary cooperation has broken down,” said Raghuram G. Rajan, India’s central bank chief, a couple of days after he was forced to raise interest rates to keep the rupee from sinking. “Industrial countries have to play a part in restoring that, and they can’t at this point wash their hands off and say, ‘We’ll do what we need to and you do the adjustment.’ ”
Andrew G. Haldane, executive director for financial stability at the Bank of England, also seemed to suggest that international cooperation was the answer. “What is going on with the head-to-head combat is people pursuing policies of individual countries,” he said. “What is at stake is the system as a whole.”Andrew G. Haldane, executive director for financial stability at the Bank of England, also seemed to suggest that international cooperation was the answer. “What is going on with the head-to-head combat is people pursuing policies of individual countries,” he said. “What is at stake is the system as a whole.”
Yet it is questionable what coordination could achieve. “It’s not reasonable to think that somehow a cooperative solution will be found where everybody adjusts the policy slightly differently and the world is much better off,” said Donald Kohn, a former vice chairman at the Fed who is now at the Brookings Institution.Yet it is questionable what coordination could achieve. “It’s not reasonable to think that somehow a cooperative solution will be found where everybody adjusts the policy slightly differently and the world is much better off,” said Donald Kohn, a former vice chairman at the Fed who is now at the Brookings Institution.
Mr. Kohn pointed out there were risks involved in committing to a coordinated course of action and then having circumstances change.Mr. Kohn pointed out there were risks involved in committing to a coordinated course of action and then having circumstances change.
What’s more, it’s not even clear what governments should do about presumed bubbles. Should they “lean against” them by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way? “The conversation tends to presume that you are going to do the leaning right,” Mr. Summers warned. “It is likely to be substantially imperfect.”What’s more, it’s not even clear what governments should do about presumed bubbles. Should they “lean against” them by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way? “The conversation tends to presume that you are going to do the leaning right,” Mr. Summers warned. “It is likely to be substantially imperfect.”
The world’s top economic authorities hold out hope that finance can be harnessed to prevent such wild lashings in the future. “Macroprudential rules” — from taxes on short-term foreign loans to countercyclical loan-to-value ceilings on mortgages — are the talk of the town.The world’s top economic authorities hold out hope that finance can be harnessed to prevent such wild lashings in the future. “Macroprudential rules” — from taxes on short-term foreign loans to countercyclical loan-to-value ceilings on mortgages — are the talk of the town.
Banking regulators have huddled periodically in Basel, Switzerland, since 2009 to hash out rules to limit the leverage of big financial institutions. The logic is that banks will make more prudent investments if they have to set aside more reserves that will raise the cost of credit, and they will be in better shape if their investments go awry.Banking regulators have huddled periodically in Basel, Switzerland, since 2009 to hash out rules to limit the leverage of big financial institutions. The logic is that banks will make more prudent investments if they have to set aside more reserves that will raise the cost of credit, and they will be in better shape if their investments go awry.
But José Angel Gurría, a three-decade veteran of Mexico’s financial crises who now heads the Organization for Economic Cooperation and Development, may have the best advice for a developing country standing in the headlights of foreign capital flows: “Reforms, reforms, reforms and more reforms and after that reforms of the reforms.” But José Ángel Gurría, a three-decade veteran of Mexico’s financial crises who now heads the Organization for Economic Cooperation and Development, may have the best advice for a developing country standing in the headlights of foreign capital flows: “Reforms, reforms, reforms and more reforms and after that reforms of the reforms.”
It’s old advice. It does nothing about curtailing fickle capital spinning on a dime. But it makes sense to go swimming with a bathing suit to avoid undue exposure when the financial tides, inevitably, recede.It’s old advice. It does nothing about curtailing fickle capital spinning on a dime. But it makes sense to go swimming with a bathing suit to avoid undue exposure when the financial tides, inevitably, recede.