- The Obama Recovery. The U.S. economy was in free fall in late 2008, whether measured by GDP statistics, the monthly jobs numbers, or inter-bank spreads. Was the end of the recession in mid-2009 attributable to policies adopted by President Obama? A full evaluation of that question to economists’ standards would require delving into the complexity of mathematical models. The public generally has a simpler standard: was the impact big enough to be visible to the naked eye? Amazingly, the answer is “yes.” Whichever of those statistics one looks at, and whether it is coincidence or not: the economic free-fall ended almost precisely the month that Obama took office, January 2009.
- Emerging markets have generally had much better economic fundamentals over the last decade than advanced economies. For example, one third of developing countries have succeeded in breaking the historical syndrome of procyclical (destabilizing) fiscal policy. For the first time, they took advantage of the boom of 2003-08 to strengthen their budget balances, which allowed a fiscal easing when the global recession hit in 2008-09.
- The 15-year cycle in EMs. Market swings that start out based firmly on fundamentals can eventually go too far. Some emerging markets like Turkey look vulnerable this year. A crash would fit the biblical pattern: seven fat years, followed by seven lean years. Here are the last three cycles of capital flows to developing countries:
- 1975-81: 7 fat years (”recycling petrodollars”)
- 1982: crash (the international debt crisis)
- 1983-1989: 7 lean years (the “Lost Decade” in Latin America)
- 1990-1996: 7 fat years (Emerging Market boom)
- 1997: crash (the East Asia crisis)
- 1997-2003: 7 lean years (currency crises spread globally)
- 2003-2011: 7 fat years (the triumph of the BRICs)
- 2012: ?
Posts Tagged ‘crash’
Emerging markets have performed amazingly well over the last seven years. They have outperformed the advanced industrialized countries in terms of economic growth, debt-to-GDP ratios, and countercyclical fiscal policy. Many now receive better assessments by rating agencies and financial markets than some of the advanced economies.
As 2012 begins, however, emerging markets may be due for a correction, triggered by a new wave of “risk off” behavior among investors. Will China experience a hard landing? Will a decline in commodity prices hit Latin America? Will the sovereign-debt woes of the European periphery spread to neighbors such as Turkey in a new “Aegean crisis”?
Engorged by large capital inflows, some emerging market countries were in an overheated state a year ago. It is unlikely that the rapid economic growth and high trade deficits that Turkey has experienced in recent years can be sustained. Likewise, high GDP growth rates in Brazil and Argentina over the same period could soon reverse, particularly if global commodity prices fall - not a remote prospect if the Chinese economy falters or global real interest rates were to rise this year. China, for its part, could land hard as its real-estate bubble deflates and the country’s banks are forced to work off their bad loans.
The World Bank has now downgraded economic forecasts for developing countries in 2012 (Global Economic Prospects, Jan.18, 2012). Brazil’s economic growth, for example, came to a halt in the third quarter of 2011 and is forecast at only 3.4 percent in 2012 …well below the rapid 2010 growth rate of 7.5 percent. Reflecting a sharp slowdown in the second half of the year in India, South Asia is coming off of a torrid six years, including 9.1 percent growth in 2010. Regional growth is projected to ease further to 5.8 percent in 2012.
But will economic slowdown turn to financial crash? Three possible lines of argument support the worry that emerging markets’ performance are fated to suffer dramatically in 2012: empirical, literary, and causal. Each line of argument is admittedly tentative.
The empirical argument is just historically based numerology: emerging-market crises seem to come in 15-year cycles. The international debt crisis surfaced in Mexico in mid-1982, and then spread to the rest of Latin America and beyond. The East Asian crisis erupted 15 years later, in Thailand in mid-1997, and then spread to the rest of the region and beyond. We are now another 15 years down the road. So is 2012 the time for the third round of emerging markets crises?
The hypothesis of regular boom-bust cycles is supported by a long-standing scholarly literature, such as the writings of Carmen Reinhart. But I would appeal to an even older source: the Old Testament - in particular, the story of Joseph, who was called upon by the Pharaoh to interpret a dream about seven fat cows followed by seven skinny cows.
Joseph prophesied that there would come seven years of plenty, with abundant harvests from an overflowing Nile, followed by seven lean years, with famine resulting from drought. His forecast turned out to be accurate. Fortunately the Pharaoh had empowered his technocratic official (Joseph) to save grain in the seven years of plenty, building up sufficient stockpiles to save the Egyptian people from starvation during the bad years. That is a valuable lesson for today’s government officials in industrialized and developing countries alike.
For emerging markets, the first phase of seven years of plentiful capital flows occurred in 1975-1981, with the recycling of petrodollars in the form of loans to developing countries. The international debt crisis that began in Mexico in 1982 was the catalyst for the seven lean years, known in Latin America as the “lost decade.” The turnaround year, 1989, was marked by the first issue of Brady bonds, which helped write down the debt overhang and put a line under the crisis.
The second cycle of seven fat years was the period of record capital flows to emerging markets in 1990-1996. Following the 1997 “sudden stop” in East Asia came seven years of capital drought. The third cycle of inflows, often identified as a “carry trade,” came in 2004-2011 and persisted even through the global financial crisis. If history repeats itself, it is now time for a third sudden stop of capital flows to emerging markets.
Are a couple of data points and a biblical parable enough to take the hypothesis of a 15-year cycle seriously? We need some sort of causal theory that could explain such periodicity to international capital flows.
Here is a possibility: 15 years is how long it takes for individual loan officers and hedge-fund traders to be promoted out of their jobs. Today’s young crop of asset pickers knows that there was a crisis in Turkey in 2001, but they did not experience it first hand. They think that perhaps this time is different.
If emerging markets crash in 2012, remember where you heard it first - in ancient Egypt.
December 31 is technically the end of the first decade of the 21st century. It is perhaps an appropriate time to review one’s predictions. It seems to me that I got some things right over the last decade. Indulge me while I review the predictions that came true, before turning to those that did not work out as well.
Stock market peak At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market” (Nov. 20, 1999). This was four months before the bubble burst in 2000. So far so good.
The Euro Also at the start of the decade, I thought the european currency was undervalued. My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000). Over the next eight years the euro in fact rose 60% in value. (But ”I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)
The big economic story of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it. A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right). I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini. A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.
What parts of the crisis did I get right?
Severity of recession After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:
”Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…” (Oct. 30, 2003. Also Dec.2003 and Nov.2004).
That seems to me precisely what has happened.
Budget deficits At the start of the decade: “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001). But of course the Administration chose the latter policy. Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible. The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.” (May 24, 2006.) Indeed.
Market underestimation of risk I was dubious of the “Great Moderation.” By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high. (May 24, 2006.) The markets were underestimating this risk:
”How can the implied volatility in options prices be so low? Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.” (Nov. 2006.) “The implicit volatilities in options prices are substantially too low, and will rise. … market estimates of risk are lower than they should be. … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies. Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.” (Jan.12, 2007. And again, May 14, 2007.)
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written. It was to go as high as 80 when the full financial crisis hit in 2008.
The carry trade “should be reversing.” (Jan.12, 2007.) Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)
International crises When asked “Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.” (March 1, 2007) I identified Hungary and other Eastern European countries as particularly vulnerable. (Jan. 2008.)
The coming financial crash The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:
”The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…” (In Responding to Crises, Cato Journal, Spring 2007.)
Housing Of the various asset markets, housing was the area where policy had most clearly gone awry. I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.” (March 26, 2007.) “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.” (April 28, 2007.)
The start of the recession “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….” By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.
Banking crisis resolution When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work. (March 23, 2009.) I felt pretty isolated. Others attacked the plan, from both left and right. They expected Tim Geithner’s stress tests to be phony. The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks. They wanted either to nationalize the banks or leave everything to the free market. As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.
The trough Financial markets stabilized in the first half of 2009. Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then. This turns out in fact to have been the case: The record shows that the recession ended that June.
Predictions gone wrong Needless to say, I got plenty wrong in the decade as well. For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came. For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022. It now seems unlikely. I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar. Yet flows into the U.S. showed that the dollar is still a safe haven. For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.
My most spectacularly wrong predictions were all in the area of politics. I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College. (This did not happen after January 2001.) I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise. (Not!) In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president. (Wrong again.)
In the coming decade, I resolve to eschew political forecasts, and stick to economics.
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