My Speech at the Symposium of the Banque de France
Speech of Nouriel Roubini at the Symposium of the Banque de France on March 4th 2011
I think that this is a very important conference, especially because, as we know, this year is the G20 presidency of France; and France has put on the table the important question of how to reform the international monetary system (IMS). The topics we are discussing today including the issue of global imbalances are essential.
If you think about these questions at the center of the debate on the reform of the IMS, we have many to address. First, we have a problem of large global current account imbalances in general; and as I will discuss, in particular the asymmetry of adjustment between surplus and deficit countries when we consider these imbalances. How can we resolve this asymmetry?
Second, there is a problem of how to satisfy the demand for liquidity especially by emerging market economies that worry about liquidity risk and maturity mismatches. As we have seen that during the recent crises foreign reserves seem to never be enough when liquidity runs do occur, which raises the question of how to deal with this massive demand for self-insurance by emerging markets.
Third, we also have these imbalances because advanced economies have a system of floating exchange rates while emerging market economies fear excessive exchange rate flexibility and resist it via their intervention policies. How can we change the system in a direction of greater exchange rate flexibility for both advanced and emerging market economies, a flexibility that can contribute to the reduction of these global imbalances?
Fourth, there is the “Inconsistent Trinity” problem: emerging market economies are intervening aggressively to prevent their currencies from appreciating; this implies that they risk losing monetary and credit independence; they are therefore now resorting increasingly to capital controls as a way to deal with the inconsistent trinity between fixed exchange rates, monetary independence and capital mobility. So, as they go in the direction of capital controls, how can we have rules or principles about managing capital flows better in a world in which we want to go towards greater globalization of capital?
Fifth, how can we move in a world in which the dominant role of the US Dollar as a major reserve currency could change over time? This is becoming an issue in the vein of the famous and traditional “Triffin Dilemma”: a country whose currency represents the global reserve currency will undermine this special status once it has run current account deficits for too long. I think this is a fundamental issue in terms of the global imbalances.
And sixth, I think it is also important to think about questions related to a restructuring of unsustainable debts including ideas like the one of Kenneth Rogoff of converting debt into equity as a way of dealing with the issues of excessive leverage. Indeed, the problems of the global economy are not just problems of excessive amounts of debt and leverage in the private and public sector but also of illiquidity. Eventually if these issues are not just of illiquidity but also of insolvency, debt reductions, debt restructuring or conversion of debt into equity have to be a part of the solution.
So these are the important key issues that we have to think about. This session is about which imbalances that still exist after the crisis and that are very relevant for thinking about how to reform the international monetary system. But probably the starting point for the discussion should be the imbalances that led to the crisis in the first place.
Hence I will start with the problem of global current account imbalances because I think that one of the fundamental problems in the international monetary system. This is not just the issue of the US Dollar’s status as the main reserve currency; it is, more importantly, the problem of asymmetry of adjustment that exists between countries that are running current account deficits towards those who are running surpluses.
This has been a fundamental problem for a long time. It led to tensions in the 1930’s and was not really resolved when the Bretton Woods system was instituted after the Second World War. It manifested itself again in the last decade with these global imbalances. An important caveat is the following one: traditionally the asymmetry argument has been that if you are running a current account deficit eventually that is going to become unsustainable because either the bond market vigilantes are going to wake up or you are going to run out of foreign reserves; thus, eventually a currency and a financial crisis occurs that force adjustment and reduction of such deficits. For a surplus country, however, there is an asymmetry as there is not the same kind of pressure by the markets to adjust because you can always intervene for a long time, accumulate reserves and thus prevent your currency from appreciating; you can thus maintain your current account surplus for a very long period of time. But there is one important caveat: if there is a country that has “exorbitant privilege” in the sense that its currency has the status of a major reserve currency – and in the case of the current financial system this is the United States with the Dollar – then by being able to print its own currency this country can run deficits for much longer than otherwise; so it is not forced to adjust. So the argument that markets force adjustments of countries with a current account deficit has an exception in the case of a country that provides the major reserve currency. As a consequence, the deficits of this country can last for much longer than otherwise.
Now if we think about the causes of this very severe financial crisis over the last few years and if I were to characterize the global economy I would say that on one side we had a bunch of countries – starting with the United States – that were the consumers of first and last resort, spending more than their income and running ever larger current account deficits for a long period of time. Usually we emphasize the role of the United States in this context, but let us not forget that there were many other countries that were in the same situation: the United Kingdom, Spain, Ireland, Iceland, some of the Baltic States, some of the countries in central Europe and even some other countries like Australia and New Zealand. Common to all these countries was a housing bubble and/or a credit bubble; this bubble was driven by easy monetary policy, a loose supervision and regulation of the financial system, excessive leverage and risk taking. That bubble led to an increase in wealth especially housing wealth; and even though part of the increase in wealth was fake as was driven by a bubble that eventually burst, it led – via wealth effect and home equity withdrawal – to a sharp increase in private consumption and a reduction in savings rates. Thus, the boom in residential investment implied that as private savings were falling while residential investment was rising, a large current account deficit emerged. Hence, these current account deficits were associated with a large accumulation of debt mostly private debt of the household sector, of the financial system and even of parts of the corporate sector. Of course since some of this wealth was fake – wealth driven by an asset bubble – this accumulation of debt and investment in relatively unproductive forms of capital like housing capital eventually was going to become a problem.
Now, on the other side of the world of course you had the producers of first and last resort. These were the countries that were spending less than their income and were running ever larger current account surpluses. These were China, emerging Asia and a number of other emerging market economies but also, among the advanced economies, countries like Japan and Germany. All these countries were having high savings rates for a number of reasons – including probably demographics in the case of China, Japan and Germany – and these high savings rates were behind the large current account surpluses.
Now the problem was of course the fact that the surplus countries were willing and able to finance the deficit countries which enabled those countries which were running current account deficits to keep this unstable equilibrium based on rising leverage continue for a long time. The deficit countries could borrow cheaply starting with the United States but not just the US; even the deficit countries in the periphery of the Euro-zone benefited from that ability to cheaply finance large external deficits.
So these were the global imbalances; and while people were referring mostly to the imbalance between the US and China or between the US and other emerging market economies, similar kind of current account imbalances existed even within the Euro-zone. The ECB and the Europeans attempted to dismiss the importance of these imbalances within the Euro-zone by saying that the global imbalances were between the US, Asia and China because the Euro-zone overall did not have a current account deficit; it was rather in a balance. However, the overall balance within the Euro-zone was hiding the fact that Germany and part of the core was running surpluses while most of the periphery was running large external deficits. And these imbalances eventually became a source of severe financial distress even for the peripheral countries of the Euro-zone.
Now this happy party of debt, leverage and imbalances lasted for almost a decade but eventually the accumulation of unproductive forms of capital, housing capital and accumulation of debt in the private sector became unsustainable. The sub-prime crisis and the housing bust in the US and other countries led to a financial crisis which had elements both of excessive debt and insolvency but also elements of illiquidity because of maturity mismatches of households and financial institutions. So once the crisis emerged you had and balance sheet imbalances became unsustainable you had a collapse of private demand in most advanced economies that led a global recession. Many deficit countries experienced not only a credit bust and a credit crunch; but there were also severe issues of illiquidity for banks, households and eventually even governments.
As a consequence, we experienced the Great Recession and of course at some point after the collapse of Lehman this Great Recession even led to the risk of another Great Depression.
The global policy response tried to prevent this great recession from becoming something much worse. So what was the policy response? First, it was monetary stimulus in the form of traditional reductions of interest rates all the way down to zero, the provision of liquidity to countries and or agents in the economy that are presumed to be illiquid rather than insolvent; so we had both domestic and international lender of last resort support and we also had unconventional monetary policy in the various forms of quantitative or credit easing policies.
On the fiscal side we also tried to prevent a collapse of economic activity by (1) allowing automatic stabilizers to kick in (2) perform Keynesian policies to try to stimulate demand by increasing spending and cutting taxes; and (3) we also socialized some of the private losses through a variety of policies of backstopping of the financial system and/or of the household sector; call them “bailout” policies. But the result of these policy reactions especially on the fiscal side was a very sharp rise in public debts and deficits primarily in advanced economies. This occurred as a result of partially automatic stabilizers, fiscal responses and the socialization of losses of the financial system in countries like the US, UK, Ireland, Iceland, Spain and many other countries.
For a while, the policy stimulus on the monetary and fiscal side compensated for the collapse of private demand that occurred in both deficit and surplus countries; indeed, even the surplus countries went into a recession given the collapse of demand in the deficit countries and their net export source of growth. So you had a recession even in Germany, Japan, East Asia or a near recession as in China. But after a while we had two types of problems (1) the recovery of private demand remained anaemic in many of the deficit and leveraged countries because of the burden of large private debt and the need for their deleveraging via lower spending and higher savings; and (2) the bond market vigilantes now imposed fiscal adjustment and discipline starting with the Euro-zone, the United Kingdom and other countries. So, in many cases you could not keep on boosting demand on the domestic side via the fiscal channel as both private and public sector deleveraging has to start to occur. Thus, we saw the anemic, sub-par, below trend U-shaped recovery of many advanced economies suffering of balance sheet problems.
So what is the balanced solution that we need to return to sustained growth in a world where there are these debt and global imbalances? It is clear that deficit countries are going to have a painful process of private and public sector deleveraging and therefore they are going to have weak domestic demand. Thus, these countries need a nominal and real depreciation of their currencies to reduce their trade deficit and thus restore their growth towards it potential rate. But if that process of nominal and real depreciation in the deficit countries occurs and thus the surplus countries need to experience a nominal and real appreciation of their currencies then in order for these surplus countries to maintain their own economic growth close to potential they need to switch away from a model based mostly on export led growth. Thus, they have to reduce their savings and increase domestic spending, especially on consumption, in order to maintain their economic growth close to potential. So that is the adjustment that is necessary in the surplus and the deficit countries to return to potential growth.
The trouble – and obstacle to this orderly adjustment – is that in most of the surplus countries either for political reasons or for structural ones the ability and willingness to reduce savings and increase consumption is limited. Thus, these surplus countries can, at least for a while, resist the nominal appreciation of their currencies via aggressive forex intervention; look for instance at what is happening in China and other emerging markets. Moreover, for a while these surplus countries can even resist a real appreciation of their currency if they do sterilized interventions – that prevent monetary growth and thus prevent a rise in inflation; and if they impose capital controls they can resist even longer this nominal and real appreciation. Indeed, at least for a while you can resist a real appreciation by preventing inflation from rising via policies that partially mop up the liquidity caused by the forex intervention.
However, think about the fundamental problem: the deficit countries need a nominal and real depreciation which the surplus countries successfully can prevent for quite a while. So if surplus countries can prevent the nominal and real appreciation of their currencies, then the only way in which the necessary real depreciation of the deficit countries can occur is through deflation in such deficit countries.
But we know that deflation is destructive because it leads then to significant increases in the real value of private and public deb. So you have a process of debt deflation and that is exactly the risk that the periphery of the Euro-zone may experience over time. Since the exchange rate tool is not available to individual Euro-zone countries the necessary real depreciation occurs via destructive deflation that increases the real burden of private and public debts and ensures that such countries remain in a stagnation or recession trap. Now the United States had tried to avoid this risk of deflation as an adjustment channel for its real depreciation by doing monetary easing, in particular quantitative easing I and II. So this was the response of the United States: an attempt to trigger a weakening of the US to avoid deflation and to achieve the needed depreciation. But, for a while China and many other emerging market economies have resisted this dollar weakening through the forex policies. So this currency tension is the source of the risk of currency wars and, eventually possibly, trade wars.
In the case of the Euro-zone you have a bigger problem because, by having one common currency, you cannot have this independent nominal depreciation of the peripheral countries that have a deficit when the surplus countries (Germany) can live with and enjoy a stronger euro. Therefore the relative price adjustment between the core of Europe that is running surpluses and the periphery that is running deficits has to occur through a painful process of deflation in the periphery countries that eventually changes relative prices. The question is: can that deflationary process be associated with restoration of economic growth in the periphery? My worry is that it is not the case. You might – as in Argentina in the late 1990s – have a nasty debt deflation in the periphery that will maintain stagnation and recession and that, eventually, is going to lead to disorderly defaults and debt restructurings.
In the case of emerging market economies that have been resisting their own real appreciation, at least for a while, through sterilized interventions, eventually this intervention is only partially sterilized. The combination of the US implementing quantitative easing I and II, China effectively pegging to the US Dollar, and other emerging market economies also aggressively intervening because they do not want to lose global market shares to China, this becomes a process that eventually leads in these economies to overheating, goods inflation, credit and asset bubbles and even commodity inflation. So this is one of the risks we are facing right now; the risk of a rise in inflation in many emerging markets.
But let us think about how we can resolve these unsustainable debt problems. We started with private debt, we pretended this high private debt was only a situation of illiquidity even when in cases of clear insolvency. Therefore we socialized some of these private losses and we ended up with a large stock of public debt. And now we have a public debt problem in a number of countries that eventually lost market access. Then, we have tried to deal with this public debt problem in the Euro-zone by essentially having super-national authorities – the IMF, EFSF, EFSM, ECB – bailing out the country that is distressed, first Greece, then Ireland, soon enough Portugal, and maybe eventually even Spain.
But if you think about it, kicking the can down the road, going from private debt to public debt to super-national debt, is not a solution because if the problems are of insolvency, rather than illiquidity, no one is going to come from the moon or Mars to bailout the IMF or the EFSF or the ECB. So at some point you have to resolve otherwise these debt problems.
Let us think briefly: how can you resolve these debt problems? One solution of course is high growth because growth can heal most wounds, especially debt wounds. The problem is that in most of the advanced economies growth is going to be anaemic for the next few years because of the painful process of private and public sector deleveraging. So high growth is not going to resolve the debt problem.
The other solution is to say consume and spend less in the private and public sector, save more and thus reduce debts over time. That is a good idea but it leads – as we know – to the paradox of thrift. If people suddenly start to consume too little and save too much the economy is going to double dip and then the debt to income ratio is going to rise because output is falling; and thus the debt becomes again unsustainable. The paradox of thrift holds both for households and governments: in the public sector excessive front loaded fiscal austerity – however necessary may be in the medium term to avoid a fiscal train wreck – might lead to another recession and thus undermine the debt stabilization process. So the paradox of thrift is a constraint to how much you can resolve your problems by saving more.
One solution could be inflation but of course this is taboo for central banks. You could reduce debt deflation through inflation but inflation has its own consequences. Once inflation expectations are out of the genie bottle pushing them back into the bottle is going to be very hard and painful. Inflation could lead to a collapse of the Dollar if the creditors of the US resist the attempt to wipe out the real value of their dollar holdings that inflation entails. So high inflation, however appealing theoretically may be, is not a sensible solution to debt problems. Therefore if growth is not going to resolve the debt problem, if saving more and consuming less is going to lead to the paradox of thrift and inflation is a bad idea as it is a capital levy, the only other solution at the end of the day is debt restructuring, debt reduction or even debt conversion into equity. We have to do it for insolvent sovereigns, we have to do it for insolvent banks and financial institutions as well as for households and for countries that are in clear conditions of insolvency.
In many cases the problems we are facing are not just of illiquidity but also of insolvency. Thus, unless we focus more on these problems, destructive debt deflation and eventually disorderly defaults are going to occur. So I would certainly want to put on the table of discussion of the reform of the international monetary system the question of orderly debt restructuring when necessary and unavoidable.
One Response to “My Speech at the Symposium of the Banque de France”
THE CANS, THE KICKING, AND THE ROADSThis, and your posting of “Honey, I Shrank the Gross National Debt” (love the play on the word “Gross”), are must reading for all interested in predicting the future of economies and markets. I hope you can get the Wall Street Journal or New York Times to print the Honey piece for a wider audience.I have a particular interest in the timing of the resolution of the imbalances between the US and China.Specifically, how long can China avoid hitting either the Scylla of inflation and the social chaois it is now causting or the Charybdis of revaluation and the lowered employment and social chaos that would cause? In past talks, you have said that China can kick the can down the road till 2013, leaving the US with two more years of contractionary pressures on its economy. I question whether this timeframe gives too much credit to the Communist Part for perfection in steering between the two risks, and too little attention to the risk of a sooner US reaction via trade policy to escape from the contractionary pressures.I would appreciate a deep analysis of the assumptions behind the timing you visualize for the correction in this imbalance.Similarly, I would enjoy more detailed analysis of the timing of corrections within the Eurozone, given the politics in Germany and Greece and Portugal (and Ireland and Iceland).My own bet is that the US has more “road” to kick the can down than anyone else (at least for this bubble cycle, if not the next), and that we will see a flight to the safety of Treasuries as others “run out of road” first…Anyone else think differently?