Global Interdependence: Are the U.S and Other Markets 'Sowing the Seeds' for the Next Crisis?Published: January 06, 2010 in Knowledge@Wharton
Despite renewed GDP growth and other positive signs, the U.S. isn't out of the woods, says Wharton finance professor Franklin Allen. In fact, the country could be heading into a "double dip" scenario that tips it back into a recession. That depends on how a number of factors play out in the coming months -- or even years -- not only in the U.S., but also around the world. Global interest rate policies, property markets and public deficits will all demand attention, Allen notes in a recent interview with Knowledge@Wharton.
The following is an edited transcript of the conversation.
Knowledge@Wharton: Lots of experts seem to think that the U.S. recession ended a few months ago or sometime recently. What do you think about that?
Franklin Allen: They are probably right and it did. The question is whether we are going to have a double dip [with the U.S. going] back into recession.
Knowledge@Wharton: What were the signs that we have come out of it?
Allen: GDP is growing, which is the main thing, and the financial markets are doing much better. Although there is a serious question as to how much of [the GDP growth] is due to the actions of the Fed's quantitative easing and printing of a lot of money. But that is a good sign, potentially. There are a number of other good things. Property markets seem to be stabilizing and unemployment seems to at least not be growing as fast as it was in recent months, which is a very good sign.
Knowledge@Wharton: You mentioned the risk of a "double dip." What are the factors that could drive us back into trouble?
Allen: We are in such an interdependent world that what happens in the rest of the world is going to be very important for [the U.S.]. In Asia, there is good news and bad news. The good news is they seem to be doing okay. The bad news is they are having problems with bubbles. For example, in Singapore in the third quarter, property prices went up 16%, which is a staggering amount given the state of the world economy and that Singapore's economy was quite badly affected by the financial crisis. [Observers have noted] a lot of people coming in from China and Indonesia with suitcases of cash. This is just a sign of part of the problem that we are facing.
Central banks have just gone wild in terms of the amount of credit and liquidity they are providing. This has stopped the crisis much as it did in 2003 to 2004. But it is sowing seeds for a future crisis, and that's the real worry.
Knowledge@Wharton: The Fed now seems to be winding down some of the programs it put into effect -- buying bonds and that sort of thing. Is it the right time for such a move, or too premature or too late?
Allen: My view is that they should not have done it in the first place. In essence, it's too late. But there will be an issue when it starts removing the programs and presumably, at some point, raises interest rates. That is going to [show] just how strong the financial system is. At the moment, not only are [Fed officials] effectively still supporting the system in the ways they did during the crisis, but by having such low interest rates, they are also effectively providing a huge subsidy, particularly to the banks.
One of the reasons why the banks are doing so well is that the rates they are lending at have not come down nearly as much as the short-term rates. When interest rates start going up again, it is going to cause a change, and it will be interesting to see how strong indeed the banks are.
Knowledge@Wharton: With so much support for the banks, why is it that people are still complaining that it is hard to borrow money?
Allen: There is always an issue in credit crunches of which side of the market the problems are coming from. Is it that people don't want to borrow? Or is it that people don't want to lend? Usually it's a lot of both. But there is always a group that does want to borrow, and that's the group the banks don't want to lend to because they are the ones in trouble. That's why they need to borrow and that's why we get stories that they can't borrow. I'm sure many firms want to borrow, but can't. But how many firms want to invest and borrow large amounts of money in the current climate is questionable. It is just not a good time for most firms to be borrowing and investing.
Knowledge@Wharton: Another effect of the low interest rates is that mortgage rates are extraordinarily low. They are at near record lows and have been so for months. Is the housing market a key to the U.S. recovery?
Allen: Again, this is part of the bubbles issue. The Fed put rates so low that it helped the housing market a lot, and prices have stopped going down, and in some cases have started going up. But the question is whether this is sustainable. When rates go up again, what is going to happen? That's why we might see a double dip.
Knowledge@Wharton: One of the big issues not on the front burner recently, but is lingering, is the deficit. It is enormous. How important is it to wrestle the deficit down?
Allen: The conventional view is that we need to do something about the deficit but not quite yet, maybe in a couple of years. There is some truth to that, but it is very worrying in the medium and long term. We still have all the long-term problems of the baby boom generation [including] medical expenses and Social Security. Social Security is probably curable by a few fixes. Medical expenses are going to be a big problem and are now compounded with all the problems of the recession, low tax revenues and so forth. We need to start worrying about that.
As interest rates go up, of course, it will be much more costly for the government to fund these. And because our debt is going up to levels near 100% of GDP in a fairly short time, every percent on the interest rate means another percent of GDP we have to pay out in interest.
Knowledge@Wharton: Could you briefly walk us through why a deficit matters and how it influences our lives?
Allen: It matters because future generations have to bear the burden of this debt. If you think of the real interest rate as being about 2.5% in the long run -- even if you borrow 100% of GDP, you are only paying 2.5% in real terms.
Is that such a big burden? As long as you cap it at relatively low levels, it is fine. But when you put in place spending programs and so on, they usually are not temporary. Once you start running a deficit of 5% to 10% of GDP or more, it becomes very difficult to bring that down. Within a few years, you are well over 100% of GDP, and then you start having the problem we are beginning to see in Greece -- that is, once you get to 120% or 130% of GDP, the question is, will [authorities] stabilize it and pay it down in the long run -- hopefully by growing -- so it becomes small?
It is a slippery slope. If people worry that you are inflating the deficit away, bond rates start going up. Then it becomes a burden because you have to keep borrowing more to pay the interest. Suddenly, the whole thing becomes unmanageable and people stop lending. This is what happened in many countries historically. We are, fortunately, still some way away from that.
Greece is right at the edge of this precipice. Moody's didn't downgrade it that much. S&P and Fitch did. Moody's wanted to wait and see what it would do. It's submitting a plan for cutting the deficit to the EU, but if people in the bond markets think what it is proposing is not credible, we will see a bigger spike in spreads over bonds.
Greece could well fall down this precipice in the next few months or couple of years. Then we will see how painful it is for a sovereign country to default. The UK also potentially has problems. It has a big deficit and already put tax rates up. Whether it can put them up more, we will see. But there may well be a run on the pound because of that.
Knowledge@Wharton: Dubai and Greece are not isolated cases. Are they indicators of bigger problems lurking out there?
Allen: The original problem in Dubai was a wake-up call that sovereign entities can default. After Dubai, people started looking at Greece. Spreads went back up to where they were at the beginning of 2009. Then they came down because the German finance minister said [Germany] wouldn't allow a default. I doubt now that the Greeks would be bailed out by other EU countries, in particular the Germans. So that's why it is back on the agenda.
Knowledge@Wharton: Have we seen the worst of the Dubai World story?
Allen: Someone in my class who I think is from that area said the other emirates are trying to teach Dubai a lesson. I think that's largely happening. But as long as the price of oil stays at what it is now, there is no long-term problem. There may be some problem between Dubai and Abu Dhabi and the other emirates, but there isn't a fundamental problem.
Knowledge@Wharton: It is not going to ripple across the world?
Allen: Not unless oil prices go down. If they do, we will [face it] very quickly. But we have seen the ripple to Greece and the focus is now there.
Knowledge@Wharton: Back in the U.S., the Federal Reserve Chairman Ben Bernanke said a few days ago that looking back over the recent crisis, the cause of the crisis had more to do with lax regulation allowing poor underwriting standards and mortgages and things like than the Fed's persistently low interest rate policy from the early part of the decade. Do you agree?
Allen: I don't agree with him. The Fed fights every action to avert blame for the crisis because a lot of things are happening in Congress that would take responsibilities and power away from it, if one takes that view. It is culpable both ways, because it was overseeing many of the banks that did the mortgage underwriting and so on. It has a difficult one to argue there. My view still is that low interest rates were the primary problem. The main evidence is that it wasn't just the U.S. that had these problems.
Spain had very good banking regulation and it didn't have irresponsible mortgages in the sense of low underwriting standards. Yet it had the same kinds of problems, or even worse because the bubble was bigger there. Although the European Central Bank didn't set low interest rates in an absolute sense, it did in a relative sense. The interest rates there were too low given the huge boom going on. If you look at other parts of the world and you look back at history, one can see low interest rates are a big part of bubbles.
Knowledge@Wharton: We have seen a remarkable resurgence in the U.S. stock market and elsewhere. Can that continue?
Allen: This is again part of the problem of having a loose monetary policy. It tends to boost the stock market and create bubbles. This is what is going on in the stock market now. There is just too much easy money. When the Fed starts tightening [monetary supply], we will find out whether the stock market is boosted by ... a monetary phenomenon. Most economists deny there is a link between monetary policy and asset prices. But this is going to be the big issue.
Knowledge@Wharton: But some indicators like price-to-earnings ratios are not far out of line with historical norms.
Allen: That's true. Earnings are doing well. But, again, one has to look at the monetary phenomenon. What is going to happen in the economy and are the earnings sustainable? We will find all this all out.
Knowledge@Wharton: On to China. There have been a number of stories recently about the rebound in China. It seems to have emerged from [the downturn] faster and in a more healthy way than many other countries. Do you see it that way and why?
Allen: China has two huge advantages. The first is it is in a very strong fiscal position. It has relatively low government debt compared to most other large economies. This gives it the power to borrow and spend large amounts. The second is that it still has tremendous control over the economy. It owns a large part of industry, banks and many other things.
This means it can stimulate the economy easily. One of the issues there though is property prices in Beijing and Shanghai going up at a fairly fast pace. Are they causing a bubble, and if it bursts, is [the country] going to have a problem? It needs to move away from just building infrastructure such as roads, bridges and those things needed in many parts of the country. It needs to slow down slightly on that and worry more about building human infrastructure in terms of education, health and those kinds of things, which is somewhat below par in many parts of China.
Knowledge@Wharton: If much of the resurgence in China is due to its centralized system, are there lessons the West can learn from the way the Chinese responded to the downturn?
Allen: It would be good if we had, for example, publicly owned banks that might compete with the private sector. Many countries that have frequent crises have banks like these so that when things go bad, they don't have to rely on the central bank to become a commercial bank and make credit decisions. One reason China did so well is that it owns big banks and was able to direct them, which you can't really do in a privately owned financial system. I don't think we should replicate the Chinese system, but maybe move a little bit towards that.
Knowledge@Wharton: So there is a sort of back-up system?
Allen: So there is a back-up system.
Knowledge@Wharton: Let's look at Japan. It doesn't seem to be resurging in the same way. What is the problem there?
Allen: Japan has many strengths, and many weaknesses. It has a huge amount of debt outstanding from the 1990s and 2000s. This is going to be a drag on it. If interest rates go up, it is going to have a huge interest bill. At the moment, [the bill] is very low because interest rates are near 0%.
The reason it was doing well in recent years is because China did well. So when China was hit, Japan was hurt badly. It hasn't managed to do as well from the current resurgence of China.
It also has a long-term problem if you look at companies like Sony.... At the moment, Korean companies like Samsung and LG are doing better than them.
It also has political problems. The transfer of power [in August] from the Liberal Democratic Party to the new government is not something Japan is used to. That is causing a lot of uncertainty. We will see how that plays out. It is not even clear where the power lies in Japan at the moment, whether it is with the head of the [Democratic Party of Japan] or the Prime Minister [Yukio Hatoyama]. All these uncertainties make things difficult for the Japanese economy.
Knowledge@Wharton: Looking at the rest of Asia, do you see things getting better or worse?
Allen: It is very mixed. Korea is doing very well. It has among the best of all countries to have survived the crisis -- especially given that it has an export profile like Japan and Germany have, it hasn't been nearly as badly hit. Australia is doing very well. It already raised interest rates. It is benefitting from how China is doing and the big infrastructure projects China is undertaking. Some of the other countries have long-running problems. The Philippines is not doing so well. But by and large, Asia is doing okay and hopefully it will continue to do okay.
Knowledge@Wharton: I take it you see positive signs here and there, but you are still worried about the next year.
Allen: I am still worried. There are negatives in the U.S. and Europe. In Asia, there are positives, but a few negatives. Our world outlook will change somewhat because the U.S. hasn't had crises over the last 40 years or so. That world is now gone. When will we have the next crisis? Is it going to be five years or 10 years? Are we back in a world where we are not immune to crises? I'm not sure people have adjusted to that.
They seem to think that some problem in the mortgage industry caused the crisis. But one thing we should learn is that crises have been around for centuries and they will continue to be around. It's just that now they are back with us in a way they haven't been [for a long while].
I would recommend a book by Carmen Reinhart and Kenneth Rogoff called, This Time is Different: Eight Centuries of Financial Folly. They document, over many centuries, how frequent the crises are -- not year to year, but decade to decade. Each time, people think, "Oh, now it is different." That's where the title comes from. But [these crises] have always come back. It hasn't been different.