Is there a serious threat of a world recession?

Most economists like myself have come to believe that monetary policy now carries so much punch because a reduction in interest rates has a compound impact on borrowing costs, on exchange rates and on asset prices that it is unthinkable that we will have a serious recession ever again. That is, the RBA will always come to the rescue.

Paul Samuelson, the famed textbook writer who first taught me economics and subsequent winner of the Nobel Prize for Economics, has now shaken my belief more than a little. He has written a piece in the Herald Tribune (November 19) which is surprisingly pessimistic about the role of monetary policy in the current sub-prime mortgage crisis. He writes (brackets are mine):

It used to be enough for a central bank to lean against the wind. That means lower interest rates when unemployment is too high.. Today central bankers cannot know whether current interest rates are too high or too low. The safest bond interest rates are indeed low (he means relative to inflation). But financial panic (engendered by the mortgage lending crisis) means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

If he is right, the present crisis could easily develop into a serious US recession. Samuelson reminds us that, while China, India, Russia etc. may partly make up for any US recession, US still accounts for 20 per cent of global output. And financial market contagion across the world can be deadly.

His policy prescription is radical. First, he wants quasi-public agencies, like Fannie May and Freddie Mac, to fill the vacuum in the lending market and secondly (perhaps at a later date?) he wants prudential regulations tightened to discourage predatory lending. Samuelson obviously does not believe that central banks can solve the problem on their own. I have no problems with his prescriptions as an ultimate resort but I am not so sure he is right about the impotence of the central bank. Still, it makes one think!

Back in Australia, the implications are twofold. Firstly, it is possible to argue that the RBA was a little rash to raise interest rates earlier this month. A wait and see policy might have been better. Secondly, fiscal policy may need to play a bigger role in preventing a recession here. If monetary policy does prove less effective, lets hope a Howard or Rudd government will not be afraid to go into deficit financing (net borrowing or drawing on Future Fund) to pay for badly needed social and economic infrastructure. Unfortunately, although both Howard and Rudd say that they will run surpluses over the business cycle, they seem at times to be promising cash surpluses come what may. Heaven help us if that proves correct!

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Joshua Gans
Joshua Gans(@joshua-gans)
14 years ago

Samuelson’s article is here.

Ken Lovell
14 years ago

Unfortunately Fred I think a Rudd Government would be absolutely crucified by the mindless hordes (led of course by the cynical conservatives) if it so much as mentioned the word ‘deficit’ in its first term. A Howard Government would have a somewhat easier time but he’s waved surpluses around as one of the few concrete indicators of his god-like economic manager status so he I can’t see either side of politics entertaining the idea no matter now compelling the arguments.

Didn’t Ian Macfarlane say in his Boyer lectures that the cause of the next recession is always something that nobody had anticipated? It’s a bit like generals always getting ready to fight the last war.

Dave Bath
14 years ago

Ken Lovell said: Unfortunately Fred I think a Rudd Government would be absolutely crucified by the mindless hordes (led of course by the cynical conservatives) if it so much as mentioned the word deficit in its first term.

Agreed. IMHO, Rudd should give the RBA the duty to comment on the desirability of Keynesian tactics if things get ugly, as well as what types of government spending (or tax cuts) are worse for the economy that others (such as how many “hops” it takes for the dollar to go overseas to pay for a plasma TV).

The The Economist is pessimistic now – predicting if not a full recession, then a painful slump. It’s not just the credit crunch, but the change in retail spending as the housing bubble hits home. (The “spot the differences” between the cartoons at the top of articles about the US and Chinese economies is a bit of a giggle).

Nicholas Gruen
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Nicholas Gruen(@nicholas-gruen)
14 years ago

Rudd should give the RBA the duty to comment on the desirability of Keynesian tactics if things get ugly

Precisely my point about greater independence of fiscal policy. How much better might Rudd’s promises have been – more believable to the electorate and sensible once in power – if he’d spoken of moving towards having a body like the RBA – or the RBA itself make public advisory comments on the stance of fiscal policy.

Fred Argy
Fred Argy
14 years ago

Nicholas, you were of course a pioneer (many years ago) in proposing an independent fiscal authority which would be given the authority to enforce fiscal policy changes for stabilisation purposes (including the right to make small across the board adjustments to tax rates). The idea of conferring so much fiscal power to an arms-length body made a lot of sense (because such a body would have more flexibility than political government when tax increases or spending cuts were required) but the politics of it seemed insurmountable.

You now have a softer version – asking the RBA to make public advisory comments on the stance of fiscal policy. The Treasury would have a fit of course and Treasurers would still find it objectionable – at least when the RBA is suggesting tax increases or spending cuts were needed; but it would work better in a recession by giving the Government more moral authority to run deficits.

harry clarke
14 years ago

The incoming government won’t need to run deficits – it can just postpone the tax cuts.

I think 2 issues not addressed by Fred that are of equal importance to those he mentions are:

(a) Global abandonment of the US dollar and a panicked rush to get out of dollars. The comments by the Saudi’s last week were revealling ‘don’t even talk about demoninating oil prices in a basket of currencies – the US dollar would collapse completetely wiping out a large slab of our reserves’. Of course dealing with this threat would need a rise in US interest rates which will worsen the debt problems in the US.

(b) Possible collapse of the Shanghai stock market precipitating a shock to the Chinese economy that takes the shine off the international growth situation. 1/3 of Chinese corporate profits are now estimated to come from share trading – the index has risen 102% this year. This bubble will collapse.

Note Samuelson’s interesting comments on the way derivative markets just make monetary management so complex. I am a bit of a reactionary on monetary policy and favour a partial return to limited credit rationing.

The free market approach to allocating credit does not work for moral hazard and adverse selection reasons. There need to be strict standards imposed on lending – minimum deposits toward mortgages and lower interest rates for all given lower credit risk. These problems are asserting themselves now because we have expanded for so long that borrowers have foregotton about risk.

Patrick
Patrick
14 years ago

Dave, The Economist 5my favorite mag, btw) has for decades now maintained a very successful strategy – it’s called the stopped clock strategy.

Like the way it predicted the dotcom crash, a year or three early. Etc. They also think it is amazing that Australians could think of voting out Howard, which I suspect you don’t agree with.

Harry, you’ve said:

The free market approach to allocating credit does not work for moral hazard and adverse selection reasons.

Can you expand on that? I would have thought that your last sentence implied the contradiction of what I have quoted, to start with.

harry clarke
14 years ago

Adverse selection – bad risk borrowers will tend to be the only people prepared to pay very high interest rates. The Alan Bond model also played by property developers.

Moral hazard – if a manager borrows a stack of money at high interest rates they have incentives to invest in risky projects – heads the project is successful and they are covered in glory, tails they lose and shareholder money goes down the tube just after they have forecast problems and moved on.

I think Joe in the street who hasn’t done much investing (and has not ridden out a downturn) just sees everyone making millions and without much thought moves in. Tough not to do the same when people have been successfully following this strategy for a decade.

Jennifer
14 years ago

I suspect that the cost of funds in the Australian market has gone up (because of the subprime crisis) more than most people realise. Mortgage rates have not gone up, but up in the instutional end they have. So our economy and investment decisions will be hit, just as the US ones have been.

Mortgage rates will probably go up too, once the election is out of the way and banks don’t have to worry about getting in between two political parties desperate to score interest rate points.

cs
cs
14 years ago

I have a lot of time for Paul Samuelson, but cannot help noting that, at the 50th anniversary of the US National Bureau of Economics Research, he somewhat [in]famously claimed that the Bureau had “worked itself out of one of its jobs, the business cycle.” That was 1970.

Nabakov
Nabakov
14 years ago

It’s of those irregular verb things.

We’re suffering a recession
You’re experiencing a readjustment
They’re capitalising on a realignment

Fred Argy
Fred Argy
14 years ago

Harry, thanks for your interesting comments. But I am a little perplexed by your observation that “the incoming government won’t need to run deficits – it can just postpone the tax cuts”.

The hypothetical scenario I am envisaging is one where the economy is facing an old fashioned Keynesian recession with inadequate aggregate demand and the RBA finds it difficult to reduce the cash rate enough to pre-empt a recession (for the kinds of reasons raised by Samuelson – which I do not necessarily concur with).

In that scenario, fiscal policy would need to inject an additional demand stimulus. It would mean increasing government spending by much more than revenue and forgetting about cash surpluses in the short term. This is what Treasury intended when it defined the primary objective of the medium-term strategy as being “to maintain budget balance, on average, over the course of the economic cycle”. It clearly wanted to leave room for both discretionary spending and the automatic stabilizers to operate. It is only our politicians who now seem to be making cash deficits a taboo in all circumstances.

In view of the above, what would be the point of “postponing tax cuts”? In the scenario I envisage tax cuts would need to be brought forward not postponed. Or have I missed something, Harry?

Patrick
Patrick
14 years ago

Harry, isn’t adverse selection the point of a market in interest rates? One hardly expects good credit risks to pay high rates?

Plus what Fred said – I am surprised to see you effectively advocating government spending as a superior stimulant than private spending. Wouldn’t the Keynesian ideal be tax cuts plus increased government borrowing?

Fred Argy
Fred Argy
14 years ago

Patrick, in my last comment I did not indicate any particular preference for government over private spending. All I said was that (if recession is threatening) spending had to increase by more than revenue to deliver a cash deficit. Putting it very crudely and simplistically and assuming all tax cuts are spent by recipients, if the desired stimulus is 5% this can be achieved (relative to status quo) with a spending increase of 5% and no change in revenue or with a spending increase of 10% and a 5% increase in revenue. In the former case there is more reliance on private spending than in the latter case. As an economist, I am indifferent between the two.

Now if you ask me to don my values hat, I would say I prefer the latter because of what I see as neglect of social infrastructure and human capital investment – but that is purely a value judgment.

Nicholas Gruen
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Nicholas Gruen(@nicholas-gruen)
14 years ago

Fred,

If you read the fiscal policy stuff I wrote at the time – 1999 – you’ll find it was never as cut and dried as you say. It always suggested the prospect of a gradual introduction via an advisory body. I wrote a column about this recently.

And sadly it was always read against the backdrop of familiar themes relating to fiscal policy – mainly was this ‘activist’ or not, was it ‘Keynesian’ or more ‘fiscally conservative’. The answer was that it was whatever one made of it. It is simply an innovation in architecture and so is empty as far as actual fiscal policy is concerned.

But a better architecture puts the sensible policy maker in a better position to make policy. Though the policy was often taken to be some endorsement of ‘fine tuning’ which it never was, I have always imagined the situation we may be getting into in which a government should run a larger deficit than political forces suggest are prudent. As in 1992 for instance. Then the mini-budget going by the propaganda title of ‘One Nation’ expanded spending by half a percent of GDP in the midst of a savage recession before which we’d been running strong surpluses.

harry clarke
14 years ago

Sorry Fred, Jetlagged. I should have said bring tax cuts forward. Bananas.

Jc
Jc
14 years ago

“Samuelson obviously does not believe that central banks can solve the problem on their own.”

He’s wrong, fred. There were 4 major panics under Greenspan. the 87 crash, S&L issue, Long term capital and the Dot Com crash. Every single one of these was averted only with monetary policy.

The Subprime issue looks like it’s turning into a $300 billion problem. Meanwhile , the Fed under Helicopter Ben is not keeping its eye on the ball. He shouldn’t be waiting until the next meeting, He ought to be cutting right now. The Fed is now beind the 8 ball. The trouble is that Ben is not a market guy and seems to have trouble understanding markets and market sentiment. You need to be a good economist and have a sense of market savvy like uncle Al which ben doesn’t have.

The mess can only be averted with monetary policy and they had better ease up right now. The dollar will be may have to go lower , but so what.