Jody Clarke talks to economist Kenneth Rogoff about the financial crisis, and what we should prepare for now.
Where are we heading?
We're moving from a banking to a government debt crisis. Looking back over a couple of hundred years of global banking crises, a wave of sovereign defaults or very high inflation tends to follow two to three years after. That seems awfully likely to me now. Abu Dhabi has stepped in to help Dubai. The Europeans will step in if needed to support Greece. But there are just too many countries with too much debt for Germany, the US and Japan to hold up forever. Some will go bust.
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Could the US and UK default?
Britain has a history of sucking it up, even if in the past it's happened after wars rather than peace-time. But in the US, the public is thoroughly unprepared to face broad tax hikes, which I think are inevitable. I don't think a default will happen in either case. But inflation will probably happen in both. That's not just because of public debt, but because the bail-out did little to deflate balance sheets in the economy. There is still too much debt in the US and UK. We won't see 50% inflation. But we will see 5%-6% in both countries in the next few years.
What can investors do?
Inflation-indexed bonds look a good buy at the current premia. Other good hedges in the past have included commodities (not just gold) and art. But for most people, it's awfully pricey to invest in art.
Is China on shaky ground?
It's very rare for a country to grow for 30-40 years without facing a financial crisis at some point. And with the huge amounts of credit pouring into the economy, weak governance structures and social problems, I think China will definitely have one. The timing is hard to call. But I think the chance of China facing a severe crisis within the next five to ten years is greater than 50%.
Has the housing market levelled out?
The only reason the US housing market has stabilised is because the federal government has jacked up the subsidies. There's the direct subsidy to new buyers, the $8,000 credit. More importantly, the Federal Reserve is underpinning the mortgage market. It's indirectly buying all the mortgages issued. And a big share of the mortgages are with no money down, just like at the height of the bubble. The Federal Housing Administration, which is making a lot of the loans, gives buyers 97% of the cash. They get the remaining few% via the $8,000 tax credit. This is not sustainable. When the Fed pulls out, mortgage rates will rise by at least 1%. That will have a big effect on housing prices. So I think house prices will fall another 5%-10% from these levels.
What about stock prices?
One thing we've found from past crises we don't completely understand it, but it's firm from the data is that stock prices do come back. And not just part way. They typically reach the previous peak in three years. That's surprising because the rest of the economy doesn't do so well. Unemployment just grinds on for a long time and housing doesn't spring back. But stock prices do. It's happened in every post-war financial downturn, with the exception of Japan.
Could we turn Japanese?
If we've learnt one thing, it's that it's not so easy to get out of these deep financial crises, especially if we don't take the bull by its horns and deal with balance sheet problems in the private and public sector. Getting out of the liquidity trap 0% interest rates is tough. I'm not sure the US will get as bad as Japan. But as time goes on we're going to experience more of these Japanese-like symptoms than people would like to admit. The consumer is still way over-leveraged and it's going to take a long time to grind down. There are still a lot of bad debts around, with commercial real estate being the most obvious.
Should we have let banks go bust?
Yes. We were too cautious. Bondholders the Chinese, pension funds, rich individuals who lent money through bond markets should have taken the haircuts. It shouldn't have all come from the taxpayer. We're going to pay in blood now, because the moral hazard problem, which already existed, has grown tenfold. If you thought before the crisis that the US wouldn't let Goldman Sachs go bust, now you know it's true. That means they can borrow as if they were the government. So can every other financial firm. If they can borrow at the government rate and do risky foreign-exchange trading, of course they can make money. But the taxpayer is taking the risk.
Who is Kenneth Rogoff?
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