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RADIO 4 CURRENT AFFAIRS ANALYSIS THE WORLD’S SHIFTING BALANCE TRANSCRIPT OF A RECORDED DOCUMENTARY Presenter: Martin Wolf Producer: Sandra Kanthal Editor: Hugh Levinson BBC White City 201 Wood Lane London W12 7TS 020 8752 7279 Broadcast Date: 17.07.08 2030-2100 Repeat Date: 20.07.08 2130-2200 CD Number: Duration: Taking part in order of appearance: Charles Dumas Chief Economist, Lombard Street Research, London Peter Bernstein Market Historian Kenneth Rogoff Professor of Economics, Harvard University Former Chief Economist, International Monetary Fund Raghuran Rajan Professor of Finance, Graduate School of Business, University of Chicago Former Chief Economist, International Monetary Fund Ngaire Woods Professor of International Political Economy, Oxford University Justin Lin Chief Economist, World Bank WOLF: I’ve been observing economies around the world for forty years, including twelve as Chief Economics Commentator of the Financial Times. In all that time, I cannot remember such a combination of economic challenges: the world’s balance is shifting. HEADLINE 1: American homebuyers with poor credit histories defaulting on mortgages have caused mounting problems in the US financial markets. HEADLINE 2: The President of OPEC, Chakib Khelil, has warned that the cost of oil could reach $170 a barrel this summer. His comments caused the price of oil to surge to a record high. This contributed to sharp falls in share markets on both sides of the Atlantic. HEADLINE 3: Striking farmers in Argentina, there have been food riots in Mexico, rationing in Bangladesh and even a stampede in a supermarket in Beijing. WOLF: The combination of financial crisis with rising inflation is astonishing: in the past, a crisis in the world’s biggest economy would have brought lower global demand, a decline in growth, and so lower commodity prices and reduced inflation. We are not witnessing that today. Does this mean that a fundamental shift in global economic influence is under way? Big emerging countries like China and India seem to have become decoupled from the long-dominant US. They are on their own independent tracks. But have they also been transformed into locomotives of global growth? In this programme, we will ask these questions of some of the most influential analysts of the world economy. Easy times have certainly ended for the world’s largest market. What is much less obvious now is what that means for everybody else. DUMAS: Under the old Goldilocks system, as it was called, or Goldilocks economy, people were able to live beyond their means, enjoy capital gains on their assets, nevertheless, and have low inflation all the while. And now it’s exactly the opposite, so it’s give back time; and people on the whole developed the idea that they were entitled to all these nice things they were getting under Goldilocks and they’re going to have to give it back. WOLF: Charles Dumas, Chief Economist of Lombard Street Research in London. DUMAS: It is unquestionably in the United States that the pinch is hardest and the worst pain is being suffered. In Europe, there will be areas where things are very difficult, but they will be for the most part areas within countries, not even whole countries. In the Indian case, you’ve seen the country just permit a series of overheating to happen on a largely domestic basis for several years now, so they’re seriously overheated, and of course with an election coming up, the difficulty of running a tight policy is greater than it would be even usually. In the Chinese case, there are a lot of things which ought to slip into place quite easily, but it’s perfectly easy for people to make mistakes; and once they make mistakes, they tend to carry on making more mistakes and compound the previous mistakes. So the main thing is to get through this really, it is a crisis really, without people giving up on the free market system that has created so much wealth over the last twenty to twenty-five years. WOLF: Yet how bad are conditions in the Western economies, particularly the US, going to be? To answer this question, we must start with the troubled financial sector. We have witnessed a series of highly disturbing events: the collapse of the US housing market; the huge losses on sub-prime mortgages recorded by a number of global financial institutions; and the need to rescue Bear Stearns, the fifth biggest investment bank on Wall Street. It has now been nearly a year since the crisis began. But how long might it last? Peter Bernstein is an eminent market historian based in New York. Despite all his decades of experience, he admits that even he did not see this crisis coming and he fears that the US has now entered uncharted territory. BERNSTEIN: I think this is a major shock not only in my lifetime, but I think since the Great Depression. Nothing quite like this has happened to freeze up the entire credit system that a capitalist system or even a socialist system, I suppose, but certainly a capitalist system needs to go forward. And the kind of bare foolishness that so many people were caught up in a set of bets in the financial system that turned out to be bad, I think it is unique and the problems run very deep. People had this conviction that we were in a low risk environment, which we indeed had been, but that was encouraging them to take higher and higher risks. It’s alright if you and I do it, but when everybody is doing it then the nature of the environment itself is changing. But when the shock began to hit in the sub-prime area, nobody seemed to be prepared for it in any way and the contagion was very rapid. There’s another strange thing about this: the number of people who warned that something bad was going on of this nature was very small. We all sat by there and watched it happen. After the fact, everybody is explaining in elegant detail what went wrong, but I didn’t read anything about that before it was going on. I had no sense of foreboding about it at all. WOLF: Now if we look at where the US is now and the prospects for the economy and the financial system, are we looking at a pretty weak financial background in terms of credit creation for some years now or do you expect that the American financial system can come back with the help it’s getting fairly quickly? BERNSTEIN: I think the American financial system will probably survive as a result of us getting … because we don’t know what else is lurking in the corners after this kind of experience, so there may be further shocks ahead that we’re not prepared for. But if there are not, yes I think it will survive, but the healing period is going to be very long. After all, credit is a matter of trust and that has been smashed, shattered, so it’s got to take a long time to revive and it will revive in very tentative ways. In terms of coming out in the clear where you have a functioning credit system again, when people say a year that’s much too short. And this is not only in the United States. We see signs, echoes of it abroad - certainly in Britain but in other countries as well - and now may be rubbing off on the developing countries. So the whole tenor is one of caution. WOLF: With the US economy in profound difficulties, what is happening in the emerging world? At the beginning of this financial crisis, last August, there was talk about how fast-growing developing countries would offer a counterbalance to the slowdowns taking hold in the industrialised world. So far the hoped for decoupling has indeed happened. But can the emerging countries continue to grow despite a marked slowdown in the richer countries? Kenneth Rogoff, Professor of Economics at Harvard University and former Chief Economist of the International Monetary Fund, questions the view that the divergence in performance will prove as long lasting as many now suppose. ROGOFF: It’s true that in the end China have become larger in the global economy and are having a markedly greater influence, particularly on commodity prices, and it’s also true that countries in Latin America and even Africa are experiencing the best growth period they have in years even as the United States, Europe and Japan are slowing down. But I wouldn’t overstate it. I would say this is more of an accelerated evolution rather than a wholesale change and I think we’re going to find out in a year or two that some of this decoupling was really cyclical; that as the developed world slows down, it’s going to hurt the developing world. Some countries worse than others. I mean I think it’s a big question mark how different regions are going to handle the inflationary pressures they’re facing now. I suspect in some places it won’t be pretty. WOLF: Doesn’t this suggest though that the really big problem they face is this remarkable surge in inflationary pressure and the reason they’re going to slow down is that they will actually want to take action to slow their economies in the context of this inflation. So it’s not that they’re directly importing the slowdown from the US and the rest of the developed world. They have their own macroeconomic problems and they’re responding or they may be responding in a way that is appropriate to dealing with those problems. ROGOFF: Well yes and no. Commodity prices tend to rise at the end of every global business cycle and we’re saying that again here even if it’s much more so than the last couple. At the same time business cycles are not perfectly synchronised, so it’s not unusual for one region to slow down and then another, to take another year to slow down. I mean I think it’s a little early days to say that the developing world is not going to experience a significant slowdown. I think from another perspective, the inflation that many countries from China, Brazil, Chile, Columbia, all over the world are facing is really the first big policy challenge that they’ve faced in the last five years. These have been golden years and, yes, in some countries they’ve been following better policies. China’s a really good example where they really have done very, very little. There’s been a lot more talk than action. They’ve been riding the wave, they’ve been doing great. They haven’t really faced a policy challenge and I think one of the things that’s going to separate the wheat from the chaff here is really that some countries are going to mess up when they face inflation. I think already a number of governments are pressuring their central banks not to fight inflation and they’re going to be sorry later that they’re going to end up with double digit, even twenty percent inflation. We haven’t seen that in a while and I think we’re going to see it in at least half a dozen major emerging markets over the next year. WOLF: Someone with direct experience of how emerging markets are dealing with these new challenges is Raghuram Rajan, an Indian-born Professor of Finance at the Graduate School of Business at the University of Chicago. He is also a former Chief Economist at the IMF and Chairman of a committee on financial sector reforms for the Indian Government. I asked Professor Rajan if the governments of rapidly growing emerging economies, particularly central banks and finance ministries, had taken their eye off the inflationary ball - a particularly apt metaphor for his native country, cricket-mad India. RAJAN: One would think that in India at least there would be a lot of concern about inflation because as soon as inflation moves high, the politicians start agitating. But for some reason inflation hasn’t been the central focus of the Reserve Bank. I mean the reason is obvious. It’s been focused on trying to maintain a competitive exchange rate also and I think this has been really problematic and we see the consequences now of taking your eye off the ball. A similar concern of course is in China where the renmimbi hasn’t been allowed to appreciate as much as it could, and you do see some inflationary consequences of a fairly accommodative monetary policy. WOLF: How severe are the dangers here? For some of us, certainly from my perspective, the policies that the emerging economies have been following, particularly the ones we’re talking about but not only them, look really rather similar to the ones that developed countries followed in the ‘70s. That was a really miserable decade. Now nobody of course is thinking that the big emerging economies we are talking about now are actually going to stagnate, but is there a real danger that because of what they’re now doing that over some sustained period of years, in order to ring inflation out of the system again, they’re going to have to experience quite a longish period of sub-trend growth with all the disappointment that means for their peoples? RAJAN: I think that’s right. And remember we’re already at ten, eleven percent, certainly in India, in the high single digits in China, without having passed through the full extent of the commodity price rise. Now clearly when you start passing all that through, there’s going to be additional inflation. If commodity prices start stabilising or even falling, there will be some payback eventually but that’s going to be a long way off because we haven’t really passed through what’s already gone up still. So I think there is a very real danger that we move into much higher territory in terms of inflation and, as you know, and as the experience of the industrial countries show, trying to bring out those inflationary expectations that get entrenched when you’re at high levels of inflation implies fairly high interest rates and severe effect on growth. So this is a central worry that a lot of these countries should have. Part of the problem, I think, is that this decade of really low inflation the world over has made a number of central banks somewhat complacent about their ability to control inflation and they fail to appreciate that it was a worldwide phenomenon and not a phenomenon which was centrally focused on their doing. So when they’re on their own and the worldwide effect is in the opposite direction, it’s going to be much harder. WOLF: The continued rapid growth of countries like India and China has contributed to an extraordinary boom in commodity prices: oil prices are higher in inflation-adjusted terms than at any moment since the beginning of the 20th century. The higher prices have still not fed through inside emerging countries because many subsidise oil and food for consumers, though at rising cost to their hard-pressed national budgets. These pressures are continuing to build. Oil is the most important commodity. Its price has passed through the $145 a barrel mark. Talk of $200 a barrel no longer seems crazy. Some are even talking about $300 a barrel. The spectre of global stagflation - the combination of soaring prices with slowing growth - looks ever more menacing. Yet what is causing this havoc in commodity markets? Is it fast growth in demand, dwindling supply or speculation? There are many reasons and so no simple answer to these questions, as Charles Dumas of Lombard Street Research explains. DUMAS: One has to accept the existence of multiple causes when it comes to commodities. People are always trying to say it’s all speculation or it’s all China or it’s all peak oil or whatever. Truth is it’s quite a lot of these things put together. The price of oil is now twice what it was a year ago and what’s happened in the meantime is that the Western world economy has deteriorated sharply, as we all know. What has also happened is that the full overheated extent of the Chinese boom has become evident and that is probably a factor behind the oil price increase. But the fact is that the annual increase in Chinese oil demand is exactly half the annual reduction of US imports going on right now - so if you put the two together, bearing in mind that the US still consumes nearly three times as much oil as China, the net of it is a substantial reduction in the call on the world’s oil. WOLF: So is speculative activity - trading on expectations of future prices of oil - at the root of the current price rises? DUMAS: You have to say that the speculative story is a big part of it. And of course we can be polite and call it investment if you like, but the fact is that the over the counter positions in commodity futures in general, revealed by the end of 2007, were eight trillion dollars in volume, of which probably as much as half is oil, which is to say four trillion dollars, which is approximately the annual turnover of the oil business worldwide. So you’re looking at a situation in which the speculative interest is huge. And we know of course that from the moment when Ben Bernanke at the Federal Reserve started to cut interest rates in a very aggressive and frankly panicky way last October, we were looking at ten dollar increases in oil every time he lifted an eyebrow because the basic perception of the world is that the Fed is trashing the dollar. Or was trashing the dollar. They’ve turned around a little bit over the last two or three months. My personal feeling is that when the Chinese slow down - and it is very much when, not if, which is probably going to be this autumn and winter - then the speculative interest could quickly turn round. And of course it only takes one or two percent of world oil usage to turn the price round very sharply. It doesn’t take anything like four trillion dollars worth of activity. So if a very small piece of that over the counter activity turns negative on oil, the price could come crashing down. WOLF: This view of the future path of commodity prices is rather optimistic, though far from inconceivable. But one point is now quite clear: the world economy is no longer the property of the old club of Western countries, plus Japan. The big emerging nations and the oil suppliers have also become hugely important players. Countries like Abu Dhabi and Singapore are even propping up weakened Western banks through their government-owned investment vehicles: the so- called Sovereign Wealth Funds. So do we need to reconsider how the global economy is regulated and managed? The dominant club, historically, has been the Group of Seven - the US, Japan, Germany, France, the UK, Italy and Canada, whose finance ministers meet regularly. The heads of government of the Group of Eight, the G7 plus Russia, held its annual meeting in Japan this month. Have these groups become increasingly irrelevant? Ngaire Woods, Professor of International Political Economy at Oxford University, thinks the answer to this question is yes. WOODS: Economic interactions have globalised. There has been tremendous globalisation, but regulation hasn’t followed suit. And markets left to do their own thing will bring about crisis, and the failure to regulate globally is what has catalysed the financial crisis and it’s only now that people are running backwards to try to find ways to deal with it. WOLF: When we look at this as a system - the whole world together - we have significant inflationary pressures in a large swathe of developing countries; we have this really quite significant financial crisis; we have huge increases in essential prices - commodity prices, oil and food in particular. Now this looks like a breakdown of the global governance. The whole system is no longer being governed in any satisfactory way, presumably partly because the G7 is no longer in control of it and it’s become so much more complicated. So how do we think about the governance problem we face and where should we be taking the governance of the world system? WOODS: The governance of the world system is all premised on a world where the United States was the largest creditor, where the G7 could cluster around the United States and they could be the directorate of the global economy to some degree. The United States is now the world’s largest debtor. Trillions of dollars worth of reserves are being held in emerging market economies. In other words, global financial stability depends not just on decisions being made in Washington DC but on decisions being made in Beijing, in the Gulf and elsewhere. Even the banking crisis can no longer be managed. Banks cannot be bailed out in the G7. Every major bank is now relying on Sovereign Wealth Funds; in other words, the funds being produced by governments in the emerging world. So it means we’ve got an architecture which is horribly out of date. We’ve got a nice, small, comfortable, intimate grouping called the G7 who like to get together, who say they share values and they can regulate the world economy - making pronouncements, telling China what to do with its aid, telling China what to do with its Sovereign Wealth Funds. And needless to say China and many other emerging economies are saying well thank you for that piece of advice, but I think we’ll ignore it. And why should they not ignore it? WOLF: One sign that China is breaking into the club of the rich nations is the appointment of Justin Lin to the post of Chief Economist at the World Bank. In practice, this is the organisation’s most influential position, after that of the President, who has always been an American. Professor Lin has an extraordinary background. Approximately thirty years ago, he left Taiwan for China for political reasons. He did so by swimming to China. Eventually he became Advisor to the Chinese Government. His new position reflects both the rising clout of China and the growing worldwide interest in learning from the Asian giant’s economic success. Professor Lin has only been in his post for a matter of weeks, but does he think that the developing countries are now decoupling from the old industrialised nations? Yes, but only up to a point. LIN: One of the reasons why the developing country can grow so fast was the further integration with the global economy. However, if the growth rate in the developed country drops, their unemployment increases on its own. People will still spend a little bit less and this will hurt the export of this developing country. WOLF: Is this actually a situation in which the most vulnerable are the most successful economies of the last ten or twenty years? LIN: Not necessarily true because we know that the East Asian economy or the country export manufactured goods, in effect their inter-trades are the major parts. And, secondly, this Asian economy in an emerging market and most other developing countries, their domestic fundamental improves a lot. So they have a lot of opportunity for making investment domestically to improve their infrastructure, to upgrade their industries, to increase their production capacity. And those kind of investment needs will create a lot of trade between the developing country and in effect also create the demand for export for underdeveloped country. And that is the reason why in effect the strong growth in the developing country will in a way help the developed country to reduce their slowdown. WOLF: Professor Lin thinks that many emerging economies, particularly those that have been successful in developing exports of manufactured goods, will indeed continue to do well. But not all developing countries are in such a strong position. In particular, many small and poor developing countries are also commodity importers. These countries contain a large portion of the world’s most impoverished people. They will surely need lots of help if the fate of the desperately poor is not to worsen still further and the world’s progress against extreme poverty is not to be reversed. LIN: So I think international donors need to come up with something because the increase in the food price, the increase in the fertiliser prices and other prices are external shocks because fundamentally for the poor people they spend up to fifty percent or even eighty percent of their expenditure on food and on energy. And if the price increase so much, they are the first group of people to lose. I just came back from a visit to Ethiopia. I understand that for Ethiopia the implication of the surge in the oil price, fertiliser price, and food price means that they need to spend one billion US dollars actual just to cover that price increase. WOLF: Well if it’s one billion more for Ethiopia, it must be tens of billions if you look at the world as a whole, so this is a really big challenge. Even if we think that many developing countries are going to survive quite comfortably and have the choice, it does remain the case that these are huge challenges which need a lot of assistance in some very large parts of the world. LIN: The developing country, they are different from country to country because it depends on their net export, their natural resources. And sometimes they are net importer of petroleum products, but they are net exporter of other commodities. So it’s not necessary all the developing country they are hit by similar magnitude, so we need to look into country to countries and to have a very careful analysis so we can come to a conclusion how much relief is necessary. WOLF: Justin Lin, Chief Economist of the World Bank. So the situation of developing countries is very diverse: some are experiencing huge commodity booms; others enjoy rapid industrialisation; and yet others have suffered large losses as import prices have soared. Yet all countries have one thing in common: the threat of higher inflation at a time of substantial financial crisis in the US and a number of other high income countries. This combination is challenging central banks as they have not been challenged since a quarter of a century ago. Then Paul Volcker, Chairman of the Federal Reserve, wrung inflation out of the US economy and many emerging countries, particularly in Latin America, suffered a huge debt crisis. Does this mean the glory days for the central banks may now have passed? Back to Professor Kenneth Rogoff of Harvard University. ROGOFF: Central banks have done a good job, but they’ve also had the wind at their backs. Globalisation rises and productivity have enabled them to deliver high growth with low inflation. They’re rock stars everywhere in part because everybody thinks they’re doing a great job. They think Alan Greenspan created growth. They think whoever their local central banker is the one who made it happen and the fact that inflation is low is just icing on the cake. And I think as we see a turn in the global cycle where the real side of the economy becomes more challenging, it’s also challenging for central banks and they’re nervous to deliver the message, they’re nervous to let growth slow down too much. They say that they really want to keep inflation low, but when push comes to shove they back down. They’ve been doing a good job - I don’t want to say it’s all good luck, it’s certainly not - but we’re going to see that some of them are not as strong as they think. Some of these “inflation targeting frameworks” are going to prove to be just a façade in the face of difficult challenges. WOLF: I think decoupling is real: emerging countries are able to grow quickly even though the US and other Western countries are in a slowdown. The global balance has indeed shifted. With it must change how we manage the global economy. Yet the developing countries will not emerge from these troubles unscathed. Their rapid growth is generating higher prices globally. The danger now is of slowing growth and higher inflation worldwide. Such a stagflation would damage everyone.