The Knife’s-Edge Economy

Since 2003, I have been saying that the global economy is badly unbalanced and vulnerable to a macroeconomic catastrophe that would yield one of the worst episodes of economic distress of modern times. Since 2004, I have been saying that the situation, once it started, would probably become clear within a year: we would know whether the global economy would right itself or begin a downward spiral. In 2004-2007, I considered that I might be wrong about a relatively rapid resolution to the world’s economic distress: as the late Rudi Dornbusch put it, unsustainable macroeconomic imbalances can sustain themselves longer than economists (with their touching faith in rational human decision making) believe is possible.

A year ago, however, with the subprime mortgage meltdown of August 2007, I became certain. The situation had to resolve itself within a year – or else. Either central banks would manage somehow to thread the needle and guide exchange rates and asset prices back to some stable and sustainable equilibrium configuration, or the chaos and disruption in financial markets would spill over into the real economy and a major global downturn would begin. The odds heavily favored the second outcome: global macroeconomic distress.

But I was wrong. Here we are, fully a year later, and things are still balanced on the knife’s edge.

Let me stress that I have no complaints about the policies implemented by the United States Federal Reserve, which has had the main burden of responsibility for “managing” the crisis. I wish – as the Fed does – that some way could have been found to make financial-sector equity holders bear an even larger share of the losses that are coming down the road than they have borne so far or are likely to bear. But I agree with Fed Vice Chairman Donald Kohn that it is not wise to focus on teaching financiers lessons about moral hazard when doing so risks collateral damage in the form of the destruction of millions of jobs.

The Fed’s first priority is to try to keep the American economy from dropping too far below full employment, and to try and avoid a US meltdown contaminating other economies. If employment and incomes in America crash, US demand for imports crashes – and not just America but the whole world will slide into recession.

Employment in construction and related industries is collapsing, as Americans and foreigners recover from their fit of irrational exuberance over housing prices. Less enthusiasm about housing means that manufacturing firms will no longer be squeezed when they seek capital to expand. It also means a lower value for the dollar, and thus more opportunities for US-located firms to export and supply the domestic market. Jobs are moving from construction (and related occupations) into tradable goods and services production (and related occupations).

But if the system of financial intermediation collapses in universal bankruptcy, producers of tradable goods will be unable to get financing to expand. And if housing and mortgage security prices don’t just fall but collapse, everyone should remember that construction employment falls faster than employment in tradable goods can grow.

That would not be good for America or the world.

And so far, so good, at least on the real side of the US economy. Of course, US unemployment is rising, but if the American economy is in recession, it is the mildest recession ever. On the financial side, however, the magnitude of the chaos is staggering: mammoth failures of risk management on the part of highly leveraged financial institutions that must be first-rate risk managers in order to survive.

If you had asked me a year ago whether this degree of financial chaos was consistent with a domestic US economy not clearly in recession, I would have said no. If you had asked me a year ago whether a year could pass without either a restoration of confidence in financial institutions or widespread nationalizations and liquidations, I would have said no. Unstable and unsustainable configurations must come to an end.

Rudi Dornbusch was right: imbalances can last for longer than economists believe possible. But that does not mean that the water will not eventually run down the hill.

J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former Assistant US Treasury Secretary.