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Monday, January 02, 2006

Saving for a Rainy Day

Ken Rogoff has some good advice:

In the best of times, it’s wise to ponder the worst, by Kenneth Rogoff, Commentary, Financial Times: In today’s benign environment of global growth, anyone who cautions that good times might end is a heretic. What if Pharaoh had beheaded Joseph for daring to suggest higher taxes during the fat harvest years so people would not starve during the lean ones? Instead, Egypt’s leader cast his lot with the world’s first recorded business cycle theorist and the rest is, well, history. But are our leaders today preparing for the inevitable downside of the cycle? I wonder.

Let us first acknowledge that we are indeed living in boom times. ... Moreover, under­pinning this ... are numerous positive developments. First and foremost ... is the continued rise of Asia (especially China) with huge and diverse benefits for the global economy. Second, thanks to greater independence, improved ­policy ... and ... globalisation, central banks have been enormously successful at bringing down inflation. This is a worldwide phenomenon... Third, most countries have ­experienced a clear trend decline in income volatility over the past 20 years... Fourth, long-term interest rates are back to 1950s levels, due partly to a temporary global investment shortfall.

Low interest rates, in turn, have underpinned a worldwide housing boom. Together with reduced output ­volatility, they have helped bring down risk spreads on virtually every kind of debt, not least that of emerging ­markets. ... Still, are the risks to the fat years as low as most markets and policymakers now perceive them to be? It does not take a prophet to think of things that might go wrong.

The number one risk to global growth ... has to be ... a terrorist incident involving weapons of mass destruction. ... Imagine, for example, that nuclear material were found in a container ship headed into New York. (Perhaps ... it might be found wrapped in one of the multitudinous bales of marijuana smuggled into the US every day.) Even if catastrophe were forestalled, governments would almost surely start treating container shipments with the same indignity now accorded to airline passengers. The ensuing delays would wreak havoc across ... global supply chains, effectively constituting a huge tax on global trade.

Equally problematic would be a meltdown in one of the world’s many hotspots, for example in the Middle East, North Korea or the Taiwan Strait. Imagine that a military standoff led to a sustained pause in shipping from greater China. A pandemic such as avian flu could cause similar problems, by interfering with the movement of individuals both within and across ­borders.

Markets seem to fantasise that the US Federal Reserve would simply step in in the event of a catastrophe and sharply cut interest rates as it did after September 11, 2001. But a sustained blow to the global transportation network would have far more dire economic implications than a localised disaster. Is anything being done to prepare for this risk? ...

As good as the economic fundamentals are, it is easy to find ... vulnerabilities. Top of the list has to be global housing prices – which are not actually all that close to earth any more. ...[In] China, the leadership there still faces a delicate social, economic and political balancing act to sustain the country’s break-neck development pace. ... A pause in China’s growth would have huge global implications for commodity prices, inflation and productivity. Then there is energy. Yes, the run-up in oil prices over the past two years seems to have had a relatively modest effect on global growth. ... Still, oil has not lost its ability to sting. ... Lastly,... explosion of unregulated hedge funds and the widespread use of derivatives such as credit default swaps pose risks that are simply impossible to calibrate until the system is stress-tested. ...

In the light of these and other risks, today’s policy climate seems marked by a discouraging level of political paralysis. The US is running a substantial budget deficit in spite of a booming economy. In Europe, reforms are at a standstill. Asia needs more flexible exchange rates to share the burden of global imbalances and, in Latin America, reform paralysis in major countries has produced tepid growth in spite of a phenomenally supportive global backdrop. The common-sense biblical wisdom of using good times to prepare for worse ones does not seem to have many adherents these days. Perhaps that complacency is the greatest risk of all.

Yes. We are in a better position with respect to monetary policy now, but for awhile we had very low interest rates coupled with very high budget deficits. In such a case, when you've already thrown your two best punches, what do you do if trouble hits? It's important to reload the policy guns - get deficits and interest rates in order - so when trouble hits you won't have already fired your best shots. I also wonder if we are saving enough for the next rainy day.

    Posted by on Monday, January 2, 2006 at 04:53 PM in Budget Deficit, Economics, Monetary Policy, Policy | Permalink  TrackBack (1)  Comments (8)


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    » Ken Rogoff on risks to the good times from New Economist

    Via Mark Thoma, Harvard's Kenneth Rogoff writes in today's Financial Times that In the best of times, it’s wise to ponder the worst (subscription required):The number one risk to global growth ... has to be ... a terrorist incident involving weapons of... [Read More]

    Tracked on Tuesday, January 03, 2006 at 02:59 AM


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