US Financial Crisis Is a Black Eye for Capitalism

Every year the Nobel Laureates Plus service of NPQ publishes the Milken Global Conference roundtable of Nobel laureates in economics, chaired by the financier Michael Milken and held in Los Angeles in April. This year's discussion includes Gary Becker (1992), Myron Scholes (1997), Michael Spence (2001) and Ed Phelps (2006). In this excerpt, the Nobel laureates discuss the depth of the US financial crisis, its effect on the rest of the world and the commodity price rises for oil and food.

Michael Milken | Almost 50 percent of the world's growth in the period 1981-1995 came from the United States and Japan. Japan and Germany together in those years accounted for about 25 percent of growth. In the last decade, however, while US growth has remained about one-quarter of the world growth, Japan has contributed less than 1 percent of world growth and Germany 3 percent. The growth in China, India and Brazil has taken up that slack.

This raises the question of whether the new phenomenon of "decoupling" is taking hold—the notion that world growth is less and less dependent on the Western economies. In particular, one wonders what effect, if any, the current US financial turmoil will have on these new, strongly growing countries.

Michael Spence | Decoupling is too strong of a word for now. What is different is that the countries that grew quickly 10 or 20 years ago had small mass in terms of GDP or trade. Now, to take the case of China, its 10 percent annual growth, at current exchange rates, equals a 2 percent increment of growth in the United States. So we are indeed in a transition period. But I'm sure my grandchildren will live in world where economic distribution is different. We are seeing a snapshot of that in process.

It is true there are more growth poles that are important in the world now than ever before, but at the same time the rapid growth in developing countries, especially the poorer ones, is export-led. So those countries are not going to decouple from the major Western economies

Myron Scholes | Because of comparative advantage, countries are idiosyncratic. Policy trajectories and investments sometimes turn out to be profitable, in which case they have a larger share of global GDP, and sometimes not. Japan, for example, was a major competitor with the US in patents and innovation until after the 1990 crisis when their real estate and securities bubble burst. Since then, they have had to retrench and recapitalize, contributing little to growth.

Milken | Confidence in Japanese financial institutions has fallen dramatically around the world and at home. You can see the consequences today: Sixty-six percent of all assets in Japan are in government securities or bank deposits. In short, they have elected not to invest.

Gary Becker | There are two aspects of decoupling. One is the effect of the US on others. How will our financial turmoil affect others in terms of being more cautious about deregulation in their own markets? I do think current US problems will lead to less attractiveness abroad to the low-regulated aspect of American financial markets. The US will also see more regulation. Others countries will say, "See, the US is not so great; now it has slipped badly." That would be a mistake, but I do think that is one consequence.

The other aspect is the effect of the rest of the world on the US. China, India and Brazil will continue with rapid growth, and that will be beneficial for the US because we can still sell to them.

Ed Phelps | Our friends in the financial sector have given capitalism a black eye. Suddenly capitalism is held in less awe around the world. That is a very serious impact.

Coupling and decoupling works through two channels, and it works differently in each. When the US goes into a slump, that is tough for exporters in the rest of the world. So, production of goods for export tends to fall. At the same time, when the US goes into a slump, that tends to reduce real interest rates in the US—which to some extent pushed down real rates around the world. That can send up asset prices globally and actually stimulate investment because investors are looking for higher returns.

So there are these two opposite effects, one through trade and one through asset prices.

Up until the 1980s, my conviction was that the asset prices were the dominant channel. Fiscal stimulus in the US did more damage to the rest of the world by raising world interest rates and lowering overseas asset prices than it did good by raising the demand for exports. Because trade has become a much larger proportion of economic activity in the last 20 years, I now think it is a horse race between the two.

Milken | Another Nobel Laureate, Joseph Stiglitz, has said recently that the US is facing one the worst downturns since the Great Depression. Does anyone agree with that?

Spence | That is very unlikely. It would take mistakes in policy in a number of areas to cause that outcome. The American economy is functioning remarkably well in view of the financial turmoil. The rest of the world has not been directly affected in financial terms by our problems. There is a lot of steam out there in the rest of the world.

China has an enormous set of fiscal resources it will use if there is a downturn in exports to stimulate its domestic economy. That is a good thing because it needs to shift more focus to stimulating consumption at home.

China's debt/GDP ratio is under 20 percent—that is way low by global standards. Its savings rate is absurdly high, which has led to the controversial and ridiculous current surplus, which it needs to get rid of. When you add that up, it has tremendous capacity.

We may be going through the bumpy process of returning to equilibrium in our economic relationship with China.

Becker | The unemployment rate in the US now is 5.1 percent. Unemployment was 25 percent in the Great Depression. We are so far from that, it is ridiculous. We won't even get close. Things may get worse than at present. But at the outside, the only issue is whether unemployment might rise somewhere between 6 and 9 percent.

Phelps | I'm surprised at how slow unemployment has been rising. So far, this downturn barely qualifies as an official recession, let alone a Great Depression.

Scholes | It is erroneous to compare this to the Great Depression. But there is more unraveling to come. We have to worry about effects on the housing market and where it is going to end. Will the housing shock lead to consumption fallout, which leads to more unemployment and further consumption fallout?

There has to be new learning about the affordability of a home. Banks have already written off $250 billion in losses. Some say that could reach a trillion. Housing prices in some places like Southern California might have to fall 40 percent from their peak to clear markets. We have a ways to go in this adjustment.

Becker | In the end, we would do best to look back on how the US had dealt with past crises. The US has responded to so many shocks in recent times—the bursting of the Internet bubble, 9/11, the Iraq war, the twin deficits (the current account deficit with China and the huge budget deficit)—yet we've done well. As I read history, we have a flexible economy. Just as in the past, the US has a great capacity to absorb shocks. Europe and Japan don't have that kind of flexibility. From this perspective, it is hard to be pessimistic about America's economic prospects.

There is one other area of concern globally, and that is the price rises in oil and food. Oil price increases are driven by increased demand, including from China and India. Food price increases, though, are in large measure supply-driven; there has been a reduction in supply due to the shift of acreage from food crops to corn for biofuels. That means more corn is grown and less soybeans. As corn and soy prices increase, the consumer shifts to rice, which causes the price of rice to go up.

So, supply-and-demand-driven rises are merging. Oil supply can't be increased without sufficiently high prices, which will spur further exploration and investment. To get food prices down, you can increase acreage and improve productivity with technology. The food crisis will be solved by supply adjustments.

Spence | The poorest spend 60 percent of their income on food. For now, we need a rapid response to malnutrition whatever the long-term solutions. Over time, productivity can increase, as was the case with the Green Revolution. Yet, 50 percent of Chinese still work in rural agriculture and 70 percent of Indians. Capital-intensive agriculture and higher productivity would displace them from their living. It's a double-edged sword.

Scholes | If you move too fast to improve productivity in food, you create a surplus population that is forced to move to the already over-urbanized cities. That is a huge cost. There are 1.25 billion people in agriculture in India and China. Where will they go?