The Knife’s-Edge Economy

Berkeley – 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.