Paul Krugman on the state of the global economy live at MegaTrends in Abu Dhabi

The biggest highlight of the MegaTrends conference for me (other than my own keynote :-) ) is the presentation by Paul Krugman, who won the Nobel prize for economics last year, on the state of the global economy. I have a lot of respect for his outlook. Live notes from his speech:

The volume of world trade has fallen off a cliff – down 15% over the last year, the biggest since the Great Depression. In fact there are many similarities to the Depression, but that doesn’t mean that it will be the same. The global economy is stabilizing, but not recovering. Things are getting worse, but more slowly. It *probably* won’t be another Great Depression. Extraordinary declines in output, employment and more. There have been no havens.

So how did it happen? The crisis was far more global than those that point to US mortgage lending as the source. European debt losses will probably be as large as those in the US. There was an epidemic of excessive borrowing across all domains. The IMF now predicts $4 trillion of bad debt.

One of the key issues is that banking regulation did not keep pace with a changing world. There was a failure to expand financial regulation as banking expanded. Many non-bank institutions (what Krugman calls “shadow banking”) overtook conventional banks to generate 60% of lending. Lehman Brothers and AIG turned out to be effectively banks.

Changes in the international finance system also contributed. Before the Asia financial crisis many Asian countries were importers of capital. They then shifted to be massive savers, funding the rest of the world including US borrowing. Developing Asia financial surpluses are over $400 billion. This glut of savings destabilized the world economy.

In 2005 Ben Bernanke spoke of the moderation of economic change, being self-congratulatory in saying that there had been no major downturns in 25 years, there was far lower variance in growth rates, and inflation had been beaten. This mentality started to become pervasive, setting up the conditions for system risk-taking that people believed was fundamentally safe. The idea was that central banks would be able to deal with any problems. The US Federal Reserve was the ‘designated driver’ to deal with inebriation. However there is a limit to monetary policy: zero interest rates. In the Western world this has been hit twice: in the Great Depression and now.

That is why this is not just a severe recession. Policy response has been overrun by events, so there is no way central banks and governments can effectively response. We cannot expect a fast recovery.

However unlike in the 1930s policymakers have a framework to understand what is going on. They have at least an idea about what to do. Decades of economic research have provided useful insights, and a better response than we did eight decades ago. One tool beyond the usual short-term interest rate mechanisms is buying longer-dated securities, something the US Federal Reserve has done with alacrity.

The other tool is fiscal stimulus. Massive budget spending (and accompanying deficits) are helping, and are a key difference with the 1930s

So it looks like we have avoided the Great Depression Two. Measures suggest the global economy is stabilizing. I wouldn’t be surprised to see figures such as trade stabilizing, and positive GDP in the US in the second half of the year. The patient is not going to die, but he still is an acute condition and the outcome cannot be known yet.

Right now the major developing countries look too similar for comfort to Japan and its lost decade. Japan’s problems were due to extraordinary debt build-up, and it took them a decade to work through that. Household debt has risen consistently over the last three decades to be close to 100% of income. It looks likely to decrease.

The US savings rate was around 10% in the 1970s and 80s, but fell to zero a few years ago, as people felt that rises in the value of their houses were effectively their savings. The US savings rate has recently risen to 4%, but this is still not enough. In Europe, Germany has a massive current account surplus, funding many other European countries.

The Obama fiscal stimulus package of $800 billion will contribute 2.5% to GDP, but the economy is 6% below its trend, so this is just mitigating the problem. There is a limit to increased spending, not least from investors’ willingness to fund extraordinary levels of debt.

Ireland has been forced to cut spending through lack of faith in its creditworthiness. The UK government is being threatened with ratings downgrades.

What needs to happen is a big increase in private investment. Corporations are in pretty good shape, so what will make them take the step and invest? Given time, they will have to. Machinery wears out, and just to continue production. A technological revolution would force and drive investment. Perhaps more likely, a change in policy, notably environmental policy, could drive very high levels of investment. Companies will need to invest for a new regulatory regime. While the regulation will be for the environment, it could drive investment. This is possible, but not a certainty.

We need to change the way we do business so that this doesn’t happen again. Krugman worried for 20 years that something like this could happen. Now that it has, he can’t wait for it to be over.

In the Q&A session. Krugman said he believes that there will still be a long-term secular uptrend in oil prices, due to demand from large developing countries. The oil prices is still $60, from $20 at the beginning of the decade.

There may be an opportunity to invest in some governmental and corporate debt which is being underpriced and may soon be revalued.

The repeal of Glass-Steagall contributed to the problem. While AIG was regulated in its insurance activities, it was its off-balance sheet activities that were less regulated that created the problems.

The spirit of the basic rule is that anything that functions like a bank needs to be regulated by bank. There should be no financial intermediary that has 30 to 1 leverage.