Unforeseen Future Global Developments Jeffrey Frankel Harpel Professor

1. Unforeseen Future Global DevelopmentsJeffrey FrankelHarpel Professor Windsor Conference Harvard Faculty Club September 20, 2010

2. As a rule, it is highly probable that something improbable will happen Consider 3 events that occurred last spring over the span of less than one month: • A volcano in Iceland shuts down European air traffic (April 14, 2010) • An oil platform explosion leaks some 30 million gallons into the Gulf of Mexico(BP, April 20). • Some unknown glitch briefly sends the stock market down about 7% in 15 minutes -- some stocks almost to zero(flash crash, May 6). Who would have thought, beforehand, to put a probability as large as 1% on any of these events?

3. I will make three passes at the subject: • Black Swans • Some possible developments, each of which is highly improbable • Some more probable future paths.

4. Black Swans • We have heard a lot about “black swans” ever since the 2007-08 financial crisis. • Unfortunately, the phrase is used simply to mean a very unlikely event.

5. In 1998, LTCM managers said that they could not be expected to have allowed for their crisis, because it was a 7-standard-deviation event, • or even a 22-std.dev. event. • In 2007, Goldman Sachs’ CFO said the sub-prime mortgage crisis was a 25-s.d. event. • Nonsense. • My guess: if our normal distribution tables reported numbers out to 22 standard deviations, we would be in the realm of the probability that 2 meteors hit Earth at once.

6. Slightly more enlightened are people who cite Knightian uncertainty or “unknown unknowns”: • Ignorance with humility is better than ignorance without it. • A still better interpretation is that distributions have fat tails. • Why? Unconditional distributions may have fat tails because conditional distributions, even if normal, have time-varying variances; • Perhaps, in crises, people’s actions become less independent. • It would be nice, however, to get beyond the Jurassic Park lesson (“don’t be surprised if things go wrong”),to say intelligent things about the tail events.

7. Definition of black swan? • In my view, “black swan” should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries and other decades/centuries. • Consider 5 examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

8. Example #1: “All swans are white.” • The origin of the black swan metaphor was the belief, which might have been held by a 19th century Englishman based on induction from a lifetime of personal experience, that all swans were white. [1] • But ornithologists already knew that there existed black swans, because explorers had discovered them in Australia in 1697. [1] The proposition that all swans are white goes back to ancient Roman philosophy, where it was considered a truism. But induction from observation has its limits, as pointed out by Hume (1739), followed by Mill (1843) & Popper (1959): All it takes is a single black swan to falsify a generalization based on thousands of observations of white swans.

9. Example #1: “All swans are white.” • An Englishman encountering a black swan might have considered it a 7-standard deviation event, even when the relevant information to the contrary had already been available in ornithology books. • It seems to me a waste of a good metaphor to use the term just to mean a highly unexpected event; [2] • a better use of it is to refer to an event that would not have been so unexpected ex ante if forecasters had adopted a perspective broader than their immediate personal experience. . [2] Taleb (2007).

10. Example #2: “Terrorists don’t blow up tall office buildings” • Before Sept. 11, 2001, some terrorist experts warned that terrorists might try to blow up big US office buildings. [1] • The warnings were not taken seriously by those in power at the time, nor by the public. • “It’s never happened before.” • Most Americans probably did not know the history of terrorist events in other countries & in other decades. • Still today, there is a large gap between the probability of a nuclear event as perceived by the public and the probability as perceived by terrorism experts (Graham Allison, 2005: 50% ).[2] [1] They included the anti-terrorism director at the National Security Council in the Clinton & Bush Administrations. Clarke(2004): Against All Enemies. [2] “…on the current trend line, the chances of a nuclear terrorist attack in the next decade are greater than 50 percent.”

11. Example #3: “Housing prices don’t fall.” • Many Americans up to 2006 assumed that nominal housing prices, even if they slowed down, would not fall. • After all, “they never had before,” [1] • which meant that they had not fallen in living U.S. memory. • Few Americans were aware that housing prices had fallen in other countries, and in the US before the 1940s. • Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline.[1] Shiller (2007).

12. As of 2006, 30 years of house prices seemed to show a clear upward trend,with no declines in nominal terms

13. But 100 years of data could have revealed that the last decade was an aberration: Housing prices can fall, even in nominal terms, and in real terms tend to revert to their 1950-75 level

14. House prices had also fallen in other countries.

15. The crash Irish home prices

16. Example #4: Volatilities are low.“The Great Moderation” • Financial markets perceived risk as very low • especially during 2004-07. • This was most directly visible via the implicit volatilities in options prices such as the VIX. • But it was also manifest in • junk bond spreads, • sovereign spreads, • and other financial prices. Sovereign spreads, 1998-2007

17. Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008juanpablofernandez.wordpress.com/2008/05/ In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted. So did spreads on US junk & emerging market bonds. In 2008, it all reversed. 17

18. Example #4: Low volatilities. • Why this historic mis-pricing of risk? • Traders plugged into their Black-Scholes formulas variance estimates that went back only a few years, • or at most a few decades, • the period of the late Great Moderation. • Risk officers did the same with VaR models. • They should have gone back much farther – or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.[1] [1] E.g., Frankel (2008).

19. Example 5: “European governments don’t default.” • Greece’s recent debt troubles should not have caught anyone by surprise, • least of all northern Europeans. • The same with Portugal, Spain, Italy & Ireland. • And yet from the time they joined the euro,until 2009, these governments could borrow at interest rates virtually as low as Germany. • Among the reasons: a perception that advanced countries in general, and euro countries in particular, were fundamentally different from emerging markets and would never default.

20. Judging from spreads, 2001-07, investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations

21. Example 5: “European governments don’t default.” • Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. • Even when the Greek crisis erupted, leaders in Brussels & Frankfurt seemed to view it as a black swan, • instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, • and many others in history, • including among European countries.

22. Are these examples hindsight?How can one gauge risk, other than time series estimation? • Consider a talk I used to give, 2005-07 • This particular slide is taken from a version I gave to State Street Global Investors, May 24, 2006. • Did I predict the financial crises? No. But…

23. Medium-term global risksOdds of each alone small; but cumulative odds > 1/2 • Hard landing of $: foreigners pull out => $ ↓ & i ↑ => possible return of stagflation in US. • Bursting bubbles => consumption would fall . • Bond market: conundrum of low LT rates 2004-05. • Housing market: valuations very high . • New oil shocks, • e.g.,from Russia, Venezuela, Nigeria, Iran, S.Arabia… • New security setbacks • Big new terrorist attack, perhaps with WMD • Korea or Iran go nuclear/and or to war • Islamic radicals take over Pakistan, S.A. or Egypt This bubble indeed burst soon after this presentation The other risks remain.

24. Some possible events -- each of which is improbable taken alone --in four categories • Financial markets • Macroeconomic • Geopolitical • Environmental & miscellaneous

25. Financial markets • Housing prices fall another 1/3 • Equity prices fall by ½ • Bond prices fall by ½ • US i10 yr. rises from 2 ½ % to 5%+ • Hard landing: Dollar falls by ½ • Repeat of financial crisis: interbank spreads in major countries go back to Sept. 2008 high (350 basis pts.)

26. Financial markets, continued • Sovereign default crisis, • beginning with debtrestructuring in Greece -- P=½ • spreading through Europe -- P= ½ ½ = ¼ • and to the US -- P = ½ ½ ½ = 1/8 by contagion

27. Desmond Lachman, Euro Will Unravel, and Soon, American Enterprise Institute, Sept.2010 Debt dynamics:Greece can’t achieve primary surplus & keep its GDP growth rate above its interest rate. => Its debt/GDP could rise to 175% over the next few years.

28. Macroeconomy • Return of high inflation • the monetary base more-than-doubled in 2008, • and that money is still out there. • Deflationary trap • central bank loses ability to expand monetary policy: • higher real interest rates • <= negative inflation • + zero-lower-bound on nominal interest rates. • Like Japan. • Unemployment stays veryhigh foradecade,as the long-term unemployed lose skills

29. Geopolitics • Military conflict • between Iran and US or Israel • between North Korea and US • Between India and Pakistan • Other new serious military conflict • Islamist extremists take over in: • Saudi Arabia (oil) • Egypt (population & cultural center of Arab world) • Or Pakistan (nuclear weapons) • Nuclear or biological or radiological terrorism

30. Environment & miscellaneous • Severe contagion, • like SARS, Avian flu, H1N1,… but worse • Price of oil goes above $200/barrel • Price of wheat goes above $500/metric ton • Severe drought, probably brought on by global climate change • Some other environmental catastrophe • Some IT disaster

31. More-probable scenarios • We are seeing a historic reversal of roles between those countries traditionally viewed as advanced/industrialized and those viewed as emerging/developing. • No longer do industrialized countries automatically have higher creditworthiness than the latecomers. • Indeed, China, Chile, and others have been able to follow fiscal countercyclical policy over the last decade, while the US & UK have forgotten how to. • The advanced countries are now the debtors.

32. A remarkable role-reversal: • Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets; • and rising rapidly. • By 2014 (at ≈ 120%), it could be triple.

33. 1. Fairly likely scenario. Muddling through in short-term: • Recovery is long & slow among advanced countries, • especially with no further fiscal stimulus, because politicians • are either unwilling (Hoover economics) • or unable (as a legacy of Bush economics). • Growth barely above potential • => unemployment comes down only slowly. • No more major disruptions for a while. • Long-term debt problems lead to eventual crises.

34. World Economic Outlook Projections, IMF, July 2010 Growth rates(% change) Year over Year  Q4 over Q4Projections  Estimates Projections  2008 2009 2010 2009 2010 2011  World Output 3.0 –0.6 4.6 4.3  4.2 4.3   Advanced Economies 0.5 –3.2 2.6 2.4  2.3 2.6   United States 0.4 –2.4 3.3 0.1 3.2 2.6   Euro Area 0.6 –4.1 1.0 –2.1 1.1 1.6     Japan –1.2 –5.2 2.4 –1.4 1.1 3.0   United Kingdom 0.5 –4.9 1.2 –3.1 2.1 1.9   Canada 0.5 –2.5 3.6 –1.1 4.0 2.6   Other Advanced Econ.s 1.7 –1.2 4.6 3.1 3.4 4.6     NewlyInd.AsianEconomies 1.8 –0.9 6.7 6.1 4.3 6.3   Emerging&Developg.Ec.s 6.1 2.5 6.8 5.7 6.9 6.8

35. 2. Hard landing for the dollar: Definition: foreigners lose willingness to continue accumulating US assets => $ ↓ & i ↑ => possible return of stagflation in US • Many have warned of this possibility for some time. • So far, foreigners have happily financed US deficits. • But just because the $ has been the leading international currency for 70 years, doesn’t mean it always will. • Cautionary tale: £ (1914-1956) • With a lag after US-UK reversal of economic size & net debt, $ passed £ as #1 international currency.

36. Global current account imbalances – China’s surplus and America’s deficit – are now widening again, with recent recovery in US income & the $.

37. Pre-2007, economists were split between Martin Feldstein Ken Rogoff * Maury Obstfeld Nouriel Roubini Larry Summers Menzie Chinn Me Lots more Ben Bernanke Ricardo Caballero * Richard Cooper Michael Dooley Pierre-O. Gourinchas Alan Greenspan Ricardo Hausmann Lots more those who saw the US deficit as unsustainable, requiring a $ fall, and those who saw no problem. 37 *Some claim that the financial crisis of 2007-09 fits their theories.

38. The 2007-09 financial crisis did not help resolve the debate over current account imbalances • Those of us who predicted an unsustainable US current account deficit and a $ hard landing were proven wrong by the 2008 movement into $. • Meanwhile, those who said the US CA deficit was sustainable because of the superior quality & desirability of US assets were also proven wrong. • corporate governance, rule of law, • accounting system, rating agencies, • securities markets, … MSN Money & Forbes

39. Projection of $ vs € as shares of central banks’ foreign exchange reserves: a function of country size, financial market depth, & rate of return, with parameters estimated on 1973-98 data.Simulation assumes $ depreciation continues at 2001-04 rate. Chinn & Frankel (2005) birth of € This scenario showed € overtaking $ as top international reserve currency in 2022.

40. Multiple International Currency System • The € is now a rival international currency. • The ¥ & Swiss franc have gained a bit too. • The SDR came back from the dead in 2009. • Gold has also made a comeback as an international reserve asset. • Someday the RMB will join the roster. • = a multiple international reserve currency system. SDR

41. 3: Global crisis insovereign debt • EU has long-term debt problems as bad as the US, • esp. future liabilities related to retirement & health. • Not just the PIIGS countries. • Japan is perhaps even worse. • Only Canada has done things better. • Worldwide savings shortage is in the offing. • I now think that a sharp fall in bond markets among advanced countries generally is somewhat more likely than a hard landing for the US per se, relative to the others.

42. 4. The best of the four scenarios, is the least likely • Recovery becomes firmly established, and then • the US and other major advanced countries seriously address their long-term fiscal situations, to reduce chance of long-term crisis. • Good economic policy would combine, in my view, • Fiscal stimulus today, designed with high bang-for-buck: • More money for states, to avoid lay-offs • Infrastructure investment, for the future • Among tax cuts, extending Bush benefits for super-rich should be last priority (e.g., 2010 abolition of estate tax) • together with steps today to lock in long-term return to fiscal discipline • including social security reform,e.g., raising retirement age

43. Other possible events around the world -- each of which is improbable taken alone -- • The euro-zone breaks up • China has a financial crisis at some stage • China-US military conflict • over Taiwan, or South China Sea • Mexico collapses(narcotics violence)

44. China could suffer the rite-of-passage of any new trade+manufacturing power: an asset market bubble & collapse Real Beijing land prices

46. References • Allison, Graham, 2005, Nuclear Terrorism: The Ultimate Preventable Catastrophe (Henry Holt) • Clarke, Richard, 2004, Against All Enemies: Inside America's War on Terror (Free Press). • Frankel, Jeffrey, “Responding to Crises,” Cato Journal, vol. 27, no. 2, Spring/Summer 2007, pp.165-178. • Frankel, & George Saravelos, 2010, "Are Leading Indicators of Financial Crises Useful for Assessing Country Vulnerability? Evidence from the 2008-09 Global Crisis"  NBER WP 16047. • Hume, David, 1888, Hume's Treatise of Human Nature (Oxford, Clarendon Press). Originally published 1739–40. • Mill, John Stuart, 1843, A System of Logic: Ratiocinative and Inductive. (Harper & Bros.). • Popper, Karl, 1959, The Logic of Scientific Discovery (Basic Books). • Reinhart, Carmen, and Kenneth Rogoff, 2009, This Time is Different: Eight Centuries of Financial Folly (Princeton University Press). • Shiller, Robert, 2007, Understanding Recent Trends in House Prices and Home OwnershipCowles Foundation Discussion Paper No. 1630 . • Taleb, Nassim Nicholas, 2007, The Black Swan: The Impact of the Highly Improbable (Penguin).

47. Appendices • Doubling of US monetary base • Creditworthiness: Some advanced economics have fallen as emerging markets have risen • Competing international currencies €

48. Federal Reserve Assets($ billions)have more-than-doubled, through new facilities, rather than conventional T bill purchases 48 Source: Federal Reserve H.4.1 report

49. Sovereign spreads for 5 euro countries shot up in the 1st half of 2010 Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.

50. Ratings for “Advanced Economies” Ratings for “Emerging Economies”