The biggest threat to the world economy comes not from global financial imbalances but from the protectionist sentiment these imbalances are generating, former US Federal Reserve chairman Alan Greenspan declared yesterday. Protectionism could deal a savage blow to the global economy, and to emerging economies in particular, he warned. Delivering the annual Per Jacobbson Foundation lecture, Greenspan defended his conduct of monetary policy during his time as Fed chairman, and also argued that recent financial market turmoil represented a example of “creative destruction.”
He warned too of the “politically” distorting impact that sovereign wealth funds could have on financial markets. “We must be acutely aware of how dangerous the drift toward protectionism is”, said Greenspan as a “postscript” to his lecture – in which he had expressed the hope that there could be a “benign, market-determined outcome” to the problem of global imbalances. An outbreak of protectionism could negative this benign scenario, he said.
Dealing with financial market turmoil, Greenspan rejected the idea that low interest rates during much of his term in office (1987-2006) were responsible for a “housing bubble” in the US, which eventually resulted in the sub-prime mortgage market crisis. This would not explain housing bubbles in other countries where rates were higher, he argued.
Many of the sophisticated financial products that have been at the heart of the financial system turmoil are examples of the kind of financial innovation that symbolizes the US’s “flexible and efficient” financial markets, he said. “Like all such products, some fail,” he said.
Some of the “curious financial structures” that have been at the heart of recent problems “are about to disappear,” he said, citing fact that sub prime mortgages have already declined from 20% the total US mortgage market to “zero”. It is “part of the process of creative destruction”, he suggested.
Greenpsan had argued in an earlier interview with Emerging Markets that financial markets ought to have been allowed to clear themselves in the wake of the sub-prime mortgage crisis. He attacked leading banks’ plans to intervene by launching a “super fund” that aims to restore market liquidity.
Greenspan also predicted that the rapid expansion of sovereign wealth funds in emerging economies creation would come to an end. They represent an attempt by governments to earn increased returns on their reserves. But higher returns will come with higher risks. “Defaults will rise and we will be back to where we were.”
But he acknowledged a danger that the growth of sovereign wealth funds might not be guided only by financial considerations and that they could be used for “political purposes.” If so, this could have a major distorting effect on the operation of financial markets.
Greenspan forecast that China’s huge current account surpluses would dissipate over time. The surpluses are largely a function of China’s underdeveloped financial system and of the absence of social safety nets within the country, he argued. As these systems develop, China’s surpluses will diminish – “but I would not like to predict when”, he added.