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The threat of extreme events Samuel Brittan: Financial Times: 18/06/04 We are now in one of those phases where highly favourable economic data clash with an anxious mood among large parts of the business community. Contrast for instance the upbeat remarks of the governor of the Bank of England on "a synchronised world recovery" with the warning by Bill Gross of Pimco that the global outlook is at its most uncertain for 20 or 30 years. A thoughtful explanation of the discrepancy comes from Kenneth Rogoff, formerly chief economist of the International Monetary Fund, in the May issue of the Central Banker. Mr Rogoff was always an untypical international official - he gave up a career as a chess grand master to concentrate on economics. He now puts his finger on a weakness of official assurances by saying "people tend to resist thinking about low probability extreme events". He uses this expression in relation to the risks to consensus economic forecasts of modest US consumer price inflation of some 2 per cent a year stretching ahead. But many low probability events cumulate to a substantial risk. There are other kinds of extreme events outside the range of conventional forecasts. There are those that may not happen quickly, such as a violent regime change in Saudi Arabia, but which would be very disruptive if they did. There are also dangers that are highly likely, but the timing of which is uncertain. Mr Rogoff cites the US current account deficit of 5 per cent of gross domestic product, which he, like many others, regards as unsustainable. Suppose, however, this suddenly reverts to balance. For instance, a steep collapse in US house prices could lead to a sharp rise in private savings. Indeed, he believes there is a high risk of a housing slump in the US even though the boom there has not gone as far there as it has in the UK or Australia. A future correction would need to be accompanied, according to the former IMF economic director, by a drop in the the dollar of over 40 per cent in the short run and in the long run of about 12-14 per cent. But he shares the view that fixed exchange rates would worsen matters. He considers that the US economy has sufficient flexibility to survive the turmoil he foresees. But how would the inflexible economies of Europe and Japan handle a sudden drop in the dollar? "Very poorly I would venture." There are weaknesses in the world economy that have a high rather than a low probability of doing damage but to an uncertain extent and over uncertain time horizons. Mr Rogoff cites the low value of official short-term rates, the "unusually lax stance of fiscal policy" and global imbalances. He believes that we underrate the long-term threat to price stability posed by the steady deterioration in budget positions forecast over the Organisation for Economic Co-operation and Development area in the next 30 years, due mainly to ageing populations. Central banks will thus need to strengthen their independence so that "irresistible spendthrift governments" meet "immovable anti-inflation monetary authorities". Yet he is critical of the obsession with inflation targets over fairly short horizons. He would like central banks to have a longer focus and also take into account output, the exchange rate and asset prices, especially housing, as well as consumer prices. Meanwhile, what is the immediate world conjuncture? Outside the core eurozone countries there is indeed a pretty vigorous world economic expansion. At the same time inflation rates, although still low, are rising faster than expected. Nor is it only oil. Other commodity prices are creeping upwards and so are core consumer inflation rates. The pattern is that of an economic upturn beginning to press on primary producing capacity, and in the UK on the labour market too. The last thing required now are policies designed to stimulate activity further. Yet monetary policies are still highly expansionary. Short-term real interest rates in the Group of Seven countries are still negative. In the US, they are minus 1 per cent. In core euro countries, they are around zero. This compares with a normal historical level of, say, 2 or 3 per cent. There is also a gap of over 2½ percentage points between prevailing international nominal short-term rates and the rates on 10-year government bonds (an upwardly sloping yield curve). Monetary policy is, in the awful US financial jargon, "behind the curve". It is difficult to escape the conclusion that central banks still practise "the pretence of knowledge". They believe they can estimate phenomena such as the output gap or the rate of inflation to be expected for any specified behaviour of real activity. The sooner they forget these pretensions and move back towards a neutral policy, the better they will be prepared to meet future threats from any direction.
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