Crisis Economics Part 13

Even more radical reforms must be implemented as well. Certain inst.i.tutions considered too big to fail must be broken up, including Goldman Sachs and Citigroup. But many other, less visible firms deserve to be dismantled as well. Moreover, Congress should resurrect the Gla.s.s-Steagall banking legislation that it repealed a decade ago but also go further, updating it to reflect the far greater challenges posed not only by banks but by the shadow banking system.

These reforms are sensible, but even the most carefully conceived regulations can go awry. Financial firms habitually engage in arbitrage, moving their operations from a well-regulated domain to one outside government purview. The fragmented, decentralized state of regulation in the United States has exacerbated this problem. So has the fact that the profession of financial regulator has, until very recently, been considered a dead-end, poorly paid job.

Most of these problems can be addressed. Regulations can be carefully crafted with an eye toward the future, closing loopholes before they open. That means resisting the understandable impulse to apply regulations only to a select cla.s.s of firms-the too-big-to-fail inst.i.tutions, for example-and instead imposing them across the board, in order to prevent financial intermediation from moving to smaller, less regulated firms. Likewise, regulation can and should be consolidated in the hands of fewer, more powerful regulators. And most important of all, regulators can be compensated in a manner befitting the key role they play in safeguarding our financial security.

Central banks arguably have the most power-and the most responsibility-to protect the financial system. In recent years, they have performed poorly. They have failed to enforce their own regulations, and worse, they have done nothing to prevent speculative manias from spinning out of control. If anything, they have fed those bubbles, and then, as if to compensate, done everything in their power to save the victims of the inevitable crash. That's inexcusable. In the future, central banks must proactively use monetary policy and credit policy to rein in and tame speculative bubbles.

Central banks alone can't handle the challenges facing the global economy. Large and destabilizing global current account imbalances threaten long-term economic stability, as does the risk of a rapidly depreciating dollar; addressing both problems requires a new commitment to international economic governance. The IMF must be strengthened and given the power to supply the makings of a new international reserve currency. And how the IMF governs itself must be seriously reformed. For too long, a handful of smaller, aging economies have dominated IMF governance. Emerging economies must be given their rightful place at the table, a move reinforced by the rising power and influence of the G-20 group.

All of these reforms will help reduce the incidence of crises, but they will not drive them to extinction. As the economist Hyman Minsky once observed, "There is no possibility that we can ever set things right once and for all; instability, put to rest by one set of reforms, will, after time, emerge in a new guise." Crises cannot be abolished; like hurricanes, they can only be managed and mitigated.

Paradoxically, this unsettling truth should give us hope. In the depths of the Great Depression, politicians and policy makers embraced reforms of the financial system that laid the foundation for nearly eighty years of stability and security. It inevitably unraveled, but eighty years is a long time-a lifetime.

As we contemplate the future of finance from the mire of our own recent Great Recession, we would do well to try to emulate that achievement. Nothing lasts forever, and crises will always return. But they need not loom so large; they need not overshadow our economic existence. If we strengthen the levees that surround our financial system, we can weather crises in the coming years. Though the waters may rise, we will remain dry. But if we fail to prepare for the inevitable hurricanes-if we delude ourselves, thinking that our antiquated defenses will never be breached again-we face the prospect of many future floods.

Outlook.

During the global financial crisis of 2007-8, the world looked into the abyss. In the fourth quarter of 2008 and first quarter of 2009, global economic activity plummeted at rates last seen at the onset of the Great Depression.

Only swift, radical policy measures in a number of countries stanched the bleeding. Though not always coordinated or careful, this collective response successfully prevented another depression, and economies around the world stopped their free fall. The dangers of deflation faded, and the world started to recover. Emerging economies turned around first, and by the third quarter of 2009 most advanced economies stopped contracting too.

But while the global economy has started to rebound, its risks and vulnerabilities may lead to renewed crises in the coming years. One possible outcome is that exploding fiscal deficits may prompt some countries to default on their debt, or to resort to the printing press to mitigate it, triggering the sort of high inflation last seen in the 1970s.

Other troubles may emerge as well. Extremely loose monetary policies and quant.i.tative easing-combined with a growing reliance on the carry trade in the dollar-may foster an even bigger bubble than the one that just burst. Should it deflate suddenly, the value of risky a.s.sets and global wealth would fall sharply, with the danger of a double-dip global recession.

Other equally frightening events might occur. The European Monetary Union could break up. Or j.a.pan might return to deflation and near depression, triggering a major sovereign debt crisis. Even China faces growing risks: its investment-led recovery could lose steam, possibly triggering a rise in nonperforming loans and, ultimately, a banking crisis. All of these scenarios could lead to a backlash against globalization.

Much rides on how the global economy recovers-or falters-in the next few years. Here, then, is a glimpse of the near-term dangers facing us. (For a far more detailed a.n.a.lysis, please visit Roubini Global Economics at www.roubini.com.)

V, U, or W?

Recoveries come in different forms, reflecting their relative vigor or sustainability. A V-shaped recovery is swift and vigorous; a U-shaped recovery is slow and underwhelming; and a W-shaped recovery is a double dip, in which the economy experiences a fleeting recovery, then plunges downward again. The most likely scenario at present is a U-shaped recovery in advanced economies, featuring weak, below-trend growth for a number of years. Here's why.

First, labor market conditions remain weak. In 2010 the U.S. unemployment rate reached 10 percent. (A more comprehensive measure that accounts for partially employed workers and discouraged workers topped 17 percent.) Many jobs in real estate, construction, and the financial sector have disappeared forever. Likewise, many manufacturing and service-sector jobs that have been outsourced offsh.o.r.e will not return.

Even workers who have kept their jobs have seen their income decline. Many firms, as a way of "sharing the pain," asked their employees to work fewer hours or accept furloughs or even wage cuts. The fall in hours worked was equivalent to the loss of another 3 million full-time jobs, on top of the 8.4 million jobs formally lost by the end of 2009. Those losses may continue: a recent study by Alan Blinder suggests that up to one-quarter of all U.S. jobs could be eventually outsourced. Therefore the unemployment rate may continue to rise for a while, and when it finally falls, it will do so very slowly.

Moreover, the current recession is different from previous ones. This recent crisis was born of excessive debt and leverage in the household sector, the financial system, and even the corporate sector. The recession wasn't driven by monetary tightening; it was a "balance sheet" recession driven by a staggering acc.u.mulation of debt. Recent research by Carmen Reinhart and Kenneth Rogoff suggests that a "balance sheet" recession can lead to a weak recovery, as every sector of the economy "deleverages" and cuts down its debt.

This will take a while. Households in the United States and the United Kingdom have saved too little and spent too much. Though U.S. savings rates rose above 4 percent by the end of 2009, studies done by the IMF and other scholars suggest that this rate needs to rise to 8 percent or higher in the next few years. That will mean lower growth rates of consumption. But since consumption is 70 percent of GDP in the United States (and very high in other countries that have also seen declining savings rates), reduced consumption growth may undercut economic growth.

Other indicators point toward a U-shaped recovery. In a typical V-shaped recovery, the corporate sector plows money into capital expenditures-better known as "capex"-contributing to a rapid rebound. Unfortunately, in this recovery, capex spending will be anemic because much of the economy's capacity (factories, machines, computers, and other fixed a.s.sets) sits unused. Indeed, capacity bottomed out at a much lower number (67 percent) than in previous recessions (75 to 80 percent). Even by the end of 2009, 30 percent of capacity remained idle in the United States and Europe. Why, in this climate, would firms want to undertake new capex spending?

In addition, for all the government support that the financial system received, vast swaths of it have been damaged. As of this writing, in the United States alone the FDIC shut down more than 130 banks and placed 500 or more on a watch list. More important, much of the shadow banking system has collapsed or been irreparably damaged; much of it has become a ward of the state. Despite public subsidies, securitization is a shadow of its former self, and even private equity firms continue to struggle with the consequences of having taken on too much leverage.

The financial system will take a long time to mend. The damaged financial system's ability to finance future residential investment, construction activity, capex spending, and consumption of durable goods will be seriously constrained. We will not return to the kind of growth we saw during the go-go years of 2003-7, financed by an unsustainable credit bubble Other factors suggest the likelihood of a U-shaped recovery. The policies that helped the economy recover-especially the fiscal stimulus-cannot last forever. When it's withdrawn, slower growth will follow. If it's not withdrawn-if policy makers resort to even bigger deficits to pay for tax cuts and spending increases-then we'll simply set ourselves up for a bigger fiscal train wreck. Continued stimulus spending will also lead to fears that countries will default on their debt or inflate it away, pus.h.i.+ng long-term interest rates higher and crowding out the economic recovery.

Finally, persistent global current account imbalances imply slower global growth in the next few years. During the last decade the United States-as well as countries like the United Kingdom, Ireland, Iceland, Spain, Dubai, Australia, New Zealand, the Baltic states, and other central European economies-functioned as the world's consumer of first and last resort, spending more than its income and running current account deficits. Conversely, China, emerging Asia, most of Latin America, j.a.pan, Germany, and a few other Eurozone economies served as the producers of first and last resort, spending less than their income and running current account surpluses.

The first group of countries is retrenching by saving more and importing less, but the second group is not compensating by saving less and consuming more. This necessarily means a net decline in the global demand for goods. Given that our world already has a glut of industrial capacity, the recovery of global aggregate demand will be weak at best.

All of these factors point toward a slow U-shaped recovery in the United States and in other spendthrift advanced economies. The recovery may not appear to be U-shaped at first: indeed, U.S. growth for the fourth quarter of 2009 was 5.9 percent, the strongest in six years. But most of that figure can be explained by the direct and indirect effects of the fiscal stimulus as well as by the fact that in the final months of 2009 companies replenished inventories.

These forces may boost growth to 3 percent or higher in the first half of 2010. So too may the lingering effects of the cash-for-clunkers programs and tax credits for first-time home buyers. The U.S. Census will hire almost a million temporary workers, which will help sustain growth for a brief period. But growth will stall in the second half of 2010 as the effects of these temporary factors fizzle out. At that point growth will slump well below par until the necessary increase in saving and the deleveraging of the private and public sectors have occurred.

Europe on the Edge.

As bad as things look in the United States, the medium-term prospects of the Eurozone and of j.a.pan may be equally bad, if not more so. In both regions the recovery will be U-shaped for many reasons.

First, the potential growth rate of the Eurozone and j.a.pan (around 2 percent) is lower than that of the United States. Second, these countries will have a harder time using fiscal policy to counter the effects of the crisis: even before 2007 they ran large fiscal deficits and had large stocks of public debt relative to their GDP (in many cases close to or above 100 percent). Third, these countries face serious challenges over both the short term and the long term: poor productivity growth and aging populations. None of these problems can be easily addressed.

Moreover, a group of Eurozone countries known as the PIGS-Portugal, Italy, Greece, and Spain-are in grave trouble. In recent years their debts have soared and their compet.i.tiveness has declined. The reasons are complicated. The adoption of the euro enabled them to borrow more and consume more than they would have otherwise. The ensuing credit boom supported consumption but also led to rising wages. This made their exports less compet.i.tive. At the same time, excessive bureaucracy and other structural impediments discouraged investment in high-skill sectors, even though wages in these countries trailed behind the average for the European Union.

The resulting noxious mix of large current account deficits and budget deficits left the PIGS countries heavily indebted to banks elsewhere in Europe. All are highly leveraged, making them a likely source of financial contagion. Worse, the dramatic appreciation of the euro in 2008-9 has increased the loss of compet.i.tiveness, leaving them even more vulnerable to default and threatening to burden the wealthier, healthier members of the European Union.

This wasn't supposed to happen. The European Monetary Union was designed to bring stability and unity to Europe. When member states joined, they ceded control over monetary policy to the European Central Bank; they also joined the Stability and Growth Pact, which imposed restrictions on the size of their fiscal deficits. In theory their members.h.i.+p would force these countries to undertake structural reforms and force a convergence of economic performance among all member states. Instead, the opposite happened. Germany and a few other countries spent a decade reducing their fiscal imbalances and improving their compet.i.tiveness via corporate restructuring. But the opposite occurred in Italy, Spain, Greece, and Portugal, where fiscal imbalances remained high and labor costs rose above productivity growth. As a consequence, we now have two Europes instead of one.

Other factors have aggravated the divergence. Labor mobility within the union is only modest, as language and culture hamper migration. So a rise in unemployment on the periphery of the union will not lead workers to migrate to more prosperous regions as much as they otherwise might. As a consequence, labor markets in the European Union are much less flexible than those in the United States. Equally troubling, the individual nations of the EU do not share the fiscal burden of government, as states do in the United States. The fact that fiscal policy is left in the hands of the individual countries limits the degree to which one nation can help another.

If these economic divergences persist and widen, the European Monetary Union could break up. For example, suppose Greece resorts to financial engineering and fiscal fudges to deal with its problems. If it continues to do so, Greece could lose access to debt markets sometime in 2010. It would then have to go hat in hand, begging for direct loans from other member states, the European Central Bank, the European Commission, or the IMF.

These players might bail out Greece for the sake of the survival of the Monetary Union. But if similar trouble spreads to Spain, Italy, Portugal, or other member states, the willingness and ability of the European Central Bank, much less the French and German taxpayers, to bail out other member states would reach a limit. Greece would then have to exit the Monetary Union and adopt a new, devalued currency like the drachma to replace the euro.

This twin scenario-default and devaluation-could have terrible consequences. By adopting a new, depreciated drachma, Greece would necessarily default on public-and most likely private-debts denominated in euros.

Something like that happened in Argentina in 2001. Its exit from a currency board and a sharp devaluation of the peso triggered a ma.s.sive default on public and private debts denominated in U.S. dollars. It also led to the forced conversion of dollar-denominated domestic debt into peso liabilities with a much lower value, a process known as "pesification." Likewise, a devaluation and default by Greece or Italy would lead to a "drachmatization" or "liralization" of domestically issued euro liabilities, effectively imposing ma.s.sive losses on anyone holding these claims, mostly other European banks.

No currency union has ever survived without a fiscal and political union as well. Should such defaults and devaluations take place, the contrast between the Eurozone and the United States would become ever starker. California and many other states in the United States face budget crises, but a strong tradition of fiscal federalism-as well as provisions in the bankruptcy code-makes it possible to solve some of these local problems at a national level. The Eurozone lacks such burden-sharing mechanisms.

A breakup of the Monetary Union could even lead to the partial destruction of the European Union itself. Any member nation that exits the Monetary Union and defaults on debts held by other member nations may ultimately be expelled from the EU. That fate, inconceivable a few years ago, has become a very real possibility for authorities in Athens, Rome, Madrid, and Lisbon. Years of economic divergence and an erosion of economic compet.i.tiveness in these countries have made such an outcome far more likely than ever before.

Whither j.a.pan?

j.a.pan is in as much trouble as the Eurozone. As we have seen, the bursting of its real estate and equity bubble in the early 1990s led to a Lost Decade of economic stagnation-punctuated by four recessions-as well as serious deflation. In the wake of the bubble, j.a.pan made many policy mistakes: it adopted monetary easing and fiscal stimulus too late, then abandoned them too early. It kept zombie banks alive for too long, recapitalizing only late in the decade. A double-dip recession in 2000 only exacerbated the twin problems of deflation and stagnation. j.a.pan returned to a potential growth of 2 percent only after 2004.

During the recent crisis the contraction was more severe in j.a.pan than in the United States, despite the fact that most of j.a.pan's financial inst.i.tutions had little exposure to toxic mortgages or structured financial products. Instead, j.a.pan proved vulnerable on account of its heavy dependence on foreign trade, which was itself dependent on a weak yen. When global growth and trade collapsed in 2008-9, exports collapsed. The yen-based carry trade unraveled, driving the yen to appreciate. Its recovery since then has been anemic at best.

j.a.pan faces a host of long-term problems. Its aging population, combined with its reluctance to welcome immigrants, has put its economy in a demographic vise that will reduce growth. An inefficient, somewhat ossified service sector with low productivity has proven resistant to change, as have rigid economic and social conventions like lifetime employment. The political system is equally rigid, showing no will to undertake the structural reforms necessary to break free of these restraints. j.a.pan's position as the world's second-largest economy is probably no longer secure: China is likely to supplant it in the coming years.

More worrisome, j.a.pan's high public deficits, weak growth, and persistent deflation point to a possible fiscal crisis. So far that fate has been avoided, thanks in part to high private savings rates. In addition, j.a.pan's large current account surpluses have led both the private sector and the central bank to acc.u.mulate foreign a.s.sets, providing a buffer of savings that could be eventually used to service the growing domestic debt. For this reason j.a.pan's government can still borrow at relatively low rates, even though it now shoulders a gross public debt equivalent to almost 200 percent of GDP.

Still, in the recent crisis the household savings rate fell sharply as income-strapped households had to spend more to maintain their standard of living; even the current account surplus shrank, as rising budget deficits and falling private savings overwhelmed the fall in private investment. Should these trends continue, j.a.pan may be headed for a serious fiscal crisis, as continuing deflation, anemic growth, soaring deficits, and a strong yen conspire to drive down confidence in its economy.

In fact, some rating agencies have put j.a.pan on a possible sovereign downgrade watch. If j.a.panese households lost confidence in the government's ability to tackle the deficit and public debt, they might dump domestic a.s.sets (starting with government bonds) and resume yen-based carry trades, sharply pus.h.i.+ng down the value of the yen and sending long-term government bond yields upward. This could eventually trigger a public debt crisis.

Unfortunately, the j.a.panese political system's ability to deliver the kind of fiscal adjustments and structural reforms necessary to turn things around is limited. In 2009 the opposition Democratic Party of j.a.pan (DPJ) finally ousted the dominant Liberal Democratic Party (LDP), which had maintained a virtual monopoly on power for over fifty years. This political s.h.i.+ft suggested that j.a.pan might be on the road to reform, but events soon suggested otherwise.

Upon a.s.suming office, the DPJ's new leader, Yukio Hatoyama, made ambitious but contradictory promises. Acknowledging the constraints on j.a.pan's budget, he and his party promised to cut inefficient and wasteful state spending. At the same time, he called for "an economy of the people" that depended on significant state subsidies, as well as a budget that required record borrowing. Equally troubling, Hatoyama then announced plans to halt the privatization of j.a.pan Post Bank. This enormous enterprise, which holds more than $3 trillion in a.s.sets, has helped finance state spending for decades, and the move made it clear that Hatoyama expects to continue this tradition.

These policies will likely increase debt and keep growth at subpar levels. Unfortunately, Hatoyama's ability to pursue these goals has few political checks: in recent years, the DPJ built a strong single-party majority in the lower house while joining forces with coalition partners to dominate the upper house. Hatoyama also faces fewer inst.i.tutional obstacles, a.n.a.logous to the filibuster of the U.S. system, to setting and pus.h.i.+ng a political agenda.

At the same time Hatoyama is unlikely to reform the larger economy. Prior to the DPJ's ascent to power, business elites worked with an LDPDOMINATED bureaucracy to frame legislation. Suddenly, the business elite has seen the one-party system s.h.i.+ft to a no-party system; indeed, the new ruling coalition has far fewer connections in the business world. That means it has few opportunities for the kind of compromises necessary to achieve the sorts of structural reforms that would ensure higher growth in the coming years.

That may eventually leave j.a.pan in a very dangerous position, as soaring deficits and a sclerotic economy bring about the unthinkable: a sovereign debt crisis or a surge in inflation and a decisive fall from grace for a country once considered likely to dominate the global economy.

BIC? BRIC? BRICK?.

On paper, most emerging economies can reasonably expect robust medium-term growth ranging between 5 and 8 percent, depending on the country. This growth rate is much higher than the 2 or 3 percent that most advanced economies expect in the coming years.

Their strength has much to do with the advantages they possessed going into the recent crisis. Except for parts of central and eastern Europe, emerging markets lacked the leverage in the financial and household sectors that became the Achilles' heel of many advanced economies. Moreover, having endured financial crises in recent decades, these countries cleaned up their financial systems, followed sound fiscal policies, and insulated central banks from political pressure so that they might better provide price stability.

These strengths and lessons learned enabled the emerging economies to weather the crisis well. They implemented effective monetary and fiscal policies to restore demand and growth, setting themselves up for a quick recovery. In fact, most of them will grow at a healthy clip, should they stick with the market-oriented reforms and policies adopted before the crisis.

That's the best-case scenario. But we should keep a few caveats in mind. First, these economies aren't self-sufficient; they have extensive trading and financial ties to more advanced economies and cannot fully decouple from their problems. An anemic recovery in the United States will inevitably act as a drag on even the most dynamic emerging markets.

The emerging economies include dozens of nations. The BRICs-Brazil, Russia, India, and China-are the biggest of the bunch, and China is the undisputed king. But China faces serious challenges. While it has weathered the crisis, its all-too-effective response may set it up for problems in the medium term.

For example, China has reacted to the crisis with state-directed credit growth. State-owned banks have been told to provide ma.s.sive amounts of credit and loans to state-owned enterprises in order to induce them to hire more workers, produce more goods, stockpile more commodities, and increase capacity. Every province now induces banks to lend recklessly to state-owned enterprises in order to increase capacity in steel, cement, aluminum, car making, and other heavy industries. But China already has a glut of capacity in these areas.

Thanks to the boom in public and private investment, China now has an infrastructure that outstrips its level of development: it has plenty of empty new airports and highways with very few cars. It also has a staggering increase in real estate development that will inevitably lead to a glut in commercial and residential properties. While economic growth and urbanization will eventually make use of these improvements and properties, the supply is starting to outstrip the demand. Unfortunately, some of these distortions are a function of the fact that land is not properly priced at a market rate; the state continues to control the supply.

Some of the credit now flooding through the Chinese economy is going toward other, equally unproductive uses, including speculative, leveraged purchases of commodities, equities, and real estate. This has the potential to become a dangerous bubble, eventually leading to a significant downward correction in a.s.set prices. The authorities recognize this possibility, and rising prices in energy, food, and real estate have prompted them to contract the money supply and credit in the hopes of engineering a soft landing.

China occupies a paradoxical position in 2010. While stimulus programs inst.i.tuted the previous year pushed growth back up into the 9 percent range, its economy still hasn't made the necessary s.h.i.+ft from an emphasis on exports to a reliance on private consumption. Consumption in China remains stuck at a paltry 36 percent of GDP, compared with 70 percent of GDP in the United States. There's certainly a happy medium between these numbers, but so far China hasn't done much to move toward it.

Other problems may bedevil China in the coming years. The country itself is growing at two different rates: coastal, urban areas that depend on exports are advancing more quickly than rural areas in the central and western parts. Moreover, economic growth in all regions has been pursued with a reckless disregard of the environment, leading to pollution that disfigures the landscape and causes significant health problems for millions of Chinese. Finally, an authoritarian political system that seems unable to tolerate any dissent, as well as the growing restlessness of ethnic minorities, may also spell trouble down the line.

The other members of the BRIC elite face a different set of challenges. Compared with China, India has a vibrant democracy, a stronger rule of law, and greater protection of property rights. But democracy is a mixed blessing: weak coalition governments in India have slowed down necessary structural economic reforms. These reforms include reducing budget deficits at the central and state levels, cutting inefficient government spending, and reforming the tax system.

Other liberal reforms must be inst.i.tuted as well. Government intervention in the economy must be restrained; red tape and a bloated bureaucracy must be cut back. Labor markets remain too rigid and must be liberalized; so should trade and restrictions on foreign direct investment. Entrepreneurs.h.i.+p should receive more encouragement, as should investment in human capital and skills. While India has made some progress on these fronts, the risk remains that these reforms will occur too slowly, increasing the gap between the Chinese hare and the Indian tortoise.

Brazil's situation is different still. It's a dynamic economy with plenty of natural resources, a sophisticated financial system, and an advanced manufacturing sector that could maintain robust growth for a long time. But even in the best of all times-the years between 2004 and 2007, when average growth in the other BRICs topped 8 or even 10 percent-Brazilian growth lagged far behind at 4 percent.

The Luiz Inacio Lula da Silva administration deserves credit for having followed sound macroeconomic policies-a low budget deficit and an independent central bank committed to low inflation-but more must be done. In order to get growth above 6 percent, the next president will have to deal with unfunded pension liabilities; reduce government spending and taxes that can badly warp economic decision making; increase the skills of the labor force by investing in education and training; and improve and expand infrastructures via private and public partners.h.i.+ps-all the while maintaining socially progressive policies that gradually reduce income and wealth inequalities.

The recent economic crisis exposed the remaining BRIC as a potential imposter. The weakness of the Russian economy-in particular, its highly leveraged banks and corporations-had been masked by the windfall generated by spiking oil and gas prices. After growing 8 percent in 2008, Russia's economy contracted by an equally stunning 8 percent the following year.

In effect, Russia's economy consists of one somewhat healthy sector-oil and gas-that fluctuates with the price of these commodities. It needs to diversify, but that would require the privatization of state-owned enterprises, the liberalization of the economy, a reduction in the kind of red tape that hampers the creation of new firms, and a serious crackdown on the corruption that permeates the private sector. Even the energy sector has to be liberalized. Unfortunately, foreign investors remain reluctant to sink money into facilities that might eventually be expropriated or nationalized.

Russia has plenty of other problems that should disqualify it from BRIC status. It has a decaying infrastructure and a dysfunctional, corrupt political system. Its population is rapidly shrinking, and serious health problems-alcoholism, most obviously-have driven down life expectancy to worrisome levels. While Russia retains the world's largest nuclear a.r.s.enal, and maintains a permanent seat on the UN Security Council, it is "more sick than BRIC."

In fact, several other countries probably have a better claim to BRIC status, even if that means adding some letters to the acronym. Given its potential, the case is far stronger for including South Korea in the BRIC-or BRICK-club. South Korea is a sophisticated high-tech economic power: innovative, dynamic, and home to a skilled labor force. Its only major problem is the danger that North Korea will collapse and inundate it with hungry refugees.

Turkey too deserves to be included in the inner circle. It has a robust banking sector, a thriving domestic market, a large and growing population, a savvy entrepreneurial sector, and a comparative advantage in labor-intensive manufacturing. It has ties to Europe (NATO and European Union members.h.i.+p candidacy), to the Middle East, and to Central Asia.

Indonesia may be the strongest candidate of the bunch. The world's largest Muslim state, it boasts a rapidly expanding middle cla.s.s, stable and increasingly democratic politics, and an economy that outshone much of Asia despite the damage done by the global recession. From the perspective of the United States, Indonesia presents a rather attractive alternative to Russia, which increasingly vies with Venezuela for leaders.h.i.+p of the "America in decline" cheering section.

Indonesia has displayed resilience not only as an economy but also as a nation. It has a remarkably diverse and far-flung population, attributes that might cast doubt on its ability to make the transition to a world-cla.s.s economy. Yet the country has left behind the legacy of a military dictators.h.i.+p and has recovered from multiple setbacks. Though the Asian financial crisis in 1997, the tsunami in 2004, and the emergence of radical Islam have all done damage, Indonesia continues to move forward at an impressive rate.

While Indonesia's per capita GDP remains low compared with that of other aspirants to BRIC status, it has remarkable potential. It depends far less on exports than do its Asian peers (never mind Russia), and its markets in timber, palm oil, coal, and other a.s.sets have attracted major foreign investment. The government in Jakarta, meanwhile, has taken a strong stand against corruption and has moved to address structural problems. Even demographic trends favor Indonesia, which, with 230 million people, is already the fourth-largest country in the world by population, equivalent to Germany and Russia combined.

The hype about the BRICs-or BIICs or BRICKs-reflects an important long-term trend: the rise of a broader range of emerging-market economies with economic, financial, and trading power. A few years ago Lawrence Summers argued that the integration of China and India into the global economy-with close to 2.2 billion "Chindians" joining the global labor force and the global markets-was the most significant event in the last thousand years of human history, after the Italian Renaissance and the Industrial Revolution.

How that plays out remains to be seen. China, India, and the other leading emerging economies all face their share of challenges and will need to pursue very specific reforms to move to the next stage. But in all likelihood, most will end up playing an increasingly central role in the global economy in the coming years.

A New Bubble?

Since March 2009 a range of risky global a.s.sets have undergone a ma.s.sive rally. Stock markets rebounded in the United States; energy and commodity prices started to climb back upward; and stocks, bonds, and currencies in emerging markets shot skyward. As they regain their appet.i.te for risk, investors have moved away from U.S. government bonds and the dollar, which has sent bond yields gently up and the value of the dollar down.

While this recovery in a.s.set prices is driven in part by better economic and financial fundamentals, prices have shot up too fast too soon. Why? The most obvious reason is that the central banks of the advanced economies have used superlow interest rates and quant.i.tative easing to create a "wall of liquidity" that has managed to surmount the "wall of worry" left behind after the crisis. And that's helping to fuel a ma.s.sive rally in risky a.s.sets.

But something else is also fueling this global a.s.set bubble: the carry trade in the dollar. In a carry trade, investors borrow in one currency and invest it in places where it will yield a higher return. Thanks to near-zero interest rates in the United States, investors can borrow dollars and sink them into any number of risky a.s.sets around the world. As the prices of these a.s.sets go up, the investors make a tidy profit, which they can then use to pay back those borrowed dollars, which by this point have depreciated, making it even easier to return the loan. In practice, that means investors aren't borrowing at zero percent interest rates; they're borrowing at negative interest rates, negative 10 or 20 percent, depending on how much the dollar depreciates. In this climate, it's pretty easy to make a profit: 50 to 70 percent since March 2009.

The Fed has inadvertently kept this game going. By buying up a range of a.s.set cla.s.ses-U.S. government bonds, mortgage-backed securities, and the debt of Fannie Mae and Freddie Mac-the Fed has reduced volatility in the markets. That only makes the carry trade more appealing, minimizing people's sense of risk and drawing more and more investors into a bubble. These measures, when combined with the Fed's policy of keeping interest rates near zero, have made the world safe for the "mother of all carry trades" and the mother of all a.s.set bubbles.

The growing weakness of the dollar has put central banks in Asia and Latin America in a difficult position. If they fail to intervene in foreign exchange markets, their currencies will appreciate relative to the dollar, making it even more attractive to borrow in dollars. If they do intervene to prevent this appreciation, buying up foreign currencies like the dollar, the resulting foreign reserves can easily feed a.s.set bubbles in these economies. Either way the outcome is the same: a global a.s.set bubble that grows bigger by the day.

Eventually the carry trade will unravel. The Fed will end its program of purchasing a.s.sets, effectively restoring some volatility to the markets; and at some point the dollar will stabilize, as it can't keep declining indefinitely. When it stabilizes, the cost of borrowing in dollars will no longer be negative; it will merely be close to zero. That's bad news for anyone who has bet that the dollar will continue to decline, and it will force these speculators to suddenly retrench and "cover their shorts."