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Cause and effect, Part II

Cause and effect, Part II

Nobel laureate Paul Krugman tells Ian Munroe about the origins of the financial crisis, and how its fallout will change the global economy. Part II.

August 31, 2009 2:20 by

Click here to read part I of this interview.

Paul Krugman, recipient of the 2008 Nobel Prize for Economics, is a professor at Princeton University. He writes opinion pieces for New York Times twice weekly and has authored several books including, most recently, “The Great Unraveling.”

Credit rating agencies have taken a credibility hit. How do we make them better at what they do, especially when it comes to assessing financial institutions in the future?

Who knows, is the short answer. This is very difficult. We have a problem that doesn’t seem to have an easy solution. The rating agencies are paid essentially by the people they rate. And while crude corruption may be reduced, may be avoided, there’s clearly a built-in tendency not to recognize the realities.

Try and think of an alternative model and it’s not so easily done. Have them taxpayer financed? How do we avoid politicization? Try to get some other model for their payment? It’s not clear exactly how you do this. It does require some thought, and it is a real problem because, like it or not, the rating agencies have an enormous impact. Institutional investors almost have to base their decisions on those ratings. But I don’t know what the answer is.

Beyond that, the major changes are going to be a return to a world of more balance, you might say. It’s unlikely that we can have a full world recovery while these very large surpluses for some reason persist [in some countries], and there are large deficits in others.

So we’re probably going to be in a world in which China is one way or another pushed more to rely on domestic demand, and in which the United States is pushed to rely more on its domestic saving capacity. It’s a little bit hard to figure out how the Gulf region fits into this, because it will have a high income – I think oil prices will at least partially recover – but limited absorptive capacity [to increase further].

So you don’t think they’ll become any less influential?

Well the trouble is, no matter how much people say “I don’t really trust the rating agencies,” it is nonetheless very difficult for institutional investors to ignore what they say. If the rating agencies put a downgrade on your country’s debt, then your sovereign debt spreads will rise because there are so many players who are more or less mechanically forced to divest themselves of holdings of your debt because of that action.

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