The second part of Martin’s Wolf’s The Shifts and the Shocks examines the deeper economic causes of the financial crisis. “This crisis was the product not just of easily fixable failings in the financial sector….It was also the product of failings of the global economic system….Moreover, both are among the consequences of fundamental shifts in the world economy.”
Wolf’s interest in looking for deeper causes sets his book apart from more superficial treatments that just blame the crisis on easy credit, foolish borrowing, and loose monetary policy by the Federal Reserve. Wolf regards these as symptoms rather than underlying causes. Returning to full employment and high economic output may be harder than most people realize, since it will require addressing some fundamental economic problems.
This part of the book is divided into two chapters: “How Finance Became Fragile” and “How the World Economy Shifted.” Again, his approach is to examine financial effects before economic causes, so the reader must follow the argument all the way through to arrive at the key conclusions.
How finance became fragile
Financial crises have been endemic to capitalism. The financial system often fluctuates between phases of boom and bust, optimism and pessimism, credit expansion and credit contraction. Wolf summarizes Hyman Minsky’s description of five stages in a financial bubble:
‘displacement’ – a trigger event, such as a new technology or falling interest rates; ‘boom’ – when asset prices start rising; ‘euphoria’ – when investors’ caution is thrown to the wind; ‘profit-taking’ – when intelligent investors start taking profits; and ‘panic’ – a period of collapsing asset prices and mass bankruptcy.
For the most recent episode of credit boom and bust, Wolf identifies five factors that contributed to financial fragility:
- a trend toward financial liberalization and weakening of financial regulations
- globalization of banking, lending and holdings of assets
- financial innovations such as derivatives and shadow banking (trading of asset-backed securities)
- leveraging (holding more debt relative to equity, magnifying returns on the upside but also losses on the downside)
- incentive systems that rewarded risk-taking and short-term success
He also identifies three failures of policymakers:
- underestimating the need for regulation
- focusing monetary policy on controlling inflation, while overlooking other sources of instability
- not intervening in the banking collapse soon enough (specifically, letting Lehman Brothers fail)
How the world economy shifted
Once again, Wolf emphasizes that despite all of these financial weaknesses, “the failure does not lie only or even mainly within the financial system or with financial regulators. The crisis had wider economic causes–and consequences.” In particular, the boom in easy credit and excessive lending depended on what Ben Bernanke called–even before the crisis–a “global savings glut.” Wolf argues that this should also be thought of as an “investment dearth,” or a problem of balancing savings and investment. The issue is sustaining economic activity by using the money not spent on consumption for investments in future production.
To a degree, investment adjusts to savings through fluctuations in interest rates. If the desire to save is greater than the desire to invest in the means of production, interest rates fall, capital becomes cheap, and balance is restored by discouraging saving (through low return) and encouraging investment (through low cost). But in an economic slump, this balancing mechanism can fail to put capital to productive use. People may choose to sit on cash, neither spending it nor buying low-interest bonds, and businesses may refrain from investing in production because the demand for products is so weak. “In brief, Mr. Bernanke’s global savings glut would be visible in a combination of two phenomena: weak economies and/or low interest rates. Today, this combination is precisely what we see in the high-income countries.”
What caused the global savings glut was primarily a shift in many emerging economies, especially China, from being net importers of capital to being net exporters of capital. Although it has been common for investors in developed countries to find investment opportunities in less developed ones, some of the latter prefer to avoid dependence on foreign capital. They choose to strengthen their economies by encouraging saving over spending, financing their own industries, emphasizing exports over domestic consumption and running trade surpluses. At the same time, some developed countries, especially Germany and Japan, were also becoming net exporters of goods and capital, partly because their aging, slow-growing populations required less investment in new infrastructure and capital equipment at home. In the words of Raghuram Rajan, “So long as large countries like Germany and Japan are structurally inclined–indeed required–to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis.”
The largest of such countries was, of course, the United States, whose own industries were threatened by the ease with which American consumers could buy foreign goods. Making that situation worse was the strong American dollar–still the world’s most popular currency for holding cash reserves–which made American products more expensive and foreign products cheaper. However, the glut of foreign savings seeking investment opportunity brought interest rates down, discouraging saving and making it easier for Americans to buy expensive things on credit, especially housing. Investors who were reluctant to invest in faltering American manufacturing could invest in mortgage loans, including very shaky ones, which were packaged in clever ways to disguise the risks. So there was a credit boom that took multiple forms: creditor countries like China and Germany lending to debtor countries like the United States and Greece, an exploding finance industry lending to consumers within the United States, and rich investors around the world financing the US government deficit.
For most of the years leading up to the financial crisis, US business remained highly profitable, and contributed to the savings glut by running large surpluses. “With rising profits and a weak desire to invest, the non-financial corporate sector became a net supplier of savings to the rest of the economy.” The only way to keep the economy humming was for households and government to absorb excess savings by running deficits. “Persuading the household sector to spend consistently more than its income is quite hard,” Wolf says, but it was managed with easy credit. I would add that getting a Republican administration to accept large deficits ought to be hard too, but it was managed with tax cuts and wars.
One additional contributor to the savings glut and credit boom was rising economic inequality. “Finally, there was a huge shift in the distribution of income inside many economies, notably including high-income countries, from wages to profits, and, within wages, from those at the middle and bottom towards the top, partly due to globalization, partly due to technology, partly due to financial liberalization, and partly due to changes in social norms, particularly corporate governance.” While those with higher incomes could afford to save more, those with lower incomes relied more on credit to sustain consumption.
In the end, the global savings glut resulted in a massive waste of economic resources, as too little capital was put to productive use. “Instead, the resources were wasted in building unneeded and unaffordable houses or in fiscal deficits caused by unfunded wars, unfunded entitlement spending and unfunded tax cuts. The capital imported by the US, in particular, was wasted on a colossal scale.”
The final post on Wolf’s book will deal with ideas for putting the global economy on a more sustainable footing.