Beneath the Surface

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The last part of Martin Wolf’s book deals with solutions to financial instability and the sluggish economic recovery. This is the hardest part to summarize, since Wolf discusses a great many ideas, organizes them rather loosely, provides little in the way of prioritization, and conveys little confidence that some of the more promising ideas will actually be adopted. In keeping with Wolf’s interest in underlying macroeconomic causes of financial crisis, I will highlight the solutions that would address those causes.

To review some of the main themes, Wolf describes a global economy in the aftermath of a great credit boom and bust. Underlying the financial crisis was a global savings glut that was really an excess of saving over investment. When an economy generates more income than is spent on current consumption, the surplus should sustain economic activity through investment in future production and consumption. Also, some people’s savings can go to finance other people’s consumption, as long as the loans are sound and the debtors can repay them out of future earnings. But in the global economy prior to the crisis, not enough of the world’s savings was used for either sound investment or sound consumer borrowing, and too much was used to finance high-risk consumer loans and asset bubbles, especially in housing.

The world became more divided into creditors and debtors: creditor and debtor countries (such as Germany in relation to peripheral Europe and China in relation to the US), creditor and debtor economic classes (increasingly unequal households, especially in the US), and creditor and debtor economic sectors (the corporate sector with surplus income and the government and household sectors running deficits). When the credit boom got too far out of hand, some debtors defaulted, some creditors stopped lending, and the system crashed.

The challenge for the future is then to tighten financial rules to discourage credit excesses, but also to reform the system to make better use of economic resources. It isn’t enough just to stop creditors from making risky loans and force debtors to pay down debt. If something else isn’t done to put excess savings to good use–in either investment or consumption–austerity will only weaken economic demand, increase surplus savings and produce long-term economic stagnation. That is what Wolf fears:

Far more likely [than adequate reform] is an enduring slump in high-income countries, at least relative to pre-crisis expectations. That would impose huge costs – of investments unmade, of businesses not started, of skills atrophied and of hopes destroyed. Should that fate be avoided, another temporary credit-driven boom might emerge, followed by another and still bigger crash.

Wolf argues that the long-term costs of failing to sustain high economic output are greater than the costs of wars, and also greater than the costs of inflation (relevant because fighting inflation has often been such a high priority of economic theorists and policymakers).

Banking reform

Throughout his discussion of solutions, Wolf is willing to entertain more radical reforms than have been adopted so far, although he acknowledges the difficulties of implementing them. For example, he would like to make fundamental changes in the way bankers do business:

So the business model of contemporary banking is this: employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; invest in high-risk assets; promise a high return on equity, unadjusted for risk; link bonuses to the achievement of this return target in the short term; ensure that as little as possible of those rewards are clawed back in the event of catastrophe; and become rich. This is a wonderful business model for bankers….For everybody else, it was a disaster.

The solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.

Before the crisis, the median ratio of debt to equity in UK banks was 50:1. That meant that a mere 2% drop in the value of the typical band’s assets would make it insolvent. Wolf would like to see a maximum ratio of 10:1.

Wolf also devotes considerable space to a discussion of the even more radical “Chicago Plan,” which would eliminate the role of bank lending in the creation of money and dramatically increase the government’s control over the money supply. But he acknowledges that this would be too disruptive, and that more moderate reforms should be tried first.

Macroeconomic reforms

The deeper problem is how to stimulate demand and put savings to constructive use, so that excessive credit is not needed to maintain economic activity.

Wolf deplores the almost exclusive reliance on monetary policy (low interest rates and bond purchases by central banks) to bring about economic recovery. At least in the short run, increases in government spending would have accomplished more in a shorter time. “The decision to withdraw fiscal support for the recovery, taken at the G – 20 Summit of June 2010, delivered a longer and deeper slump than necessary….It has also meant relying on a more uncertain tool – that of unconventional monetary policy – and abandoning a less uncertain one – that of fiscal policy.” The notion that government borrowing and spending interferes with private investing lives on, although it made more sense when capital was scarce and expensive than it does now, when capital is abundant and cheap.

In the longer run, total economic demand must be increased by reducing the excess savings of creditors and increasing the income of debtors. High-saving, high-export countries like China and Germany need to stimulate domestic demand by allowing their workers to consume more, while debtor countries need to stimulate foreign demand by becoming more globally competitive and earning more income abroad. Corporations should be discouraged from accumulating excess savings, but encouraged by changes in corporate governance and taxation to distribute profits not needed for investment. Government should have the tax revenue it needs to create needed social goods. Low-income households should get a larger share of income through higher wages or progressive taxation, so they can maintain consumption without relying so heavily on debt.

Saving the Eurozone

Wolf minces no words in his discussion of the European Monetary Union; he regards it as a “bad marriage,” since it created a unified currency without first creating a unified state. “Proponents thought that creating a currency union would bring the peoples of the Eurozone closer together. Crises divided them into contemptuous creditors and resentful debtors instead. This has been a march of folly.”

As I discussed in the first post, the common currency made it easier for strong economies to export and weaker ones to borrow. But when the credit bubble burst, there was no central state to help repair the damage. Wolf notes that in the United States, some states are economically weaker than others, but their citizens participate in a federal safety net and their bank deposits are federally insured. The European Central Bank was very slow to intervene to maintain liquidity in the countries hardest hit by the financial crisis. Wolf maintains that since “the creditor countries bear a full share of the responsibility for the mess, they should expect to bear a full share in its resolution as well,” by refinancing some debt with lower interest rates and longer terms. Wolf also wants to see a strengthening of the central bank, with stronger powers to regulate banks and issue eurobonds “for which the Eurozone states are jointly and severally liable.”

From a macroeconomic perspective, the Eurozone will suffer from weak demand if Germany continues to rely for its prosperity on its high level of exports while weaker economies import less in order to pay down debt. If all of Europe is trying to consume less than it produces, that will in turn aggravate the problem of weak demand in the global economy. Austerity may work for some countries, but it cannot work for all.

The implications of the attempt to force the Eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the Eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, probable….Not least, the shift of the Eurozone into surplus is a contractionary shock for the world economy.

Wolf thinks that the chances are good that many European countries will suffer from economic stagnation for a long time, putting an economic drag on the entire European and global economies.

Secular stagnation?

Clearly Wolf regards many of our economic problems as secular (long-term) rather than just cyclical (tied to phases of expansion and contraction). He believes that developed countries with aging populations can expect to experience slower economic growth from now on. “Not only will the labour force shrink absolutely in many countries, as the population falls, but the proportion of it that is young, flexible and innovative will decline further.”

I’m not entirely convinced of that, especially the part about innovation. Age may be related to innovation, but so are education and occupation; consider Richard Florida’s The Rise of the Creative Class. Slower population growth does reduce one obvious reason for new investment–the need to expand the quantity of existing goods and services–but there can still be innovations in type and quality. And even if businesses do find it harder to come up with things to invest in–which I gather is Wolf’s point–a thriving economy remains possible as long as enough income finds its way into the hands of those who will use it for something useful. These could be working families trying to raise children, or governments trying to fund improvements in infrastructure or education. They certainly don’t have to be wealthy financiers squandering the world’s income on risky loans.

Neither economic evil–stagnation on the one hand or credit binge on the other–is inevitable. Wolf helps us understand how we might avoid them, if we have the wisdom and the will. However, the author himself is not sure that we do.

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Martin Wolf. The Shifts and the Shocks: What we’ve learned–and have still to learn–from the financial crisis. London: Penguin, 2014.

British economic journalist Martin Wolf provides a comprehensive account of the global financial crisis and its aftermath. The story unfolds slowly and covers a lot of ground, so the reader needs to read the entire book carefully to get the full picture.

Wolf’s own policy perspective is fairly moderate. He supported much of the economic liberalization and limitation of state power under Margaret Thatcher and Ronald Reagan, but he now believes that liberalization got out of hand and became a major cause of the financial crisis. “The financial driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis.” He also faults naïve economists for exaggerating the efficiency of free markets and overlooking the signs of increasing instability, thus condoning the risky behaviors that led up to the financial meltdown.

The title of the book refers to Wolf’s distinction between the underlying shifts in the global economy that made financial markets less stable, and the actual financial shocks that caused a sharp contraction of economic activity and created a need for government intervention. In organizing the book, Wolf chose to cover the shocks in Part I and the shifts in Part II. I thought that made the book’s argument harder to follow, reversing the chronological order of events and putting the financial cart before the economic horse that was pulling it. Wolf describes the financial crisis in Chapter 1, but doesn’t discuss the reasons for financial instability until Chapter 4. He only sets the scene briefly by describing four features of an ultimately unsustainable global situation: “huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain.”

When investors lost confidence in the value of the loans they had made and the assets they had helped inflate, major investment banks failed and credit dried up. That forced governments to intervene, very likely bringing to an end the era of financial liberalization. The US government took over the biggest mortgage lenders, injected capital into failing businesses, lent money to banks at zero or near-zero interest rates, and held down longer-term rates by purchasing private bonds.

Post-crisis recovery and its limitations

Judging from the size of the banks that failed, the financial crisis was even worse than the crash of 1929, but the rapid policy response kept the economic situation from becoming as bad as the Great Depression. Nevertheless, the success of the recovery has been limited by the failure of government to be even more aggressive. Wolf’s verdict is that it rescued the world economy “fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned.”

The post-crisis recovery has been weak for many reasons: Borrowers reduced borrowing and spending and turned to paying down debt. Investors also pulled back as a reaction against previous overinvestment, especially in housing that buyers couldn’t really afford. Financial institutions became more reluctant to lend, and borrowers could no longer count on inflation to increase the price of their assets while reducing the real value of their debts. The result was a general state of economic “malaise” in which low consumer demand and low investment reinforced each other.

Wolf also discusses “sectoral balances,” the balance of income and spending within the household, corporate, government and foreign sectors of economic activity. When US households and corporations reduced spending and started generating large surpluses, the economy required deficit spending by government to avoid protracted recession. This turned on its head the old idea that government spending crowds out private spending by borrowing money that could be put to better use by business. With the central bank lending money for practically nothing and corporations failing to invest much of it anyway, Wolf argues that “the private-sector cutbacks crowded in the fiscal deficit.” He believes that if the government had followed the advice of conservatives and slashed the deficit, that would have caused an economic depression.

Nevertheless, world economic leaders became so concerned about fiscal deficits that they pledged to cut them in half at the Toronto Summit of 2010. In the US, ideological opposition to government intervention remained strong, heightened by Republican opposition to the Obama presidency:

In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance.

The crisis in the Eurozone

While the United States was starting to recover from the financial crisis, “the epicenter of the crisis moved inside the Eurozone, where it subsequently remained.” The contraction of credit exposed weaknesses in European national economies that had been masked by the adoption of a common currency.

When each nation has its own currency, the strength of that currency can reflect the competitiveness of its economy. Weak demand for its products on world markets will usually weaken demand for its currency, and the low buying power of its currency should keep it from buying more than it produces and trades. Investors from stronger economies can lend to weaker ones, but usually at high interest rates to reward lenders for taking more risk. The common European currency papered over these national differences and encouraged an excessive flow of goods and credit from the stronger economies, especially Germany, to the weaker economies of Southern Europe, such as Spain. The fiction that every euro was worth the same made it too easy for the Spanish, Greeks, Italians and others to borrow from German banks and buy German goods. The various economies appeared to be thriving together, but only until the end of the credit boom brought the game to an end.

The credit crunch put the poorer countries in the position of either defaulting on their debts or adopting austerity measures that threw their economies into recession:

Given their difficulty in borrowing and their lack of access to central-bank financing, the crisis-hit countries could not offset these deep recessions, indeed true depressions, with fiscal or monetary stimulus, at least without external support. That was not to be forthcoming on any significant scale. This was partly because Germany, supported by other creditor countries and the European Commission, argued that necessary structural reforms would not occur without remorseless economic pressure and, for that reason, regarded greater external support as counter-productive.

Wolf criticizes Germany for refusing to accept any responsibility for the crisis:

Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis. As Bagehot indicates, excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip. A country that chooses to run current-account surpluses, indeed, one that has built its economy around generating improved competitiveness and increased external surpluses, has to finance the counterpart deficits and must, accordingly, bear responsibility for the wastage of funds.

Wolf thinks it is misleading to blame the European economic crisis on government deficits in particular. What the troubled economies had in common before the crisis were not government deficits but balance-of-trade deficits, which were a consequence of policies in both creditor and debtor countries. After the crisis, private spending declined, but government deficits increased due to falling tax revenues and counter-recessionary spending. Fiscal austerity alone, without any other economic reforms, is a recipe for continued recession.

Emerging economies

Emerging economies in Asia and Latin America generally grew at a faster rate both before and after the financial crisis. Most of them managed to avoid credit booms that would leave them as heavily indebted as the United States or Southern European countries. On the contrary, some of them, especially China, ran large surpluses by exporting more than they imported and investing heavily in other countries. Although this has been a successful growth strategy in the short run, Wolf questions its sustainability. Again, if countries like Germany and China run surpluses, others must run deficits; and if too many countries embrace austerity at the same time, global output must fall. Like Michael Pettis, Wolf thinks it is silly to treat austerity and lending as moral goods, while treating spending and borrowing as moral evils. At the macroeconomic level, the problem is finding a balance, for example by having creditor countries increase domestic demand and debtor countries increase their exports.

My next post will deal with the global economic shifts to which Wolf attributes the financial crisis in the first place.

Continued