Global Inequality (part 3)

August 8, 2016

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This final post on Branko Milanovic’s Global Inequality will focus on the future prospects he sees for reducing economic inequality in the world. He discusses three kinds of inequality: inequality among countries, inequality within poorer countries, and inequality within richer countries, especially the United States.

Inequality among countries

Milanovic expects the median incomes of countries to continue to converge as the economies of poorer countries continue to grow faster than those of richer countries. However, he expects this convergence to be limited in several ways. Currently “it is only Asian countries that have been catching up with the rich world.” Progress has been much slower in other parts of the world, especially Africa. And although growth in China accounts for a lot of the global convergence in incomes, this may not always be the case. In a few years, China may be so far above average that further development there may increase global inequality rather than reduce it. Then continued convergence will depend on what other countries do.

Although the narrowing gap between rich and poor countries is encouraging, it is occurring so slowly that “one cannot expect global inequality to be reduced by more than one-fifteenth of its current level” over the next twenty years.

Inequality within poorer countries

Milanovic suggests that countries like China are passing through a phase of the first Kuznets wave that more developed countries experienced at least a century ago. They are experiencing a familiar pattern in which industrialization initially increases opportunities for the few, and only later for the many, as discussed in the previous post. Although the data are somewhat sketchy, Milanovic sees signs that economic inequality has peaked in China and is beginning to subside. Mass education and a reduced supply of cheap, unskilled labor would be among the reasons for the transition.

On the other hand, many poor countries are still in an even earlier phase of the transition, in which inequality is increasing because the benefits of economic development have yet to be experienced by large portions of their populations.

Inequality within richer countries

I found Milanovic’s views on this topic a bit confusing. On the one hand, he maintains that information technology and globalization have initiated a new Kuznets wave of economic change, in which inequality is rising again but will ultimately fall. To make that case, he needs reasons for the fall as well as the rise. Otherwise, he cannot distinguish his theory from more pessimistic assessments like Piketty’s Capital in the Twenty-first Century, which sees rising inequality as a fundamental feature of capitalism. However, when Milanovic tries to identify mechanisms by which inequality might fall, he expresses little confidence that they will work any time soon.

Milanovic identifies five “benign forces” that could theoretically reduce inequality:

  1. Political changes could result in higher and more progressive taxation. However, the global mobility of capital makes it easier for the wealthy to escape taxation. In addition, many citizens of modest means have trouble supporting higher taxes, even when that might be in their own best interest.
  2. The widening wage gap between more and less educated workers could be narrowed by improvements in the quantity and quality of education. However, Milanovic has trouble imagining that average years of education could rise above thirteen. He also thinks that improvements in the quality of education “face natural limits, given by the aptitude and interest of students to excel in whatever they choose to do.” Some would object that if better education were more widely available, more students would rise to the occasion.
  3. As the technological revolution proceeds, innovations that originally profited the few can be more widely adopted. On the other hand, the ownership of capital has become more concentrated lately, so the control of profitable innovations remains largely in the hands of a few.
  4. As wages rise in poorer countries, workers in richer countries should face less competition from foreign low-wage labor. However, it could be a long time before poor countries outside of China and a few other Asian countries experience much wage growth.
  5. Technological progress could raise the productivity of low-skill workers specifically. But this would go against the historical experience of capitalism, in which technological change normally boosts the income of the more skilled over the less skilled.

I found the last point especially troublesome, since it seems to me to undercut one of the strongest reasons for a Kuznets curve in the first place. Surely the mass-production technologies of the twentieth century helped bring many blue-collar workers into the middle class by boosting their productivity, raising their wages, and making former luxuries like automobiles more affordable. If we are looking for mechanisms for reducing inequality in the new wave of change, shouldn’t we be looking for a new productivity revolution along the lines suggested by Rifkin’s The Zero Marginal Cost Society or Paul Mason’s Postcapitalism? Milanovic  doesn’t anticipate anything that radical, but maybe the falling inequality phase of the alleged Kuznets curve won’t work without some fairly dramatic change. Ironically, Milanovic begins his chapter on future inequality by criticizing previous attempts at prediction for assuming too much continuity from the present to the future.

The United States: A “perfect storm of rising inequality”?

Milanovic is especially pessimistic about reducing inequality in the United States. He provides five reasons he expects the rise in inequality to continue:

  1. The share of national income going to capital rather than labor will remain high, especially since businesses find it economical to replace labor with machinery.
  2. The income from capital will remain highly concentrated.
  3. The people with the highest incomes will also be the ones who can save and invest the most, so the same people will be getting most of the benefits from both labor income and capital income.
  4. These labor-rich and capital-rich individuals will also tend to marry each other, so that wealth and income are even more concentrated for households than they are for individuals.
  5. The rich will use their political power to support policies that protect their economic interests at the expense of those of the middle class and the poor.

Milanovic concludes:

It is hard to see where any forces might come from that could counter rising income inequality in the United States….Forces promoting offsetting policies such as more widespread education, a higher minimum wage, and more generous welfare benefits seem weak compared with the almost elemental forces that favor greater inequality.

By this time, the reader who has followed the argument from the beginning may be wondering what happened to the original idea of the Kuznets curve, with its rise and fall of inequality. Well, “the second Kuznets curve will have to repeat the behavior of the first if inequality is to decline again. But it is doubtful whether this second decline will be accomplished by the same mechanisms as those that reduced inequality in the twentieth century….” What mechanisms Milanovic does suggest are mostly political, especially changes in tax policies and improvements in public education, changes that seem unlikely in the light of his previous remarks. The reliance on political rather than economic mechanisms sounds more like Piketty than Kuznets.

To summarize, Milanovic starts with a Kuznets theory emphasizing economic reasons why inequality first rises and then falls. He does broaden it by suggesting that extreme inequality generates malign forces like violent conflicts that can destroy the wealth of some and create opportunity for others. Yet he ends with a pessimism that economic forces will reduce inequality either benignly or malignly. This leaves it an open question whether what we are living through is a second Kuznets wave at all. If it isn’t, then the first Kuznets curve was a unique historical event from which we cannot generalize, and the book’s theoretical framework falls apart.

In general, I found the book’s data very informative and its interpretations thought provoking. But in the end I found its theoretical position on the central question of falling inequality too ambiguous to be convincing.

Global Inequality

August 3, 2016

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Branko Milanovic. Global Inequality: A New Approach for the Age of Globalization. Cambridge: Harvard University Press, 2016.

Branko Milanovic is a Serbian-American economist specializing in economic development and inequality. His global perspective on inequality goes beyond the familiar idea that gaps in wealth and income always seem to be widening. There is some truth to that, but it is far from the whole truth.

Who is gaining from globalization?

Economists are in a much better position to talk about global income now that they have some decent global data. Milanovic’s data come from “more than 600 household surveys covering about 120 countries and more than 90 percent of the world’s population over the period 1988-2011.”

He uses the data to construct a remarkable chart, in which he plots percentiles of income on the horizontal axis and cumulative percentage growth in income on the vertical axis. The chart then shows which percentiles from poorest to richest have benefited the most in this period of globalization. The poorest people on earth, such as most Africans, have seen almost no improvement. However, the people in the middle of the distribution, from the 20th to the 70th percentiles, have experienced over 40% growth in income.

Who are these people? They are not the middle class in rich countries like the United States; they would be above the 70th percentile. They are the emerging middle class in rapidly developing countries. Ninety percent of them live in Asia, especially China, India, Thailand, Vietnam and Indonesia. They are not yet as rich as our middle class, but they are moving rapidly in that direction. In about three decades, the Chinese are expected to be as rich as citizens of the average European Union country.

Above the 70th percentile of global income, the recent gains in income rapidly fall off, reaching zero for people at the 80th percentile! (Remember that means zero gain, not zero income.) Who are they? They are mostly the lower middle classes within the richest countries, people who have been relatively well off historically but are not currently gaining from globalization. Think of the less-educated American blue-collar workers who are now in competition with foreign labor and haven’t seen wage gains in decades.

Above the 90th percentile of global income, income gains rapidly rise again, with a gain of over 60% at the top of the distribution. This group is the global 1%, the richest people on earth. Half of them are in the United States, and the other half are mostly from Europe and Japan. Together they receive 29% of the world’s entire income and control 46% of its wealth. They include the world’s billionaires, 1,426 individuals who together own twice as much as all the people of Africa.

For those of us who would welcome a reduction in economic inequality, globalization brings good news as well as bad news. The good news is some decline in inequality among countries, as the benefits of economic development spread to the developing world, especially Asia. The bad news is twofold. In the world as a whole, some countries remain stuck in poverty. And within the most developed countries, the benefits of globalization are going almost entirely to the upper class, at least so far.

Historical trends in inequality

Now let’s put these recent trends in historical perspective. How much of this is new, and how much of it have we seen before? The answer depends on which aspect of inequality we consider.

Milanovic makes a simple but important logical distinction: “Global inequality, that is, income inequality among the citizens of the world, can be formally considered as the sum of all national inequalities plus the sum of all gaps in mean incomes among countries.” This is just standard statistical logic: Whenever a population is divided into subgroups, the total variation within the population is the sum of the between-group variance and the within-group variance. In this case, the subgroups are countries. Milanovic refers to the between-country differences as “location-based inequality” and the within-country differences as “class-based inequality.”

The two kinds of inequality have developed differently in different historical periods:

  1. In the early 1800s, only about 20% of the total inequality in the world was due to location; far more was due to class differences within countries. But over the course of the century, as the industrial economy took shape, location-based inequality increased because the countries that industrialized first became much richer than the rest of the world. At the same time, the class divide within the industrializing countries got worse.
  2. From about the 1920s to the 1970s, country differences in income reached a peak, accounting for about 70% of all global inequality. However, class differences diminished as the middle class grew within the richer countries. The world seemed divided into largely prosperous Americans and Europeans and mostly poor Africans, Asians and Latin Americans.
  3. In the most recent period so far, globalization has reversed both twentieth-century trends. Country differences have started to decline, because growth has accelerated in Asia while decelerating in Europe and North America. But at the same time, internal inequality has increased in many rich countries, especially the US, UK and Italy. The middle class has been shrinking and the rich have been getting richer.

To put it simply, the recent decline in inequality among countries is new in the industrial era. The recent increase in inequality within wealthy countries is not quite as new, but it’s a return to something last seen in the nineteenth and early twentieth centuries.

Next we will turn to Milanovic’s attempt to make sense out of these developments and anticipate where the two components of global inequality may go next.


The Shifts and the Shocks (part 3)

December 19, 2014

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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.

The Shifts and the Shocks (part 2)

December 17, 2014

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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.


The Shifts and the Shocks

December 15, 2014

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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.