The Shifts and the Shocks: What We've Learned--and Have Still to Learn--from the Financial Crisis

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9780143127635: The Shifts and the Shocks: What We've Learned--and Have Still to Learn--from the Financial Crisis

From the chief economic commentator for the Financial Times—a brilliant tour d’horizon of the new global economy
 
There have been many books that have sought to explain the causes and courses of the financial and economic crisis that began in 2007. The Shifts and the Shocks is not another detailed history of the crisis but is the most persuasive and complete account yet published of what the crisis should teach us about modern economies and econom­ics. Written with all the intellectual command and trenchant judgment that have made Martin Wolf one of the world’s most influential economic com­mentators, The Shifts and the Shocks matches impressive analysis with no-holds-barred criti­cism and persuasive prescription for a more stable future. It is a book no one with an interest in global affairs will want to neglect.

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About the Author:

Martin Wolf is the associate editor and chief economics commentator for the Financial Times. He is the recipient of many awards for financial journalism, for which he was also made a Commander of the Order of the British Empire in 2000. His previous books include Fixing Global Finance and Why Globalization Works.

Excerpt. © Reprinted by permission. All rights reserved.:

Acknowledgements

In writing a book one accumulates many debts. Here I acknowledge just a few of them.

I have to start with thanking Andrew Wylie, my agent, whose boundless energy and enthusiasm made this book happen. I want to thank John Makinson, chairman and chief executive of Penguin, who decided to publish it. I also acknowledge the invaluable contributions of Scott Moyers and Stuart Proffitt, my editors at Penguin, whose care and attention to detail have made the book immeasurably better and clearer than it would otherwise have been. Stuart in particular was inexorable. I recognize the immense importance of his contribution and greatly appreciate the time he took and the attention he bestowed on this book. I also want to note their patience with the delays in completing a book whose writing had to fit in with my normal duties. In addition, I extend my thanks to Richard Duguid and Donald Futers on the Penguin production team, and to Richard Mason for his very helpful editorial input.

I would also like to thank Lionel Barber, the editor of the Financial Times, for accommodating the needs of the book. I have taken off a substantial amount of time in order to write it, more than I had hoped, in fact. I appreciate enormously the way the FT has accommodated this and promise not to do it again in the near future. I also want to thank colleagues at the FT from whom I have learned so much. Particular thanks for contributions to ideas in this book go to Chris Giles, Ferdinando Giugliano, my former colleague Krishna Guha, Robin Harding, Martin Sandbu and Gillian Tett.

I owe thanks to an immense number of thinkers and policymakers from whose writings I have been privileged to learn over many years. I recognize most of these debts via citations in the text, endnotes and references. I would like to record particular thanks to three individuals. The first is Max Corden, who taught me at Oxford and whose remarkable combination of clarity, rigour and good sense has marked me for life. I have aspired, not always successfully, to match these qualities in my professional activities. It was a great honour and still greater pleasure to deliver a lecture, named after him, in his home town of Melbourne in October 2012.1 The second person is Adair Turner, former chairman of the Financial Services Authority. Adair was kind enough to read the third part of the book and the concluding chapter. I have greatly appreciated his wisdom and support, and learned immensely from his writing on the crisis and its aftermath. The final person is Mervyn King, former governor of the Bank of England and a friend for more than two decades. Despite inevitable professional disagreements, I have always greatly admired his intelligence and integrity. I am grateful to Mervyn for reading the book in draft and giving me supportive and helpful comments. He encouraged me to be even more radical than I had intended to be.

Others to whom I owe gratitude for conversations on the topics of this book include Anat Admati of Stanford University, C. Fred Bergsten of the Peterson Institute for International Economics, Ben Bernanke, former Chairman of the Federal Reserve, Olivier Blanchard of the International Monetary Fund, Claudio Borio of the Bank for International Settlements, Paul de Grauwe of the London School of Economics, my former colleague Chrystia Freeland, Member of the Canadian Parliament, Andy Haldane of the Bank of England, Robert Johnson of the Institute for New Economic Thinking, Paul Krugman of Princeton University, Philippe Legrain, former adviser to the president of the European Commission, Michael Pettis of Peking University, Adam Posen of the Peterson Institute for International Economics, Raghuram Rajan, governor of the Reserve Bank of India, Carmen Reinhart of Harvard University, Kenneth Rogoff of Harvard University, Jeffrey Sachs of Columbia University, Hans-Werner Sinn of CESifo, George Soros, Joseph Stiglitz of Columbia University, Andrew Smithers of Smithers & Co., Lawrence Summers of Harvard University, Alan Taylor of the University of California, Paul Tucker, formerly of the Bank of England, David Vines of Oxford University, William White, formerly of the Bank for International Settlements, and Malcolm Wiener. I wish also to offer thanks to John Vickers, Claire Spottiswoode, Martin Taylor and William (Bill) Winters, with whom I had the pleasure to serve on the UK government’s Independent Commission on Banking in 2010–11, as well as to the members of its admirable secretariat. I apologize to all who might feel slighted by omission from this list. It is far from exhaustive. Needless to say, none of the people I have listed bears any responsibility for what appears in this book.

I also want to give my special thanks to Douglas Irwin of Dartmouth University and Kevin O’Rourke of Oxford University for permission to use the title The Shifts and the Shocks, which I have drawn from their interesting paper, ‘Coping with Shocks and Shifts’.2 This phrase captured my theme perfectly.

Finally, and far above all, I must offer my deepest thanks to Alison, my wife of more years than she would like to admit. She has given me everything that could make a man’s life happy, including the three children to whom this book is dedicated. Beyond that, I thank her for her encouragement and support in writing this book, which was far from an easy process. Without her, I am sure it would not have been finished. I must thank her, not least, for reading all of the draft and giving me comments that were both sensible and to the point, as she has always done. Above all, she forced me to explain what I mean to a highly intelligent reader who does not live in the world of international macroeconomics and global finance. The value of such a reader is and has always been beyond measure.

List of Figures

1. Libor–OIS Swap

2. General Government Borrowing Requirement

3. Real GDP Since the Crisis

4. Employment

5. US Cumulative Private Sector Debt over GDP

6. Spreads over German Bund Yields

7. Spreads over Bund Yields

8. Current Account Balances in the Eurozone 2007 (US$bn)

9. Current Account Balances in the Eurozone 2007 (per cent of GDP)

10. Unit Labour Costs in Industry Relative to Germany

11. Current Account Balances

12. Average General Government Fiscal Balance 2000–

13. Ratio of Gross Public Debt to GDP (Ireland/Spain)

14. Ratio of Gross Public Debt to GDP (2007/2013)

15. Ratio of Gross Public Debt to GDP

16. Spread Between UK and Spanish 10-year Bond Yields

17. Real GDP of Crisis-hit Eurozone Countries

18. Unemployment Rates

19. Growth in the Great Recession

20. Increase in GDP 2007–

21. Average Current Account Balances 2000–

22. Average Current Account Balance 2000–

23. GDP Growth in Central and Eastern Europe in

24. Foreign Currency Reserve

25. Capital Flows to Emerging Economies

26. Demand Contributions to Chinese GDP Growth

27. Real Commodity Prices

28. Tradeable Synthetic Indices of US Asset-backed Sub-prime Securities

29. Central Bank Short-term Policy Rates

30. Yields on Index-linked Ten-year Bonds

31. Real House Prices and Real Index-linked Yields

32. Global Imbalances

33. US Financial Balances since

34. Eurozone Imbalances on Current Account

35. Sectoral Financial Balances in Germany

36. Spread on Government 10-year Bond Yields over Bunds

37. Backing for US M

38. Real Profits of US Financial Sector

39. US GDP

40. UK GDP

41. US ‘Money Multiplier’

42. Structure Fiscal Balances

43. UK Sectoral Net Lending

44. Whole Economy Unit Labour Costs Relative to Germany

45. Eurozone GDP

46. Core Annual Consumer Price Inflation

47. Optimal Currency Area Criteria

48. Gross Public Debt over GDP

49. US GDP per Head

50. UK GDP per Head

Preface: Why I Wrote this Book

This book is about the way in which the financial and economic crises that hit the high-income countries after August 2007 have altered our world. But its analysis is rooted in how these shocks originated in prior shifts – the interactions between changes in the global economy and the financial system. It asks how these disturbing events will – and should – change the ways we think about economics. It also asks how they will – and should – change the policies followed by the affected countries and the rest of the world.

The book is an exploration of an altered landscape. I must start by being honest with myself and with the reader: although I spend my professional life analysing the world economy and have seen many financial crises, I did not foresee a crisis of such a magnitude in the high-income countries. This was not because I was unaware of the unsustainable trends of the pre-crisis era. My previous book, Fixing Global Finance, published in 2008 but based on lectures delivered in 2006, discussed the fragility of finance and the frequency of financial crises since the early 1980s. It also examined the worrying growth of huge current-account surpluses and deficits – the so-called ‘global imbalances’ – after the emerging market crises of 1997–99. It focused particularly on the implications of the linked phenomena of the yawning US current-account deficits, the accumulations of foreign-currency reserves by emerging economies, and the imbalances within the Eurozone.2 That discussion arose naturally from the consideration of finance in my earlier book, Why Globalization Works, published in 2004.3 That book, while arguing strongly in favour of globalization, stressed the heavy costs of financial crises. Nevertheless, I did not expect these trends to end in so enormous a financial crisis, so comprehensive a rescue, or so huge a turmoil within the Eurozone.

My failure was not because I was unaware that what economists called the ‘great moderation’ – a period of lower volatility of output in the US, in particular, between the late 1980s and 2007 – had coincided with large and potentially destabilizing rises in asset prices and debt.4 It was rather because I lacked the imagination to anticipate a meltdown of the Western financial system. I was guilty of working with a mental model of the economy that did not allow for the possibility of another Great Depression or even a ‘Great Recession’ in the world’s most advanced economies. I believed that such an event was possible only as a consequence of inconceivably huge errors by bankers and regulators. My personal perspective on economics had failed the test set by the late and almost universally ignored Hyman Minsky.

This book aims to learn from that mistake. One of its goals is to ask whether Minsky’s demand for a theory that generates the possibility of great depressions is reasonable and, if so, how economists should respond. I believe it is quite reasonable. Many mainstream economists react by arguing that crises are impossible to forecast: if they were not, they would either already have happened or been forestalled by rational agents. That is certainly a satisfying doctrine, since few mainstream economists foresaw the crisis, or even the possibility of one. For the dominant school of neoclassical economics, depressions are a result of some external (or, as economists say, ‘exogenous’) shock, not of forces generated within the system.

The opposite and, in my view, vastly more plausible possibility is that the crisis happened partly because the economic models of the mainstream rendered that outcome ostensibly so unlikely in theory that they ended up making it far more likely in practice. The insouciance encouraged by the rational-expectations and efficient-market hypotheses made regulators and investors careless. As Minsky argued, stability destabilizes. This is an aspect of what George Soros, the successful speculator and innovative economic thinker, calls ‘reflexivity’: the way human beings think determines the reality in which they live.5 Naive economics helps cause unstable economies. Meanwhile, less conventional analysts would argue that crises are inevitable in our present economic system. Despite their huge differences, the ‘post-Keynesian’ school, with its suspicion of free markets, and the ‘Austrian’ school, with its fervent belief in them, would agree on that last point, though they would disagree on what causes crises and what to do about them when they happen.6

Minsky’s view that economics should include the possibility of severe crises, not as the result of external shocks, but as events that emerge from within the system, is methodologically sound. Crises, after all, are economic phenomena. Moreover, they have proved a persistent feature of capitalist economies. As Nouriel Roubini and Stephen Mihm argue in their book Crisis Economics, crises and subsequent depressions are, in the now celebrated terminology of Nassim Nicholas Taleb, not ‘black swans’ – rare and unpredictable events – but ‘white swans’ – normal, if relatively infrequent, events that even follow a predictable pattern.7 Depressions are indeed one of the states a capitalist economy can fall into. An economic theory that does not incorporate that possibility is as relevant as a theory of biology that excludes the risk of extinctions, a theory of the body that excludes the risk of heart attacks, or a theory of bridge-building that excludes the risk of collapse.

I would also agree with Minsky that governments have to respond when depressions happen, this being the point on which the views of the post-Keynesian and Austrian schools diverge – the former rooted in the equilibrium unemployment theories of John Maynard Keynes and the latter in the free-market perspectives of Ludwig von Mises and Friedrich Hayek. Minsky himself put his faith in ‘big government’ – a government able to finance the private sector by running fiscal deficits – and a ‘big bank’ – a central bank able to support lending when the financial system is no longer able to do so.8 Indeed, dealing with such threatening events is a big part of the purpose of modern governments and central banks. In addition to tackling crises, as and when they arise, policymakers also need to consider how to reduce vulnerability to such events. Needless to say, every part of these views on the fragility of the market economy and the responsibilities of government is controversial.

These events have not been the first to change my views on economics since I started studying the subject at Oxford University in 1967.9 Over the subsequent forty-five years I have learned a great deal and, unsurprisingly, changed my mind from time to time. In the late 1960s and early 1970s, for example, I came to the view that a bigger role for markets and a macroeconomic policy dedicated to monetary stability were essential, in both high-income and developing countries. I participated, therefore, in the move towards more market-oriented economic perspectives that took place at that time. I was particularly impressed with the Austrian view of the market economy as a system for encouraging the search for profitable opportunities, in contrast to the neoclassical fixation with equilibrium: the writings of Joseph Schumpeter and Hayek were (and remain) powerful influences. The present crisis has underlined my scepticism about equilibrium, but has also restored a strong and admiring interest in the work of Keynes, which had begun when I was at Oxford.

After a passage of eighty years, Keynes’s concerns of the 1930s ...

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