The Great Recession has spawned a shelf of books, many of them good, on what went so wrong. So far this year, we’ve had at least two first-rate books on where we are now and what will happen next.
The first was Capital in the Twenty-First Century, the much praised study of wealth inequality by Thomas Piketty, discussed here earlier. Now comes The Shifts and the Shocks: What We’ve Learned – and Have Still to Learn – from the Financial Crisis, by Martin Wolf, the esteemed economic columnist for the Financial Times.
Both authors argue that the big problems – inequality, for Piketty, or economic instability, for Wolf – are built into our free-market system, and are exacerbated by globalization. In other words, unless we not only reform but transform this system, both inequality and instability will get worse. Wolf predicts more crises, bubbles, busts, and recessions ahead and wonders just how much battering our democratic system can take.
Both authors propose reforms. But neither thinks his ideas have much chance of becoming reality any time soon.
Piketty commanded attention because of his unprecedented use of historical data to make his point. Wolf, who will be speaking to The Chicago Council on October 14, commands attention because of who he is. A former senior economist at the World Bank, he is today the world’s leading economic commentator whose columns are required reading in every central bank and world capital. Paul Krugman may stimulate more debate but Wolf, a centrist who draws his stately judgments from piles of data, sets the global economic agenda.
To be clear, Wolf is a mainstream economist who believes in capitalism and free markets, but thinks they are deeply – maybe fatally – flawed. His goal is to save them from themselves.
“Crises,” he writes, “are an inherent element of the market-based financial system, as we know it. They follow periods of rising fragility, created by the rise of apparently hugely profitable risk-taking generated within the system. So it was this time. Success bred excess and excess bred collapse.”
Over the past 40 years, he says, this system has fallen prey to forces and trends – including liberalization of finance, weak regulation, globalization, technology, rising inequality, huge savings imbalances – that produced repeated international financial crises, culminating in the Great Recession of 2007-2008.
The irresponsibility of bankers lies at the core of all these crises, and Wolf doesn’t spare them. But he assumes that bankers were just doing what bankers do, which is to make as many loans as possible, to good risks and bad, until it all seizes up in a crisis like the sub-prime mortgage fiasco.
But Wolf reserves the most condemnation for “the ignorance and arrogance” of the financial elites – academics like the Chicago School of economists, plus government officials and central bankers – who are supposed to keep bankers in check.
Like many post-recession economists, Wolf is a fan of Hyman Minsky, the late Chicago-born economist who taught that a capitalist economist swing “between robustness and fragility.” Booms start when some event, such as falling interest rates, triggers investment, which leads to rising prices for assets such as housing. This lead to “euphoria,” when bankers lend to anyone with a pulse. Eventually, smarter investors begin to pull out, which leads to panic among dumber investors, which leads to falling prices and, eventually, a recession. There’s a moment – dubbed the “Minsky moment,” when the bubble expands as far as it will go, prices stop rising, and the panic sets in.
In other words, capitalist economies are inherently unstable. This means they need firm regulation to avoid periodic calamities.
But this time, that adult supervision wasn’t there. Instead, free-market economists taught that markets are always efficient, imbalances are always self-correcting, and prices were always right. The logical conclusion of this thinking is that booms, bubbles and busts are impossible, so regulators should just get out of the way and let the good times roll. In theory, a crisis is improbable. In practice, Wolf says, “this insouciance….ends up making it far more likely.”
Wolf singles out two of the University of Chicago’s Nobel Prize-winning economists, Robert Lucas and Eugene Fama, for particular ridicule. He also says that Federal Reserve Bank President Ben Bernanke was “almost clueless” before the recession, but praises the Fed’s post-recession response for preventing a repeat of the Depression.
Wolf criticizes governments in Europe and the United States for the austerity-focused policies that have blocked a more vigorous recovery. But he’s more worried that we haven’t made the kind of basic reforms in the free-market system that would keep another recession at bay.
In particular, he fears the impact of savings imbalances, globally, and nationally. One cause of the recession, he says, was the huge “savings glut” in emerging countries such as China, which were loaned to developed countries such as the United States, which wasted the money on the housing bubble instead of using it productively on public programs, such as infrastructure repair. That imbalance remains, made worse by the post-recession savings glut of American corporations and consumers.
As before, Wolf says, we’re whistling in the dark.
“Much of the political and financial establishment pretends that everything will soon return to the old normal,” he writes. “This is not going to work.” A few reforms have taken place, but they’re “an attempt to preserve the essence of a system that we already know is extremely fragile, and which is sure to implode once again in our current world of global financial integration, fast trading and huge flows of funds across borders.”
More regulation is needed, especially in global markets, Wolf says. He would like to see sharply higher reserve requirements for banks, forcing them to set aside more money to cover severe losses. He also would like to see a sort of global version of the American Glass-Steagall Act, now repealed, which kept commercial banks from risking depositors’ income in investment banking.
Wolf also sees that the multi-trillion-dollars flows of money around the world is a global explosion waiting to happen. This global finance can continue, he says, only if there is global regulation. Otherwise, this global flow “might have to be sharply curtailed.” He implies this would be no great loss.
Unlike Piketty, Wolf presents no new economic theory, and much of what he has to say has been said by other commentators. The strength of his book is his ability to bring all this thinking together, to connect the dots, to demolish foolish ideologies, and to suggest a future that understands the mistakes of the past.
Wolf’s book, unlike many of his columns, can be tough going. As with Piketty, there are large internal stretches that can be jumped. Also, much of his book (ignored so far in this review) deals with the euro crisis. Americans should understand this, if only because a crisis in the world’s second biggest economy can impact us all. But some readers could be forgiven for giving these chapters a pass.
The real problem with the euro, he says, is the threat it poses to the whole postwar project of European integration. Similarly, the real threat of more global financial crises is the erosion of public faith in the ability of our elites – not only economists but government officials – to run the economy .
“The loss of confidence in the competence and probity of elites inevitably reduces trust in democratic legitimacy,” Wolf writes. The real threat to the future of democracy lies not in the rise of an authoritarian China but in the inability of democratically-elected leaders at home to deliver the goods.