If you think the global financial crisis of 2007-2009 was a one-time event caused by lax regulation and a financial industry run riot, then Financial Times chief economics commentator Martin Wolf has some bad news for you. Wolf, one of the world’s most respected economists, says these circumstances were only part of its proximate cause and that the financial crisis was the inevitable product of the global economic system. If that system does not undergo radical change, says Wolf, financial crises may keep on recurring until the world economic order collapses.
In the course of a long and extraordinarily erudite tutorial on the macroeconomic origins of the financial crisis, Wolf states: “The kernel of the story, then, is one of the interaction between global macroeconomic forces and an increasingly fragile, liberalized financial system.”
Let us explore why he believes that and what he thinks can be done about it.
The savings glut and the investment dearth
For Wolf, among others, the story really began with the Asian financial crisis of 1997-98. That crisis was sometimes dubbed the “Asian flu” because of its viral spread to neighboring countries. Short-term lending in nonlocal currencies, principally U.S. dollars, in what were perceived to be vibrant economies like Thailand’s were suddenly curtailed – i.e., not rolled over – when whiffs of economic problems arose. This curtailment both resulted in and was exacerbated by runs on those countries’ currencies. Dollar loans could only be repaid with debased local currency at high costs, if at all. Economic collapse ensued.
The crisis had serious detrimental impacts on the economies of Indonesia, Malaysia, South Korea and the Philippines, as well as Thailand. Those countries required emergency loans from the International Monetary Fund (IMF). The IMF imposed draconian conditions in exchange for the loans, reducing the countries’ internal spending and driving many people into extreme poverty.
Asian countries, especially China, learned a lesson from this. The lesson was never to be short of U.S. dollar reserves again.
Furthermore, stocking up on dollar investments by creating local currency to purchase dollar-denominated assets like U.S. Treasury bonds had a depressive effect on the local currency’s value relative to the dollar. This made the country’s exports cheaper. Hence, the same policy that inured the country against runs on its currency also fueled export-driven growth.
As is well known now, that policy worked wonders, particularly for China’s economy. China amassed a vast repository of foreign currency reserves, accompanying high levels of export-driven economic growth. At the same time, commodity prices soared in the 2000s, partly due to China’s growth, so that commodity-exporting countries also amassed savings.
The result was a “savings glut” – which Wolf says is the same thing as an “investment dearth.” In other words, there were more funds looking for a place to be invested than there were investments. Savings have to equal investments in the end. The way to tell that there’s a savings glut is that interest rates are low. Otherwise the demand for investment would exceed the supply.
Tradable and non-tradable consumption goods
Continuing to paint the picture, Wolf uses language that only an economist would employ. The economy in tradables was now out of balance because of China’s and other countries’ export-driven growth. Wolf calls these “external imbalances.” He means that importing countries like the United States had a trade deficit while exporting countries like China had a trade surplus.
“Because the dollar was too strong, U.S. output of tradable goods and services was relatively unprofitable and such output grew weakly. The Federal Reserve offset this drag on output and employment (and so inflation) by pursuing a more aggressive monetary policy. As domestic demand for both non-tradables and tradables expanded, a huge excess demand for tradables emerged. The expansion of production abroad, notably in China, satisfied this excess demand, so generating huge trade and current-account deficits. Meanwhile demand and supply for non-tradables returned to balance, producing the full employment the Federal Reserve was seeking. In this way, internal balance – full employment – was achieved, albeit temporarily, at the price of a huge external imbalance – excess demand for tradables and so trade and current-account deficits.”
Let’s put this in non-economics language. China’s tradable goods were cheap so Americans bought them instead of products made in the U.S. This put a “drag on output and employment”, because American production of tradable goods fell. To shore up employment, as is its mandate, the Fed pursued a “more aggressive monetary policy” – lowering interest rates further. This caused demand for, and production of non-tradables in the U.S. to increase.
What are those non-tradables, and how could that demand increase? By inflating a property bubble. The chief “non-tradable” is real property. Its price increased because of the lowered interest rates. This drove property lending and a “wealth effect” – people with inflated-value property thought their wealth had increased, and thus spent more on the cheap tradables. It also caused a boom in building construction, as well as finance, with strong employment in those industries. So the U.S. economy seemed in good shape.
But it was only a bubble.
What if the Fed had not inflated that bubble? There was already resentment toward China for taking away American jobs with its huge reservoir of cheap labor and what was perceived as currency manipulation. If the result were only increased unemployment, without offsetting increases in employment in non-tradables production, what other societal pressures would have built?
And if the only way for the U.S. to offset the “external imbalance” of current account deficits – i.e., trade deficits – and create “internal balance” was through promotion of commerce in non-tradables, largely a property bubble, what would that mean for the future? This is why Wolf says, “Even without the crisis, pre-crisis trends in the global economy were unsustainable in certain important respects. This being so, the world cannot embrace its old future. It has to go forward to a different one.”
Macroeconomic imbalances Eurozone style
The macroeconomic imbalances – both internal and external – were most damaging in the Eurozone, because of the straightjacket of the euro. Wolf’s prose is unremittingly sober; and yet in this particular case, he explains the saga of the Eurozone’s agreement to the euro and its later crisis quite accurately, and with what biting humor:
“The groom [Germany] came to the altar out of a sense of duty, not out of a strong belief in the monetary marriage. The brides [the other euro countries] did not understand what they were doing. Then came an irresponsible honeymoon when everybody seemed to be getting what they wanted. The brides were able to borrow freely at far lower rates of interest than ever before: predictably, they went shopping. The groom went back to hard work, building up a hugely competitive export sector and a vast external surplus matched by growing claims on the debtors. Then came the crisis. The groom complained that the brides had wasted his money. The brides complained that the groom was forcing them into penury. So the marriage went very bad, in part because it always was a bad idea, but also because the honeymoon had been so irresponsible.”
The root problem is what Wolf calls the well-known trilemma, which the countries of Europe (other than Germany) seemed not to understand, or at least to ignore – “that a country cannot simultaneously enjoy monetary policy freedom, absence of exchange controls and fixed exchange rates.” Countries locked together by a fixed exchange rate yoke like the euro must therefore either lose monetary-policy freedom or have to impose exchange controls.
The Eurozone countries were oblivious to the constraint of the trilemma during the “honeymoon” period, in which bride countries like Spain and Greece could borrow at rates only marginally higher than Germany’s. Lenders were apparently also oblivious to the trilemma, including Germany itself, and loaned to these profligate brides on the assumption that their credit was virtually as good as the groom’s.
The solution for the Eurozone is not unlike the solution for the world
How can the Eurozone get out of this mess? Loans to private borrowers in Greece, Spain, Portugal, Ireland and Italy turned out to be not as sound as was thought. Wolf thinks it is absurd to believe that the borrowers in those countries bear more blame for their irresponsibility than the irresponsible lenders. He reminds us of a view held by the famous 19th century British economist Walter Bagehot; as Wolf puts it, “excess borrowing by fools would have been impossible without excess lending by fools”.
The solution is either divorce – break up of the euro – or creating a better marriage through tighter economic integration. But creating a more unified euro economic system is difficult because of the diversity of its members. So the fate of the Eurozone still hangs in the balance.
As for the global economic system, the alternatives are similar. Says Wolf, “Broadly, two outcomes seem possible: less globalized finance or more globalized regulation”; that is, either more disintegration or tighter integration.
On the one hand, less globalized finance means more restrictions on cross-border currency and lending flows. Wolf believes that flows of investments between nations should be in the form of equity. He makes this interesting – and debatable – assertion: “The advantage of debt, as against equity, is that lenders do not have to monitor what borrowers are doing, which is inherently costly.” If true, this implies that lenders are more easily caught unaware than equity investors when the value of their investment plummets. Therein lies debt’s danger.
More globalized regulation might entail a global currency. Both of Wolf’s outcomes are radical by the conventional wisdom of market liberalization that has built up over the last 30-40 years.
Wolf’s actual recommendation is more humble. He believes experimentation is necessary and wishes that different countries – and presumably different regions – could try out different economic and financial solutions. The Eurozone is, of course, such an experiment, one that does not seem to be going well. He believes, in particular, that the mainstream economic theories that have become so prevalent in the last 30-40 years, theories that caused ever more financial liberalization and loose regulation, bear much of the responsibility for the mess we are in.
It is difficult to escape concluding that Wolf’s verdict is not optimistic. He himself says, “It is unlikely that the high-income countries could cope with another such crisis within the next decade or two without large-scale defaults in the private or public sectors, either openly or via inflation. It might indeed be the fire next time. This is a desperate situation.”
Rational versus irrational expectations
Although Wolf writes in this book broadly and eloquently across an amazing range of topics, he does not answer how economic theory might be patched up.
Wolf, like many others, has strong words both for the financial industry and for the economics profession.
He believes 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.”
Economic theory cannot be rejected in toto because much of it has proven sound. Rejecting only part of it, however, will imply that humans make rational economic decisions in some situations but irrational ones in others. For example, in allocating their resources – their budgets – across a range of purchases it is assumed that they do so in rational accordance with their preferences. In other situations, though, like investing in financial products or recognizing that the market’s assessed value of their home may be short-lived, they are guided by irrational considerations – such as the quality of the financial product salesman’s suit, or the denseness of his jargon, or the extrapolated future value of something whose value cannot be extrapolated.
The late, belatedly lionized Cornell economist Hyman Minsky believed that periods of prosperity would beget financial bubbles, and bubbles would beget crashes. His theories rely on the assumption that people – including even and perhaps especially finance professionals – assume that current economic trends will continue, however erroneous that assumption may be.
The theory that had commandeered much of the mainstream of economics before the crisis, rational expectations, took all previous economic assumptions to their logical conclusion. It assumed, contrary to Minsky that – as Wolf puts it – the world we live in is “a world of perfectly equilibrating markets with full foresight.” But, Wolf says, “This is not our world.” In the actual world, people, for example, “start to see the rising prices of assets as a long-term upward trend, instead of what it really is – a one-off adjustment.” And this is what causes bubble trouble.
If people in economic situations sometimes practice rationality and look-ahead perspicacity, and at other times act on illogic, myths and mindless extrapolation, how is economic theory to distinguish when to assume the one and when to assume the other? Efficient market theory, which assumes investor rationality and omniscience – while imperfect – has considerable power to help explain the random and unpredictable nature of market prices. How to reconcile it with the assumptions of irrationality that Minsky requires?
The answer, I believe, may lie in what New Yorker journalist John Cassidy calls “rational irrationality” (though he did not invent that term). There are many situations – a bank run is the classic case – in which each participant is acting rationally, believing for example that she should rush to withdraw her money from the bank if she senses that others are about to withdraw theirs, for whatever reason; but the end result can be an “irrational” one: the collapse of a perfectly solvent bank.
The turmoil – both in the real world of global economics and its theoretical counterpart – will take a long time to resolve. The prevailing scenario in the interim – or longer – could be “secular stagnation,” a condition which the Financial Times defines by “negligible or no economic growth in a market-based economy.” If so, as Larry Summers has suggested, we may be in for a long, bleak period.
Michael Edesess, a mathematician and economist, is a visiting fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, a principal and chief strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, has just been published by Berrett-Koehler.
Read more articles by Michael Edesess