Saturday, 8 February 2014

The Shifts and the Shocks: Lessons of the Global Financial Crisis

"In economic terms, the only other disaster that matches this is a world war. [...] This wasn't some minor event. We will be living with the consequences of this possibly forever."

The quote above is from Martin Wolf, the associate editor and chief economics commentator at the Financial Times, specifically from the highly passionate and immensely thought-provoking lecture he delivered at the University of Birmingham on Wednesday (5th October). Mr Wolf is, as his Wikipedia page puts it, 'widely considered to be one of the world's most influential writers on economics' and so it was with great excitement that I came to listen to him speak on what he is most passionate about: the financial crisis of 2008. I was not disappointed.

In outlining the key arguments which shaped his lecture, I will follow the same structure which he did by looking first at where we are post-crash, then how we got here, and finally what we should learn. Along the way I will insert my own comments and also some references to books, videos and ideas which I feel have already contributed well to the existing debate and which you readers may want to look into. In an effort to keep this article of a moderate rather than excessively long length, I have taken the liberty to condense Mr Wolf's arguments as much as possible, so please do forgive any ambiguity present. Comments are, as always, very welcome and I will be delighted if you make the effort to share your thoughts with me.

Martin Wolf can be seen here on the far left.

1. Where we are

Mr Wolf stressed that despite pursuing the most stimulative monetary policy in history (by which he meant extremely low base interest rates and the use of quantitative easing, which I have explained in another article) the high income countries have not recovered very well at all in the years following the crisis. In 2013, the Eurozone's output was 13% below its pre-crisis level; the US's was at 15% below the pre-crisis level; the UK's was at a shocking 19%. The loss in GDP for the UK has been between 5 and 6 times the size of our GDP, and since nearly all the lost output was in productivity, we have now had six years without productivity growth.

"This is the slowest recovery in British recorded history and we still haven't got [back] to the starting point." 
Mr Wolf went as far as to compare the devastating impacts of the crash on the high income countries' economies as equivalent to those created by a world war - and he didn't make that comparison lightly.

Fig 1. Central banks' interest rates hit rock bottom after the crash.
It is clear that all these governments did as much as they possibly could in terms of monetary policy as the graph below shows, with money having been effectively close to free since 2009. Mr Wolf argued that, in fact, from 2008 to 2010 the Federal Reserve had in essence become the United States' credit system, which I found incredibly shocking, especially since, as Mr Wolf said, "this, remember, is the country which strongly believes in the free market".

 Despite all these attempts to prevent their respective countries' economies from collapsing, it is truly horrifying to see (as already demonstrated by the statistics I've mentioned) that those economies have been doing so badly (until very recently). It makes me wonder just how awful the situation might have been had the governments not stepped in and literally taken over the banking system.

 2. How we got here

How did we get into such a terrible state? There have been numerous outstanding books and documentaries on this subject, but I personally recommend the 2010 documentary film 'Inside Job', which is very well-made and which made me feel utterly outraged when I saw it. In his lecture, Mr Wolf called the financial crash the result of  "a complex interaction of two forces: a global savings glut and a fragile financial system". Let's explore that further:

A global savings glut

The 'global savings glut' manifested in the form of a housing bubble after real interest rates on 10 year government bond yields plummeted and so real house prices began to soar upwards. When the real interest rates on assets started becoming negative (note that 'real' interest rates are interest rates after accounting for inflation), all the net capital importer nations using the surplus savings of the world went into crisis. (Even now, the return for China on US assets will be "monstrously" negative as the US is defaulting on its debts.) There were huge increases in the gross debt levels of debtor countries, especially in those sectors which had been highly leveraged, such as the household and financial sectors.  

A fragile financial system

The financial sector, as already mentioned, had been (and still is!) highly leveraged. But the figures themselves are staggering. The normal pre-crash leverage ratio was 20:1, which was already a precarious figure as it meant that banks could lend £20 for every £1 that they had in 'hard cash' (which is also known as narrow money, or M0). Just before the crisis, however, the ratio had become something close to 50:1. The banks were creating money which they did not really have (known as 'fiat money') with the belief that everybody would not come knocking for their money all at once. However, once the economy started to falter and people began to lose confidence (what Keynes would have referred to as low 'animal spirits') there was a comprehensive run on the banks, leading to those institutions collapsing as they simply did not have enough money to pay all the 'hard cash' being demanded. 

Fig 2. Banks are failing to carry out what should be their primary duty.
Not only was this the case, but banks were, and indeed still are as Figure 2 shows, failing in their primary and most basic duty: that of lending to businesses so that they might improve their productivity. The graph shows that in August of last year, financial institutions in the UK were making 43% of their loans to individuals for their mortgages, 34% to other banks and only 9% to non-financial businesses. This last statistic is outrageous. 

At the very moment that his audience was wondering why the British government doesn't put some sort of control on mortgage lending, he proclaimed:

"No British government will consider a lower housing policy. Sorry. If they did, the banking system would implode." 

Unfortunately, this is completely true.

The Eurozone 

Mr Wolf focused on the Eurozone at this point and said that in his view, "the core of the Eurozone crisis is not fiscal", but rather that the fiscal crisis was a "symptom" of the financial crisis. Countries with budget deficits faced the largest difficulties as a result of the crash. For example, though Ireland's net public debt had only been around 10% of GDP in 2007, it rapidly escalated to over 100% of GDP by 2013. 

3. What we should learn

I felt that this was the most important and most interesting part of Mr Wolf's talk. The things mentioned up till this section of the lecture were shocking, yes, but not really things I hadn't really heard before. It was Mr Wolf's personal opinions on what he feels we need to do now that I was most interested in. So what did Mr Wolf tell his (by now thoroughly scared) audience?

There are five key things which Mr Wolf feels we should learn from the financial crisis:

A) The financial system is fragile and crisis prone

Mr Wolf believes that we have made a huge mistake in allowing private institutions to serve a fundamental public service: that of creating money. The result has been a fragile, explosive system. He also emphasised the idea that the financial system is always part of the state and that it is foolish to think otherwise. For this reason we need to have higher capital ratios and "workable macro-prudential policies".

B) Large current account imbalances virtually always suggest a crisis is on the way

Mr Wolf mentioned that the concern Keynes had raised over imbalances at Bretton Woods (where a new agreement was formed between 44 countries aiming to reshape the world's international financial system after the shock of the Great Depression) remains valid today. He feels that unlike then, there is not currently a mechanism to ensure global balance, but that the role of the dollar actually seems to make balance "impossible to achieve". This has a clear link with his point D).

C) We may be moving into secular stagnation in the high-income countries

The combination of weak demand in the private sector, slowing trend productivity growth, deteriorating demographics, debt overhangs and financial repression is one which may be the cause of stagnation in the high-income economies according to Mr Wolf.

D) Management of the world economy has become more difficult as the economic and political weight of the West has declined 

We are in a period of transition between hegemonic powers according to Mr Wolf, and just as the old transition in the 1920s and 1930s from the UK to the US was deeply uncomfortable, this period is also difficult. He feels that China cannot become the hegemon of a global market economy, but didn't really get the time to explain why. His assertion is intriguing, and it would have been brilliant to have heard his arguments in its defence.

E) The Eurozone is a 'bad marriage' but divorce would be costly

Mr Wolf feels that things that have not yet happened but which might save the marriage are: the restructuring of debt to tackle the large debt overhangs; financing, largely supported by the ECB (European Central Bank); a symmetrical adjustment of income and spending; and a banking union with a minimum fiscal union to ensure the success of the banking union.

Some interesting points from the Q&A session

There was only time for a couple of questions, but some of the key things which emerged from the session were that:

  • Mr Wolf would ideally like us to follow the 'Chicago plan', which he didn't go into any detail about as he didn't have the time, but which I have briefly outlined here. The Chicago plan was actually suggested in the 1930s by US economists as a method to escape the Great Depression, but was brought to the fore in 2012 by the IMF (International Monetary Fund). The plan was really quite radical as it required banks to put up 100 percent reserve backing for their reserves (no more 20:1 or 50:1 leverage ratios) and no longer to have the ability to create money from nothing. The Week magazine has written an excellent article on the matter, which is definitely worth a read, as it explores the key issues clearly and succinctly.
  • We (the UK) are the only country which implemented ring fence policies where we separated the retail and investment sections of banks to reduce the risks associated with investment banking from contaminating retail banking. Other countries are now considering following suit. Mr Wolf was himself involved in pushing the legislation through and says that although it is quite far from the ideal, in his opinion, it "can be made to work".

My own thoughts...

I think the financial crash has illustrated that our entire system needs reform. By this I don't just mean our financial system, which certainly needs more reform than has already occurred, but our entire way of life in the high-income countries. Do we really need to have a system of economics which acts as though we never, ever have enough and constantly need more? We live in a 'Story of Stuff' world, and this is not making us any happier. Indeed, inequality levels have sky-rocketed since the crash, and the people who seem worse off are the (relatively innocent) general public who were duped by those with power, influence, and huge amounts of money. I realise that these comments have not been supported with evidence here, but I will be writing a detailed article exploring my thoughts once I have finished reading 'How Much is Enough: Money and the Good Life' by Robert and Edward Skidelsky. I highly recommend you read the book and please look out for my article on the matter which I will write as soon as possible.

Many thanks to Mr Wolf for his passionate lecture and to the University of Birmingham for organising and hosting it!


  1. Minsky has been chosen as SourceForge's Project of the Month for January 2014

    Learn more about Minsky analysis, some different economics, view Prof Steve Keen's YouTube page:

    1. Great, thanks. Prof. Keen's views are certainly very intriguing. I recently listened to his discussion on BBC Radio 4's Analysis on why he thinks economics is 'bunk':


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