“The Shifts and the Shocks” by Martin Wolf

Martin Wolf, a financial columnist with the Financial Times for almost 40 years who is generally considered one of the most thoughtful and influential in his field, has a new book on the latest financial crisis and the condition and future of the global financial industry.

Those wanting a clear explanation for what happened and the policy options for the future will not be disappointed.

Wolf provides a clearer exposition of the Great Recession than you will find most places. His primary focus, however, is on the broader shifts that have influenced the evolution of global financial institutions, the alternative policy responses that might be considered.

He states that three broad shifts in the global environment have impacted economic and financial developments over the last 30 years: “The first is liberalization – the reliance on market forces across much of the world economy, including, notably, in finance.

The second is technological change, in particular the information and communications technology revolution, which supercharged the integration of economies, again, quite particularly, financial markets. The third is aging, which transformed the balance between saving and investment in a number of high-income economies.” (page 114)

The first two of these have produced dramatic reductions in poverty and increases in average living standards for much of the world. Given the legal and policy environment in which they have occurred, however, they have also increased risk-taking, leverage and the vulnerability of the financial system to shocks. The third, aging, has lowered interest rates (the global savings glut), challenged the financing of expenditures associated with old age, and highlighted the importance of immigration policies.

In this new environment, financial instruments proliferated and the value of financial assets relative to the real economy exploded. However, the legal and regulatory environment created incentives for greatly increased risk taking.

These incentives included “the shift from partnerships to public companies on Wall Street in the 1980s and 1990s, the embrace of stock options and the payment of bonuses, frequently linked to a single year’s performance, with little or no claw-back in light of subsequent events. Accounting rules that allowed the recognition of profits on signing the deal, rather than over its life, also shifted incentives toward the short term.” (page 134)

To these must be added tax systems that favored debt over equity and the almost universal practice, except in the United States, of government backstopping bank losses (bailouts).

The combination of economic liberalization and globalization generated downward pressure on the prices of traded goods. “Taken together, these changes in market conditions not only permitted, but encouraged inflation targeting central banks to pursue aggressive monetary policies without having to worry much about inflation. Those policies then supported asset prices and associated credit growth.” (page 186)

“What then stops the bank-led financial system from expanding credit and money without limit?… If the activities of the hyperactive intermediaries in aggregate create the perceived opportunities: credit growth breeds asset-price bubbles that in turn breed credit growth. This is, at core, a disequilibrating process.” (page 198)

The relative growth of the financial sector (both its share of income and its political influence), and of the government’s efforts to regulate it, produced the crony capitalist coalitions denounced by the Occupy Wall Street protests.

“One important aspect of this is rent-extraction by well-connected elites – that is, the ability to earn incomes over and above their economic contributions, by virtue of their powerful position within the economic system.” (page 187)

The response to these developments has been what Wolf calls the new orthodoxy.

“The authorities want largely to preserve a system they also mistrust. That is why the regulatory outcome has been so complex, and insanely prescriptive.” (page 234) Wolf worries that the growing regulatory burden will sacrifice many of the benefits of modern finance without succeeding in eliminating excessive risks, though he accepts the widely held view that a large increase in bank capital and bank debt convertible to capital when needed will strengthen the system.

In the search for more far reaching reforms, Wolf briefly reviews alternative theories that have generated pockets of support.

These include Knut Wicksell’s broadly accepted distinction between the natural and the monetary rates of interest, which suggests that central banks should increase interest rates more than suggested by their inflation target alone during periods of rapid credit growth; the Austrian views on cyclical credit growth and the resulting malinvestment that led Ludwig von Mises to propose 100 percent reserve requirements for demand deposits and a return to the gold standard; Henry Simons’ and his University of Chicago colleagues’ elaboration of the 100 percent reserve requirement idea into the Chicago Plan; Milton Friedman’s monetarism and belief in the importance of clear policy rules (monetary as well as fiscal), both to better anchor market expectations and to protect policy from the short-termism of political pressure; and  Abba Lerner’s chartalism and modern monetary theory’s belief that all money should be government money (i.e., the Chicago Plan) to be used to stabilize the economy, in the spirit of Keynes, such that all government debt would be money financed.

The book is rich with Wolf’s clear-eyed discussion of the whole range of policy options including extensive discussions of the problems of the eurozone and proposed solutions. He is too soft in my view on the viability of Keynesian fiscal stimulus, but after expressing skepticism that our current direction – the new orthodoxy of more and more regulations – will work, he has serious reservations that we can rely fully on “liquidationism – a return to nineteenth century free market capitalism (no bailouts, etc). While he rejects “no bailouts” as too harsh, he concedes that “liquidationism is still quite correct on one thing: shareholders should never be rescued.” (page 335)

Wolf briefly considers more radical reforms of the system. His primary concern is that the universal practice of fractional reserve banking by which banks create money (deposits) when they lend and do the reverse when demand for credit falls has imparted a pro-cyclical instability to the banking system.

When the economy is booming banks increase credit, and thus money, more than would be possible under, for example, a gold standard, thus feeding the boom; and contract money and credit during busts when the opposite would be helpful. The Chicago Plan of 100 percent reserves would remove this feature and provide a safe payment system without the need for further regulations.

The national fiat currencies that replaced the gold standard have introduced significant volatility and uncertainty into global trade and its financing and have driven much of the growth in the financial sector in an effort to hedge those uncertainties.

Wolf rejects the restoration of a gold standard-like global currency as politically infeasible. “That would mean the creation of what amounts to a global central bank. There is no possibility of agreement on such an arrangement in the absence of a world government.” (page 347)

“The evolutionary approach being taken to reform of the global financial and monetary systems is unlikely to prevent further crisis. Further financial disintegration and greater discipline over global imbalances will almost certainly be needed…. If so, the obvious alternative is to give up on full global financial integration.

In the context of the current global monetary system, which largely reflects continued national sovereignty, financial integration has proven highly destabilizing. It might have to be sharply curtailed.” (page 348)

Wolf would prefer more radical reforms of the system such as a truly international reserve currency with fixed exchange rates and the Chicago Plan but doubts they are achievable. At least he has pretty much laid out the range of options that deserve serious discussion and in so doing has made an important contribution to that discussion.


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Warren Coats
Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kenya, Serbia, Turkey, and Zimbabwe). He was a member of the Board of the Cayman Islands Monetary Authority from 2003-10. He is currently Visiting Scholar in the Institute for Capacity Development Department of the International Monetary Fund (February 20, 2018 through April 30, 2019) and a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise. He has a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. In March 2019 Central Banking Journal awarded him for his “Outstanding Contribution for Capacity Building.” Warren CoatsT.  +1 (301) 365 0647E. [email protected]W: www.wcoats.spaces.live.com