Can We Avoid Another Financial Crisis?
The crisis of 2008 is the "greatest disintegration of the world’s core financial system that has ever happened." And a crisis of similar magnitude is "almost certain to happen again."
This was the warning shared by Martin Wolf, Chief Economics Commentator at the Financial Times. Considered to be one of the world’s foremost economics journalists and writers, he joined an audience with Professor Pedro Videla at IESE this month, to discuss the findings of his book The Shifts and The Shocks: What We've Learned – and Still Have to Learn – From the Financial Crisis.
How Did We Get Into "This Mess?"
The 2008 meltdown took many economists, Wolf included, by surprise. And while he describes the magnitude of the crash as "in some ways unforeseeable," he criticized the "gross failure" of economic institutions that had previously dismissed this kind of crisis as inconceivable.
Citing the "comprehensive failure of the old, pre-crisis economic orthodoxy," Wolf argued that regulatory institutions and central banks had failed to understand the interconnection between macroeconomic forces and the financial system.
In his book Wolf talks about the probable causes or "shifts" that led to the crisis. Globalization, he says, was the key factor.
"Globalization helped bring about global savings imbalances, had large effects on income distribution, drove the behaviour of companies in crucial ways, and changed where they invest. It also played a role in rising inequality, reinforced by technological change."
Wolf pointed to the Asian crisis of 1997-98, which had shifted the global balance of demand and supply of savings and investments, shrinking investment demand in many countries and leading to policies that generated huge excess savings in emerging economies.
"It is insane to run the world economic system on the assumption that it is desirable for poor countries with good investment opportunities to export capital to rich countries with bad investment opportunities," he said. "It should be the other way around, but rich countries are nervous about running large current account deficits."
Strong Response, Weak Recovery
Describing the monetary response to the crisis as "unlike anything ever seen in the history of the world economy," - with the effective interest rates of most major economies slashed to or near to zero percent - Wolf conceded that central banks had worked hard to re-inflate economies. The strategy had, however, so far failed to bear the necessary fruit: "Inflation should be exploding as a consequence, but it isn’t."
The US recovery, though slow, is real. But the picture in Europe is very different he said, with domestic demand remaining five percent below the pre-crisis peak, and a "very, very weak" recent upturn unlikely to reverse fortunes any time soon.
Good News for Spain …
Although he attributes the eurozone slump to mismanagement of the crisis on the part of the ECB, Wolf does concede that effective action has been taken to deal with the liquidity problem in public debt markets. The Outright Monetary Transaction system in August 2012 was, he said, a "decisive event" for Spain and Italy.
As a result, Wolf believes that Spain has justifiably become a source of (limited) optimism in the larger global economy.
… But Bad News for Europe?
The European recovery is likely to remain disappointing, said Wolf. The next four years, he believes, will see a catalog of debt write-offs with the Greek situation being a sort of "canary in the coalmine" in terms of public debt.
Wolf described the "chronic demand deficiency syndrome" facing Europe as difficult to resolve, with quantitative easing only practicable as a temporary solution. An increasing external surplus, he said, was not tenable without counterparties to facilitate it.
The worst prospect for Europe, said Wolf, was the "zero-sum game" of a persisting slump in which one country’s success would come at the expense of the rest.
"When things go wrong on this scale, somebody has to bear the losses."
Are We Sowing the Seeds of a Future Crisis?
The pursuit of monetary policy to compensate for weak demand growth by manipulating asset markets, says Wolf, could be creating serious new financial fragilities.
"I’m not convinced we’ve created the conditions for another crisis on this scale in the developed world – though I’m not confident we haven’t – but perhaps we will create a serious, though not catastrophic, one in the emerging world," he warned.
To head off future crises would require reform of the IMF leading to the creation of macroeconomic insurance and radical changes in banking. With a true leverage ratio of around 25:1 in major banks, he warned that the sector is now significantly more concentrated than before the crisis.
"Banks are still unambiguously too big to fail, and it is hard to stop them taking risks if they know they will always be bailed out."
In his FT column, Wolf has endorsed the idea of states being given complete control over money creation, as outlined in the 2012 IMF paper "The Chicago Plan Revisited." Under this system, banks would become mere account managers, restricted to lending only as much as they held in their reserves.
"The transition to a system in which money creation is separated from financial intermediation … would bring huge advantages," says Wolf. "It would end ‘too big to fail’ banking."