Notes on "The shifts and the shocks" (Martin Wolf)

The shifts and the shocks : what we've learned - and have still to learn - from the financial crisis

Martin Wolf, 1946-, author.

London : Penguin Books  2015

• The Crisis
• A sudden stop in capital markets
• Policymakers put the full resources of their states behind the financial system
• Injecting capital, providing liquidity and guaranteeing liabilities
• The central banks slashed their interest rates to unprecedentedly low level
• Fiscal deficits of a number of significant high-income countries rose to unprecedented peacetime levels when the crisis hit
• Why is the impact of a financial crisis so prolonged
• Prior to the crash, unsustainable increases in private debt, or leverage, had occurred within several economies
• The sustained rise in debt and associated spending distorts economies
• The adverse impact on the financial sector
• Overloaded with bad debt and under-capitalised, financial institutions become far more cautious
• Inflation may become too low or worse, deflation may set in
• Economies may end up in a state of sustained malaise
• As John Maynard Keynes argued, this paralyses what he called the 'animal spirits' of business
• A vicious spiral: low investment means weak demand and low economic growth, and so justifies the decision to postpone investment
• At the lowest interest rate the central bank could create, the private and foreign sectors would have had a large excess of income over desired spending at full employment
• This could be dealt with in only one of two ways:
• A collapse in income greater than the associated collapse in spending - that is, an outright depression
• A large fiscal deficit
• Austerity
• Fiscal tightening did indeed begin in 2010 or 2011 in all the big countries
• Fiscal austerity proved contractionary, given that post-crisis private demand was so weak and interest rates were very close to zero
• Why did this premature policy reversal occur?
• Influential academic research on the limits to public indebtedness and the feasibility of 'expansionary contradictions'
• Mistaken belief that the recovery was already entrenched
• 'paradox of thrift' - a phrase first popularized by Paul Samuelson
• Politics
• Conflicts between different parties' policy beliefs
• Huge housing bubbles and credit booms
• Germany was the largest creditor
• The political benefits of the Eurozone are that it is the capstone of the European project, to which Germany has been strongly committed since shortly after the WW2
• Unravelling the Eurozone would create huge economic and political disruption
• Fearful of 'moral hazard'
• The crisis of Spain and Italy has made investorss worried about the destructive nexus between banks and sovereigns
• The ECB's response to the crisis: outright monetary transactions
• Improve the functioning of monetary policy and safeguard the viability of the euro
• The European currency union represents the worst of both worlds: members are not on their own, as are sovereign countries with fixed exchange rates, while the credibility of the currency arrangement is also greater than that of a unilateral commitment; but members also do not benefit from most of the automatic risk-pooling features of a modern federal state, while their currency union is less credible than one embedded in such a federation
• Direct financing of deficits was ruled out by the founding treaties of the currency union
• China is unsustainable, for two reasons:
• A long-run: ultimately, the goal of production is consumption. It makes no sense, in the long run, for investment to grow faster than consumption. If it does, it is likely that investment to grow faster than consumption. If it does, economic returns on investment is falling

A short-run: the level of investment itself depends on the rate of the economic growth: the higher the growth rate of an economy, the higher the share of investment in GDP is likely to be. As the Chinese growth rate slows, as everybody (including the government) expects - now that the country no longer enjoys the benefits of huge amounts of surplus labour and has become a middle-income country - the need for investment is likely to fall sharply. But that is also going to take way a crucial prop to demand

• The risk-management models were wrong. They assume a certain distribution of possible outcomes
• Pre-crisis regulation is based on the theory of efficient and rational markets
• Policymakers assumed the system was far more stable responsible, indeed, than it was.
• This assumption was so widely shared that so many countries were affected
• Policymakers thought stable inflation would deliver economic stability that they successfully stablised the inflation but failed to offer economic stability
• Property assets: illiquid markets
• The US has little direct influence on the value of the US dollar, because of the currency's role as a reserve asset
• The US dollar is an 'exorbitant privilege
• Explanations for the crisis in terms of savings and credit:
• The savings-glut hypothesis
• The rise in gross leverage and gross cross-border flows vastly exceeded net flows from surplus to deficit countries
• The expansion in gross leverage was overwhelmingly inside high-income countries
• Gross-capital flows across frontiers vastly exceeded the net flows
• The high German savings rate was the consequence of policies aimed at generating rapid employment growth by restraining German consumption in order to subsidize German manufacturing - usually at the expense of manufactures elsewhere in Europe and the world
• What were the deeper force behind the huge shifts in global patterns of saving, investment and capital flows?
• The shift towards economic liberalization
• A rapid shift in production from high-income economies to cheaper low-cost producers
• The rise of state capitalism
• Directly control and mange their capital outflows
• Lack of high-quality, liquid and apparently safe opportunities
• The rise of vast sovereign wealth funds
• Put assets in the markets of high-income countries
• The rise in inequality (the driver of this is very complex)v
• Technology
• The prices of investment goods are falling rapidly relative to goods and services in general. This is particularly true for information and communication technology
• Ageing, notably in Germany and Japan
• The big failures lay in not recognizing how large the risks were to the system as a whole, how bad risk management was, and how big the mess bequeathed by the crisis would turn out to be
• It is easy to accept that the timing of a crisis is unknowable
• Adair (Lord) Turner's answers to what had economics got wrong:
• Debt contracts create specific financial and economic stability risks; and those risks intensify as the proportion of all contracts which take a debt and in particular a short-term debt form increase
• The existence of banks exacerbates these risks because banks can create credit and private money, and unless controlled, will tend to create sub-optimally large or sub-optimally unstable quantities of both credit and private money
• Bank or shadow-bank lending secured against real assets which can change in value, can be even more volatile and pro-cyclical, resulting in credit and asset price cycles which end in crashes and subsequent recessions
• What stops credit expansion
• A crisis stops it
• The central bank stops credit expansion by raising interest rates
• The reason orthodox economics failed to pick up the risks was that it ruled out what most mattered
• Modern financial economies do not equilibrate smoothly, they are dynamic systems characterized by uncertainty and 'animal spirits'
• Mr. Bernanke (the former chairman of the Fed) made three fundamental points about the role of central banks
• Interventions during the crisis
• Preventing a cascading collapse into ban.kruptcy not just of the financial sector, but of large parts of the domestic and world economies
• Stabilizing the financial system
• The new orthodoxy
• To stabilize inflation
• To stabilize the financial system
• Central bankers are strengthened in their role as lenders of last resort, but want to avoid rescuing insolvent institutions
• Powerful objections to Mr. Bernanke's approach
• The new orthodoxy gives enormous discretionary power to bureaucrats in managing the financial system
• The new orthodox doctrine does not resolve the confused relationship between the state and the private sector as suppliers of money. On the contrary, it reinforces that confusion
• The doctrine assumes that monetary policy can targeted at price stability, while macroprudential policy is targeted at financial stability
• The alternatives to the new orthodoxy
• Knut Wicksell on the market and natural rates of interest
• Henry Simons and the Chicago Plan
• Hayek and Keynes
• Minsky's instability hypothesis
• Lerner, Chartalism and Modern Monetary Theory