Fans of his columns in the Financial Times will know there’s no danger of finishing reading a whole book by Martin Wolf in an optimistic frame of mind. So it is with his new book, The Shifts and The Shocks. The subtitle is ‘What we’ve learned – and still have to learn – from the financial crisis’, and the message of the book is that there is more still needing to be done than sorted out already.
The main thing the book argues has been learned (by some people) since the crisis is that pre-crisis ‘official’ macroeconomics comprehensively failed. To echo the title of the relevant chapter, orthodoxy has been overthrown. Props to Wolf for acknowledging his own change of mind in the light of events (after all, he wrote an earlier book called Why Globalization Works.) He points out that the features of the global economy that turned out to matter in real life – the accumulation of debt and the growth of shadow banking – had been assumed to be unimportant or irrelevant. Wolf has become a wholehearted Minskian, but you obviously don’t need to jump into any new camp to agree that pre-crisis dynamic stochastic general equilibrium models were a nonsense. What’s rather depressing is that some macroeconomists still seem to think these DSGE models just need a bit of tinkering, a little bit of financial ‘friction’ adding in. As the book’s introduction forcefully points out, a theory in which something that did happen is impossible is a rubbish theory.
The first chunk of the book is a high-level description and an analysis of the origins and unfolding of the financial crisis, with particular emphasis on the Eurozone. He has long been writing in his Financial Times columns about the problem global imbalances, particularly between the US and China. This book focuses more on Europe. Much of the description is familiar territory, but seen this time through Wolf’s new spectacles of the Minsky convert.This section culminates in the ‘orthodoxy overthrown’ chapter, which includes a quick rundown of the various alternatives, in a nice, brief summary of the history of macroeconomic thought including those turned into renegades by the DSGE triumphalists of the 1990s and 2000s. Wolf ends by concluding that in a system in which the state is the ultimate supplier of money but most money and credit in use is created by the private sector is a ‘pact with the devil’. “Moreover, the liberalization of finance seems to lead to crises almost automatically. Surely this suggests the need for a new kind of system.”
So what might a new system look like? To fix finance, he advocates – following Anat Admati and Martin Hellwig’s outstanding The Bankers’ New Clothes – a much higher equity ratio for banks, maybe 20%, and serious macro-prudential tools. These seem such no-brainers that the real question is why regulators are so hesitant about them – but this takes us into the analysis of power in the western economies. A chapter on the Eurozone concludes that it isn’t working but it isn’t clear either how to turn it into a ‘good marriage’. This chapter is surprisingly diffident – Wolf writes: “Germany’s insistence on retaining its huge external surplus, on keeping inflation so low, on national responsibility for bank debts and on ever tighter fiscal discipline will not work. The Eurozone needs to become something different.” I would have expected him to predict the unlikeliness of this happening – although he does also acknowledge how messy a divorce would be.
The final chapter has a key point: “Unless regulation and the supply of fiscal backstops is to be much more global, finance should be far less so.” Little would be lost by decreasing the global integration of banking, he argues. Wolf is more radical than what he describes as the ‘new orthodoxy’, which aims to preserve the globally integrated financial system through incremental reform – and, I would say, keeping fingers tightly crossed.This section echoes the chapter in Ian Goldin’s The Butterfly Defect, which underlines the inherent risks in the complex, integrated financial network.
Wolf argues that western elites are continuing to let people down, to a dangerous degree. He accuses them of ‘three huge failures’ – misunderstanding the consequences of financial liberalization and fantasizing about the self-stabilizing features of finance; ignoring the consequences of the emergence of a plutocratic global elite for the civic glue that enables democracy to function; and turning what should have remained a mundane common currency or currency management plan in the EU into a German currency administered by unaccountable ECB and Commission officials without channels of accountability to other Eurozone countries and citizens.
If we cannot implement radical changes – more radical than most people recognize, Wolf says – then, well he doesn’t explicitly spell it out, but implies, economic and political disaster.
By and large, I agree. There’s no point just tinkering with a fundamentally broken system. There are some questions not covered in the book that would only add to the gloom. For example, the extent of outstanding debt left over from the crisis is ginormous. Without a growth miracle – no sign of that on the horizon – the options are explicit or implicit default. How will that happen? The large international banks have returned to pre-crisis behaviours with only marginally more capital – and are still being allowed to judge their own riskiness! What happens when a modest decline in some market somewhere sets us off on the downward spiral of liquidity and solvency we saw in 2008, but this time without any fiscal or monetary firepower left? And by the way, what about demographic and environmental challenges?
The Shifts and the Shocks is a dense and chunky book about economics, not a manifesto for the Occupy movement. I can’t quite picture Martin Wolf in a Guy Fawkes mask outside the ECB. Still, he makes a good case that the ‘new orthodoxy’ of minor reforms favoured by global finance is madness. Radicalism is the only sanity.