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That the Great Recession was a financial crisis of gigantic proportions is supported by the many postmortems still being conducted by policymakers, academics, investors, economists, and journalists. Few, like Martin Wolf, associate editor and chief economics commentator at the Financial Times, have worn all of these hats. Wolf’s views about the causes of the crisis, and especially about how to escape its continued intense gravity, are distilled in his recent book, The Shifts and Shocks: What We’ve Learned — and Have Still to Learn — from the Financial Crisis, and were the subject of a plenary session at the 68th CFA Institute Annual Conference in Frankfurt.
In brief, Wolf believes that markets are hugely out of balance because of poor policies and that both these policies and their consequences must be reversed. Policy change requires political change, and unfortunately, both the United States and the European Union remain in political gridlock.
Three Challenges of the Financial Crisis
Wolf says that the crisis has presented three interlinked challenges.
- Intellectual: In the lead up to the crisis, the orthodox view was that low and stable inflation partnered with financial deregulation resulted in prosperity. Yet, this prescription led to a very sick patient. This is because economists missed Hyman Minsky’s observation that long periods of stability generate endogenous risk-taking behavior.
- Policymaking: Despite the colossal failure of past economic policies, there has been remarkably little soul searching and lesson learning, according to Wolf. In particular, he points out that new institutions have yet to be devised. Neither are there new policy rules being considered to ensure future economic stability. Wolf thinks that new rules must address the interaction between global macroeconomics and financial fragility.
- Economic: Most would agree that the costs to the global economy, however measured, are self-evident.
Why the Financial Crisis Happened
Wolf believes that the right way to understand the crisis is to consider the interaction between two types of triggers:
- Macroeconomic: The crucial macroeconomic event was a series of shifts in the global economy and inside economies themselves. They included shifts in income distribution; the propensity to invest; and massive capital flows, net, from emerging countries to developed countries. This latter trend ran counter to what economists expected when the financial system was liberalized. Such people as Ben Bernanke call this a “savings glut,” but Wolf shrewdly says one could also call this an “investment dearth.” This imbalance between savings and investment critically led to the dramatic decline in the real interest rate worldwide.
- Financial: Among the financial triggers of the crisis that Wolf highlights are financial innovation, financial liberalization, and a resultant surge in credit creation. The preceding factors led to the emergence of endogenous fragility.
Toxic Mixing of Triggers
The interaction between these two forms of triggers led to an upsurge in the price of real assets, then to a massive oversupply of these assets, and a subsequent crash. The Asian financial crisis of 1997 led the most dynamic economic region on the planet to invest its surplus capital in first world regions that could not make use of the capital rather than invest back into its own economies. In short, the financial crisis was caused by:
Negative returns on capital, almost entirely in the private sector.
After the crisis, the demand for credit has remained depressed, and this is why real interest rates has remained so low. Other evidence of the gross imbalances in the system are the large foreign currency reserves of China, other Asian developing economies, and industrial countries. This compares with the cumulative private sector debt overhangs in the deficit countries. Unfortunately, these imbalances, the causes of the financial crisis, remain, according to Wolf.
Subsequent to the crisis, what explained the continued secular stagnation of the global economy? Wolf suggests four sources:
- Pre-crisis trends were unsustainable.
- The crisis bequeathed a debt overhang.
- The crisis damaged credit and thus the economy.
- Policymakers adopted bad post-crisis policies.
Law of the Conservation of Bubbles and Breaking the Law
Wolf summarizes his postmortem of the financial crisis as the development of the Law of the Conservation of Bubbles. That is, the global economy seems unable to support itself unless there is a bubble of some kind — equity, credit, real asset, etc. — somewhere in the world. So, what can be done to end this bubble dependency?
- Restoring growth
- Stabilizing finance
- Rebalancing the world economy
To restore growth, according to Wolf, macroeconomic demand must be stronger — ideally through higher public investment in both the developed world and in emerging market countries. This is because real interest rates are unbelievably low — either 0% or below that!
Furthermore, there must be greater coordination between monetary and fiscal policy. But the Achilles’ heel of Wolf’s presentation was the lack of discussion about how to end the fiscal gridlock that cripples the United States and the European Union. Monetary injections done post-crisis are a permanent part of the macroeconomic picture and must be accepted as such, in Wolf’s view, but are easily manageable (e.g., through changes in reserve requirements).
Wolf also believes that banks remain undercapitalized so they cannot afford the necessary massive debt restructuring, especially the writing off of huge amounts of debt. This is especially true in the eurozone, according to Wolf. Supply must also be stimulated through structural reforms (including product and labor market liberalization); financial reforms (currently, the system is incentivized primarily to finance property and housing investments, which do not contribute much to growth); and tax reforms (most tax policy is dysfunctional and does not promote growth).
Demand in the eurozone also needs to be stronger, with higher inflation in Germany and debt restructuring. Wolf also calls for the end of Germany, Inc., as the ostensible purpose of the eurozone. If both the eurozone and Japan choose external surpluses, then other countries must accept external deficits. But, as Wolf asks, which nations are so willing?
Capital levels in banks must be increased in order to absorb debt writedowns. There also has to be a radical deleveraging of economies, with the elimination of the favorable tax treatment of debt. Also, in property transactions, there needs to be equity/risk sharing between those underwriting property transactions and those that ultimately hold the monetized assets. Most controversially, Wolf believes there need to be experiments with 100% reserve banking and state-created money.
Rebalancing the World Economy
For the global economy to be stable long term, excess capital must flow from developed countries to emerging market countries. Yet, this will not happen without better insurance for developing country deficits. Wolf suggests that the International Monetary Fund could fill this role but would need to be substantially bigger. Additional stabilization could come from higher cross-border equity flows as well as from long-term bonds. Currently, most cross-border capital flows are of a short-term nature, and this leads to instability. Last, Wolf believes that there must be global monetary reform, such that the only nations able to borrow money safely and globally also hold the reserve currency. The net effect of this is that large deficits accumulate in these countries, the United States among them.
In conclusion, Wolf believes that unfettered markets work and that bad policies must be reversed and new policies implemented. But it is politicians who implement policy, and Wolf offered little insight into how they may be cajoled into action.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo credit: W. Scott Mitchell