HISTORY REPEATING ITSELF: Alan Dukes on how we can learn from the financial crisis

The proposals presented by Martin Wolf in ‘The Shifts and the Shocks’ merit close consideration if another crisis is to be avoided, writes economist and former finance minister Alan Dukes

THE sub-title of this profound, disturbing and prophetic analysis is “what we’ve learned — and have still to learn — from the financial crisis”, meaning, of course, the crisis that hit the Western world’s financial system in 2007 and the fallout from which continues to depress living standards in all the affected countries.

Martin Wolf is associate editor and chief economics commentator at the Financial Times. Since the onset of the crisis, his columns in that paper have provided thought-provoking and frequently contrarian views on the origins and nature of the crisis and on the actions of both the public and private sectors to deal with its effects.

In this book, he presents a wealth of insights, analysis, and reflections, drawing not only on his own research and judgement but also on the speeches and writings of many others, including many with whom he fundamentally disagrees. His analysis is rigorous and deals fairly with opposing points of view. As a result, the proposals he presents for future action merit very close consideration.

While Wolf finds that measures taken in response to the crisis have generally gone in the right direction, he makes it repeatedly and abundantly clear that many of the factors that led to the 2007 crisis are either still present or have been inadequately addressed. The stakes could not be higher. In Wolf’s view: “It is unlikely that the high-income countries could cope with another such crisis within the next decade or two without large-scale defaults in the public or private sectors, either openly or via inflation.”

He takes the view that, without radical changes in the structure of the financial sector and in the interaction of macroeconomic policy with the financial sector, another crisis is likely within a decade. The “new orthodoxy”, even with the financial sector reforms currently being implemented or contemplated, is not an adequate response to the crisis.

The 2007 crisis arose from global macroeconomic shifts and the actions of a globalised and liberalised financial sector. Following their crisis in 1997 to 1999, the countries of East Asia set out to reduce their vulnerability to potentially unstable financial flows. They built up their ability to generate large external surpluses, generating substantial foreign reserves and becoming exporters of savings.

The new and more economically open China became a dominant player. Part of their ability to generate external surpluses was at the price of internal consumption. In this way, the East Asian countries were at the root of both the “savings glut” and the emergence of a chronic weakness in demand.

At global level, the total of external surpluses equals that of external deficits. The high-income countries of the West ran external deficits (with some exceptions, notably Germany). At the same time, their developed and liberalised financial sectors took up the flows of funds from the surplus countries and added them to their operations.

The availability of funds exceeded demand for investment in the real economies of these countries, so funds were instead channelled into property, creating asset price booms in some countries, into increasing household debt (encouraged by income shifts from lower to higher earners), and into securitised products offering (superficially) the prospect of higher returns than equity investment or other investment in the real economy.

Wolf quotes a telling remark by Floyd Blankstein of Goldman Sachs to the effect that, in January 2008, there were 12 triple-A rated companies in the world and 64,000 structured finance instruments.

Funding from wholesale interbank markets became more and more important in the high-income countries’ banking systems. Heavy and growing reliance on this kind of wholesale financing exacerbated the vulnerability of banks to the basic mismatch of maturities inherent in their business models. This seems generally to have escaped the notice of regulators. The huge flows of funds through international markets and what Wolf calls the “investment dearth” in high-income countries created opportunities for explosive growth in new financial products, many of them based on securitisation.

Warren Buffet famously termed such products “weapons of mass destruction”. The proliferation of these instruments happened under the noses of largely uncomprehending regulators and governments.

On top of all that, most of the activity of the financial sector in high-income countries finances the transfer of existing assets rather than the creation of new productive assets.

Concerns about the solidity of the high-income countries’ financial sectors began to surface in mid-2007: Confidence soon collapsed and the flow of funds halted abruptly, leaving the financial sector hugely exposed.

Wolf demonstrates clearly that the crisis — including the eurozone crisis — is a financial crisis that has inevitably had fiscal consequences. At its root, it was not and is not a fiscal crisis, and so cannot and will not be resolved by fiscal means alone. While there are structural weaknesses in the most-affected eurozone economies, these weaknesses were not at the root of the crisis: They will, rather, hamper efforts at recovery. Wolf points to a number of directions for reform.

For the banking sector (globally and in the eurozone), suggestions include:

-Higher capital ratios (he is scathing about the Basel 3 proposal of 3% equity capital);

-New and much stricter limits to leverage;

-Effective resolution rules with bail-in of creditors;

-Moving away from fractional-reserve banking and ending banks’ ability to “create” money simply by extending credit;

-Strong macroprudential regulation to prevent runaway credit booms.

For the eurozone, Wolf suggests:

-An adequate supply of safe credit in the form of some type of eurobonds (possibly up to 60% of a member government’s borrowing);

-An expanded role for the European Central Bank, to give it more freedom to manoeuvre in exceptional circumstances, including the ability to finance governments directly;

-An element of fiscal union in the form of collective backstops for the banking union, as well as for eurobonds.

WOLF acknowledges that eurozone moves on banking union are steps in the right direction, but ones that do not go far enough.

He is critical of the G20 commitment at the Toronto summit in June 2010 to move from the promotion of stimulus (as agreed at Pittsburgh in September 2009) to a commitment to deficit reduction, a move which he believes was premature and based on the mistaken belief that recovery was entrenched. He points to an IMF Working Paper in 2009 which suggested that, the more expansionary the immediate macroeconomic policies are after a financial crisis, the smaller are the long-term losses in output. He contends that, both at global level and in the eurozone, policy errors since the onset of the crisis and, in particular, the heavy over-emphasis on fiscal retrenchment, have had what will be long-lasting depressing effects on output and employment.

On the need for global rebalancing, Wolf suggests:nEncouragement of less risky flows of finance (eg FDI and purchases of equity) or new forms of debt or quasi-debt;

-Increasing insurance (e.g. via unconditional financing by the IMF or by the pooling of resources by emerging economies);

-The creation of global money (although he regards this as a very remote prospect);

-Making all money creation a function of government (and therefore removing this de facto function from the banking system).

Looking at the political feasibility of his suggestions in the current eurozone and the international political climate, one can only agree that Wolf is right not to be sanguine about the prospects of progress in the foreseeable future. On the other hand, it is fair to say that the eurozone is important enough on the global scene to suggest that, if it could be brought to be more adventurous and ambitious in the area of reform, the demonstration effect at global level would be important.

For that reason, and in light of Wolf’s convincing demonstration that the fundamental problem is financial and not fiscal, this book should be required reading for German chancellor Angela Merkel and finance minister Wolfgang Schäuble. Perhaps the heads of government of Ireland, Spain, Portugal, Poland, Slovenia, and the Czech Republic, who have all gone the fiscal flagellation route, might sit down with Angela and Wolfgang and introduce them to the real world?

* Alan Dukes is an economist and was leader of Fine Gael. He served as Minister for Finance from 1982 to 1986.