What We’ve Learned From the Crash – Review of ‘The Shifts and the Shocks’, by Martin Wolf

Richard Toye
History Department, University of Exeter

Follow on Twitter @RichardToye

Cross-posted from the Guardian

shifts_758504zMartin Wolf’s new volume on the causes and consequences of the world financial crisis comes with generous advance praise from, among others, Mervyn King, Larry Summers and Ben Bernanke. That, you might think, is a bit like a manual on maritime safety with jacket blurbs from the crew of the Titanic. But there is not much comfort for the these men within the book’s pages. Bernanke, in particular, gets it in the neck: “even two months before the crisis broke, the chairman of the Federal Reserve had next to no idea what was about to hit him, his institution and the global economy. To be blunt, he was almost clueless.” It seems he’s not too careful about reading the books he endorses, either.

That is a pity, because this is a work that repays close attention. Wolf, a highly respected FT journalist, admits that he himself failed to anticipate the near-apocalyptic events of 2008, having placed too much faith in the benefits of market liberalisation. Noting that orthodox views of how the global economy functions were actually “nonsense”, he observes, with just a hint of understatement: “This poses an uncomfortable challenge for economics.” Actually, it is not economics that is at fault so much as a politico-financial power structure that privileges certain views of the economy at the expense of lucid dissenting voices. Wolf is certainly to be counted among the latter, as he alternates sophisticated technical explanations with powerful blasts of robust common sense. In the future, anyone who wants to understand why the arteries of the economy suddenly seized up – and why it has taken so long for recovery to come – will be obliged to refer to this book. Yet in spite of its helpful attempts to draw lessons, there still remains the unanswered question of how sound economic thinking can be made politically operational, when the politicians in charge are so strongly under the influence of the vested interests that seek to maintain the system in its current form.

Key aspects of the story are, of course, familiar: the triumph of free-market ideology followed by waves of blithely optimistic deregulation; the housing bubble accompanied by the often fraudulent promotion of sub‑prime mortgages to vulnerable householders; the complex financial products sold to people who didn’t understand them by people who claimed, and perhaps believed, that they had eliminated risk; the excessive leverage; the perverse incentives – the list goes on. Wolf’s distinct contribution is to show how all these things were linked to the growth of global imbalances – the payments surpluses and deficits held by different countries. He notes that in the 10 years to 2006 these imbalances quintupled relative to the world’s GDP and argues that three underlying factors – liberalisation, technological transformation and the ageing of populations – together drove massively increased international capital flows, rising inequality and shifts in investment patterns. These are Wolf’s “shifts”, which created “a world of structurally deficient aggregate demand”. The lax monetary and regulatory policies that created financial instability in high-income countries were thus in part “the way to sustain demand in an economy suffering from demand-deficiency syndrome”. The increasing precariousness of the financial system was the price of continued economic growth – for the time being.

In the end, of course, the wheels fell off. If there is any crumb of comfort to be extracted from Wolf’s account, it is that, as the “shocks” of the crisis reverberated, governments actually responded as sensibly as could reasonably be expected in the first flush of panic. But then, from 2010, there was the premature turn to austerity. Large fiscal deficits were the consequence of the crisis, not its cause, and in fact the stimulus they gave – cut off too quickly – was a necessary part of the cure. The language of “responsibility” often plays well with voters, but, as Wolf shows, it can be terribly misleading. He is scathing about how such discourse has played out in the eurozone. The harsh policies that “creditor eurozone” (led by Germany) has inflicted on “debtor eurozone” (symbolised by Greece) are predicated on the idea that current-account surpluses are necessarily virtuous and that deficits are a sign of imprudence. Yet, whatever the mistakes of the debtors, they were ultimately facilitated by the behaviour of the creditors: “the borrowing would have been impossible without the lending. It is stupid to finance profligacy and then complain about the consequences of one’s own choices.” Wolf illuminates the euro’s own flaws with much skill, but does not see any clear way out of the mess. In his view, the consequences of even a partial breakup are too horrible to contemplate, and so it will be necessary to keep muddling through, in spite of the currency’s inherent structural defects.

In other spheres, the book offers more positive solutions. That banks need to be better capitalised is unarguable. Wolf sees Thomas Piketty’s proposals for a global wealth tax as “too ambitious”, but would nonetheless like to see greater taxation of very high incomes. He is also keen on the so-called “Chicago Plan” for 100% reserve banking, whereby central banks are solely responsible for the creation of money in all its forms, and banks must have complete backing for everything that they lend. “A system that is based, as today, on the ability of profit-seeking institutions to create money as a byproduct of often grotesquely irresponsible lending is irretrievably unstable”, we are told. But an obvious problem with the plan, as Wolf acknowledges, is that no one would dare try something so drastic; intense resistance from the banks would be inevitable. Radical reform of some kind is undoubtedly necessary, but there is a huge gap between the economically desirable and the politically possible.

This, then, is the difficulty. Clear-sighted on the economic issues, Wolf has less to offer on the questions of power that underlie them. In his introduction he endorses Keynes’s remark that “it is ideas, not vested interests, which are dangerous for good or evil.” If that is true, all that is required is a sound intellectual analysis of our problems, which can be translated into workable policy and implemented by our more or less benign rulers. But elsewhere in the book Wolf describes the lobbying power of the financial industry as “the corruption of a political process in which organised interests vastly outweigh the public interest”. If that is true (and I think it is) it is hard to see how a suitably enlightened democratic course-correction away from neoliberal dogma can realistically emerge.

Arguably, the muddled reasoning seen in the runup to the crisis was not so much a cause as a symptom. People will believe impossible things if they are given the right incentives do so, and at the same time do their best to squash any outbreaks of rationality that threaten their positions. The Queen famously asked why nobody saw the crisis coming. In fact quite a few people did, but the financial and political elites did not find it in their interests to listen. Better thinking at the top will follow improvements to the economic system, not the other way round. Such changes, if they ever come, will be a testament to the shifting balance of interests rather than to the power of ideas.

• To order The Shifts and the Shocks for £18.99 go to bookshop.theguardian.com or 0330 333 6846.