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Saturday, January 17, 2015

Book Review: The Shifts And The Shocks

The book The Shifts and the Shocks: What We've Learned - And Have Still To Learn - from the Financial Crisis, by Martin Wolf (a prominent writer for the Financial Times)  offers a comprehensive explanation of the malaise in the economies of the developed world, as well as suggested reforms. One thing that stands out is how he has given up on mainstream economics, and looks for guidance from heterodox economists. Although not his intention, his book underlines my suspicion that reforming increasingly sclerotic developed countries will not be easy.

The book is written at the same level as what you would see in the financial press, although it has more references than usual. It is not aimed at academics, although they should pay attention (but they probably will not). For someone new to finance and economics, it should be straightforward, although the description of the financial crisis could be confusing if you are completely unfamiliar with it. This is not the fault of Wolf, who explains what happened in a straightforward fashion. The problem is that the crisis was the result of complexity, in which highly paid financial professionals and highly educated regulators proved that they had no idea what was going in within the financial system (and Wolf does a good job of documenting this). It would take an extremely long treatment to explain all the things that went wrong during that era.

Book Description

The book is 438 pages, and was published by Penguin in September 2014. (I have the electronic version of the book, and so the page numbers I list could be slightly off.)

The book is divided into three parts. The main sub-divisions are:
  1. Part One, "The Shocks", which describes the financial crisis, the post-crisis austerity policies.
  2. Part Two, "The Shifts", explains why the developed economies fell into its current predicament.
  3. Part Three, "The Solutions" discusses a wide range of solutions to problems in the financial system, economic theory, as well as the Euro area.
The book has extensive footnotes as well as references.

As Martin Wolf is the Chief Economics Commentator for the Financial Times, he probably does not an introduction from myself.

Background Survey Is Solid

Although Wolf does a good job of covering the recent historical background, he emphasises that this was not the focus of the book. He needs to provide context for the solutions that he discusses in the third part of the book.

Despite the sub-title, the book is just not a description of the financial crisis, it also covers the post-crisis policy of austerity. Therefore, it is not just a re-hash of the "mainstream economics did not foresee the financial crisis" story.

The narrative he gives describes the follies of the era quite well. I would describe the approach as being more journalistic than an academic history. I would assume that an historian could find faults with parts of his explanation. But such persons are not in the target audience of the book. He is not attempting to provide a unified historical theory, rather he is covering the major events in a readable fashion.

His description matches my views on the history fairly closely. The only substantive point I would note is the predictable absence of a discussion of the crisis in Canada. This is entirely reasonable, as probably only Canadians would normally be interested in that aspect of the history. However, the Canadian experience is pertinent with regards to his suggested reforms, as I discuss below.

I will follow the author's intention, and concentrate more on his discussion of solutions within this review.

The Solutions

The discussion of solutions are split up amongst four chapters, each covering a single broad topic.
  1. Reforming economic theory.
  2. Reforming the financial system.
  3. Coping with "Secular Stagnation".
  4. Dealing with the "Bad Marriage" that is the Eurozone.
I will break discuss these solutions within the following sections.

Reforming Economic Theory

Within the book, Martin Wolf surveys a wide range of economic theories. This is probably useful for someone new to economics, as this gives them a broader view of the various schools of thought, and get an idea of how they fit together. He does this by citing a great number of studies and economists, which is what you would expect in journalistic coverage of economics.

An alternative approach would be to follow a fixed theoretical school of thought throughout. This has the apparent disadvantage of not presenting a wider point of view. But the implicit weakness of the survey approach is that if you embrace contradictory schools of thought, you can explain any possible outcome. This is useful for wrapping up a newspaper column, but it is less useful for an analyst that wants to make forecasts - you have to be able to rule out some possible scenarios.

In particular, I would not say that the book is internally inconsistent, but I would say that I have a somewhat difficult time characterising what Martin Wolf precisely believes about economics.

Mainstream economists will probably not be very happy reading this book, as Wolf documents the lousy track record of mainstream economics both before, during and after the crisis. This is not particularly new; there are a lot of books taking pot shots at the mainstream out there. But if I were a mainstream economist, I would be somewhat worried that someone who is highly knowledgeable about economics and the markets and is open to an extremely wide range of opinions, has almost no hope for mainstream economics.  

Within the book, he discusses a wide range of "heterodox" (unorthodox) economics (although Marxism did not make the cut). He focusses on questions of money, such as 100% reserve banking, which I will discuss below. In particular, he spends some time discussing "Austrian" economics, Minsky, and Modern Monetary Theory (MMT).

I have my doubts about the emphasis solely upon money. But more importantly, I believe that little can be gained from trying to juggle the views of Austrians and economists such as Minsky or MMT economists. Firstly,there is an obvious political mismatch - very few Post-Keynesians are libertarians. Secondly, the two approaches are theoretically incompatible. One of the key theoretical underpinnings of Post-Keynesian approaches is that the aggregate behaviour of sectors cannot be deduced from the behaviour of individuals, whereas the Austrians believe that only individuals matter, and aggregates should not be studied. There is no possible way of finding a middle ground between those theoretical viewpoints.

Reforming Finance

One possible reason Wolf embraces a wide range of approaches is to capitalise upon the discontent with fractional reserve banking, to find support for his reform ideas. After the financial crisis, banks and bankers have created a fairly impressive group of critics from across the political spectrum.

His thesis can be summarised as:
We know it is possible to run economies without financial crises: that is what happened between 1950 and mid-1970s in high-income countries. The there were not crises is simple: finance was caged. (Page 348.)
Although constraints upon finance were important, I would argue that the reason for the lack of crises was more complex. (I discuss that in this article, which is largely a summary of Minsky's views on the topic.) You need to also take into account balance sheet trends within the broad private sector. Regulating banks differently will do little to affect what pension funds are doing.

One of the most interesting reforms Wolf discusses is the Chicago Plan, in which banks have to hold 100% against deposits. This is equivalent to replacing bank deposits with Treasury Bill funds, or "Postal Savings" accounts, where one directly loans money to the government. His endorsement of this idea is somewhat guarded, as being an "ideal" (as in idealistic). He realises the weak point of such a scheme:
Thus, it would be crucial to curb excessive credit creation and maturity mismatches outside the banking system. That would continue to require regulatory oversight. But if the payments system were unquestionably safe, regulators might be able to be more relaxed than in the past about failure elsewhere. (Page 337.)
Migration to financing outside the banking system is exactly what would happen, as any reading of Minsky would suggest. Treasurers at corporations will choose to "optimise returns" on their cash holdings, and keep their liquidity buffers parked in private sector short-term paper. When those short-term paper markets seize up, those real economy corporations will have to curtail operations. No politician will accept that outcome, and the central bank will be forced to bail out those short-term paper markets, since the private banking system will no longer be able to do so.

This is an easily foreseeable problem. Moreover, if increasing bank reserves increased stability, why was Canada - which has a 0% reserve requirement - able to largely shrug off the crisis? I would note that:

  • Canada was not isolated from the crisis, as were some countries like Japan. 
  • The Canadian asset-backed commercial paper market seized up early in the crisis.
  • Canada had a housing bubble of similar magnitude to the United States.
  • The value of its commodity exports collapsed (which blew a hole in GDP, but this exaggerates the effect on things like the labour market).
  • Canada has a massive cross-border trade exposure to the economy within the United States, where activity plummeted and only recovered slowly. 

Yes, Canada had a recession and Canadian credit spreads widened, but there was no plausible threat to the payments system.

I am not holding Canada out as some form of financial utopia; our banking model will come under pressure as our housing bubble unwinds. But proponents of radical, untested banking system changes that will cause easily foreseeable side-effects should take into account the experience of a real-world banking system that has functioned without ever losing a major bank. The most that "full reserve banking" can achieve is to match the historical safety record of the Canadian banking system. So what advantages are to be gained?

Wolf also covers more incremental regulatory reforms. In fact, a fairly dizzying array of ideas is surveyed, and so I will not list them here. The most important is to increase the required capital buffers of banks. This is a worthy goal (one of the distinctions of Canadian banks heading into the crisis was a higher level of capital), but one has to be realistic. Financial activity will drift into the cracks where lower levels of capital are required. Regulation is an ongoing activity; financing structures do not reach a final state.

I am much more pessimistic than Wolf regarding the ability to regulate "shadow banking". Although people like to focus on the esoteric stuff like CDOs and SIVs, the reality is that all non-bank finance comprises the "shadow banking system". And that includes vanilla corporate bonds and commercial paper. As long as there are large stores of capital held outside of the banking system (for example, pension funds), the circularity of capital flows means that non-bank lending is going to be large.  Given that this an international market where the participants have no moral objections to "regulatory arbitrage", how is regulation going to work? You could just as easily ask when multinational corporations will start paying their "fair share" of national income taxes.

Secular Stagnation

In addition to reforming the financial system, Wolf addresses in Chapter 8 the slow growth environment that the developed economies have found themselves trapped within..

He identifies the shift to austerity after the crisis was a major driver of weak growth, particularly in Europe. He gives an extensive coverage of both sides of the debate,  He dismisses the popular argument "one cannot get out of debt by adding more debt". He also discusses various structural factors that lead to diminished growth.

He suggests:
  • Increase capital flows from rich countries to poor countries, in a safer form (such as equity and direct investment).
  • Increase insurance, in form of the availability of unconditional liquidity from international bodies, to allow developing countries to reduce their foreign exchange reserves.
  • Create a global reserve asset, such as Keynes suggested. 
  • Monetary financing of fiscal deficits.
The first three reforms require international coordination, which makes them chancier. The last is under the control of a single government. Although he credits the last idea as being part of Modern Monetary Theory, I would suggest that MMT describes the policy quite differently. Within MMT, one consolidates the central bank with the Treasury (the fiscal arm of the central government). The distinction between "monetary policy" and "fiscal policy" is blurred, as it all just "government policy". The government can choose to abolish government bond issuance, and replace all government liabilities with money. This would lock interest rates at 0% (and force me to find other markets to write about). He suggests that the government could raise required reserves to allow the government to have an abnormally high monetary base and non-zero interest rates at the same time. However, such a policy is just a disguised tax on banks, and the financial sector will just move towards non-bank finance.

The Euro Zone "Bad Marriage"

Martin Wolf summarises the topic as: "The euro has been a disaster." (Page 288).

His view of European policymakers is only slightly more charitable than mine.
For all its cultural and economic achievements, Europe has a long history of catastrophic errors, which have usually been the result of blind arrogance and wishful thinking bordering on insanity. (Page 289.)
He correctly draws the parallel between current policy in the euro area and that of the 1930s,
Europe is under the sway of ideas of Heinrich BrĂ¼ning, the German chancellor between 1930 and 1932, whose disastrous policy of austerity prepared the way for Adolf Hitler. (Page 291.)
He argues that a dissolution of the euro would be disastrous. He offers several reforms that might allow the euro to work.
  1. A banking union, to create truly euro area-wide banks.
  2. Eurobonds - bonds that are jointly guaranteed by all euro area sovereigns, with an issuance size up to 60% of GDP. Governments with debts that cannot be converted to euro bond format would likely restructured.
  3. The "ECB needs to become a true modern central bank determined to underpin stability in the Eurozone economy." (Page 315.) 
  4. Some form of fiscal union is needed to support the above.
What is needed is symmetric adjustment between countries with current account surpluses (notably Germany) versus those with deficits - "an 'adjustment union'." (Page 339.)

I agree that steps such as he outlines are necessary in order for the euro to survive, yet I would remind readers of the earlier quotes about European policymakers.

Concluding Remarks

This is an ambitious book, with a great many ideas to reform global economies. I am perhaps too pessimistic regarding reform, yet it is important to discuss these topics. 

But readers will have to understand that this is a survey of the issues and potential reforms. It is not focussed on just a few reforms, with very detailed analysis of those selected topics. Such books would be of less general interest, but that is the form of analysis that has to be undertaken before going too far down that road.

Finally, the book is available at: The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis (affiliate link)

(c) Brian Romanchuk 2015

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