I need to read Martin Wolf’s new book, “The Shifts and the Shocks,” his diagnosis of the factors that brought on the financial crisis and his prescriptions for getting out of this terribly damaging bubble, bust, repeat cycle.
But in the meantime, it’s worth giving a read to Felix Salmon’s review in yesterday’s NYT. Salmon comes to both praise and critique Wolf, the latter in no small part for the author’s turgid writing. While many of us in this biz try to make the complex if not simple, then accessible to non-experts (Salmon himself being a great example), Wolf chooses not to bother so much with that.
But if you’re willing to slog through, the rewards are great, as few macro analysts so acutely understand the moving parts between countries, sectors, markets, governments, and central banks. Moreover, Wolf writes with a tangible sense of shock and outrage at the foolishness of policy makers who stubbornly continue to make bad economic policy choices at tremendous costs to their constituents.
The results comes out sounding like an intermediate macro textbook but with a sharp, pissed-off edge.
Coincidently, in pulling out a characteristic Wolfish passage, Salmon quotes the following, which is a theme I too have been stressing for a while now (see here and here):
“With the eurozone in internal and external balance and creditor eurozone seeking internal balance via ever-larger external imbalances in the form of current-account surpluses, debtor eurozone could only attain internal balance with ever larger external imbalances in the form of current-account deficits.”
This is a key theme of Wolf’s work, one to which I was first exposed in Ben Bernanke’s seminal paper on what he called the “global savings glut.” The key point about this work—the one I emphasized in the second link above about the downsides of running the world’s dominant reserve currency—is that the expansion of global trade has evolved in ways such that persistent imbalances in one country infect other countries.
Under such conditions, it will do little good to exhort Americans to save more so as to reduce our demand-reducing trade deficit. Our savings rates are in part set elsewhere, in much the same way southern Europe over-consumed (ran current account deficits) to offset Germany’s under-consumption (and their current account surpluses).
Few understand and emphasize these dynamics as well as Wolf, and it’s one good reason to make the perilous journey through his prose.
I’m also looking forward to learning about his ideas for repairing the system. Salmon emphasizes one idea Wolf has been pushing for awhile, full reserve banking (aka 100% reserve banking):
Modern banks hold just a small fraction of their deposits in cash. But Wolf, finding that fractional-reserve banking was a key cause of the financial crisis, says all should have much higher capital requirements, and then goes much further: He spends a lot of time describing an economy in which banks have to back up all their deposits with reserves held at the central bank.
This got me to thinking how various scholars called for full reserve banking after the Great Depression in the 1930. In fact, the current dynamics and their 1930s counterparts have commonalities: underpriced risk fueling bad underwriting leading to over-leveraging creates a large financial bubble. Regulators, co-opted by fables of self-correcting markets snooze at their switches. Inequality rises to historical highs as unregulated and over-leveraged financial markets create inflate asset prices.
Eventually, the weight of the leveraging crashes the system and the ensuing negative wealth effects ensure a deep depression in the 30s and “great recession” in the most recent case (the difference is in no small part due to policy lessons at least partially learned over that interval).
In the wreckage, reformers argue that fixing what’s broken will require restraining the chain of events in financial markets. In the 1930s, it was separating commercial and investment banking, insuring the deposits in the former, the creation of the SEC and more. Though full reserve banking was floated, FDR, among others, judged that these other measures went far enough.
The reforms following the Great Recession, like Dodd-Frank, while useful, are of a considerably smaller scale. That’s partly due to the continued existence of the FDIC and parts of the regulatory structure harking all the way back to the 1930s, but it’s also due to the greater influence of today’s financial lobbyists and market-friendly economists.
I worry that full reserve banking would ultimately go too far in reducing access to short-term credit, leading to the growth of shadowy, unregulated lending (sound familiar?). Also, in contemplating such an extensive change, one must be mindful of the absence of a functional federal government that could offset the impact of reduced credit flows with fiscal policy or public goods/infrastructure investment.
Still, I appreciate the idea as a viable position at one end of the regulatory continuum (and Wolf himself suggest that full reserve banking should be tried as a pilot project prior to full-scale adaptation). For example, staking out such a position would surely help us end up with larger capital buffer requirements for lenders that leveraged up 60:1 before the crash.
As I’ve always said, you can get a lot wrong in financial reform, but if you set and enforce the right leverage rules, you’ve got a solid first line of defense against the next bubble.