I have been reading Martin Wolf’s “The Shifts and the Shocks,” a detailed analysis of the 2008-2009 financial crisis and its aftermath. Wolf is the chief economic columnist of the Financial Times, an English paper with a global audience. He and New York Times columnist Paul Krugman are probably the world’s most influential economic commentators. What Wolf says matters because he is hugely well-informed and respected.
By and large, he rejects the standard American explanation of the financial crisis, which blames greedy bankers, incompetent government regulators and naive home buyers. All these actors contributed to the debacle, says Wolf, but they were responding to larger impersonal forces. These were the crisis’s underlying causes and reflected how the broader economic system operated (or didn’t).
Massive trade imbalances in the 1990s and the early 2000s are among Wolf’s main culprits. China, Germany and some oil-exporting countries ran big surpluses, while the United States and some other countries had corresponding deficits. Although the connection between trade imbalances and the financial crisis seems baffling, Wolf’s logic is powerful.
The trade-surplus countries couldn’t spend all their export earnings, so they plowed the excesses into dollar investments (prominently: U.S. Treasury bonds) and euro securities. This flood of money reduced interest rates. The resulting easy credit induced dubious lending, led by housing mortgages.
Of course, low interest rates didn’t ordain bad loans. Someone had to make them; either bankers or regulators could have stopped that. Here, other causes become relevant. One is the nature of the financial system. Prolonged economic stability makes the financial system unstable, Wolf says, quoting the late economist Hyman Minsky, because bankers and others take stability for granted. Believing in this stability, they assume greater risks. Why didn’t regulators prevent this? The answer, Wolf argues, is that they were captured by free-market thinking that markets would spontaneously correct errors.
To be sure, this theory isn’t Wolf’s alone; it’s been advanced, in whole or in part, by others, especially economists. It’s a coherent explanation of why the credit bubble formed. It improves on the usual U.S. narrative, which effectively blames the financial crisis on bad character. Still, I think, Wolf’s story is only half right.
It is right in arguing that the behaviors feeding the crisis were not just the failings of human nature — avarice, complacency, conformity. After all, human nature is fairly fixed. Where Wolf errs is misidentifying the changes that conditioned people in ways that fostered the financial crisis. The crucial influences were not global trade imbalances and their effect on interest rates. The pivotal influence (as I’ve written before) was the decline of double-digit inflation in the early 1980s, which launched a 25-year boom.
In 1980, annual consumer price inflation was 13 percent. By 1999, it was 3 percent. As inflation fell, interest rates followed. From 1981 to 1999, mortgage rates dropped from 15 percent to 7 percent. Declining interest rates caused stocks and home prices to soar. People felt richer, and on paper they were. From 1982 to 2007, only two mild recessions lasting 16 months in total interrupted the boom.
All this made a huge, if mostly subconscious, impression. The economy seemed to have stabilized. This perception — reflecting people’s experiences more than any ideology — underlay the psychology that bred the financial crisis. Bankers made dumb loans because they thought the risks of doing so had subsided. People borrowed more because they thought that in a more stable economy they could handle more debt. Regulators got out of the way. We had a classic boom and bust.
My main takeaway from Wolf is that economics is in disarray. He spends much space refuting or ridiculing ideas that he rejects. The point is not who is or isn’t correct; the point is that there’s no consensus on how to proceed. In two decades, we’ve gone from the blissful assumption that the Federal Reserve (and other governments’ central banks) could ensure fairly stable economic growth to a state of desperate experimentation where policies struggle to make a bad situation slightly better — or at least not worse.
We’re muddling through. Economics has become muddle-nomics. Now, there’s nothing necessarily wrong with experimentation, especially if it leads to better policies. But this is hardly guaranteed. Most advanced nations — the United States, Japan and many European countries — seem trapped between high debts and deficient demand. The resulting debate has pitted those who advocate added debt (a.k.a. “stimulus”) to strengthen demand against those who fear more debt. Similar disputes engulf central banks’ easy-money policies.
What’s misunderstood is that these debates themselves corrode confidence. People intuitively grasp what’s happened. We believed we had a basic control over our economic environment; now we acknowledge a loss of control. The first emboldened people to spend, the second deters them. This shift is a fundamental reality of our time.
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