Crises are an inevitable outgrowth of the modern capitalist economy. So argues Martin Wolf, chief economics commentator for the Financial Times,
in his authoritative account of the 2008 financial crisis. Instability
reveals itself in the form of shocks; even a seemingly small deviation
from the norm can set off a major crisis. Consider the decline in U.S.
housing prices, which began in 2006 and hit its nadir in 2012. In
isolation, the trend appeared manageable. After a period of
exceptionally high housing prices, U.S. policymakers initially welcomed
the drop, which they saw as a much-needed correction to the market, a
gradual unwinding of excess. They did not expect a crisis of the
magnitude that eventually arrived; nearly no one did.
With characteristic thoroughness and clarity, Wolf identifies a
number of culprits for this failure. At the broadest level, it was a
failure of imagination. Bankers, regulators, and policymakers assumed
that a long period of macroeconomic stability had made the economy
invulnerable to shocks. In the United States and the United Kingdom, it
had been many decades since the last major busts. Unfamiliarity, Wolf
writes, bred complacency. “Why did the world’s leading economies fall
into such a mess?” Wolf asks. “The answer, in part, is that the people
in charge did not believe that they could fall into it.”
Wolf walks through developments in the United States, Europe, and the
developing world, identifying key events and policies that collectively
made the crisis the biggest, baddest, and costliest in a century. He
pinpoints a host of troubling trends, including the global savings glut,
an unsustainable credit boom, and an increase in the level of fraud. In
the final chapters of the book, Wolf sketches a road map for the
future, offering his vision for a more stable financial system.
Wolf’s book contains a wealth of illuminating details and sharp
analysis. Two subjects, in particular, stand out: his critique of the
mainstream economic ideas that held sway prior to the crisis and his
analysis of the disaster in the eurozone. Wolf highlights a number of
weaknesses in economic theory and practice that spurred the collapse,
among them faulty modeling and shortsighted monetary policy. But his
focus on economics comes at the expense of an equally important part of
the story: politics. Political maneuvering, rather than flawed economic
thinking and policymaking, is the key to understanding why financial
regulations were so weak before the crisis—and also helps explain why,
even now, relatively little has been done to strengthen them. But that
narrative does not take center stage in his telling, even when it
arguably should.
A woman carrying an umbrella passes Fannie Mae headquarters in Washington, D.C., February 2014.
“STABILITY DESTABILIZES”
Prior to the slump, most economists—including Wolf himself—did not
conceive of the possibility of a global financial meltdown. As Wolf
writes, it was “partly because the economic models of the mainstream
rendered [a crisis] ostensibly so unlikely in theory that they ended up
making it far more likely in practice.” Regulators and investors
blithely assumed, among other things, that people tend to make rational
economic choices and that market prices reflect the true value of
assets. This false sense of security made them careless: more willing to
take risks and less concerned when warning signs arose. “Stability
destabilizes,” Wolf writes, paraphrasing the American economist Hyman
Minsky.
But the failures of economic theory alone cannot fully account for
the crisis. After all, it is not unusual for economic models to contain
simplifications. Most rely heavily on assumptions that do not wholly
correspond to reality: frictionless markets, individuals who optimize
with perfect accuracy, contracts that are enforced fully and without
cost. Such assumptions are par for the course in economics, as they are
in other fields of scientific inquiry. Political maneuvering, rather
than flawed economic thinking and policymaking, is the key to
understanding why financial regulations were so weak before the crisis.
When used correctly, economic models can be useful guides for policy;
in the wrong hands, they can spell disaster. Before the crisis, some
models did include the possibility of bank failures and financial
collapse, but they did not focus on how to minimize fluctuations in the
economy. The economy is simply too complex to be captured in a single
model; every model has limits. Still, policymakers should not dismiss
economic orthodoxy as irrelevant, even if some mistakes are inevitable.
They should be at once familiar with its tools and respectful of its
limits.
In Wolf’s telling, bad economic theory manifested itself in poor
regulatory and monetary policy. When it comes to financial regulation,
his case is convincing. In the run-up to the crisis, many mainstream
economists insisted that self-interest acted as an invisible hand,
guiding the market toward efficiency, stability, and dynamism. Reviews
of the pre-crisis regulatory and supervisory approach in the United
Kingdom and the United States have identified that part of the problem
was a philosophy that markets are generally self-correcting and that
market discipline is a more effective tool than regulation—a mindset
that led to excessive deregulation.
Wolf singles out two especially harmful regulatory errors. First,
under the Basel Accords, the global framework for banking regulation,
banks have been allowed to classify government bonds as risk free. When a
bank acquires a risky asset, it must have enough capital to hedge
against the possibility of default. The Basel rules meant that banks
holding sovereign debt did not need to accumulate extra capital. “The
assumption,” Wolf writes, “was that governments would not default,” a
belief that appeared less and less secure as the crisis unfolded in the
eurozone. Second, governments, most notably in the United States,
strongly encouraged firms to make it easier for people to borrow money
to purchase homes, which led to a frenzy of mortgage lending—including
to borrowers with little ability to pay their debts—and contributed to
the unsustainable housing bubble.
Wolf’s critique of pre-2008 monetary policy is less convincing. He
finds fault primarily with the practice of inflation targeting, whereby
central banks identify a particular low target inflation rate and then
attempt to steer actual inflation toward it. Prior to the crisis,
central banks did this by raising or lowering interest rates, a
transparent and predictable process that was believed to make the
economy more stable. Quite the contrary, says Wolf. “Central banks did
deliver stable inflation,” he writes, but that predictability led people
to underestimate the amount of risk that nevertheless existed in the
markets, which made the financial system more fragile. But crisis
prevention is not the main purpose of monetary policy. Monetary policy
should aim to achieve low and stable inflation and milder business
cycles, which inflation targeting has done. The robustness of the
financial system should be safeguarded not by monetary policy but by
tighter regulations.
IT’S POLITICS, STUPID
In his analysis, Wolf tends to depict economic policy
as the practical implementation of economic theory. The reality is more
complicated. Crafting policy is not merely an economic act but also a
highly political one. Regulatory policies, for example, can reflect the
whims of politicians, the pressures of the public, and the influence of
lobbyists.
But Wolf keeps politics behind the scenes, even when they should be
front and center. Regulatory policy failed not because of shoddy
economic theory but mainly because societies have been unable to remove
banking and finance from the orbit of political manipulation. Consider
the decision to allow banks to treat sovereign debt as risk free.
Eurozone governments benefited from this policy, as calling their debt
risk free made it cheaper to borrow, facilitating greater levels of
government spending. Banks, eager to lower their capital requirements,
were all too happy to play along. This is one example of the symbiotic
relationship between governments and banks that permeates banking around
the globe.
Politics also played a defining role in the U.S. government’s
decision to promote lending for home purchases, particularly through
government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie
Mac. The regulatory failures surrounding GSEs cannot be blamed on
faulty economic theory. In fact, in testimony before the Senate
Committee on Banking, Housing, and Urban Affairs in 2005, Federal
Reserve Chair Alan Greenspan identified the risk GSEs posed to the
country’s financial system and pleaded for more regulation. He said:
In the Federal Reserve’s judgment, a GSE regulator
must have as free a hand as a bank regulator in determining the minimum
and risk-based capital standards for these institutions. . . . We at
the Federal Reserve remain concerned about the growth and magnitude of
the mortgage portfolios of the GSEs, which concentrate interest rate
risk and prepayment risk at [Fannie and Freddie] and makes our financial
system dependent on their ability to manage these risks. . . . To fend
off possible future systemic difficulties, which we assess as likely if
GSE expansion continues unabated, preventive actions are required sooner
rather than later.
The same year, a bill was introduced in the U.S. Congress that would
have tightened the regulation of GSEs along the lines Greenspan
suggested, but support for the bill proved weak. In a 2008 op-ed for The Wall Street Journal,
the economist Charles Calomiris and the lawyer and financial policy
analyst Peter Wallison blamed the bill’s failure on political
maneuvering by Fannie Mae and Freddie Mac. To curry favor on Capitol
Hill, the companies presented themselves as champions of affordable
housing. As a result, wrote Calomiris and Wallison, “Fannie and Freddie
retained the support of many in Congress, particularly Democrats, and
they were allowed to continue unrestrained.”
Former Federal
Reserve Chairman Alan Greenspan testifies before the Senate Banking,
Housing and Urban Affairs Committee in Washington, D.C., February 2004.
To his credit, Wolf does recognize the corrosive influence of
politics, taking issue, in particular, with the ways in which the
financial industry uses its money and lobbying clout to shape policy.
The pushback against postcrisis regulation reveals that such meddling
remains alive and well. “This is one of the reasons why crises will
recur,” Wolf writes. “Regulation will be eroded, both overtly and
covertly, under the remorseless pressure and unfailing imagination of a
huge, well-organized and highly motivated industry. This is not about
fraud narrowly defined. It is more about the corruption of a political
process in which organized interests outweigh the public interest.”
Instead of dwelling on this point, however, Wolf diverts attention away
from it, making flawed economic thinking the focal point of his story.
THE POST-HONEYMOON BLUES
When it comes to Europe, Wolf identifies the
political challenges inherent in creating a single currency across the
continent, but he is less attuned to the ways in which politics also
inform crisis management. Wolf describes the eurozone as a “polygamous
monetary marriage entered into by people who should have known better,
in haste and with insufficient forethought, without any mechanism for
divorce.” The wedding was followed by an irresponsible honeymoon: debtor
countries, such as Greece and Portugal, borrowed freely and spent
recklessly, while Germany, the creditor spouse, built up a competitive
export sector and an external surplus “matched by growing claims on the
debtors.” When the crisis hit, the marriage turned bad: Germany blamed
the debtor countries for wasting its money, and they blamed Germany for
forcing them into destitution.
Wolf tends to depict economic policy as the practical implementation of economic theory. The reality is more complicated.
“The euro has been a disaster,” Wolf concludes. “No other word will
do.” He justifiably reminds readers that he foresaw this outcome as far
back as 1991, when the negotiations that led to the single currency were
just concluding. He quotes from a Financial Times column he
wrote that year, in which he judged the venture “in words used by the
ancient Greeks of the path taken by a tragic play: hubris (arrogance); atē(folly); nemesis (retribution).” A day of reckoning appeared inevitable, even in the absence of the massive shock imported from overseas.
Wolf recognizes that the eurozone has always been more than an
economic project. From the beginning, politics constrained its efficacy.
Its design was flawed and incomplete. Seeking to avoid political
resistance, European leaders intentionally designed the euro without
building in a way for the currency union to deal with crises or correct
macroeconomic imbalances. The misplaced hope was that if a crisis
erupted, future leaders would find a way to handle it. In creating an
imperfect union, European leaders acted irresponsibly; believing that it
could succeed in spite of its shortcomings was nothing short of hubris.
If a poorly constructed eurozone explains why the continent was
vulnerable to the crisis in the first place, policy blunders after the
crash explain why it had trouble recovering. Many countries adopted
austerity measures, slashing budgets and reducing their own borrowing,
which turned out to be misguided. Economic growth slowed, “given that
post-crisis private demand was so weak.” On the monetary side, Wolf
pinpoints a number of missteps by the European Central Bank, including
its failure “to ensure liquidity in debt markets.”
But again, the larger problems were political. The eurozone
governments found themselves unable to work together to manage the
crisis. Speaking in 2011 at a farewell event for Jean-Claude Trichet,
the departing president of the European Central Bank, the former West
German chancellor Helmut Schmidt highlighted the continent’s impotence.
“All the talk of a so-called ‘euro crisis’ is just the idle chatter of
politicians and journalists,” he said. “What we have, in fact, is a
crisis of the ability of the European Union’s political bodies to act.
This glaring weakness of action is a much greater threat to the future
of Europe than the excessive debt levels of individual euro area
countries.” Schmidt’s remarks, delivered in German at the old opera
house in Frankfurt, were directed at Angela Merkel, the German
chancellor, and Nicolas Sarkozy, the French president. Schmidt hoped to
galvanize at least one of the two most powerful nations in Europe, but
he failed to move either. At this critical moment, Europe’s economy was
leaderless.
PASSING THE BUCK
Wolf provides a relatively charitable explanation for why political considerations guided crisis management in the eurozone:
In a financial crisis, creditors rule. In the
Eurozone crisis, the creditor that mattered was Germany, because it was
much the largest. The aims of any plausible German government, and
certainly of one headed by Angela Merkel, the country’s popular,
cautious and self-disciplined chancellor, have been relatively simple to
understand: these are to preserve the Eurozone, but on Germany’s terms.
Like most creditor nations, Wolf writes, Germany saw the suffering of
debtor countries as their own fault. To exculpate itself, Germany
argued that the crisis was a product not of current account
imbalances—in which it was complicit—but of fiscal deficits. And because
Germany “believes in tough love,” according to Wolf, it did not want to
provide generous aid to countries, such as Greece, that it blamed for
excessive borrowing.
A less charitable explanation is that Germany did whatever it could
to avoid responsibility. Every crisis generates losses that someone must
assume. In theory, the losses from a collective failure, such as the
one in the eurozone, should be a collective responsibility. But without a
common government to manage a fair and efficient distribution of the
costs, countries acted in their own self-interest, guarding themselves
against losses wherever and however they could. Stronger countries, such
as Germany, exploited their leverage to avoid their share of the costs
and impose losses on the constituents of less powerful countries.
Greek Finance
Minister Yanis Varoufakis and German Finance Minister Wolfgang Schaeuble
address a news conference following talks at the finance ministry in
Berlin, February 2015.
Two episodes, largely absent from Wolf’s narrative, clarify the
extent of the loss-shifting game. The first occurred in early 2010, when
Greece, buckling under years of unsustainable debt accumulation and
overconsumption, turned to the International Monetary Fund for help.
According to leaked IMF documents, however, a decision to write off
Greece’s debt, which the country badly needed, was delayed due to
resistance from countries whose banks held Greek bonds. As Karl Otto
Pöhl, former president of the Bundesbank, Germany’s central bank, said
in an interview in Der Spiegel, the resultant IMF program “was
about protecting German banks, but especially the French banks, from
debt write-offs.” According to an internal IMF account of the May 2010
meeting of the IMF’s Executive Board, to gain support for a plan that
would delay a debt restructuring and thus shield their banks from
losses, the Dutch, French, and German chairs “conveyed to the Board the
commitments of their commercial banks to support Greece and broadly
maintain their exposures.”
Merkel did eventually force losses on selected holders of Greek
sovereign bonds, but only after allowing German banks the opportunity to
sell their holdings—a violation of the 2010 promise. The loser in all
of this was Greece. According to the IMF, Greece’s debt-to-GDP ratio
skyrocketed, from 126 percent in 2009 to 177 percent in 2014. Real GDP
per person sharply declined, falling by 25 percent between 2007 and
2014. If a poorly constructed
eurozone explains why the continent was vulnerable to the crisis in the
first place, policy blunders after the crash explain why it had trouble
recovering.
The second episode took place in October 2010. At a summit in the
French commune of Deauville, Merkel and Sarkozy decided to use their
countries’ veto power in the euro area to block temporary assistance
programs to eurozone member states—unless France and Germany could first
impose losses on the private creditors of those states. This policy,
known as private-sector involvement, was a serious misstep. The
realization that the French and the Germans could force losses on
private lenders alarmed those who held sovereign debt, which led to the
deepening of the crisis throughout the eurozone, beginning with the
collapse of the Irish economy. Germany, of course, came out on top. By
making euro-denominated sovereign debt of peripheral states less
attractive, Merkel masterfully created an implicit subsidy for Germany
from the euro area periphery.
Throughout the crisis, Merkel has faced the same choice again and
again: act to diffuse the crisis and avert catastrophe in the eurozone
at the risk of losing support at home or enact policies that are sure to
be popular in Germany but that will spread misery elsewhere. Put this
way, Merkel’s decisions seem understandable—even inevitable. As
Jean-Claude Juncker, the president of the European Commission, has said
about the euro crisis, “We all know what to do, we just don’t know how
to get reelected after we’ve done it.”
BEYOND BOUNDARIES
Outside Europe, the global economy is on the mend.
But inside the eurozone, the outlook remains bleak. The eurozone, in its
current form, cannot last. Wolf succinctly identifies the separation
that has emerged between “the national level of accountability and the
Eurozone level of power,” which has allowed Germany to wield outsized
control over other nations. “This structure cannot hold,” Wolf writes,
“and, if it can, it should not.”
In his final chapter, Wolf suggests several ways to mend the rocky
marriage, including creating a proper banking union; converting some
existing government debt into eurobonds, which could serve as a safe
common asset; and giving the European Central Bank more freedom to
intervene in government bond markets. But Wolf recognizes the large
obstacle in the way: Germany is currently powerful enough to impose its
views on the rest of the eurozone, blocking such reforms.
The eurozone needs a European solution. But politics are national,
and no political body exists to protect the eurozone from individual
countries that would rather pursue their own narrow interests. Europe
needs leaders who are willing to risk short-term political costs to
advance the common good, despite the misalignment of political
incentives. Judging from the record of the past five years, however, the
eurozone’s Greek tragedy may remain just that.
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