Looking Forward to the Sequel


(Illustration: Wesley Bedrosian)

This book review appears in the Winter 2015 issue of  The American Prospect magazine. Subscribe here.

The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—From the Financial Crisis
By Martin Wolf
466 pp. Penguin Press $35


Martin Wolf is one of the few people on the planet who can mingle with financial elites without being co-opted by them. Fans of his regular column in the Financial Times—and I am one—are familiar with the power of his writing, the clarity of his logic, and the independence and delightful unpredictability of his views.

But Wolf fans beware: While his columns can be devoured as easily as a Thanksgiving pumpkin pie, his new book, The Shifts and the Shocks, tastes more like the side of brussels sprouts that Aunt Millie brought to the holiday dinner—obligatory to consume and good for you, but requiring a lot of chewing. This is dense and at times highly technical reading, laden with jargon only an Oxford economist could love. But it is, nonetheless, must-read fodder for any serious student of financial markets. Though Wolf’s description of the causes of the crisis and weaknesses in the response are not novel, what is new is his ambitious effort to tie it all together. He puts the greed, mismanagement, and regulatory lapses that preceded the crisis into a larger context of the global “savings glut” where a financial system, largely unfettered by regulation or capital controls, transformed the excess savings in surplus countries such as China and Germany into loose credit and asset bubbles in the debtor nations to which those savings flowed. 

Wolf is mostly laudatory of the post-crisis measures undertaken in the United States and the United Kingdom, whose economies are growing, albeit tepidly, and observes that their ability to control their own monetary destiny has been key in engineering their recoveries. Not so for other debtor nations in the Eurozone, which are trapped in a monetary union that precludes currency devaluation and which are still struggling under austerity dictates of the region’s primary creditor, Germany. Wolf wags his finger at Germany’s harsh treatment of those nations, quoting Walter Bagehot: “Excess borrowing by fools would have been impossible without excess lending by fools.” Wolf clearly views Germany as the primary culprit in the Eurozone’s struggles and believes the Continent will never recover until Deutschland is willing to embrace greater fiscal integration, stimulus spending, and more debt forgiveness for overextended nations.

The Penguin Press

Yet, Bagehot’s observation seems to have greater applicability to the profligate bankers whose financial innovations were the transmission mechanism whereby creditor countries’ surplus savings became weapons of mass economic destruction. Exploding Pick-A-Pay mortgages, collateralized debt obligations, and credit default swaps—surely, wiser men (and they were mainly men) could have come up with better uses for the money. But Wolf gives them a pass, citing former Citigroup head Chuck Prince’s famous quote about having to dance so long as the music was playing. Wolf calls the crisis the “failure of system, not of individuals.” But in point of fact, many in the banking system did stop dancing, or never went to the prom to begin with. In the United States, community banks and regional commercial banks for the most part did not participate in the subprime craze, and remained healthy and profitable throughout the crisis and its aftermath. Larger, traditional lenders such as Wells Fargo also sat it out, even if most Wall Street leaders, like Prince, couldn’t stop their dancing feet. Wolf’s exculpation of bankers is even harder to understand given continuing evidence of the kind of shortsightedness and greed so prevalent in the run-up to the crisis. Surely, a savings glut cannot explain away the conflicts of interest, money laundering abuses, and attempted manipulation of everything from interest and foreign exchange rates to commodity prices that still dominate the financial news.

If commercial and investment bankers get off easy in Wolf’s retelling, not so the central bankers, many of whom call him friend (or at least used to). He chastises them for missing the dangerous excesses that were building pre-crisis, and for naively thinking that financial engineering had successfully dispersed risk safely throughout the system. At the same time, he excuses them for keeping interest rates low, pinning the entire fiasco on the savings glut. He fairly points out there would have been tradeoffs with tighter monetary conditions—slower economic growth, and political resistance. Yet “taking away the punch bowl” is what central bankers are supposed to do when circumstances require it—that is why our system takes such care to insulate them from political pressure, giving them job protection through fixed terms and the ability to fund themselves independently of congressional appropriations.

True, it is easy to second-guess, but retroactive clarity of vision could help find the right course for the future. And in retrospect, it seems clear that slower growth would have been more sustainable than the housing bubble mania that did such damage to the economy and, importantly, higher interest rates would have curbed the “hunt for yield” that made investors such eager buyers of Wall Street’s toxic mortgage-backed securities. With sensible financial regulation, it is possible to have growth without asset bubbles, as we experienced from the late 1930s to 1973. Wolf does acknowledge that stronger regulation, while not preventing the crisis, could have tempered it, and he embraces an aggressive regulatory agenda centered on significantly higher capital requirements. In particular (be still my heart), he advocates a strong leverage ratio—increasing the percentage of a bank’s total assets that are funded with common equity. He rightly criticizes the “risk-based measures,” currently used by regulators for large banks, as overly complex and subject to manipulation.

As an early advocate for a tougher leverage ratio, I welcome his strong, public embrace of this standard. I hope that he is also whispering it in the ears of the central bankers with whom he has such great influence. They have been all too reluctant to support dramatic increases in bank capital requirements, notwithstanding strong, bipartisan support among both progressives and conservatives. What other financial issue finds common ground among the likes of Alan Greenspan and Elizabeth Warren, or The Wall Street Journal and The New York Times? Alas, though European regulators agreed to a modest leverage ratio in 2010, they have yet to implement it. In the United States, rules have been finalized, but they still allow large banking conglomerates to borrow about $20 for every $1 of common equity. Wolf pointedly calls out the ineffectiveness of this and other regulatory reforms, saying that “the thrust of it all has been to preserve the system that existed prior to the crisis.”

Wolf also lends his considerable prestige to support other policies embraced by many in the financial reform movement. He is staunchly anti-bailout, asserting that “shareholders should never be rescued” and that there should be a clear “order of conversion of debt into equity in a well-defined resolution regime,” and concludes, “Only in extreme circumstances should a government rescue be contemplated.” He supports capital controls—surely the most direct way to constrain the destabilizing flow of surplus savings—and goes after government debt subsidies full throttle by calling for the elimination of the tax-deductibility of interest. He believes the corporate income tax should be abolished, with all corporate income attributable (and taxed) to shareholders. He wants more innovation in financial contracts, suggesting “equity sharing” arrangements for mortgages, in which lender and homeowner share in gains from home price appreciation but also share in losses when home prices fall. He wants a shift away from taxation on work (a “good”) to taxes on “bads” such as pollution. In a nod to Thomas Piketty, Wolf also suggests taxes on wealth.

All of these ideas are tantalizing in their promise, but not well developed. (One hopes they will be fleshed out in Wolf’s next book.) By far his most dramatic proposal for reform is to abolish fractional reserve banking—the traditional system of banks accepting short-term deposits to fund long-term liabilities (loans), while keeping a fraction of those deposits with the central bank to meet withdrawal demands. He is enamored of the “Chicago Plan” of the 1930s, which proposed to replace fractional reserve banking with a system in which deposits are 100 percent invested in government bonds or central bank deposits. Depositors would thus have utmost faith in the safety of their deposits, ending the risk of destabilizing bank runs.

In support of the Chicago Plan, Wolf quotes Mervyn King, the former head of the Bank of England, who calls “pretense” and “alchemy” the idea that “risk-free deposits can be supported by risky assets.” The question, of course, is that if deposit-taking banks cannot use deposits to make loans, where would the credit come from to support mortgages, credit cards, small business loans, trade finance, and all the other uses to which deposits are put? The Chicago Plan has two possible answers: One is that the capital markets would provide equity investments in funds that in turn would provide loans to the real economy; the other is that the government itself would lend money to banks, which they would then lend to households and businesses.

Wolf seems to favor the former option, but both approaches seem to have fundamental problems. Capital-market funding proved to be inherently unstable during the crisis. Indeed, the majority of subprime mortgages in the United States were funded through securitizations, not bank deposits. Once the housing market started to turn and mortgage losses mounted, non-bank mortgage lenders collapsed, leaving banks as the primary source of mortgage credit. Money market funds and commercial paper markets proved to be just as unreliable as the securitization market. These sources of funding quickly vanished at the first sign of trouble. If it had not been for the traditional banking system—funded by stable deposits, the vast majority of which were insured by the government—credit availability would have completely collapsed. The Chicago Plan was developed in response to the massive bank runs of the early 1930s, a problem that has been largely solved through deposit insurance. The 2008 financial crisis was precipitated by a run on the so-called “shadow sector”—securitizations, money funds, commercial paper, repos—all of which is more the purview of investment banking. Wolf does not explain how or whether he would extend the Chicago Plan to cover Wall Street investment banks. But if they were left to their own devices, it is hard to see how this would make the system safer.

The second option—government-provided funding for loans—would certainly be more stable than capital market funding, yet it is far from clear whether the government would be a better allocator of credit than the private sector. The tradeoff for financial stability could be loans to political cronies or bridges to nowhere in the districts of powerful committee chairs, while deserving but politically impotent small businesses and households could be left starving for credit. As a former public servant, I want to believe the government could rise above such temptations, but I am dubious. In any event, both approaches are so far removed from the politically possible that their mere suggestion seems to be a harmful diversion of effort from obtainable reforms that could make a real difference, such as much higher capital requirements for banks.

Wolf is at his best when he speaks to the powerlessness and disenfranchisement of the general population, which has suffered so greatly from the increasingly severe cycles of financial instability that have characterized the last half-century. He urges greater use of debt restructuring for both troubled European countries and overextended households. He quotes Robert Kuttner, who has observed the injustice of a system in which financial elites can utilize bankruptcy to “rearrange assets and shed debts” while families are denied the ability to escape mortgage debt without losing their homes. But Wolf gives too much credence to low interest rates as the catalyst for the de-leveraging of American households. To be sure, wealthy, credit-worthy households have been able to refinance and lower debt burdens with zero interest rates (to say nothing of their flourishing stock portfolios). But de-leveraging for millions of Americans has been accomplished only through hard-fought negotiations with insensitive loan servicers, and often at the cost of losing their homes or entering bankruptcy to achieve forgiveness of other debts. 

In the concluding paragraphs of his book, Wolf bemoans the bank-friendly rescues as “undermining the sense of fairness that underpins the political economy of capitalism: There has to remain a belief that success is earned, not stolen or handed over on a platter.” He says, “People feel even more than before that the country is not being governed for them, but for a narrow segment of well-connected insiders who reap most of the gains and, when things go wrong, are not just shielded from loss but impose massive costs on everybody else.”

This imbalance of power—between decision-makers and those whose lives are impacted by their decisions—is the crux of the problem. I hope Mr. Wolf will apply more of his formidable intellect to correcting it in his next book.


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