Mind-changing facts

Tony Curzon Price
16 March 2009

A short version of this review appeared in the March 09 Spectator Business

If there are silver linings to the economic crisis, one has to be enjoying the clarity, poise and judgement, delivered six times a month, of Martin Wolf's Financial Times commentary. "Fixing Global Finance", completed just after the September 2007 collapse of Northern Rock, provides his dense and fascinating account of a bursting global economy, one of such teetering imbalances--especially China's massive dollar savings and the US's corresponding domestic borrowing binge--that catastrophe is the background drum-beat of the lucid analysis. Wolf's knows that "something will need to give." And, as we now know, give it has, again and again.

Wolf's "savings glut" account of the build-up to crisis is that the huge excess of production over consumption (saving) in China, East Asia and the energy-rich Gulf since 97/98 (and especially during 02-07) entailed an offsetting excess of consumption over production (borrowing) elsewhere. Between 2002 and 2007, this borrowing mostly came from US households who took out mortgages against the apparently rising value of their houses. We now know the tragic next act, even if it was not yet clear to Wolf when he finished "FGF".

The exact mechanism and logic of this chain makes up much of the analysis of the book. East Asia was traumatised economically and politically by the Asian crises of 97/8 when they suffered a sudden flight of foreign capital; their emerging economies suffered sharp recessions; governments and corporations, owing dollars but earning devalued local currencies, found it very painful to avoid default. Domestic consumption had to fall dramatically, taxes had to be increased. To avoid such social disruptions, these countries together with quick-learning China and newly flush Russia protected themselves by accumulating dollar reserves (making it less likely that a run on the currency would snowball into a currency crisis). This meant maintaining low currencies, enforcing cross-border capital controls and "sterilising" trade surpluses--essentially making sure that the dollars earned by exporters would not turn into domestic liquidity and inflation. There are echoes of this deep diagnosis of the crisis in the calls, for example from Obama's Treasurer Geithner, that China show more currency flexibility.

Wolf is very sympathetic to the nations that sought insurance in this way. His hope is for a time when each country is sufficiently trusted to borrow in its own currency and therefore does not suffer the mood swings of the fickle global hot money flows. But as things have turned out, we have become focused now on the other half of the mechanism: how did this huge new pool of global savings turn into the financial crisis that continues to unfold? China's exporters earned dollars from US consumers and a great proportion of these probably went straight back to the US as investments in US Treasury bonds. US interest rates therefore remained extremely low after 2002 without the dollar depreciating. With a strong currency, cheap borrowing and a financial sector highly motivated to create new borrowers, US households went on their binge. Worse than that, pension funds and other wealth managers who had been used to an easy professional existence promising their clients safe returns of 5% now had to become creative to deliver in a world of long run Treasury bond rates of 3%. Conjured by nothing more than a strong desire for its existence, leverage made alpha, alpha made up the shortfall of "risk-free" returns, these returns made asset prices rise, and so leverage could increase again and keep the infernal cycle going. We now know that there is nothing more dangerous to wealth than creativity in its managers.

Given the savings glut, could things have gone better? Wolf repeats that the alternative to the US household borrowing binge would have been a deep US recession that would have reduced the Chinese surplus through a destruction for the demand for Chinese goods and so very painfully reduced the US trade deficit. Institutionally, the US Federal Reserve's double mandate of ensuring price stability and full employment made the binge inevitable, argues Wolf. But now we know the denouement, we ought to moderate that conclusion. If bankers had not thrown caution to the wind, the savings glut would still have existed, but the wishful conjuring of returns would not. Low interest rates should have encouraged productive investment rather than the satisfaction of a perverse fetishisation of home and SUV ownership. The reality of low interest rates should have led to increased provision of capital in pension funds and retirement accounts, not the convenient illusions of "risk-free" leverage. Who knows -- a responsible reaction form the financial sector might even have created domestic political pressure in the US for the kind of global macro-economic rebalancing that Wolf was recommending. To follow Wolf in saying that the alternative to binge was deep recession takes too much as fixed and tends to improperly exonerate the bankers.

But FGF is more than fascinating background for a proper understanding of the mess we're in. It tells of the start of a big moment of questioning for the beliefs of the "Good Liberal" -- the sort of position adopted by Wolf in his 2004 "Why globalisation works?" and well represented in his 2003 openDemocracy conversation on corporate power. The world viewed from the late 1990's was looking very promising -- the spread of free trade, rule of law and respect for contracts was lifting millions out of poverty. This may have upset Conservatives who see in progress only the destruction of cherished traditions, and also egalitarian social democrats who are always impatient for more justice, and faster. But the good liberal had a strong sense of being with the angels in wanting progress to raise the welfare of mankind, and with the "realists" in seeing disciplined, small government and profitable business as the best agents of change.

FGF sounds a first note of caution: the free-flow of hot capital has combined with the policy freedom of flexible exchange rates to create financial crises at a rate unimagined by the pioneers of open economy macroeconomics from whom Wolf learned his trade. Emerging nations have naturally sought insurance against these vicissitudes and created in the process the imbalances which may yet rock global capitalism to its core. Wolf has lately, in his columns, become fond of quoting Keynes, and in particular this: "When the facts change, I change my mind. What do you do, sir?" One continuing fascination of reading Wolf is how far the change of mind will go. In FGF, we find a real sympathy for the notion of national autonomy. In his columns since then, Wolf has become anti-banker, pro-stimulus, pro-nationalisation. He has developed these positions this with all the honesty and clarity of someone looking for understanding, not effect.

His views are still--just--compatible with the views of the good liberal: we deviated from the Way but these extreme policy measures will return us to it. But the strain is showing. What if even extreme policy does not work? what if there are deep social reasons for the state that rich-world finance got into? or substantial political constraints to the development of the sorts of ideally responsible governments in emerging economies that Wolf sees as the cure to the fundamental imbalances? All these are now real questions for the good liberal. Wolf opens FGF with "Finance is the brain of the economy". So, as with a deeply sick mind, much may need to change to find balance again. Keep reading Wolf, with his great virtues of clarity and honesty, to catch a once attractive Twentieth Century creed in full mutation.

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