The level of debt is not all that mattersby Martin Wolf / September 18, 2014 / Leave a comment
Published in October 2014 issue of Prospect Magazine
What lessons should we learn from the financial crises and subsequent economic malaise in high-income countries? These are not merely academic questions. They affect everybody. They are the questions I address in my new book, The Shifts and the Shocks, reviewed at length in the September issue of Prospect by the Harvard economist Kenneth Rogoff.
That essay is an important contribution to this debate, partly because it comes from one of the few academics whose research had suggested the possibility of such a crisis. In his masterpiece, This Time is Different, co-authored with Carmen Reinhart, now also at Harvard, Rogoff demonstrated the recurrence of fiscal and banking crises across the centuries. The review is also important because it highlights important areas of agreement and disagreement.
As Rogoff emphasises, my book attempts to place the origins of the crisis in the workings of the global economy. These include the entry of emerging economies, particularly China; soaring macroeconomic imbalances; and growing inequality. These underlying economic forces interacted with financial liberalisation to create the conditions for the crisis. We agree on this. We agree, too, that we need radical reforms.
Nevertheless, the review emphasises three areas of disagreement.
The first is where, in Rogoff’s view, “Wolf undercuts his important ideas on the need for radical reform by waffling on whether saving Lehman would have solved most of the problem.” On this topic, our differences are small. In the course of 2007, 2008 and 2009, there was a financial panic, which grew far larger after the failure of the United States financial firm Lehman Brothers on 15th September 2008. Asset prices fell dramatically, but then recouped most of their losses. According to Rogoff, in admitting this, I am arguing that if Lehman Brothers had not been allowed to fail, the financial crisis would have been far less acute. But, as he puts it, “if one really believes this, then why take all the risks of a radical change?”
I disagree. The costs of panics, which are real, strengthen the case for radical reforms, rather than weaken it. The memoir of Tim Geithner, the former US Treasury Secretary, suggests that he believes stopping the panic is the heart of what needs to be done. This is not so. Crises do often mark the end of unsustainable trends in credit and debt. But these panics are symptoms of past excesses. The legacy of those excesses remains at the heart of the problem.
The other two areas of criticism concern essentially one issue: the role of fiscal policy in dealing with a post-crisis collapse in aggregate demand. The most intellectually interesting issue concerns the eurozone. My argument is that the eurozone crisis was essentially one of balance-of-payments cum financing, for which creditor countries bear as much responsibility as the debtors. Rogoff has three challenges to this.
First, he argues, the eurozone is not a closed economy, which means that one cannot relate the German surplus directly to other countries’ deficits. Second, the mode of financing matters: if the capital imported by countries in the periphery had taken the form of foreign direct investment, the problem would have been far smaller. Third, he argues, a crisis might have occurred even if the countries in the periphery had run balanced trade, because of a run on their relatively short-term liabilities.
I agree with his assertion that competition from Asia was important for peripheral countries. But I hold that the eurozone is, in crucial respects, a single economy: it shares a currency and so too a monetary policy. It can no longer be seen as a collection of independent economies.
With chronically weak pre-crisis demand in Germany and other northern European countries, the central bank had to pursue a highly accommodative monetary policy, in order to hit its inflation targets. This policy worked by creating financial and asset price bubbles, most significantly in Spain.
Furthermore, the countries that got into difficulties ran sizeable current account deficits. It is true that the problems might not have existed if the finance of these deficits had taken the form of foreign direct investment. If wishes were horses, beggars would ride. The dependency of the eurozone on debt finance in general and bank finance in particular was hardly a secret.
Thus, in the actual eurozone, in the context of extraordinarily weak demand in the core countries, the single monetary policy led to a destabilising boom and associated losses of competitiveness in a number of peripheral countries.
Now turn to what should have been done. I agree with all of Rogoff’s suggestions, in theory: actions to take a euro break-up off the table; restructure debts; endorse a looser monetary policy from the European Central Bank (ECB); and expanded public investment.
An important point of disagreement, however, is that even though debt restructuring would indeed have been (and still would be) desirable, it would have been impossible to agree and implement on an adequate scale. That applies very much, as Rogoff admits, to his favoured US policy of bailing out subprime homeowners directly. I see little point in putting all our eggs in the basket of a debt restructuring policy that will not be adopted. Similar difficulties lie in recommending higher inflation, which would also be rejected, notably by Germany.
In practice an important part of any deleveraging process was bound to be retrenchment in the private sectors rather than debt restructuring. If the governments of the vulnerable countries were to be forced into retrenchment at the same time, the result would be both huge depressions and slow deleveraging, if any. And that is exactly what has happened.
A crucial part of any recovery then has to be strong aggregate demand. The case for using all tools, including fiscal policy, seems to me overwhelming. In this context, I find Rogoff’s suggestion that Germany’s economy is currently “overheating”—that inflationary pressure is building—astonishing. The country is running a current account surplus of more than 7 per cent of GDP and has inflation running at less than 1 per cent. The economy is clearly “under-heated.” Indeed, if the eurozone were to carry out his recommendation of higher inflation, Germany would surely have to overheat far more.
Would German fiscal expansion help the eurozone? Yes, through a range of spillover effects, including through the exchange rate of the euro, particularly if it were a part of an expansionary shift in fiscal policy by all member countries with room for manoeuvre. Rogoff argues that France could not join in such a shift because it needs to shrink its government. But the latter would be perfectly compatible with a fiscal stimulus, provided taxes were cut even faster than spending.
He also dismisses the view of London School of Economics professor Paul de Grauwe’s, that the difference between the long-term interest rates of Spain (high) and the United Kingdom (low) during the crisis was due to the failure of the ECB to provide credible support to the former. He does not notice that the jury is now in on this. In the summer of 2012, the President of the ECB, Mario Draghi, promised to do “whatever it takes” to eliminate break-up risk in the eurozone. The spreads between rates on Italian and Spanish government debt, on the one hand, and German debt, on the other, collapsed. Today, the yield on Spanish and Italian debt is lower than on UK gilts, just as de Grauwe predicted.
Much of the last section of his essay seems to be an argument over fiscal policy in the US and UK not with me, but with Paul Krugman, a Nobel laureate in economics and columnist at the New York Times, and with Lawrence Summers, former US Treasury Secretary and economic advisor to President Barack Obama. So let me be clear on my position on this. As I have admitted in several columns, the speed of the UK recovery has surprised me. Does this mean that my doubts about the coalition government’s fiscal tightening were wrong? I would argue, strongly, that this is not the case.
I was not the only one to be surprised. So was the Office for Budgetary Responsibility. In addition, I believed that the rise in public debt would not create any difficulties in funding at very low interest rates. This proved correct. There was no logic in tightening UK fiscal policy because of concern that the eurozone would collapse. Indeed, the reverse was the truth. Such a collapse would lead to a flight into UK bonds, not away from them, as it did.
Moreover, even with the latest revisions, the UK economy was only 2 per cent larger in the second quarter of 2014 than before the crisis hit and has expanded by a mere 5.9 per cent over four years under the present government. This is not a rapid recovery. It is a very poor one, particularly after a deep recession.
Yet, in the end, we both agree on the need to use fiscal policy. True, he focuses only on public investment, while I would add other possibilities, including tax cuts. Yet, above all, I do not understand why he makes fiscal policy so much of an issue, particularly when the UK and US governments could borrow long term so remarkably cheaply. The level of debt is not all that matters, after all. So does its cost.
More important, I want to stress our many areas of agreement. Perhaps most remarkably, Rogoff and I agree on the merits of a radical restructuring of the monetary and financial systems, which would make transactions money 100 per cent backed by the state. That would eliminate our dangerous dependence on debt-backed money created by highly leveraged and so fragile financial intermediaries.
The notion of such a radical reform is inescapably contentious. But the likelihood of further crises is so great that it must now be considered. I hope it will not only be tried somewhere, but be shown to work. The pre-crisis system failed. It is hard to believe the over-regulated post-crisis system will prove much better. The time for radical experiments is now.