Wolf’s Shifts and Shocks

Martin Wolf The Shifts and the Shocks: What we’ve learned – and still have to learn – from the financial crisis, Allen Lane, 2014

This book reflects Martin’s widespread discussions, including with Ben Bernanke, Oliver Blanchard, Andy Haldane, Robert Johnson, Paul Krugman, Kenneth Rogoff, George Soros, Larry Summers, Joseph Stiglitz and Paul Tucker. The draft was reviewed by Adair Turner and Mervyn King. It is nothing if not well-informed, but what I take from it is the poverty of ideas. There is, it seems, no-one out there for us to learn from. Nor is our experience of nother crash is enough to teach us what we need to know.

All this would seem to point to the need for deeper thinking about the subject, perhaps of the mathematical kind reflected in this blog. But the book has some clues to a different approach. China is mentioned quite often. It seems that it responded better than other major countries or blocs, thus improving its position relative to the West, becoming a major new reality. But my own experience is that whereas UK economists, financiers and politicians – in common with most Westerners – were in denial about the potential for a crisis, and (according to Wolf) still are, the Chinese were recognizing the possibility of a crash, identifying key factors and acting prior to the crash of Autumn 2008. Thus, it seems to me, it would be reasonable to discuss the issues with the Chinese and to learn from them. My own discussions (albeit prior to the crash) highlighted the importance of Keynes’ mathematical reasoning (as distinct from simplistic Keynesianism) and, at least for me, the relevance of Game Theory. So perhaps the conclusion would be the same: mathematics matters when – as now – common sense reasoning, learning by studying and straightforward learning from experience are not enough.


“[It] is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.”

Hyman Minsky, 1982

[The] crisis happened partly because the economic models of the mainstream rendered that outcome so ostensibly unlikely in theory that they ended up making it far more likely in practice. … As Minsky argued, stability destabilizes.

The solutions of three decades ago have morphed into the problems of today.

Introduction: We’re not in Kansas anymore

The work of economists who did understand these sources of fragility was ignored because it did not fit into the imagined world of rational agents, efficient markets and general equilibrium … .

[The] vulnerability to crisis was not due to what happened inside the financial system alone. Underneath it were global economic events, notably the emergence of a ‘global savings glut’ and the associated credit bubble, partly due to a number of interlinked economic shifts. … But also important … was the changing distribution of income between capital and labour and between workers.

… A particularly important aspect of the frailty of finance is its role in generating property bubbles.

… Policymakers made a big mistake in 2010 when they embraced austerity prematurely.

… However much the rest of the world resented the power and arrogance of the high income countries, it accepted that, by and large, the latter knew what they were doing, at least in economic policy. The financial crisis and subsequent malaise destroyed that confidence. Worse, because of the relative success of China’s state capitalism, the blow to the prestige of Western financial capitalism has carried with it a parallel blow to the credibility of Western democracy.

This last paragraph seems very odd to me. Even in the UK, was it really the case that majority of the population thought that their government knew what it was doing, economically? Did they have confidence, or were they merely fatalistic? If they did have confidence in those with power, might it not be a good thing for such misplaced confidence to be weakened? Further, I worry about the reference to China. Is ‘state capitalism’ the significant factor, or does Minsky – as in the preface – provide a better explanation? Asia had had a succession of crises, and so escaped the West’s delusions of rationality and stability, thus Minsky’s theory should have suggested to more than just me that they might be better prepared. (I might also quibble about the final reference to ‘Western democracy’. I tend to think of the need for a balance between democracy and capitalism, and to think of many of our problems as due to an imbalance between them. So I might lose confidence in Western democratic capitalism without losing confidence in democracy. Indeed, the solution to our economic woes may be more (genuine) democracy, not less.)

[The] rise of China, a new economic superpower, was among the explanations for the global imbalances that helped cause the crises.

Shades of Game Theory?

The combination of slow growth with widening inequality, higher unemployment, financial instability, so-called ‘currency wars’ and fiscal defaults may yet undermine the political legitimacy of globalization in many other respects.

While some people have been putting forward the view that globalization is legitimate, and one could argue that this view has not been successfully challenged, this only confers political legitimacy on globalization to the extent that the apparent democracies were actually legitimate. This point seems debateable, given the remarks of Minsky. It could be argued that the crises that Wolf is discussing were due to failures in the democratic systems, perhaps their capture by capitalists?

Yet perhaps the biggest way in which the crises have changed the world is – or at least should be – intellectual. They have shown that established views of how (and how well) the world’s most sophisticated economies and financial systems work were nonsense. … It is, in the last resort, ideas that matter, as Keynes knew well. Both economists and policy-makers need to rethink their understanding of the world in important respects.

Including reforming democratic debate?

Part 1: The Shocks


Part 2: The Shifts


Why did the world’s leading economies fall into such a mess?
The answer, in part, is that the people in charge did not believe that they could fall into it. [These] mistakes did not come out of the blue. They were, no doubt, influenced by … incentives for what I call ‘rational carelessness’. … People did not understand the risks … partly because they did not want to understand them.

It is possible to identify three huge shifts. The first is liberalization – the reliance on market forces across much of the world economy, including, notably, in finance. The second is technological change … . The third is ageing … .
These underlying forces … permitted or created significant further changes. Among the most important have been: the emergence of a globalized world economy; soaring inequality in most economies; the entry of gigantic emerging economies …; the evolution of a liberalized and innovative global financial system … and a huge rise in net capital flows across frontiers.

The language here is interesting. ‘Liberalization’ implies freedom, but whose? One of the most illiberal acts in UK history was the abolishment of the slave trade. The impact of modern-day liberalization and globalization on some countries and sectors can hardly seem ‘liberal’ to them. Surely a part of the problem which Wolf describes has been in part due to the widespread use of terms in ways that confuse, as here. (On a minor point, I blame financialization and globalization for the demise of traditional British coffee shops, which I much prefer to the American variety.)

Part 3: The Solutions


How should we manage a world of savings glut – or, which comes to the same thing, excess supply? Is there a real chance of secular stagnation and, if so, what might be done about it? [Our] big problem is addiction to ever-increasing debt … . Is it possible to balance our economies without such a huge reliance on ever-increasing leverage? … This can be done in two complementary ways. One is to close external imbalances. The other is to use the government’s ability to create non-debt money.

6 Orthodoxy Overthrown

Wolf cites an interview of his with Larry Summers:

I asked what economics, if any, he had found useful to the task of putting the US and world economies together again, after the crisis. He responded ‘There are things economists didn’t know. There are things economists were wrong about. And there were things where some economists were right … There is a lot in Bagehot that is about the crisis that we just went through, there’s more in Minsky and perhaps still more in Kindleberger … I think that economics knows a fair amount. I think economics has forgotten fair amount that is relevant. And it has been distracted by an enormous amount. ‘Later in the interview … Mr Summers referred to Keynes.

Kindleberger’s view was that stability is best achieved by a hegemon, rather than being split between similar powers (such as US, EU and China). I am not so sure. But the opposite view, that stability is best left to ‘natural forces’ seems yet more doubtful.

The failure of official economics

[The] pre-crisis official orthodoxy was that central banks would stop the excess credit expansion in time, or at least not too late, by responding to rising inflation in the prices of goods and services. But that signal would fail if rising asset prices and expanding credit were not closely related to inflation. That is precisely what happened in the 2000s.

The reason orthodox economics failed to pick up the risks was, in short, that it ruled out what most mattered. Modern financial systems do not equilibrate smoothly.  They bare dynamic systems characterized by uncertainty and ‘animal spirits’, in which the most powerful destabilizing force is the ability of the private financial sector to generate credit and money and so to produce euphoric boom and panic-stricken bust.

The official response to its errors

Wolf quotes Ben Bernanke (2012):

‘… The only solution in the end is for us regulators and our successors to continue to monitor the entire financial system and to try to identify problems and … respond to them using the tools that we have.’

Alternatives to the new orthodoxy

[So] great has been the failure of the financial system that the idea of a monoculture of banking and of financial systems, governed by the same global rules, seems inordinately foolish. … Experiment is essential. ..

The orthodoxy broke down, because of what Keynes and Friedman bnoth ignored: the tendency of the credit system to run riot .. .

[All] forms of balanced-budget household economics applied to the government are nonsense unless it has ceased to be able to create money (as happened inside the Eurozone).

Conclusion: Fire Next Time

[One] authoritative source estimates there were 147 banking crises between 1970 and 2011.

[It] is far from clear that the globalization of debt-creating flows, particularly those generated by banks, has brought much, if any, benefit to the world economy, as opposed to those who work in the financial industry.

[The] crises seem to have got bigger and more globally devastating over time . … The emerging and developing countries managed the consequences relatively well. But … it may well turn out that … fiscal loosening ands credit expansion .. have brought longer-term fragilities.

… Keynes was right: hopes and fears for the long run must not be the enemies of decisive action in the short run. … Somehow, the interaction between liberalization and globalization has destabilized the financial system.

What happened?

… Fraud and near fraud  – not to mention the masasaging of data to show a prettier picture than was justified (by rating agencies for example)- exploded.

Regulators, politicians and the economists who advised them were either unaware of the full extent of the dangers or were unable or unwilling to act to reduce them, partly because they were captured by the interests of the regulated, partly because they were intimidated or seduced, but, above all, more so because they were prey to the very same cognitive errors.

This had many elements: lack of preparedness,; lack of understanding of what was happening; political, intellectual and bureaucratic resistance to taking action soon enough; the unavoidable difficulties of handling a crisis that required cooperation across borders; and, particularly, the Eurozone’s political and institutional  lack of preparedness.

What is the legacy?

The fiscal costs are of roughly the same scale as a world war, while the present value of the economic costs could be even greater, … . Research at the [IMF] has suggested … that the more expansionary the immediate macroeconomic policies, the smaller are the long-term losses in output.

…The lower the prospective economic growth, the more policy makers will rely on … austerity, inflation, (financial) repression and (debt) restructuring. …

… Naïve confidence in the stability of a deregulated financial system has vanished, perhaps for a generation, except in particularly secluded corners of the academic world. …

What is to be done?

Long-term health- Challenges to crisis-hit economies

The logic behind the ‘no bailout’ position is that it would make everyone more prudent. [Yet very] important are false beliefs about the uncertain future – the belief in the middle of the last decade, for example, that house prices would rise forever, that … securitized financial assets … would always find willing buyers band that crucial lending markets would always remain liquid.

Long-term health – Global challenges

[Financial] integration has proved highly destabilizing. It might have to be sharply curtailed.

The challenge of Radical Reform

[Leveraging] up existing assets is just not a particularly valuable thing to do: it creates fragility, but little, if any, real new wealth.

… Too many countries are being forced to adopt much the same arrangements under the pressure of orthodoxies imposed by global institutions under the control of a limited number of hegemonic powers. That should end.

Why this matters

[Crises] undermine confidence in the elites. …

[The] economic, financial, intellectual and political elites misunderstood the consequences of headlong financial liberalization. Lulled by fantasies of self-stabilizing financial markets, they not only permitted but encouraged a huge and, for the financial sector, profitable bet on debt. The policy-making elite failed to appreciate the risks of a systemic breakdown. The financial elite was discredited by both its behaviour and its need to be rescued. The intellectual elite was discredited by its failure to anticipate a crisis or agree on what to do after it had struck. The political elite was discredited by their willingness to finance the rescue, however essential it was. The decline in confidence … is even worse if the methods used to rescue the economy then make the parts of the elite most associated with the crisis richer than before. [There] has to be a sense that belief that success is earned, not stolen or handed over on a platter.

[The] divorce between accountability and power strikes at the heart of democratic governance.

… 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.


Wolf has many detailed in sights and recommendations concerning the crash and recovery than above. My main interest is in the general problem. Economies seem to resemble dynamical systems with critical instabilities. A key part of what drives economies to change is human perception and expectation. These tend to homogenize and stabilise, the more so in ‘liberalized’ and ‘globalized’ economies. In the short-run, narrowly empirical learning and acting is optimal. Before the crisis it was common to ‘define away’ uncertainty by defining risk as mere variability. This ignored and even denied the possibility of critical instabilities. It was as if a walker in the dark was concerned about the risk of tripping over a rock, unaware that they were stumbling towards a cliff drop.

It seems to me that Wolf’s recommendations are not final, for all time (he does not claim that they are) and so the danger remains of treating a theory or ‘observation’ as if it were true, when all one can know is that it has been effective. Wolf discusses the Eurozone at some length. For me, the question is, can different nations maintain different ‘models’ within the zone? If not, it is clearly doomed. While Germany may have the best economic model, it would be dangerous for any one model to get to dominate the zone.

Another theme that emerges is that of inequality. It seems to me that liberalization implies that the wealthy get wealthier, and hence more influential, and that as wealth becomes more and more concentrated economies become more and more homogenized, in all aspects. Further a concentration of wealth leads to a savings glut, with the consequences that Wolf outlines. It used to be argued that liberalization would lead to growth that would ‘float all boats’, but this is now in doubt.

In the west, liberalization has – in theory – been constrained by democracy. In the period in question wealthy individuals and corporations increased their influence over politicians and regulation, and so this constraint diminished. (Some even argued that liberalization should be unconstrained.) As Wolf notes, the problem is not corruption in some overt sense, but that ‘elites’ fell prey to a common myth.

The new orthodoxy, in essence, is to be continually on the look out for critical instabilities, and to respond ad-hoc as they occur. Wolf doesn’t really spell out his alternative, but it involves somehow keeping alive alternative theories of economics and alternative economies, and also perhaps having some diversity within economies. I would suggest that a part of this should be attempts to discover where the critical instabilities and what different economies might emerge, and to identify the critical factors in preserving and encouraging resilience.

If we had such a theory, we might think about some of Wolf’s more particular problems, such as ageing. In the UK many houses are under-occupied by pensioners. This reduces supply, which inflates prices, which means it would be financially foolish for many under-occupiers to ‘trade-down’. This displays the signature of a critical instability: if house-building (particularly for pensioners) significantly increased we could see a drop in prices fuelled by a reduction in under-occupancy. Thus one could have two relatively stable regimes with ‘interesting times’ in between. A stabilization or drop in house prices could also reduce inequality, by reducing the nominal value of inheritances, by making houses more affordable for first-time buyers and eliminating a source of speculation, particularly buy-to-let.

If house prices were stable relative to incomes and if pensions also kept up with incomes then it is not even clear that house purchasing would be so essential as it is now. Some pensioners already have no house but use investment income to fund their flits between holiday flats, cruise ships and relatives or friends. My own view is that an economic system that severely disadvantages people who do not buy their own house is not only too homogenous but very illiberal, even if it is what most people want. There should at least be alternatives.

A current ‘hot topic’ is the apparent unfairness between the retired and the young. My view is that it would be foolish to try to think about this without considering it together with these other issues, and that in doing so we need to go beyond Wolf’s insights.

Dave Marsay



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