WASHINGTON – I have been reading Martin Wolf’s The Shifts and the Shocks, an analysis of the 2008-09 financial crisis and its aftermath.
Wolf is the chief economic columnist of the Financial Times, an English paper with a global audience. What he says matters because he is hugely well-informed and respected.
By and large, he rejects the standard American explanation of the financial crisis, which blames greedy bankers, incompetent government regulators and naive homebuyers. All these actors contributed, says Wolf, but they were responding to larger impersonal forces. These were the crisis’s underlying causes.
Massive trade imbalances in the 1990s and the early 2000s are among Wolf’s main culprits. China, Germany and some oil-exporting countries ran big surpluses, while the United States and some other countries had corresponding deficits. Although the connection between trade imbalances and the financial crisis seems baffling, Wolf’s logic is powerful.
The trade-surplus countries couldn’t spend all their export earnings, so they plowed the excesses into dollar investments (prominently: U.S. Treasury bonds) and euro securities. This flood of money reduced interest rates. The resulting easy credit induced dubious lending, led by housing mortgages.
Of course, low interest rates didn’t ordain bad loans. Someone had to make them; either bankers or regulators could have stopped that. Here, other causes become relevant. One is the nature of the financial system. Prolonged economic stability makes it unstable, Wolf says, because bankers and others take stability for granted. Believing this, they assume greater risks. Why didn’t regulators prevent this? Wolf argues they were captured by free-market thinking that markets would spontaneously correct errors.
This theory isn’t Wolf’s alone; it’s been advanced, in whole or in part, by others, especially economists. It’s a coherent explanation of why the credit bubble formed. It improves on the usual U.S. narrative, which effectively blames bad character. Still, I think, Wolf’s story is only half right.
It is right in arguing that the behaviors feeding the crisis were not just the failings of human nature. Where Wolf errs is misidentifying the changes that conditioned people in ways that fostered the financial crisis. The crucial influence was not global trade imbalances and their effect on interest rates. The pivotal influence (as I’ve written before) was the decline of double-digit inflation in the early 1980s, which launched a 25-year boom.
As inflation fell, interest rates followed. From 1981 to 1999, mortgage rates dropped from 15 percent to 7 percent. Declining interest rates caused stocks and home prices to soar. People felt richer, and on paper they were.
All this made a huge, if mostly subconscious, impression. The economy seemed to have stabilized. This perception – reflecting experience more than any ideology – underlay the psychology that bred the financial crisis. Bankers made dumb loans and people borrowed more because they thought that in a more stable economy they could handle more debt. Regulators got out of the way. We had a classic boom and bust.
My main takeaway from Wolf is that economics is in disarray. He spends much space refuting ideas he rejects. The point is not who is or isn’t correct; the point is that there’s no consensus on how to proceed. In two decades, we’ve gone from assuming the Federal Reserve (and other governments’ central banks) could ensure fairly stable economic growth to a state of desperate experimentation.
We’re muddling through. There’s nothing necessarily wrong with experimentation, especially if it leads to better policies. But this is hardly guaranteed. Most advanced nations seem trapped between high debts and deficient demand. The resulting debate has pitted those who advocate added debt (aka “stimulus”) to strengthen demand against those who fear more debt.
What’s misunderstood is that these debates themselves corrode confidence. People intuitively grasp what’s happened. We believed we had control over our economic environment; now we acknowledge a loss of control. The first emboldened people to spend, the second deters them. This shift is a fundamental reality of our time.
Robert Samuelson is a columnist for The Washington Post. © 2014 The Washington Post Writers Group.