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What we didn't learn from the economic crisis

Central bankers (like these guys) were important to the recovery. But Congress should have done more.
Central bankers (like these guys) were important to the recovery. But Congress should have done more.
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In the years since the financial crisis, countries have struggled to remove the causes of the most recent financial crisis. Thus far, they have failed. That's the view of Martin Wolf, associate editor and chief economics commentator at the Financial Times. In his new book, The Shifts and the Shocks, Wolf examines what we've learned from the crisis, and just as importantly, what we haven't learned.

DK: You write in your book that we're still not on a sustainable course. What are the main reasons we're on track for more disaster?

MW: The answer very roughly is this: we have been suffering for really quite a long time from a chronic tendency towards deficient demand in the world economy. That goes back to the '90s.

Second, we dealt with that in the run-up to the crisis by creating a huge credit boom in the US and a number of other economies. That credit boom, which is just an enormous expansion of debt, was itself unsustainable.

Furthermore, three, in the process of creating the credit boom we also inevitably more or less created this huge overextension of and deterioration of credit quality in the financial system.

Fourth, when the crisis hit, this credit boom stopped, clearly, so there was a panic as well, so our economies went into free-fall.

Fifth and final, so far as we've been able to recover out of it, we've had to try to promote a return of the credit expansion system. And because the underlying fragility in demand remains, the demand expansion has been very weak. The problem is our post-crisis recovery is both weak and in important respects fragile.

And an important role was played in making this possible, perhaps the sixth point, with government borrowing. But of course we're reducing that, which is again forcing us to try to expand private credit.

Now my view is that continuing that game indefinitely is almost certain at some point to create another crisis.

DK: You point to things in the book that nations have flat-out done wrong post-crisis: austerity, insufficient financial regulation. Why have we failed to learn?

MW: The first question is: how well did we do in bringing our economies back to reasonable levels of activity after the crisis? This is, if you like, the short-to-medium-term management of the crisis.

And then the second set of questions is do we have a credible plan for creating an economic system that will be more stable in the future?

In terms of the post-crisis response, I think we did a pretty good job in the immediate crisis. I don't think there was any realistic alternative to the policies pursued at the time. But there were two mistakes made: The first is an insufficient effort was made to reduce and restructure debt. This is true in much of the overleveraged economies, not just true of the US.

The second issue is that in order to sustain demand when the private sector has been as badly hit as it was in 2007 to 9 — and this seems to me the most fundamental lesson that Keynes tried to introduce in thinking about depressions — it is necessary for governments to run large deficits, provided governments are solvent, they have central banks that are supportive, and have good credit ratings ratings.

And unfortunately, basically in every country, including the US for different reasons, this fiscal support was curtailed in my view too soon. And that meant that the recovery was not sustained. Because the recovery wasn't sustained, business became more cautious. So that made [the recession] longer-term.

Now in the longer term we need to create a more robust financial system, a less-leveraged economy, and a more balanced world economy. These are huge challenges. I feel we have not taken the measures we need to make our economy simply more robust.

I just note one thing: I think we should have made a really big effort to deleverage the whole economy, and one of the ways to do that is to stop subsidizing debt which we now do and actually tax it. We should be encouraging shared equity contracts in housing rather than just straight debt contracts.

We encourage debt too much. So that's an example of the sort of reform we ought to be thinking about, and it's just never really gone on the political radar.

DK: But if we're not encouraging debt, does that mean central banks are wrongheaded by encouraging people to borrow?

MW: One of the arguments in my view for using fiscal policy more and monetary policy less was that it is one way of reducing precisely the risk you supposed. People seem to have this very strange idea that fiscal policy — which of course means government borrowing more — is somehow much more dangerous than monetary policy, which you rightly say means the private sector borrowing more.

But the one lesson we learned from this crisis is having the private sector borrowing vast amounts it can't afford is not great either. So this assumption that fiscal leverage is bad and private leverage is good just strikes me as completely unsubstantiated and unsupported by the evidence.

There is, of course, the even more radical possibility, suggested by of all people Milton Friedman, of helicopter money, which means direct monetary financing of larger government deficits on a permanent basis. That would have been a perfectly possible policy — in my view, the most effective of all possible policies. Of course it was seen as completely inconceivable.

But the crucial point is you have to regard these things in the round. If you want to deleverage your economies — and I think you do — you have to consider other ways to create money, other ways to allow people to buy houses, for example.

Now these things can be handled, but it is true that reform has to be quite systematic. And that's very, very difficult for any of our governments to handle, and that's certainly true of the US.

DK: Reading your book, I can't help but wonder, thinking longer-term: are we getting better at economics?

MW: So let me just make three or four comments. The first point is I do think — I know this is very controversial in the US, though it's not really controversial anywhere else — that we have learned how to deal with extreme panics and how to stop really huge depressions.

And I'm one of those people who's absolutely convinced that in the fall of 2008 and early 2009 we faced real dangers of an enormous depression. And we stopped it.

I think it's also true that what the US Treasury did in terms of forcing capital on banks, making them recapitalize, proved to be successful in stopping that panic. And in addition, Ben Bernanke's astonishing heroics in handling the panic, the seizure of credit markets — all this was incredibly successful.

So I do think economists can say we know much better than we did in the past what to do in a really big panic.

Though this is like a doctor saying, "At least we can deal with a heart attack." Well that's something, isn't it? That's not nothing.

But then the question becomes: what can we do to prevent them? Here I think economics has a very, very big problem. And the big problem is that in the canonical models that evolved in the profession since the Second World War, really the possibility of such crises does not exist within the models. They're ruled out by assumption.

I accept that to some degree crises have to be surprises. [But] it is true in my view that it is possible to identify conditions in which crises are likely. My view is that if you look at the past, the combination of huge external imbalances and huge current account deficits and even more rapid growth in credit is a warning sign that the risks of crisis are rising.

The idea that the great moderation meant that crises and risk were declining was clearly a huge mistake because it ignored what I think was Hyman Minsky's most important insight about human behavior: stability destabilizes. The more people believe that the economic environment they're in is benign, stable, and profitable, the bigger the risks they're going to take. By definition, it must be true, because the risks will be more rewarding.

That's something economists can't accept, because they believe the right way to model the economy is that everybody can see through to the future on an infinite horizon. They're all rational prudent human beings who can maximize intelligently, and they're not subject to any of the pressure I've just described.

So for these reasons, economics as practiced is structurally unable largely to to identify the dangers that have been run.

DK: Does this imply that when we send our students to get their Ph.D.s in economics or MBAs, we need to change the whole system of how we teach them?

MW: My view is that economists have to ask themselves whether their models of the economy and how the economy works are the right ones absolutely. And I think the answer they would reach is that for certain important purposes they clearly aren't.

If people are going to understand therefore what might go on, what the risks are, and so forth, they need other sources of information beyond the standard models and standard teaching.

I tend to think the most important aspect of this is a profound understanding of economic history.

One of the enormous advantages that the US had in the crisis is that the chairman of the Federal Reserve was not just a very smart man, which he was, but one who missed the possibility of the crisis, there's no question about that, but that man was a profound student of the Depression. So he had been an applied economic historian.

People have to understand, when they're being taught economics, how little we know, how limited our data are, and how unbelievably complex our economic and financial system is.

I think people have to begin with profound humility and know an awful lot of economic history, as I've suggested. And they have to be told every day, "What I've just told you is almost certainly wrong."

Doctors are supposed to be taught to be humble in the face of their ignorance. And the human body is in fact a pretty simple thing compared to the essentially insubstantially material thing which is the economic system.

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