Cover image for The shifts and the shocks : what we've learned-and have still to learn-from the financial crisis
The shifts and the shocks : what we've learned-and have still to learn-from the financial crisis
Wolf, Martin, 1946- , author.
Publication Information:
New York, New York : Penguin Press, 2014.
Physical Description:
xxii, 465 pages : illustrations ; 24 cm
"From the chief economic commentator for the Financial Times, a brilliant tour d'horizon of the new global economy and its trajectory There have been many books that have sought to explain the causes and courses of the financial and economic crisis which began in 2007-8. The Shifts and the Shocks is not another detailed history of the crisis, but the most persuasive and complete account yet published of what the crisis should teach us about modern economies and economics. The book identifies the origin of the crisis in the complex interaction between globalization, hugely destabilizing global imbalances and our dangerously fragile financial system. In the eurozone, these sources of instability were multiplied by the tragically defective architecture of the monetary union. It also shows how much of the orthodoxy that shaped monetary and financial policy before the crisis occurred was complacent and wrong. In doing so, it mercilessly reveals the failures of the financial, political and intellectual elites who ran the system. The book also examines what has been done to reform the financial and monetary systems since the worst of the crisis passed. "Are we now on a sustainable course?" Wolf asks. "The answer is no." He explains with great clarity why "further crises seem certain" and why the management of the eurozone in particular "guarantees a huge political crisis at some point in the future." Wolf provides far more ambitious and comprehensive plans for reform than any currently being implemented. Written with all the intellectual command and trenchant judgment that have made Martin Wolf one of the world's most influential economic commentators, The Shifts and the Shocks matches impressive analysis with no-holds-barred criticism and persuasive prescription for a more stable future. It is a book no one with an interest in global affairs will want to neglect. "--

"The book identifies the origin of the crisis in the complex interaction between globalization, hugely destabilizing global imbalances and our dangerously fragile financial system. In the eurozone, these sources of instability were multiplied by the tragically defective architecture of the monetary union. It also shows how much of the orthodoxy that shaped monetary and financial policy before the crisis occurred was complacent and wrong. In doing so, it mercilessly reveals the failures of the financial, political and intellectual elites who ran the system. The book also examines what has been done to reform the financial and monetary systems since the worst of the crisis passed. "Are we now on a sustainable course?" Wolf asks. "The answer is no." He explains with great clarity why "further crises seem certain" and why the management of the eurozone in particular "guarantees a huge political crisis at some point in the future." Wolf provides far more ambitious and comprehensive plans for reform than any currently being implemented"--
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From the chief economic commentator for the Financial Times , a brilliant tour d'horizon of the new global economy and its trajectory

There have been many books that have sought to explain the causes and courses of the financial and economic crisis which began in 2007--8. The Shifts and the Shocks is not another detailed history of the crisis, but the most persuasive and complete account yet published of what the crisis should teach us about modern economies and economics.

The book identifies the origin of the crisis in the complex interaction between globalization, hugely destabilizing global imbalances and our dangerously fragile financial system. In the eurozone, these sources of instability were multiplied by the tragically defective architecture of the monetary union. It also shows how much of the orthodoxy that shaped monetary and financial policy before the crisis occurred was complacent and wrong. In doing so, it mercilessly reveals the failures of the financial, political and intellectual elites who ran the system.

The book also examines what has been done to reform the financial and monetary systems since the worst of the crisis passed. "Are we now on a sustainable course?" Wolf asks. "The answer is no." He explains with great clarity why "further crises seem certain" and why the management of the eurozone in particular "guarantees a huge political crisis at some point in the future." Wolf provides far more ambitious and comprehensive plans for reform than any currently being implemented.

Written with all the intellectual command and trenchant judgment that have made Martin Wolf one of the world's most influential economic commentators, The Shifts and the Shocks matches impressive analysis with no-holds-barred criticism and persuasive prescription for a more stable future. It is a book no one with an interest in global affairs will want to neglect.

Author Notes

Martin Wolf is the associate editor and chief economics commentator at the Financial Times , London. He is the recipient of many awards for financial journalism, for which he was also made a Commander of the Order of the British Empire in 2000. His previous books include Fixing Global Finance and Why Globalization Works .

Reviews 3

Booklist Review

Economics commentator Wolf reports, The crisis that broke upon the world in August 2007, and then morphed into a widening economic malaise in the high-income countries and huge turmoil in the Eurozone, has put not just these countries but the world into a state previously unimagined even by intelligent and well-informed policymakers. Few mainstream economists foresaw the crisis or even the possibility of one, and we learn the economics establishment failed. Today the author finds the threats to liberal democracy (individual freedom and citizenship) are from financial and economic instability, high unemployment and soaring inequality. The author analyzes what the crisis tells us about the economy and economics in order to decide what needs to be done, such as reforms in financial regulation, the functioning of monetary systems, global governance, and global economic institutions. While reforms are under way, Wolf indicates there is a lack of action over global monetary and exchange-rate regimes. This challenging book provides an important perspective for the ongoing debates about the recent Great Recession.--Whaley, Mary Copyright 2014 Booklist

Publisher's Weekly Review

Tectonic changes in the global economy yielded collapse and an ill-judged fiscal austerity, according to this far-reaching study of the Great Recession. Financial Times editor Wolf (Fixing Global Finance) recaps the ongoing slump from the panic of 2008 and the frantic efforts of central banks to shore up the financial system, to the turn towards tight fiscal and monetary policies in the West in 2010, which he blames for the sluggish recovery and the subsequent Eurozone debt crisis. He ties these recent "shocks" to decades-long sea changes in the world economy: globalization and intensified competition; a "savings-glut" with few profitable outlets for investment; economic inequality that shrinks wages and demand. Wolf's provocative indictment of economic orthodoxy suggests that more government debt and fiscal stimulus are needed, and that responsible creditors like Germany are as culpable as bankrupt countries like Greece. He floats a number of radical reform proposals, including measures that would essentially abolish the private banking system. Although readers with some understanding of macroeconomics will profit the most, Wolf's discussions of the complex dynamics of investment, banking, trade and monetary policy are lucid, and his incisive analysis makes a compelling case for bold, activist economic policy. (Sept.) © Copyright PWxyz, LLC. All rights reserved.

Choice Review

Authors--and reviewers--are not without biases and attitudes. When Wolf, the well-known Financial Times economics commentator, tackles the 2007 (and continuing) financial crisis, his choice of language and emphasis reveals his sympathies and agenda: "neoclassical orthodoxy," "global imbalances," "fiscal austerity." Concomitant with this economic calamity and its aftermath, an endless stream of scholars and columnists have weighed in on the causes and consequences of the Great Recession and ensuing moderation in growth and employment. Wolf's contribution is one of the better accounts and vision. His three-part alliterative exposition lays out in detail what could not be treated in shorter, disjointed magazine or newspaper articles: the shocks (where the financial crisis occurred, including superb coverage on the eurozone), the shifts (the fragilities and vulnerabilities of the current financial system), and the solutions (the author's more normative, and quite radical, proposals for recovery and reform of an alleged broken system). This is a book for intelligent lay readers, who will find some of the dense coverage tough sledding; policy makers; and scholars. The latter may find little truly new here, but the 100 pages of endnotes, references, and index will keep them occupied. Summing Up: Recommended. Lower-division undergraduates and above; general readers. --Allen R. Sanderson, University of Chicago



Acknowledgements In writing a book one accumulates many debts. Here I acknowledge just a few of them. I have to start with thanking Andrew Wylie, my agent, whose boundless energy and enthusiasm made this book happen. I want to thank John Makinson, chairman and chief executive of Penguin, who decided to publish it. I also acknowledge the invaluable contributions of Scott Moyers and Stuart Proffitt, my editors at Penguin, whose care and attention to detail have made the book immeasurably better and clearer than it would otherwise have been. Stuart in particular was inexorable. I recognize the immense importance of his contribution and greatly appreciate the time he took and the attention he bestowed on this book. I also want to note their patience with the delays in completing a book whose writing had to fit in with my normal duties. In addition, I extend my thanks to Richard Duguid and Donald Futers on the Penguin production team, and to Richard Mason for his very helpful editorial input. I would also like to thank Lionel Barber, the editor of the Financial Times, for accommodating the needs of the book. I have taken off a substantial amount of time in order to write it, more than I had hoped, in fact. I appreciate enormously the way the FT has accommodated this and promise not to do it again in the near future. I also want to thank colleagues at the FT from whom I have learned so much. Particular thanks for contributions to ideas in this book go to Chris Giles, Ferdinando Giugliano, my former colleague Krishna Guha, Robin Harding, Martin Sandbu and Gillian Tett. I owe thanks to an immense number of thinkers and policymakers from whose writings I have been privileged to learn over many years. I recognize most of these debts via citations in the text, endnotes and references. I would like to record particular thanks to three individuals. The first is Max Corden, who taught me at Oxford and whose remarkable combination of clarity, rigour and good sense has marked me for life. I have aspired, not always successfully, to match these qualities in my professional activities. It was a great honour and still greater pleasure to deliver a lecture, named after him, in his home town of Melbourne in October 2012.1 The second person is Adair Turner, former chairman of the Financial Services Authority. Adair was kind enough to read the third part of the book and the concluding chapter. I have greatly appreciated his wisdom and support, and learned immensely from his writing on the crisis and its aftermath. The final person is Mervyn King, former governor of the Bank of England and a friend for more than two decades. Despite inevitable professional disagreements, I have always greatly admired his intelligence and integrity. I am grateful to Mervyn for reading the book in draft and giving me supportive and helpful comments. He encouraged me to be even more radical than I had intended to be. Others to whom I owe gratitude for conversations on the topics of this book include Anat Admati of Stanford University, C. Fred Bergsten of the Peterson Institute for International Economics, Ben Bernanke, former Chairman of the Federal Reserve, Olivier Blanchard of the International Monetary Fund, Claudio Borio of the Bank for International Settlements, Paul de Grauwe of the London School of Economics, my former colleague Chrystia Freeland, Member of the Canadian Parliament, Andy Haldane of the Bank of England, Robert Johnson of the Institute for New Economic Thinking, Paul Krugman of Princeton University, Philippe Legrain, former adviser to the president of the European Commission, Michael Pettis of Peking University, Adam Posen of the Peterson Institute for International Economics, Raghuram Rajan, governor of the Reserve Bank of India, Carmen Reinhart of Harvard University, Kenneth Rogoff of Harvard University, Jeffrey Sachs of Columbia University, Hans-Werner Sinn of CESifo, George Soros, Joseph Stiglitz of Columbia University, Andrew Smithers of Smithers & Co., Lawrence Summers of Harvard University, Alan Taylor of the University of California, Paul Tucker, formerly of the Bank of England, David Vines of Oxford University, William White, formerly of the Bank for International Settlements, and Malcolm Wiener. I wish also to offer thanks to John Vickers, Claire Spottiswoode, Martin Taylor and William (Bill) Winters, with whom I had the pleasure to serve on the UK government's Independent Commission on Banking in 2010-11, as well as to the members of its admirable secretariat. I apologize to all who might feel slighted by omission from this list. It is far from exhaustive. Needless to say, none of the people I have listed bears any responsibility for what appears in this book. I also want to give my special thanks to Douglas Irwin of Dartmouth University and Kevin O'Rourke of Oxford University for permission to use the title The Shifts and the Shocks, which I have drawn from their interesting paper, 'Coping with Shocks and Shifts'.2 This phrase captured my theme perfectly. Finally, and far above all, I must offer my deepest thanks to Alison, my wife of more years than she would like to admit. She has given me everything that could make a man's life happy, including the three children to whom this book is dedicated. Beyond that, I thank her for her encouragement and support in writing this book, which was far from an easy process. Without her, I am sure it would not have been finished. I must thank her, not least, for reading all of the draft and giving me comments that were both sensible and to the point, as she has always done. Above all, she forced me to explain what I mean to a highly intelligent reader who does not live in the world of international macroeconomics and global finance. The value of such a reader is and has always been beyond measure. List of Figures 1. Libor-OIS Swap 2. General Government Borrowing Requirement 3. Real GDP Since the Crisis 4. Employment 5. US Cumulative Private Sector Debt over GDP 6. Spreads over German Bund Yields 7. Spreads over Bund Yields 8. Current Account Balances in the Eurozone 2007 (US$bn) 9. Current Account Balances in the Eurozone 2007 (per cent of GDP) 10. Unit Labour Costs in Industry Relative to Germany 11. Current Account Balances 12. Average General Government Fiscal Balance 2000- 13. Ratio of Gross Public Debt to GDP (Ireland/Spain) 14. Ratio of Gross Public Debt to GDP (2007/2013) 15. Ratio of Gross Public Debt to GDP 16. Spread Between UK and Spanish 10-year Bond Yields 17. Real GDP of Crisis-hit Eurozone Countries 18. Unemployment Rates 19. Growth in the Great Recession 20. Increase in GDP 2007- 21. Average Current Account Balances 2000- 22. Average Current Account Balance 2000- 23. GDP Growth in Central and Eastern Europe in 24. Foreign Currency Reserve 25. Capital Flows to Emerging Economies 26. Demand Contributions to Chinese GDP Growth 27. Real Commodity Prices 28. Tradeable Synthetic Indices of US Asset-backed Sub-prime Securities 29. Central Bank Short-term Policy Rates 30. Yields on Index-linked Ten-year Bonds 31. Real House Prices and Real Index-linked Yields 32. Global Imbalances 33. US Financial Balances since 34. Eurozone Imbalances on Current Account 35. Sectoral Financial Balances in Germany 36. Spread on Government 10-year Bond Yields over Bunds 37. Backing for US M 38. Real Profits of US Financial Sector 39. US GDP 40. UK GDP 41. US 'Money Multiplier' 42. Structure Fiscal Balances 43. UK Sectoral Net Lending 44. Whole Economy Unit Labour Costs Relative to Germany 45. Eurozone GDP 46. Core Annual Consumer Price Inflation 47. Optimal Currency Area Criteria 48. Gross Public Debt over GDP 49. US GDP per Head 50. UK GDP per Head Preface: Why I Wrote this Book This book is about the way in which the financial and economic crises that hit the high-income countries after August 2007 have altered our world. But its analysis is rooted in how these shocks originated in prior shifts - the interactions between changes in the global economy and the financial system. It asks how these disturbing events will - and should - change the ways we think about economics. It also asks how they will - and should - change the policies followed by the affected countries and the rest of the world. The book is an exploration of an altered landscape. I must start by being honest with myself and with the reader: although I spend my professional life analysing the world economy and have seen many financial crises, I did not foresee a crisis of such a magnitude in the high-income countries. This was not because I was unaware of the unsustainable trends of the pre-crisis era. My previous book, Fixing Global Finance, published in 2008 but based on lectures delivered in 2006, discussed the fragility of finance and the frequency of financial crises since the early 1980s. It also examined the worrying growth of huge current-account surpluses and deficits - the so-called 'global imbalances' - after the emerging market crises of 1997-99. It focused particularly on the implications of the linked phenomena of the yawning US current-account deficits, the accumulations of foreign-currency reserves by emerging economies, and the imbalances within the Eurozone.2 That discussion arose naturally from the consideration of finance in my earlier book, Why Globalization Works, published in 2004.3 That book, while arguing strongly in favour of globalization, stressed the heavy costs of financial crises. Nevertheless, I did not expect these trends to end in so enormous a financial crisis, so comprehensive a rescue, or so huge a turmoil within the Eurozone. My failure was not because I was unaware that what economists called the 'great moderation' - a period of lower volatility of output in the US, in particular, between the late 1980s and 2007 - had coincided with large and potentially destabilizing rises in asset prices and debt.4 It was rather because I lacked the imagination to anticipate a meltdown of the Western financial system. I was guilty of working with a mental model of the economy that did not allow for the possibility of another Great Depression or even a 'Great Recession' in the world's most advanced economies. I believed that such an event was possible only as a consequence of inconceivably huge errors by bankers and regulators. My personal perspective on economics had failed the test set by the late and almost universally ignored Hyman Minsky. This book aims to learn from that mistake. One of its goals is to ask whether Minsky's demand for a theory that generates the possibility of great depressions is reasonable and, if so, how economists should respond. I believe it is quite reasonable. Many mainstream economists react by arguing that crises are impossible to forecast: if they were not, they would either already have happened or been forestalled by rational agents. That is certainly a satisfying doctrine, since few mainstream economists foresaw the crisis, or even the possibility of one. For the dominant school of neoclassical economics, depressions are a result of some external (or, as economists say, 'exogenous') shock, not of forces generated within the system. The opposite and, in my view, vastly more plausible possibility is that the crisis happened partly because the economic models of the mainstream rendered that outcome ostensibly so unlikely in theory that they ended up making it far more likely in practice. The insouciance encouraged by the rational-expectations and efficient-market hypotheses made regulators and investors careless. As Minsky argued, stability destabilizes. This is an aspect of what George Soros, the successful speculator and innovative economic thinker, calls 'reflexivity': the way human beings think determines the reality in which they live.5 Naive economics helps cause unstable economies. Meanwhile, less conventional analysts would argue that crises are inevitable in our present economic system. Despite their huge differences, the 'post-Keynesian' school, with its suspicion of free markets, and the 'Austrian' school, with its fervent belief in them, would agree on that last point, though they would disagree on what causes crises and what to do about them when they happen.6 Minsky's view that economics should include the possibility of severe crises, not as the result of external shocks, but as events that emerge from within the system, is methodologically sound. Crises, after all, are economic phenomena. Moreover, they have proved a persistent feature of capitalist economies. As Nouriel Roubini and Stephen Mihm argue in their book Crisis Economics, crises and subsequent depressions are, in the now celebrated terminology of Nassim Nicholas Taleb, not 'black swans' - rare and unpredictable events - but 'white swans' - normal, if relatively infrequent, events that even follow a predictable pattern.7 Depressions are indeed one of the states a capitalist economy can fall into. An economic theory that does not incorporate that possibility is as relevant as a theory of biology that excludes the risk of extinctions, a theory of the body that excludes the risk of heart attacks, or a theory of bridge-building that excludes the risk of collapse. I would also agree with Minsky that governments have to respond when depressions happen, this being the point on which the views of the post-Keynesian and Austrian schools diverge - the former rooted in the equilibrium unemployment theories of John Maynard Keynes and the latter in the free-market perspectives of Ludwig von Mises and Friedrich Hayek. Minsky himself put his faith in 'big government' - a government able to finance the private sector by running fiscal deficits - and a 'big bank' - a central bank able to support lending when the financial system is no longer able to do so.8 Indeed, dealing with such threatening events is a big part of the purpose of modern governments and central banks. In addition to tackling crises, as and when they arise, policymakers also need to consider how to reduce vulnerability to such events. Needless to say, every part of these views on the fragility of the market economy and the responsibilities of government is controversial. These events have not been the first to change my views on economics since I started studying the subject at Oxford University in 1967.9 Over the subsequent forty-five years I have learned a great deal and, unsurprisingly, changed my mind from time to time. In the late 1960s and early 1970s, for example, I came to the view that a bigger role for markets and a macroeconomic policy dedicated to monetary stability were essential, in both high-income and developing countries. I participated, therefore, in the move towards more market-oriented economic perspectives that took place at that time. I was particularly impressed with the Austrian view of the market economy as a system for encouraging the search for profitable opportunities, in contrast to the neoclassical fixation with equilibrium: the writings of Joseph Schumpeter and Hayek were (and remain) powerful influences. The present crisis has underlined my scepticism about equilibrium, but has also restored a strong and admiring interest in the work of Keynes, which had begun when I was at Oxford. After a passage of eighty years, Keynes's concerns of the 1930s have again become ours. Those who fail to learn from history are, we have been reminded, condemned to repeat it. Thus, the crisis has altered the way I think about finance, macroeconomics and the links between them, and so, inevitably, also about financial and monetary systems. In some ways, I find, the views that animate this book bring me closer to my attitudes of forty-five years ago. It is helpful to separate my opinions about how the world works, which do change, from my values, which have remained unaltered. I acquired these values from my parents, particularly from my late father, Edmund Wolf, a Jewish refugee from 1930s Austria. He was a passionate supporter of liberal democracy. He opposed utopians and fanatics of both the left and the right. He believed in enlightenment values, tempered by appreciation of the frailties of humanity. The latter had its roots in his talent (and career) as a playwright and journalist. He accepted people as they are. He opposed those who sought to transform them into what they could not be. These values made him, and later me, staunchly anti-communist during the Cold War. I have remained attached to these values throughout my life. My views on the economy have altered over time, however. As economic turbulence hit the Western world during the 1970s, I became concerned that this might undermine both prosperity and political stability. When UK retail price inflation hit 27 per cent in August 1975, I even wondered whether my country would go the way of Argentina. I was happy to see Margaret Thatcher seek to defeat inflation, restrict the unnecessary extensions of state intervention in the economy, curb the unbridled power of the trades unions, and liberalize markets. These were, I thought, essential reforms. Similarly, it seemed to me that the US needed at least some of what Ronald Reagan offered. In the context of the ongoing Cold War, a restored and reinvigorated West appeared necessary and right. I believed that the moves away from what was then an overstretched and unaccountable state towards a more limited and accountable one were in the right direction if the right balance between society and the state was to be restored. In the 1970s, I concluded, the state had become weak because overextended, notably in the UK: three-day weeks, soaring inflation, collapsed profits and labour unrest all indicated that the state was decreasingly able to perform its basic functions. The US and the UK needed to have more limited and more effective states together with more self-reliant and more vigorous civil societies. No less necessary, I concluded from what I learned as a postgraduate at Nuffield College, Oxford, and subsequently during my ten years at the World Bank, was reform and liberalization of the economies of developing countries. The results have largely been positive over the past three decades, though there, too, the threat of financial instability was never far away, as became evident from August 1982, the month when the Latin American debt crisis of the 1980s broke upon the world. The era of market liberalization has also been the era of financial crises, culminating in the biggest and most important of them, which began in 2007.10 Between 1989 and 1991 the Cold War suddenly ended. I delighted in the collapse of Soviet communism and the triumph of liberal democracy. I thought a period of peace and stable prosperity would be on offer. The period since then has indeed been a time of extraordinary economic progress in much of the developing world, above all in China and then India, countries accounting for almost 40 per cent of the world's population. No less encouraging has been the spread of democracy in important parts of the world, notably Latin America, sub-Saharan Africa and, of course, post-Soviet Europe. Today, it is possible to identify at least the spread of democratic ideals, if not working democratic practices, in parts of the Arab and wider Muslim world. What is emerging is, of course, not only imperfect and corrupt but often marred by violence and oppression. But it is impossible to look back at the developments of the past three decades without concluding that, notwithstanding the failures and disappointments, the general direction has been towards more accountable governments, more market-oriented economies, and so towards more cooperative and positive-sum relations among states.11 The creation of the World Trade Organization in 1996 is just one, albeit particularly important, sign of these fundamentally hopeful developments. Yet much has also gone wrong. During the 1990s, and particularly during the Asian financial crisis of 1997-98, I became concerned that the liberalization of the 1980s and 1990s had brought forth a monster: a financial sector able to devour economies from within. I expressed those concerns in columns for the Financial Times written in response. This suspicion has hardened into something close to a certainty since 2007. Connected to this is concern about the implications of ever-rising levels of debt, particularly in the private sector, and, beyond that, what is beginning to look like chronically weak demand, at the global level. Faith in unfettered financial markets and the benefits of ever-rising private debt was not the only dangerous form of economic hubris on offer. Another was the creation of the euro. Indeed, in a column written in 1991, as the negotiation of the Maastricht Treaty was completed, I had already judged this risky venture in words used by the ancient Greeks of the path taken by a tragic play: hubris (arrogance); (folly); nemesis (retribution).12 In addition, we have seen a marked rise in inequality in many of the world's economies, particularly in the more market-oriented high-income countries. Rising inequality has many adverse effects - declining social mobility, for example. Among these adverse effects is a link with financial instability, as people feel forced to borrow in order to make up for stagnant or even declining real incomes.13 The solutions of three decades ago have morphed into the problems of today. That is hardly a new experience in human history. Yet it is particularly likely when a philosophy is taken to its extreme. Liberal democracy is, I believe, now as threatened by financial instability and rising inequality as it was by the high inflation and squeezed profits of the 1970s. In learning lessons from that era, we have, perhaps inevitably, made mistakes in this one. 'Liberal democracy' contains two words that correspond to two related, but distinct, concepts of liberalism. Both have deep roots. One concept is freedom of the individual under the law. This form of freedom - personal autonomy - represents what the late Isaiah Berlin, in his classic essay 'Two Concepts of Liberty', called 'negative freedom'.14 The other concept is not quite that of 'positive freedom', as Berlin defined it, though it bears some relation to that concept. It is rather of the individual as citizen. As the late Albert Hirschmann argued, 'voice' - the ability to have a say in collective decisions that affect one - is just as important as 'exit' - the ability of the individual to choose alternatives, not just as a consumer and producer, but as a citizen.15 Whereas the first concept of liberty is quintessentially English, the second goes back to the ancient world.16 For Athenians, the separated individual who took no place in public life was an  - the word from which our word 'idiot' is derived. Such a person was an inadequate human being because he (for the Greeks, it was always 'he') focused only on his private concerns rather than on those of his polis, or city state, the collective that succoured him and to which he owed not just his loyalty, but also his energy. The ideal of a liberal democracy derives from the marriage of these two ideas - freedom and citizenship. It is based on the belief that we are not only individuals with rights to choose for ourselves, subject to the law; we are also, as Aristotle put it, 'political animals'. As such, we have both a need and a right to participate in public life. Citizenship translates the idea of individual self-worth to the political level. As citizens, we can and should do things together. Many of these things are, in turn, the foundation stones of Berlin's 'positive liberty', or individual agency. Obvious examples of socially provided public and semi-public goods, beyond the classic public goods of defence and justice, are environmental protection, funding of basic scientific research, support for technical innovation and provision of medical care, education and a social safety net. Making choices, together, about the provision of such goods does not represent a violation of freedom, but is rather both an expression and a facilitator of that fundamental value. Today, then, the threats to liberal democracy, as I define it, come not from communism, socialism, labour militancy, soaring inflation, or a collapse in business profitability, as was the case in the 1970s, but from financial and economic instability, high unemployment and soaring inequality. The balance needs to be shifted again. Recognizing that need does not change my view that markets and competition are the most powerful forces for economic dynamism. Nor has it changed my view that a market economy is both a reflection of personal liberty and a precondition for its survival.17 Only if people are free in their means can they be free in their ends.18 Democracy, too, will not function in the long run without a citizenry that is, to a substantial degree, economically independent of the state. But the financially driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis. This book bears witness to this perspective and attempts to make sense of how it has changed the way I think about our world. Introduction: 'We're not in Kansas any more'1 No longer the boom-bust economy, Britain has had the lowest interest rates for forty years. And no longer the stop-go economy, Britain is now enjoying the longest period of sustained economic growth for 200 years. Gordon Brown, 20042 My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck, as some have argued, though I am sure good luck had its part to play as well. The past is a foreign country. Even the quite recent past is a foreign country. That is certainly true of the views of leading policymakers. The crisis that broke upon the world in August 2007, and then morphed into a widening economic malaise in the high-income countries and huge turmoil in the Eurozone, has put not just these countries but the world into a state previously unimagined even by intelligent and well-informed policymakers. Gordon Brown was, after all, a politician, not a professional economist. Hubris was not, in his case, so surprising. But Ben Bernanke is an exceptionally competent economist. His mistakes were, alas, representative of the profession. In a celebrated speech from February 2004 on what economists called the 'great moderation', Mr Bernanke talked about what now seems an altogether different planet - a world not of financial crisis and long-term economic malaise, but one of outstanding stability and superlative monetary policy.4 Moreover, claimed Mr Bernanke, 'improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well'.5 This now seems quaint. The economics establishment failed. It failed to understand how the economy worked, at the macroeconomic level, because it failed to appreciate the role of financial risks; and it failed to understand the role of financial risks partly because it failed to understand how the economy worked at the macroeconomic level. 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 that these professors Pangloss had made up.6 The subsequent economic turmoil has done more than make the economics of even a few years ago look as dead as the dodo. It has (or should have) changed the world. That is the subject of this book. It does not offer a detailed history of the crisis. It is, instead, an attempt to analyse what the crisis tells us about the economy and economics. Only by analysing this event in some detail is it possible to discuss what needs to be done and then set that against what has been - and is being - done. Are we now on a sustainable course? The answer, I will argue, is no. OUTLINE OF THE ANALYSIS Part I - 'The Shocks' - looks at how the financial crises that hit the advanced economies after 2007 made the world what it was in early 2014. Yes, globalization is continuing. But the latest and most dangerous financial crises of the post-war era have made the world economy fragile and the economies of the high-income countries weak. Chapter One, the first chapter in Part I, looks at the global financial crisis and its aftermath, focusing on where the high-income economies now are. Economic orthodoxy treated such huge financial crises as more or less inconceivable. Nevertheless, they happened. The wave of financial crises and the policy measures used to combat them - the bailout of the banking system, the unprecedented monetary expansion and the huge fiscal deficits - were extraordinary. While such heroic measures halted the move into another Great Depression, they failed to return the high-income countries to a state of good health. Governments have been struggling with an aftermath of high unemployment, low productivity growth, de-leveraging, and rising concerns about fiscal solvency. The spectre of a Japanese malaise has loomed. Chapter Two then turns to the crisis in the Eurozone. Once the credit flows stopped in 2008, the structural weaknesses of the Eurozone became evident. Subsequently, a host of inadequate policy interventions barely staved off a meltdown. Despite some progress in tackling the crisis, the post-war European project remains at risk, since it is impossible to go forward to a far stronger union or back to monetary independence. Chapter Three, the last in Part I, looks at the consequences of the crises for the emerging economies. In general, economic growth in emerging markets remained rapid, despite weaknesses in high-income economies. But there, too, including in China and India, concerns have grown about excessive private or public sector debts and asset bubbles. In addition, the exceptional monetary policies of advanced countries and huge private outflows of capital from them, seeking higher yields, also created severe dilemmas for policymakers in emerging countries: should they accept higher exchange rates and reduced external competitiveness or resist them, perhaps by intervening in currency markets, so risking a loss of monetary control, excessive credit growth, inflation and financial disorder? Finally, evidence of slowing underlying growth has emerged. Further structural reforms are needed. Part II - 'The Shifts' - examines how the world economy got here. What created the fragility that finally turned into such huge financial and economic shocks? If we are to do better in future, we have to understand the roots of what went wrong. Chapter Four, the first chapter in Part II, focuses on financial fragility. Why did core parts of the financial system disintegrate? Was this because of inherent weaknesses in the financial system? Was it because of specific policy errors, before and during the crisis? Were the mistakes in handling the crisis, as some argue, even more important than those made before the crisis? All these views turn out to be partially correct. The chapter will analyse what makes financial systems inherently fragile. It will then look closely at what made the financial system particularly fragile, prior to 2007. It will examine the growth of 'shadow banking', the increase in financial complexity and interconnectedness, the role of 'moral hazard', and the responsibilities of governments in handling crises. It will also argue that important mistakes were made in understanding the limitations of inflation targeting in managing economies. Yet - Chapter Five will add - 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. A crucial aspect of this was the rise of the global imbalances, with emerging economies deciding to export capital to advanced countries that the latter proved unable to use effectively. After the Asian crisis, global real interest rates fell to exceptionally low levels. This triggered an asset-price boom that then turned into a bubble. But also important in forming the savings glut was the changing distribution of income between capital and labour and among workers. The chapter will argue that popular alternative explanations of the macroeconomic causes of the crisis - loose monetary policy, in particular - confuse results with causes. Behind the rising imbalances and the associated savings glut lay fundamental shifts in the world economy driven by liberalization, technology and ageing, and revealed in globalization, rising inequality and weak investment in high-income economies. Chapter Five will also look at how the combination of the credit bubble with the savings glut and the underlying design flaws drove the Eurozone into such a deep crisis. It will argue that one must understand the interaction of five elements: errors in design; errors in policymaking among creditor and debtor countries prior to the crisis; the fragility of finance, notably the banking system in Eurozone countries; mistakes of monetary policy; and failures to work out effective ways of dealing with the crisis when it hit. As a result, the risks of breakdown remain significant, with devastating potential effects on the economic stability of the continent. Part III - 'The Solutions' - then looks at where we should be going. The salient characteristic of the response to the crisis was to do barely the minimum needed to 'put the show back on the road'. This is true of macroeconomic policy. It is true of financial sector reform. And it is also true of reform of the Eurozone. All this is understandable. But it is not good enough. It makes it almost certain that the recovery will be too weak and unbalanced and that still bigger crises will emerge in future. Chapter Six, the first chapter in Part III, will take up the search for better economic ideas. The crisis has revealed deep misunderstandings of the way the modern economy works that resulted in huge policy mistakes, both before and, in the case of fiscal policy, also after the crisis. It is necessary to ask how much of the orthodox economics of the past few decades holds up in the light of events. Were the Austrian economists or the post-Keynesians closer to the truth than orthodox economists who ran central banks and advised treasuries? The answer will be that the heterodox economists were indeed more right than the orthodox. The challenge for economics is large and the need for experimentation strong. Some argue that we need to move back to the gold standard. The chapter will show that this is a fantasy. But the issue of the link between money and finance is central and must be addressed. Chapter Seven will look at how to achieve a better financial system. It will start from the reforms that are now being undertaken and ask whether they will be sufficient to generate a secure future. The discussion will then look at further possible reforms, including much higher capital requirements and proposals to eliminate 'fractional reserve banking' altogether. The discussion will conclude by arguing that further radical reform is essential, because the current financial system is inherently dependent on the state. That creates dangerous incentives, ultimately quite likely to destroy the solvency of states. A particularly important aspect of the frailty of finance is its role in generating property bubbles. The leveraging up of the stock of land is a consistently destabilizing phenomenon. Chapter Eight will then turn to the search for a better economy, both domestic and global. The starting point must be how to achieve a more vigorous and better-balanced recovery. There should have been much stronger monetary and, particularly, fiscal support for the recovery. The failure to do this will cast a long shadow over economic prospects. Policymakers made a big mistake in 2010 when they embraced austerity prematurely. But there are important longer-term constraints on achieving a return to pre-crisis rates of growth and balancing demand and supply without resort to another destabilizing credit and asset-price bubble. The obvious solutions are a big expansion of investment and net exports. Yet there are obstacles to both. The world economy needs to be sustainably rebalanced, with capital flowing from developed to emerging countries on a large scale. The chapter will explain how this might be done and why it will be so difficult. It will require reforms of the global monetary system. Among other things, there is a strong case for generating a new reserve asset that would make far less necessary the mercantilist policies of emerging economies. But if that is impossible, as seems likely, and the high-income countries are unable to generate an investment boom, the latter may have to consider radical reforms of monetary arrangements, including direct monetary financing of budget deficits. Chapter Nine, the last in Part III, will examine the search for a reformed Eurozone. Today, the Eurozone confronts an existential challenge. It has to decide either to break up, in whole or in part, or to create a minimum set of institutions and policies that would make it work much better. Dismantling the Eurozone is conceivable, but it would create a huge financial, economic and political mess in at least the short to medium term. The mess would stretch into the far distant future if dismantling the Eurozone led to the unravelling of the entire project for European integration. The alternative reforms will have to include more effective support for countries in temporary difficulties, a degree of fiscal federalism, greater financial integration, a more supportive central bank and mechanisms for ensuring symmetrical adjustment of competitiveness. Without such changes the Eurozone will never work well, and even with them it may still not survive in the long term. Finally, the Conclusion will return to what this crisis means for the world. It will argue that this is a turning point. Fundamental reforms are needed if we are to achieve greater stability. We will need both more globalization and less - more global regulation and cooperation, and more freedom for individual countries to craft their own responses to the pressures of a globalizing world. There are huge long-term tasks in maintaining the supply of global public goods - a stable world economy, peace and, above all, management of huge global environment challenges - as the world integrates and develops. Yet these challenges will not be met if we do not first overcome the legacy of the crisis. Moreover, all this must be managed at a time of transition in global power and responsibility from a world dominated by Western powers to one in which new powers have arisen. WHY THE SHOCKS MATTER What makes this analysis important? The answer is that the financial and economic crises of the West have changed the world. They change what is happening, how we should think about what is happening, and what we should do about it. Let's start with the obvious point. The world economy turned out to be very different from what most people imagined in 2007. Economies that were deemed vigorous have turned out to be sickly. In all the important high-income countries, output had remained far below previous trends and the rate of growth is mostly well below what had previously been considered its potential. Levels of activity were still below pre-crisis peaks in a number of important countries in 2013, notably France, Italy, Japan and the UK. Moreover, unemployment rates were elevated and persistent. The concern that something similar to the lengthy Japanese economic malaise was about to hit a number of high-income countries had, alas, grown more credible. Maybe the outcome would be even worse than in Japan: on balance, it has been, so far. Meanwhile, emerging countries mostly recovered vigorously. They did so, in part, by replacing the external demand they had lost with domestic stimulus. This worked in the short run, remarkably so in China. But such action could leave a difficult legacy in the form of low-quality investments, asset-price bubbles and bad debts, and might, for such reasons, prove unsustainable. At the same time, the emerging countries could not return to the strategies of export-led growth-cum-reserve accumulation followed by many of the most successful among them prior to the crisis. The weakness of private demand within high-income countries has precluded that and, in particular, the loss of creditworthiness by many households. In all, the legacy of the crises includes deep practical challenges to policymaking almost everywhere. As a result of these unexpected economic developments, crisis-hit countries have been forced to struggle with worse fiscal positions than they had previously imagined. As the work of Carmen Reinhart and Kenneth Rogoff, both now at Harvard University, has shown, fiscal crises are a natural concomitant of financial crises, largely because of the impact on government revenue and spending of declining profits and economic activity, together with rising unemployment. These come on top of the direct fiscal costs of bank bailouts.7 As was to be predicted, in the current crisis the biggest adverse fiscal effects were felt in countries that suffered a direct hit from the financial crises, such as the US, the UK, Ireland and Spain, rather than in countries that suffered an indirect hit, via trade. Worse still, the longer-term fiscal position of the crisis-hit countries was always likely to be difficult, because of population ageing. Now, the legacy of the crisis has sharply curtailed the room for manoeuvre. Along with the fiscal impact has come a huge monetary upheaval. In today's credit-based system, the supply of money is a by-product of the private creation of credit. The central banks regulate the price of money, while the central bank and government in concert ensure the convertibility of deposit money into government money, at par, by acting as a lender of last resort (in the case of the central bank) and provider of overt or covert insurance of liabilities (in the case of the government). However, because this financial crisis has been so severe, central banks went far beyond standard operations. They not only lowered their official intervention rates to the lowest levels ever seen, but enormously expanded their balance sheets, with controversial long-term effects. The most obvious of all the changes is the transformed position of the financial system. The crisis established the dependence of the world's most significant institutions on government support. It underlined the existence of institutions that are too big and interconnected to fail. It confirmed the notion that the financial system is a ward of the state, rather than a part of the market economy. It demonstrated the fragility of the financial system. As a result of all this, the crisis inflicted huge damage on the credibility of the market-oriented global financial system and so also on the credibility of what is often called 'Anglo-Saxon financial capitalism' - the system in which financial markets determine not only the allocation of resources but also the ownership and governance of companies. One consequence is that the financial system has been forced through substantial reform. Another is that a debate about the proper role and structure of the financial industry became inescapable. Yet another is that the willingness of emerging economies to integrate into the global financial system was reduced. As a result of the crises, the established high-income countries suffered a huge loss of prestige. These countries, above all the US, though counting for a steadily smaller share of the world's population, remained economically and politically dominant throughout the post-Second World War era. This was partly because they had the largest economies and so dominated global finance and trade. It was also because they controlled global economic institutions. 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. These crises also accelerated a transition in economic power and influence that was already under way. Between 2007 and 2012, the gross domestic product of the high-income countries, in aggregate, rose by 2.4 per cent, in real terms, according to the International Monetary Fund, with that of the US rising by 2.9 per cent and that of the Eurozone falling by 1.3 per cent. Over the same period, the real GDP of the emerging countries grew by 31 per cent and those of India and China by 39 and 56 per cent respectively. Such a speedy transformation in relative economic weight among important countries has no precedent. It is plausible that China's economy already is the biggest in the world, at purchasing power parity, in the middle of this decade, and will be the biggest in market prices by the early part of the next decade. The crisis has accelerated the world economy towards this profound transition. The coincidence of a huge financial and economic crisis with a prior transformation in relative economic power also occurred in the 1930s. The rise of the US as a great economic power in the early twentieth century and the overwhelming strength of its balance of payments after the First World War helped cause both the scale of the global economic crisis and the ineffectiveness of the response in the 1930s. This time, between 2007 and 2012, the rise of China, a new economic superpower, was among the explanations for the global imbalances that helped cause the crises. Fortunately, this did not thwart an effective response. In future, the world may not be so fortunate. Transitions in global power are always fraught with geo-political and geo-economic peril because the incumbent ceases to be able to provide the necessary political and economic order and the rising power does not see the need to do so. The crises have generated, in addition, fundamental challenges to the operation of the global economy. Among the most important features of the pre-crisis global economy - indeed, one of the causes of the crisis itself - were huge net flows of capital from emerging economies into supposedly safe assets in high-income countries. The governments of emerging countries organized these flows, largely as a result of intervention in currency markets and the consequent accumulations of foreign-currency reserves, which reached $11.4tn at the end of September 2013, quite apart from over $6tn in sovereign wealth funds.8 The recycling of current-account surpluses and private-capital inflows into official capital outflows - described by some as a 'savings glut' and by others as a 'money glut' - was one of the causes of the crisis. These flows are certainly unsustainable, because high-income countries have proved demonstrably unable to use the money effectively. The crisis has, in this way, too, changed the world: what was destabilizing before the crisis became unsustainable after it.9 Furthermore, the globalization of finance is also under threat. The reality is that economies have become more integrated, but political order still rests on states. In the case of finance, taxpayers bailed out institutions whose business was heavily abroad. Similarly, they were forced to protect financial businesses from developments abroad, including those caused by regulatory incompetence and malfeasance. This is politically unacceptable. Broadly, two outcomes seem possible: less globalized finance or more globalized regulation. This dilemma is particularly marked inside the Eurozone, as Adair (Lord) Turner, chairman of the UK's Financial Services Authority, has noted. This is because financial markets are more integrated and the autonomy of national policy is more limited than elsewhere.10 In practice, the outcome in Europe is likely to be some mixture of the two. The same is also true for the world as a whole, where tension arises between a desire to agree at least a minimum level of common regulatory standards and a parallel desire to preserve domestic regulatory autonomy.11 Such pressure for 'de-globalization' may not be limited to finance. 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. Inevitably, the legacy of the crises includes large-scale institutional changes in many areas of policy, at national, regional and global levels. The obvious areas for reform are financial regulation, the functioning of monetary systems, global governance and global economic institutions. Reforms are under way. But big questions remain unaddressed and unresolved, notably over global monetary and exchange rate regimes. A revealing step, taken early in the crisis, was the shift from the group of seven leading high-income countries as the focus for informal global decision-making to the group of twenty - a shift that brought with it an increase in relevance at the price of a reduction in effectiveness. This is just one aspect of the complications created by the need to take account of the views and interests of more players than ever before. Whatever happens at the global level, the crises created an existential challenge for the Eurozone and so for the post-Second World War European 'project'. The Eurozone might still lose members, though the chances of that have much reduced since the worst of the crisis. Such a reversal would imperil the single market and the European Union itself. It would mark the first time that the European project had gone backwards, with devastating consequences for the prestige and credibility of this idea. Worst of all, such a breakdown would reflect - and exacerbate - a breakdown in trust among the peoples and countries of Europe, with dire effects on their ability to sustain a cooperative approach to the problems of Europe and act effectively in the wider world. Fortunately, policymakers understand these risks. Yet even if everything is resolved, as seems likely, Europe will remain inward-looking for many years. If everything were not resolved, the collapse of the European model of integration would shatter the credibility of what was, for all its faults, the most promising system of peaceful international integration there has ever been. 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. This poses an uncomfortable challenge for economics and a parallel challenge for economic policymakers - central bankers, financial regulators, officials of finance ministries and ministers. It is, in the last resort, ideas that matter, as Keynes knew well. Both economists and policymakers need to rethink their understanding of the world in important respects. The pre-crisis conventional wisdom, aptly captured in Mr Bernanke's speech about the contribution of improved monetary policy to the 'great moderation', stands revealed as complacent, indeed vainglorious. The world has indeed changed. The result is a ferment of ideas, with many heterodox schools exerting much greater influence and splits within the neoclassical orthodoxy. This upheaval is reminiscent of the 1930s and 1940s and, again, of the 1970s. The opportunity of securing a more prosperous and integrated global economy surely remains. But the challenge of achieving it now seems more intractable than most analysts imagined. In the 1930s, the world failed. Will it do better this time? I fervently hope so. But the story is not yet over. As Dorothy says in The Wizard of Oz, 'Toto, I've a feeling we're not in Kansas any more.' PART ONE The Shocks Prologue The financial and economic crises of the Western world became visible in the summer of 2007 and reached their apogee in the autumn of 2008. The response was an unprecedented government-led rescue operation. That, in turn, triggered an economic turn-around in the course of 2009. But the recovery of the high-income countries was, in general, disappointing: output remained depressed, unemployment stayed elevated, fiscal deficits remained high, and monetary policy seemed, by conventional measures, unprecedentedly loose. This is beginning to look like a Western version of Japan's prolonged post-bubble malaise. One reason for persistent disappointment is that the Western crisis became, from 2010 onwards, also a deep crisis of the Eurozone. Crisis dynamics engulfed Greece, Ireland, Portugal, Spain and even Italy. All these countries were pushed into deep recessions, if not depressions.1 The price of credit remained high for a long time. By early 2013, the sense of crisis had abated. But chronic economic malaise continued, with no certainty of a strong recovery or even of enduring stability. Meanwhile, emerging economies, in general, thrived. The worst hit among them were the countries of Central and Eastern Europe, many of which had run huge current-account deficits before the crisis. Like the members of the Eurozone in Southern Europe, these were then devastated by a series of 'sudden stops' in capital inflows. Other emerging and developing countries proved far more resilient. This was the result of a big improvement in policy over the previous decades. Particularly important was the move towards stronger external positions, including a massive accumulation of foreign-exchange reserves, particularly by Asian emerging countries, notably including China. This gave them the room to expand domestic demand and so return swiftly to prosperity, despite the crisis. Those emerging and developing countries that could not expand demand themselves were often able to piggyback on the stimuli of others, particularly China. That was particularly true of the commodity exporters. This represents an important - and probably enduring - shift in the world economy: the old core is becoming more peripheral. But the sustainability of the expansionary policies adopted by emerging economies, and so their ability to thrive while high-income countries continue to be weak, is in doubt. Particularly important is the risk of a sharp slowdown in the Chinese economy and the likely associated weakness of commodity prices. 1 From Crisis to Austerity The central problem of depression-prevention [has] been solved, for all practical purposes, and has in fact been solved for many decades. Robert E. Lucas, 20031 When I became Treasury secretary in July 2006, financial crises weren't new to me, nor were the failures of major financial institutions. I had witnessed serious market disturbances and the collapses or near collapses of Continental Illinois Bank, Drexel Burnham Lambert, and Salomon Brothers, among others. With the exception of the savings and loan debacle, these disruptions generally focused on a single organization, such as the hedge fund Long-Term Capital Management in 1998. The crisis that began in 2007 was far more severe, and the risks to the economy and the American people much greater. Between March and September 2008, eight major US financial institutions failed - Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual, and Wachovia - six of them in September alone. And the damage was not limited to the US. More than 20 European banks, across 10 countries, were rescued from July 2007 through February 2009. This, the most wrenching financial crisis since the Great Depression, caused a terrible recession in the US and severe harm around the world. Yet it could have been so much worse. Had it not been for unprecedented interventions by the US and other governments, many more financial institutions would have gone under - and the economic damage would have been far greater and longer lasting. Hank Paulson, On the Brink (2010)2 Hank Paulson is a controversial figure. For many Americans, he is the man who bailed out Wall Street too generously. For others, he is the man who failed to bail out Wall Street generously enough. In his thought-provoking book, Capitalism 4.0, the British journalist Anatole Kaletsky blames him for the disaster, writing that 'the domino-style failure of US financial institutions that autumn [of 2008] was not due to any worsening of economic conditions - it was simply a consequence of the US Treasury's unpredictable and reckless handling first of Fannie and Freddie, then of Lehman, and finally of AIG.'3 Whatever we may think of Mr Paulson's culpability, we cannot deny his outline of what actually happened in 2007 and 2008. In this chapter, I will not attempt a detailed account of how the crisis that hit the core high-income countries in those years unfolded. That has been done in other publications.4 My aim here is rather to demonstrate its scale, the extraordinary policy response and the economic aftermath. I will postpone detailed discussion of the economic and financial origins of the crisis to Part II of the book and analysis of the very different impact upon emerging and developing countries to Chapter Four. By focusing on the high-income countries, I want to show that this was no ordinary economic event. To pretend that one can return to the intellectual and policymaking status quo ante is profoundly mistaken. THE SCALE OF THE CRISIS The world economy of the 2000s showed four widely noticed and, as we shall see, closely related characteristics: huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably including the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain. Many observers doubted whether this combination could continue indefinitely. The questions were: when would it end, and would it do so smoothly, bumpily or disastrously? The answers, it turned out, were: in 2007 and 2008, and disastrously. Already in March 2008, I assessed the unfolding crisis as follows: What makes this crisis so significant? It tests the most evolved financial system we have. It emanates from the core of the world's most advanced financial system and from transactions entered into by the most sophisticated financial institutions, which use the cleverest tools of securitisation and rely on the most sophisticated risk management. Even so, the financial system blew up: both the commercial paper and inter-bank markets froze for months; the securitized paper turned out to be radioactive and the ratings proffered by ratings agencies to be fantasy; central banks had to pump in vast quantities of liquidity; and the panic-stricken Federal Reserve was forced to make unprecedented cuts in interest rates.5 Far worse was to follow in the course of 2008. This crisis had become visible to many observers on 9 August 2007, when the European Central Bank injected €94.8bn into the markets, partly in response to an announcement from BNP Paribas that it could no longer give investors in three of its investment funds their money back.6 This event made it clear that the crisis would not be restricted to the US: in the globalized financial system, 'toxic paper' - marketed debt of doubtful value - had been distributed widely across borders. Worse, contrary to what proponents of the new market-based financial system had long and, alas, all too persuasively argued, risk had been distributed not to those best able to bear it, but to those least able to understand it.7 Examples turned out to include IKB, an ill-managed German Landesbank, and no fewer than eight Norwegian municipalities.8 These plucked chickens duly panicked when it became clear what, in their folly, they had been persuaded to buy. On 13 September 2007, Northern Rock, a specialized UK mortgage-lender, which had been offering home loans of up to 125 per cent of the value of property and 60 per cent of whose total lending was financed by short-term borrowing, suffered the first large depositor 'run' on a British bank since the nineteenth century.9 Ultimately, the Labour government nationalized Northern Rock - paradoxically, very much contrary to the company's wishes. Reliance on short-term loans from financial markets, rather than deposits, for funding of long-term illiquid assets had, it soon turned out, become widespread. This was also a dangerous source of vulnerability, since explicit and implicit insurance had made deposits relatively less likely to run than market-based finance. That lesson proved of particular importance for the US, because of the scale of market-based lending in the funding of mortgages. As managing director of the huge California-based fund manager PIMCO (the Pacific Investment Management Company), Paul McCulley in 2007 labelled this the 'Shadow Banking System' when he spoke in Jackson Hole, Wyoming, at the annual economic symposium of the Federal Reserve Bank of Kansas City. The label stuck.10 Both these lessons - the widespread distribution of opaque securitized assets (the bundling of debts into marketable securities) and the reliance of so many intermediaries on funding from wholesale markets - turned out to have great relevance as the crisis worsened in 2008. Then, on 16 March 2008, the Financial Times reported: 'JP Morgan Buys Bear Stearns for $2 a Share'.11 The Federal Reserve provided backup funding of $30bn for this operation, taking some of the credit risk in the process. Just a year before that calamity the Financial Times had reported: 'Bear Stearns yesterday became the latest Wall Street bank to report strong earnings and insist that it does not see much lasting impact from the crisis in the subprime mortgage market.'12 It would say that, wouldn't it? But the likelihood is that its management, along with almost everybody else, did not imagine the horrors to come. They were probably more fools than knaves. The rescue prompted me to write in the Financial Times of 25 March 2008: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that 'I no longer believe in the market's self-healing power'. Deregulation has reached its limits.13 The US government took the two government-sponsored enterprises, Fannie Mae and Freddie Mac, which then guaranteed three-quarters of US mortgages, into 'conservatorship' on 7 September. This proved what investors (and critics) had long believed, namely, that the US government stood behind the vast borrowings of these allegedly private companies ($5,400bn in outstanding liabilities at the time of the rescue).14 Yet it then, controversially, allowed (or felt obliged to allow) Lehman Brothers to go bankrupt on 15 September.15 Merrill Lynch was sold to Bank of America for $50bn, or $29 a share, on the same day - a big premium above its share price of $17, but a reduction of 61 per cent on its share price of $75 a year before and 70 per cent from its pre-crisis peak.16 Then, promptly after refusing to rescue Lehman, the US government saved the insurance giant, AIG, taking a 79.9 per cent equity stake and lending it $85bn on 16 September.17 In his book, Mr Paulson argues that the decisions were not inconsistent, because, 'Unlike with Lehman, the Fed felt it could make a loan to help AIG because we were dealing with a liquidity, not a capital, problem.'18 If the Fed really believed that, it was soon proved wrong. A more likely reason is that Mr Paulson believed (wrongly, as it turned out) that the markets would take Lehman's failure in their stride, but was sure the same would not be true for AIG, given its role as a seller of 'credit default swaps' - insurance contracts on bonds, including the securitized assets that had become increasingly toxic. Then, on 17 September, one of the money-market funds managed by Reserve Management Corporation (a manager of mutual funds) 'broke the buck' - that is, could no longer promise to redeem money invested in the fund at par (or dollar for dollar) - because of its exposure to loss-making loans to Lehman. That threatened a tsunami of redemptions from the $3.5tn invested in money-market funds, a crucial element in funding McCulley's 'Shadow Banking System'.19 PriceWaterhouseCoopers, the UK's bankruptcy administrator for Lehman, seized the failed company's assets in the UK, including the collateral of those who traded with it.20 This came as a shock to many hedge funds and US policymakers. The fact that bankruptcy regimes were different in different countries - obvious, one would have thought - turned out to be a significant problem in dealing with the aftermath of Lehman's failure. As Mervyn (later Lord) King, governor of the Bank of England, famously quipped: banks were 'international in life, but national in death'.21 Funding for Morgan Stanley and Goldman Sachs, the two surviving broker-dealers, dried up.22 On 21 September these two institutions turned themselves into bank holding companies, a change that gave them access to funds from the Federal Reserve.23 On 25 September the Federal Deposit Insurance Corporation took over Washington Mutual, the sixth largest bank in the US.24 Not long afterwards, on 9 October, Wells Fargo, the country's fifth largest commercial bank, agreed to a takeover of Wachovia, the country's fourth largest.25 The mayhem was not restricted to the US. On the weekend before the Lehman bankruptcy, the UK government refused to support the takeover mooted by Barclays. As Alistair Darling, then chancellor of the exchequer, claims in his memoir, 'we could not stand behind a US bank that was clearly in trouble'. Why, indeed, should the UK government provide guarantees that the US government had rejected? Moreover, he adds, 'I was determined that UK taxpayers would not end up having to bail out a US bank.'26 On 17 September, with government encouragement, Lloyds TSB announced a £12.2bn takeover of Halifax Bank of Scotland (HBOS). The government argued that the public interest justified clearing the deal, despite concerns over its adverse impact on competition, in order to 'ensure the stability of the UK financial system'.27 On 29 September the government decided to nationalize Bradford & Bingley, the biggest lender in the UK's 'buy-to-let' market, while its branch network was subsequently sold to Santander.28 Worse, it was becoming obvious that HBOS was too bad a bank for Lloyds to support unaided. Furthermore, the Royal Bank of Scotland (RBS), which had become the biggest bank in the world by assets, partly as a result of ill-considered takeovers, notably of ABN-Amro, was also in terrible trouble. The crisis went far beyond the US and the UK, affecting Iceland, Ireland and much of continental Europe. As the panic worsened, credit markets froze and assets were dumped, causing a vicious spiral of shrinking availability of credit to speculators and so further forced sales.29 The economic consequences turned out to be less severe than those of the Great Depression of the 1930s, but the financial crisis was even worse. The earlier crisis brought down banks on the periphery of the world economy (a huge number of smaller US banks and banks in vulnerable European countries, such as Austria and Germany) more than those at the core. The more recent crisis, however, tore apart the heart of the financial system: the networks connecting the big financial institutions that dominate activity in the world's two most important financial centres, New York and London. The private sector also ceased to trust almost all counterparties other than the governments and central banks of the most important and most unimpeachably creditworthy Western economies, first and foremost the US. This, then, was what Latin American economists call a 'sudden stop' in capital markets. It affected not just a range of private borrowers, but also sovereign governments whose banks had borrowed heavily in foreign currency:30 Iceland was quickly revealed as a salient example, but the same would soon prove to be true of weaker members of the Eurozone, who were, it soon became clear, borrowing something that had many of the characteristics of a foreign currency.31 One of the paradoxical features of the crisis was that the frightened money of the world flowed into US Treasury bonds and bills (shorter-term securities), even though, at least initially, the crisis had its epicentre in that country. That, of course, gave the US government an enormous margin of manoeuvre. John Taylor, a conservative economist and former member of the administration of George W. Bush as undersecretary of the treasury for international affairs, argues that it was not the decision to let Lehman fail that triggered this stop, but the decision by Chairman Bernanke and Secretary Paulson to approach Congress for a rescue package a week later.32 This is quite unpersuasive. As Thomas Ferguson of the University of Massachusetts and Robert Johnson, former chief economist of the US Senate banking committee, note, 'the evidence that the Lehman bankruptcy sundered world markets is overwhelming'.33 A fundamental indicator is the spread between three-month Libor (the rate at which banks can borrow from one another) and the Overnight Indexed Swap rate (the implied central-bank rate over the same three-month period). While traders at certain banks have distorted the measurement of Libor, no reason exists to doubt the scale of the rise in spread shown in Figure 1. This is a measure of the credit risk - the risk of default, in other words - on unsecured interbank lending (the process by which banks make short-term loans to one another out of surplus funds).34 In normal times, the spread between the two rates had been just a few basis points (hundredths of a percentage point). The spread on dollar lending had already reached 78 basis points by the end of August 2008, as worries about the solvency of counterparties rose. It rose by another 40 basis points between the Friday before Lehman's bankruptcy (12 September) and the following Friday - so before the US government's rescue package was officially launched, let alone ratified. But it did take a while for investors to realize some of the least obvious implications of Lehman's failure, including implications for AIG and so other financial institutions. The spread reached a peak of 364 basis points on 10 October 2008, precisely when the group of seven finance ministers made a commitment to prevent the failure of further systemically significant financial institutions. Ultimately, therefore, only decisive and globally coordinated intervention by governments and central banks halted the panic. Similar jumps occurred in spreads in other currencies. In sterling, the spread peaked at 299 basis points on 6 November 2008. In euros, it peaked at 189 basis points on 27 October 2008. Even these jumps in spreads understate the panic: the market for interbank lending dried up, as banks increasingly lent to one another via central banks instead. Spreads on corporate bonds over yields on US treasuries also exploded. Even on triple-A securities they rose from 181 basis points on 1 September 2008 to 414 basis points on 10 October. The spreads between yields on high-grade commercial paper (the marketed debt of top-quality corporations, such as General Electric) issued by non-financial companies and US Treasury bills rose from little more than a percentage point in August to over 6 percentage points in mid-October, partly because the rates on T-bills collapsed. This was a flight to safety, indeed. Moreover, as is usually the case, such jumps in the cost of borrowing masked a grimmer reality - a freezing of supply. Mr Paulson reports a conversation he had on 8 September with Jeff Immelt, Chief Executive Office of GE, who told him that even his company, with its rare triple-A rating, 'was having problems selling commercial paper' (that is, borrowing):35 interest rates did not go still higher because so many borrowers were rationed out of the market, just as happened in the market for unsecured interbank lending. Particularly revealing, then, is the permanent shrinkage of the commercial paper market, even though rates of interest did fall back to very low levels in the course of 2009. The seasonally adjusted value of commercial paper outstanding in the US was $2,150bn at the end of June 2007.36 A year later, this had shrunk to $1,741bn. A year after that, in June 2009, it was down to $1,229bn. It had still not recovered in June 2013, when the outstanding amount was just $998bn. Asset-backed commercial paper, which is used to finance mortgages, shrank even more dramatically, from $1,200bn in June 2007, to $523bn two years later and a mere $276bn in June 2013. An important source of funding had disappeared. While this shrinkage was surely inevitable, it forced government agencies - Fannie Mae, Freddie Mac (both now under government control) and the Federal Reserve itself - to become the overwhelmingly dominant source of US mortgages. In a country supposedly dedicated to the ideals of market economics, arguably the most important social function of finance - lending for home purchase - had become almost completely nationalized. CRISIS AND RESCUE IN HIGH-INCOME COUNTRIES The Irish government guaranteed all the money in Irish banks on the morning of 30 September 2008 - a decision that turned out to be ruinous for Irish taxpayers and the Irish economy, but also triggered interventions elsewhere. On 8 October 2010 the British government, under Chancellor of the Exchequer Darling and Prime Minister Gordon Brown, announced a £500bn rescue programme for the UK banks - up to £50bn for purchases of equity, an increase in the Bank of England's 'special liquidity scheme' from £100bn to £200bn, and £250bn in credit guarantees.37 Ultimately, the equity went only to the Royal Bank of Scotland (in which the government ended up owning 82 per cent of the equity) and Lloyds HBOS (in which it ended up owning 43 per cent). Persuading the banks to cooperate was not, claims Mr Darling, at all easy. He states that, in the discussions on the evening of 7 October, 'It crossed my mind not only that the banks had failed to appreciate that there could be no negotiation, but also that they might be daft enough to take up the option of suicide - and I simply couldn't afford a row of dead banks in the morning.'38 Rightly or wrongly (rightly, in my view, since allowing the banks to fail was unthinkable, though some still believe it should have been done, regardless of the consequences), such direct infusions of equity became the central element in the solutions chosen elsewhere. The US reached a similar destination, though the complexities of US politics made the journey rather more difficult. US policymakers first discussed what became the Troubled Assets Relief Program (TARP) with legislators on 19 September 2008. The president ratified it on 3 October 2010, though only after initial defeat in the House of Representatives.39 But the collapse of the equity markets concentrated the minds of legislators wonderfully, to paraphrase Samuel Johnson. Initially presented as a plan to purchase 'toxic assets', it was soon turned into one of injecting capital directly into banks.40 The turning point came at the meeting of the group of seven finance ministers during the annual meetings of the International Monetary Fund and World Bank, in Washington DC on 10 October 2008. I well remember the hysteria. One US-based fund manager told me he had advised his wife to take enough cash from their bank to last weeks. This was the environment in which the ministers met. Their crucial decision - taken at the suggestion of Mr Paulson, to his credit - was to scrap the draft communiqué, which had taken no account of the scale of the crisis they confronted, and agree to a new one instead.41 What they then produced was among the most important pieces of global economic policymaking since the Second World War: The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to: Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure [my emphasis]. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public, as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high-quality accounting standards are necessary. In essence, then, the ministers said three things: first, responsibility for solving the financial crisis rested on the states they represented; second, the G-7 states would do whatever it took to save the financial system; and, third, they would prevent any more failures of institutions deemed systemic. In brief, no more Lehmans. Governments had socialized the liabilities of the core institutions of the global financial system. These businesses were now wards of the state. This had to be a turning point, not just in the crisis, but also in the broader relationship between states and markets. Morally, at least, and in all probability practically, the era of financial liberalization was over. The question was only how far backwards policymakers would go. For how could taxpayers be dragooned into rescuing this industry from the consequences of its incompetence, without stronger regulation? Beyond these longer-term implications, immediate questions arose: would the world economy avoid a depression? If it did, what sort of recovery could it enjoy? Policymakers put the full resources of their states behind the financial system. Bankers had proved to be, in effect, merely exceptionally highly paid civil servants. In brief, the world soon saw huge fiscal deficits, far and away the most expansionary policies in the history of the developed countries, unlimited support for the liquidity and solvency of important financial institutions and, where that was insufficient to revive lending, direct state-funding of core financial functions, notably mortgage lending. This dependence of a supposedly free-market financial system on the state can be neither forgotten nor ignored. Policymakers lived up to their promise to support what were judged systemically significant financial institutions, by injecting capital, providing liquidity and guaranteeing liabilities. Piergiorgio Alessandri and Andrew Haldane of the Bank of England have estimated that the total value of the support offered to the crisis-hit financial system by the relevant central banks and governments, as of mid- to late-2009, was 18 per cent of Eurozone GDP, 73 per cent of US GDP, 74 per cent of UK GDP and, taken together, 25 per cent of world GDP. The support was extremely heterogeneous in nature, consisting of direct capital infusions, money creation, used to purchase a wide range of different assets, guarantees and insurance.42 According to the International Monetary Fund, the direct impact on gross public debt of post-crisis support for the financial sector up to early 2012 was 38.5 per cent of GDP for Ireland, 6.7 per cent for Belgium, 5.7 per cent for the UK, 4.9 per cent for the Netherlands and 3.2 per cent for the US.43 Yet it is impossible to measure the scale of the measures either by the sums promised or by the far smaller sums used. The full faith and credit of governments were put behind their financial systems. The only constraint was loss of creditworthiness by the governments themselves. The central banks also slashed their interest rates to unprecedentedly low levels. The Federal Reserve lowered its 'federal funds target rate' (the 'Fed Funds' rate) from 5.25 per cent in September 2007 to 0.25 per cent in December 2008. The European Central Bank (ECB), convinced for far too long that the crisis was largely an 'Anglo-Saxon' affair, lowered its intervention rate (refinancing rate) from 4.25 per cent in October 2008 to 1 per cent by May 2009. It then, in an action of astonishing myopia, raised rates back to 1.5 per cent in 2011, before lowering them, in five quarter-point reductions, to 0.25 per cent in November 2013 and then to 0.15 per cent in June 2014. The Bank of England lowered its intervention rate (base rate) from 5.75 per cent in December 2007 to 0.5 per cent in March 2009. To put this in context, prior to this the lowest rate offered by the Bank of England in more than three centuries of history had been 2 per cent. Meanwhile, the Bank of Japan stuck with the close-to-zero interest rates it had established in the 1990s. In essence, then, the developed countries' most important central banks offered free or nearly free money to their banks from 2009 or, in some cases, from slightly earlier than that. It was little surprise that this official largesse to banks, not matched by comparable largesse from banks to their own borrowers - indeed accompanied by foreclosures on a grand scale in some countries - became a source of significant popular resentment. In addition, central banks adopted a wide range of 'unconventional' policies, including, notably, the policy known as 'quantitative easing' - expansion of the monetary base and central-bank purchases of longer-term assets.44 Such unconventional policies were aimed at financing banks, lowering yields on government bonds, increasing the money supply and easing credit supply. In domestic currency, the balance sheet of the ECB increased roughly threefold between 2007 and mid-2012, before shrinking modestly, while that of the Federal Reserve rose three and a half times and that of the Bank of England more than fourfold between 2007 and early 2013.45 To take the most important example, the US monetary base rose by $2.8tn between August 2008 and November 2013 - a sum equal to 17 per cent of annualized US gross domestic product in the third quarter of 2013. Finally, consider the fiscal support. Fiscal deficits of a number of significant high-income countries rose to unprecedented peacetime levels when the crisis hit. Among the six largest high-income countries (US, Japan, Germany, France, UK and Italy), these increases were particularly big for Japan, the UK and the US (see Figure 2). In the case of the US, the general government fiscal deficit soared from 2.7 per cent of GDP in 2007 to 13 per cent in 2009 - an astounding rise.46 A number of countries ran fiscal deficits at levels previously experienced only in world wars. In the case of the UK, for which excellent historical records exist, this event will deliver the fourth biggest cumulative rise in public debt relative to GDP since 1700, behind only the Napoleonic Wars and the First and Second World Wars. In the US, too, the fiscal costs of this event rival only those of the Second World War. What explains this huge increase in deficits? The answer, contrary to conventional wisdom on the political right in the US and the UK, is not, to any great extent, discretionary fiscal 'stimuli' (increases in spending or cuts in taxation designed to increase aggregate demand) - a term that, quite wrongly, became taboo. According to the IMF's November 2010 analysis, the cumulative discretionary fiscal stimulus of these countries between 2009 and 2011 was far smaller than their actual deficits, with one - probably surprising - exception: Germany. There, according to the IMF, the discretionary stimulus explained as much as 66 per cent of the admittedly modest average deficits of 2.8 per cent of GDP.47 Italy had no stimulus. In other cases, the discretionary stimulus explained at most a fifth of the actual deficits over these three years. In the UK, the discretionary stimulus, all of it applied in 2009, explained a mere 6 per cent of the deficits. The explanation for the explosion in fiscal deficits - an immensely helpful way to cushion the immediate impact of the collapse in private spending - was simply the unexpected crisis itself. This lowered GDP far below trend, automatically raised spending on unemployment benefits and similar counter-cyclical income support, and, even more important, lowered government revenue, as consumer spending, income and profits collapsed. In 2011, GDP was, quite unexpectedly, 13 per cent below a continuation of its 1980-2007 trend in both the US and the UK. In fact, it was a pity that a form of 'sticker shock' over the scale of the unexpected deficits frightened policymakers into not giving the discretionary fiscal support then needed and, subsequently, as we shall see further below, into premature retrenchment. Nobody should be surprised by the huge fiscal deterioration that followed the crisis. In their seminal book, This Time is Different, Carmen Reinhart and Kenneth Rogoff argue that: 'Declining revenues and higher expenditures, owing to a combination of bailout costs and higher transfer payments and debt service costs, led to a rapid and marked worsening in the fiscal balance.'48 In fact, they note from an analysis of crises in thirteen countries, the cumulative increase in real public debt was 86 per cent - close to a doubling.49 What happened after 2007 is in line with that prior experience. Indeed, with interest rates close to zero, the discretionary fiscal response needed to be far stronger: in such a deep crisis, relying almost entirely on the built-in stabilizers - by which is meant the counter-cyclical effect on the economy of the way fiscal deficits rise automatically in a recession - was insufficient, as the Nobel laureate Paul Krugman has argued in his powerful book, End this Depression Now!50 But, together with support for the financial system and the monetary policy response, the willingness to let the fiscal deficit take the strain was effective at least in halting the slide into a depression. RECOVERY IN THE BIG HIGH-INCOME COUNTRIES How successfully, then, did the policy interventions of the big high-income countries - the support for the financial system, the monetary loosening and the combination of the built-in fiscal stabilizers with modest discretionary stimulus - rescue the world economy? The answer is: fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned. The immediate impact of the crisis was dramatic: global trade, industrial output and gross domestic product all fell off a cliff, as confidence collapsed, demand shrank and credit, including trade credit, froze. World industrial output fell as fast in the first year after its April 2008 peak as during the Great Depression, which began in June 1929, and the volume of world trade and world equity markets initially fell even faster than then. Thus, the volume of world trade fell by close to 20 per cent in the twelve months from April 2008, against around 10 per cent over the twelve months from June 1929.51 Again, world equity markets fell by around 50 per cent over twelve months this time, against around 20 per cent in 1929-30. Fortunately, this time, strong policy action reversed the slide far sooner.52 The British historian Niall Ferguson was quite right to call this the 'Great Recession'.53 Between the third quarter of 2008 and the first quarter of 2009, the annualized rate of decline in GDP in the six largest high-income countries ranged from 6.4 per cent in France, 7 per cent in the UK and 7.1 per cent in the US, to 10.2 per cent in Italy, 11.7 per cent in Germany and 13.8 per cent in Japan. But, then, in the second quarter of 2009, the world economy started to turn around, diverging sharply from the disastrous experience of the Great Depression, when global output and trade fell for three years. We may, in our folly, have permitted the emergence of a financial crisis rivalling that of the 1930, but at least we did not repeat all the subsequent policy mistakes: the wave of banking collapses; the willingness to allow a collapse of money and credit; the toleration of a destructive deflation; and the determination to balance budgets, at once, 'to strengthen confidence'. Avoiding a collapse in economic activity comparable to that of the 1930s was a success, but a qualified one. Global industrial output had recovered to about 10 per cent above its pre-crisis peak by December 2011, though the volume of world trade was only modestly above its pre-crisis level. Above all, in the core high-income countries the crisis threw a long shadow over output and employment. (I leave aside the crises in smaller high-income countries to the discussion of the Eurozone crisis, in Chapter Two.) The six largest high-income economies all experienced deep recessions, with output reaching a trough in the first or second quarters of 2009 (see Figure 3). After that, the US experienced much the most sustained recovery. By the fourth quarter of 2013, US GDP was 7.2 per cent above its level in the first quarter of 2008. That was significantly better than Germany's 3 per cent. By then France and Japan were back to pre-crisis levels. The economies of the UK and, far more so, Italy were still smaller than they had been prior to the crisis, as was the Eurozone as a whole. The US economy had managed to grow steadily from 2009, if weakly, by its own historic standards. Germany recovered strongly in 2009 and 2010, but grew weakly again after the middle of 2011, as the Eurozone crisis worsened. German policy bears much responsibility for this outcome, as Chapter Two will show. The French economy stagnated after a relatively mild recession in 2008 and 2009, while Italy's went into a second deep plunge from 2011, as the Eurozone crisis took hold. The UK economy stagnated from the third quarter of 2010 to the beginning of 2013 when recovery started, this hiatus in the recovery being in part due to the coalition government's ill-timed policy of austerity.54 Finally, the Japanese economy was remarkably volatile. Another measure of the effectiveness of policy is what happened to employment and unemployment. The data on changes in the ratio of employees to people of working age tells one more than changes in rates of unemployment. When people cannot find work, they often leave the labour force. But the plight of people who no longer even look for work is often worse than that of those who are still searching. Figure 4 shows that the US experienced a huge decline in the proportion of people aged 15-64 with jobs between 2007 and 2012. In Germany, by contrast, the proportion with jobs actually rose, despite the recession. In 2007 the German employment ratio was nearly three percentage points lower than that of the US. Five years later, it was nearly six percentage points higher. The explanation for this divergence is that the US had soaring productivity, while Germany had falling productivity, particularly in the early years of the crisis. This contrast was partly because the US lost many jobs for relatively unskilled men in construction and partly because Germany subsidised short-time working to avoid layoffs.55 Underlying this contrast has been the rewards that US shareholders give executives for protecting profits in a downturn, at the price of laying off workers. German executives are not rewarded in the same way. Moreover, German corporate culture and institutions are very different from those in America. Particularly important is the division between the supervisory board, which includes worker representatives, and the executive board.56 How, then, does the outcome in crisis-hit, high-income countries compare with what might have been expected from previous financial calamities? Again, the work of professors Reinhart and Rogoff is illuminating. In This Time is Different, they argue 'the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points during the down phase of the cycle, which lasts on average more than four years. Output falls (from peak to trough) more than 9 per cent on average, although the duration of downturn, averaging roughly two years, is considerably shorter than that of unemployment.'57 Against such unhappy comparisons, the big high-income countries did relatively well. Only one, Japan, experienced a fall in GDP as large as the average indicated by Reinhart and Rogoff, at 9.2 per cent. The peak to trough fall of GDP was 4.3 per cent in France, 4.6 per cent in the US, 5.6 per cent in the Eurozone, 6.3 per cent in the UK, 6.8 per cent in Germany and 9.1 per cent in Italy (still falling in the third quarter of 2013). All these were grim statistics. Yet, even so, they were not as bad as the falls suffered, on average, in the earlier crises studied by professors Reinhart and Rogoff. Moreover, the declines were relatively brief. The troughs were reached in four or five quarters, whereupon a turnaround began. Similarly, the rise in unemployment was also far smaller than the average reported by Reinhart and Rogoff. The rise in the monthly unemployment rate from the pre-crisis trough, by May 2012, was highest in the US, at 5.6 percentage points. It was only 1.6 percentage points in Japan, 2.5 percentage points in France, 3.3 percentage points in the UK, and 4.3 percentage points in Italy. Germany's rise was just 0.9 percentage points in the early months of the crisis, but unemployment then fell to well below the pre-crisis rate. Even if the post-crisis performance of these economies was not dreadful by previous standards, the crisis proved painful and enfeebling. Why do financial crises do that? And why did the recovery stall or even go into reverse, in some cases? To answer those questions, we need to understand balance-sheet recessions. THE ECONOMICS OF POST-CRISIS DE-LEVERAGING Big financial crises cause painful recessions. Big financial crises that follow huge credit booms cause particularly painful recessions and long periods of weak growth. Professor Alan Taylor of the University of Virginia, a well-known economic historian, notes that 'a credit boom and a financial crisis together appear to be a very potent mix that correlates with abnormally severe downward pressures on growth, inflation, credit and investment for long periods'.58 At bottom, there are five things going on in post-crisis economies. First and most important, prior to the crash, unsustainable increases in private debt (the stock), or leverage (the ratio of the stock to wealth and income), had occurred within several economies. (See Figure 5 for the US, which goes up to the third quarter of 2013.) One can debate whether the levels of debt ended up too high, in all cases. One cannot reasonably debate whether the pre-crisis level of borrowing could be sustained: it could not be. It was rising debt - that is, continued net borrowing - that permitted some households and businesses to spend consistently more than their incomes. After the crisis, the debtors could no longer increase their debt: indeed, borrowing became negative, as they started to repay. So erstwhile borrowers were forced to lower their spending dramatically, willy-nilly. Meanwhile, creditors found that their wealth and incomes were lower or less certain (or, usually, both) than they had been before the crisis. So they did not want to spend more either. Bringing debt to sustainable levels is a long-term process: in an important study of post-crisis private-sector de-leveraging, the McKinsey Global Institute notes that this has taken between four and six years in previous cases, such as Finland and Sweden in the early 1990s.59 The second reason why the impact of a financial crisis is so prolonged is that the sustained rise in debt and associated spending distorts economies. Asset-price bubbles encourage excessive investment in, for example, housing and commercial property. When the crisis hits and the borrowing dries up, some part of that investment will be abandoned and the country's stock of physical capital will shrink. More important, the industries that provided the goods and services demanded by those undertaking the unsustainable spending will shrink, possibly dramatically. The most obvious example is the collapse in spending on construction in some crisis-hit countries. The incomes of bankers, commissions of estate agents (realtors, in American parlance), fees of lawyers, and so on and so forth, will also shrink. Furthermore, the weakness of the economy will itself slow potential growth (that is, the rate at which the capacity to produce itself grows), as investment remains subdued. Analysts have made substantial adjustments in estimates of the level and growth of potential output for many crisis-hit economies. In the UK, for example, in 2011 the Office of Budgetary Responsibility marked down forecast real potential output in 2017 by a massive 18 per cent below its pre-crisis trend.60 The third reason why post-crisis economies are so weak is the adverse impact on the financial sector. Overloaded with bad debt and under-capitalized, financial institutions become far more cautious. Regulation tends to encourage such caution. Banks cease to lend. This forces further de-leveraging on the rest of the economy. Moreover, banks automatically create money as a by-product of their normal lending (a point explained in full in Chapter Six below). That is a fundamental characteristic of banks. When they lend, they create a debt from their client to the bank and, simultaneously, a debt from the bank to the client. This is just double-entry bookkeeping. A debt from a bank to a client is a deposit and a deposit is money. So the growth of the stock of money in the hands of the public declines when the growth of bank lending falls. The fourth reason why post-crisis economies are weak is that inflation may become too low or, worse, deflation may set in. Deflation, or falling prices, creates the danger of what the great American economist Irving Fisher called 'debt deflation' in the 1930s - rising real level of debt and debt service within a collapsing economy.61 Such debt deflation is already, alas, in progress in parts of the Eurozone. Yet deflation is not only dangerous because of what it does to the real burden of debt; it is also dangerous if it pushes the real rate of interest too high. Equilibrium real interest rates may become strongly negative in a highly leveraged, crisis-hit economy. But with deflation, the real interest rate will be positive even if the nominal rate that the central bank controls is brought down as low as zero. Moreover, longer-term rates will then be higher than short-term rates, because of what Keynes called 'liquidity preference': thus, if short-term and long-term rates were both zero, the owner of bonds would be forgoing the benefits of holding a liquid and riskless asset - money - for no compensating return. As a result, in a deflationary environment, it is even harder to make long-term real rates negative than short-term ones. In these conditions, therefore, deflation or even low inflation may prove highly contractionary for the economy. Deflation has created notoriously prolonged difficulties for Japan, which suffered a massive post-credit-boom crisis in the 1990s. Japanese consumer prices then fell for more than two decades. As a result, Japan has suffered persistently positive real interest rates, even though the official short-term rate has been either close to zero or actually zero since the mid-1990s, while the long-term rate has been below 2 per cent since 1999 and even below 1 per cent since late 2011. This is why the 'first arrow' of Prime Minister Shinzo Abe's 'Abenomics' has consisted of achieving an inflation target of 2 per cent agreed between the government and the Bank of Japan in early 2013.62 Big difficulties may even arise in a low-inflation environment, rather than in a deflationary one if equilibrium real interest rates fall low enough. With inflation at 2 per cent, for example, the real short-term interest rate cannot be less than minus 2 per cent if one ignores the extreme possibility of negative nominal rates (which are feasible up to a point, though tricky to impose). Therefore, some economists, including Olivier Blanchard, chief economist of the International Monetary Fund, have argued that the now customary 2 per cent inflation target turned out to be too low in the crisis: thus, with short-term equilibrium rates possibly as low as minus 3 to minus 5 per cent in badly hit economies, inflation needed to be closer to 4 per cent in normal times.63 Finally, economies may end up in a state of sustained malaise. As John Maynard Keynes argued, this paralyses what he called the 'animal spirits' of businesses.64 That, then, may create a vicious spiral: low investment means weak demand and low economic growth, and so justifies the decision to postpone investment. In the post-crisis world, the reasons for people to feel uncertain and act cautiously are legion. Populist politics is one source of uncertainty, notably in the US with the rise of the Tea Party. More important are weak and volatile demand and continued financial fragility. The overall impact of such a crisis, therefore, is some weakening of supply, relative to its pre-crisis trend, but, even more, a weakening of demand relative to the weakened supply. The danger is a prolonged period of what Richard Koo of Nomura Research calls 'balance-sheet recession', in which the debt-encumbered private sector either tries, or is forced, to lower its debts - or, at the least, is unwilling or unable to increase them.65 What happened after the crisis to US sectoral balances - the balance between income and spending of households, corporations, the government and foreigners - offers a classic picture of an economy going into such a balance-sheet recession. Foreigners have run a surplus with the US for a long time and continued to do so, on a slightly smaller scale, following the crisis. US households ran a growing financial deficit (or excess of spending over income) up to 2005, as they borrowed ever more against the rising value of their houses. But this deficit began to shrink as soon as the house-price bubble popped in 2006. That was predictable. Between the third quarter of 2005 and the second quarter of 2009, the financial balance of US households - the relationship between income and spending - shifted towards a surplus of income over spending by the enormous total of 7.2 per cent of GDP: such a huge reduction in spending, relative to incomes, was quite sufficient to cause a depression on its own. But in the corporate sector, an almost equally large shift, of 6.2 per cent of GDP towards surplus, started in the fourth quarter of 2008 in direct response to the crisis, and ended in the third quarter of 2009. Sectoral financial balances must sum to zero, by definition: this is saying no more than that one agent's income is another agent's spending. So, if one group of agents is spending less than their income, others must be spending more than theirs. This is simple accounting. In this case, the offset to these shifts towards austerity was the deterioration in the fiscal balance (already discussed above). That finished in the second quarter of 2009, long before any substantial policy action came into effect: the idea that deliberate stimulus caused the huge US fiscal deficits is therefore nonsense. The deterioration in the fiscal balance was an automatic and helpful response to a collapse in private spending and a rise in private saving. In this case, the fiscal deficit did not crowd out spending by the private sector. On the contrary, the private-sector cutbacks crowded in the fiscal deficit via the decline in GDP and consequent rise in spending and fall in revenue: thus, the austerity forced on private individuals and businesses by the financial crisis caused rising fiscal deficits, as private spending, output and government revenue fell, while spending on unemployment benefits and other adverse consequences of recessions automatically rose. This is quite distinct from what happens when the fiscal deficit is expanded at full employment. In that case, interest rates rise, as the deficit crowds out private spending. Reliance on the fiscal buffer (the ability to let the fiscal deficit rise in response to a private-sector led recession) was essential this time, because even a strongly expansionary monetary policy was insufficient to prevent the shifts of the household and corporate sectors into surplus. We know it was insufficient because the monetary authorities initiated such a policy. This is a situation in which Keynesian fiscal policy becomes relevant. This is no more than to say that the economy was in a 'liquidity trap': at the lowest interest rate the central bank could create, the private and foreign sectors would have had a large excess of income over desired spending at full employment (the spending that would have occurred had the economy been at full employment, which, of course, it was not). This could be dealt with in only one of two ways: either by a collapse in income greater than the associated collapse in spending - that is, an outright depression - or by a large fiscal deficit. If the government had refused to run the deficits, by slashing its own spending as the private sector was also doing, the result would have been a depression, possibly one as bad as the Great Depression. Viewing the government's finances as if they are those of a household or even a large company is nonsensical. Government must respond to what is happening in the private sector, above all during a severe crisis. This need to tolerate - even increase - the large fiscal deficits was widely, if not universally, accepted in the immediate aftermath of the crisis. But, Richard Koo argues, these fiscal deficits have to continue so long as the balance-sheet adjustment in the private sector continues. This is because the attempt by private decision-makers to lower their debts forces them to spend less than their incomes and so generate financial surpluses - excesses of income over spending. By definition, if one ignores the external sector, a private financial surplus entails a fiscal deficit: that is just a matter of arithmetic. People find that argument difficult to accept, even if they understand it. Far too soon, policymakers wanted - or, in the case of vulnerable Eurozone member states, were forced - to cut fiscal deficits again, thereby slowing, or even short-circuiting, recovery. FROM STIMULUS TO AUSTERITY The leaders of the G-20 countries embraced the argument for a strong policy response, including the strong fiscal response, at their Washington, London and Pittsburg summits in 2008 and 2009. In Pittsburgh, on 25 September 2009, they stated that 'We pledge today to sustain our strong policy response until a durable recovery is secured. We will act to ensure that when growth returns, jobs do too. We will avoid any premature withdrawal of stimulus.'66 In Pittsburgh the leaders also stated, simply and correctly of the package of policies adopted almost a year before, that 'it worked'. Indeed, it did. The frightening economic downturn that had begun in 2008 was halted and reversed in 2009. This was an important achievement of modern policymaking. Yet not long afterwards, at the Toronto Summit of 26-27 June 2010, the view had changed. The G-20 summit now referred, in a worried tone, to the fact that 'Recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, properly phased and growth-friendly plans to deliver fiscal sustainability, differentiated for and tailored to national circumstances.'67 Furthermore, the leaders continued, 'Advanced countries have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.' In the middle of 2010, therefore, the leaders shifted away from their strong counter-cyclical action towards austerity. They did so, moreover, when their economies were still far from having fully recovered from the crisis (see Figure 3). Nor was the new commitment to austerity mere rhetoric. Fiscal tightening did indeed begin in 2010 or 2011 in all the big countries. That surely helps explain why a promising recovery started to wither. Fiscal austerity proved contractionary, given that post-crisis private demand was so weak and interest rates were very close to zero. So why did this premature policy reversal occur? Part of the explanation was influential academic research on the limits to public indebtedness and the feasibility of 'expansionary contractions', to which I will turn further in Chapter Eight. Another part was a mistaken belief that the recovery was already entrenched. Yet another was the simplistic and mistaken mantra that 'one cannot get out of debt by increasing it further'. The crucial point, however, is that the new debtors are not the same as the old ones. It is necessary for the creditworthy to borrow when those who are no longer creditworthy cannot. If everybody tries to cut down on borrowing and spending at the same time, the result will be a depression: that is the 'paradox of thrift' - a phrase first popularized by the late Nobel laureate, Paul Samuelson.68 Yet another explanation was politics. In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance. In the UK, the coalition government that gained power in May 2010 made fiscal austerity its raison d'être, to differentiate itself from - and fix the blame for the crisis upon - its predecessor. Yet another and even more important event encouraged this shift towards retrenchment. That was the Eurozone crisis, which turned the Eurozone towards austerity and frightened policymakers elsewhere into following their example. The timid and the orthodox argued that every country with large fiscal deficits, even the US, would end up tomorrow where Greece was today. The Greek crisis, which will be discussed in the next chapter, left a toxic aftermath far greater than the size of the Greek economy or the wider relevance of its plight necessitated.69 That was a Greek tragedy of a new and modern kind. CONCLUSION The financial crisis was a calamity. But from October 2008, the collective response was, for about a year and a half, purposeful and effective. It could have been still bigger. However, what was done halted the immediate panic and then reversed the downswing that was well under way in late 2008 and early 2009. It succeeded in doing so even though the recession was initially as bad as it had been in 1930. Unfortunately, policymakers failed to sustain the policies required to support private-sector de-leveraging and so avoid a prolonged balance-sheet recession. Largely as a result, the recovery proved weak or even withered away altogether in 2011 and 2012. For this unhappy outcome, the Eurozone crisis was partly responsible. It turned out to be the second act of the global financial crisis. It is, accordingly, the subject of the next chapter. 2 The Crisis in the Eurozone Whatever role the markets have played in catalysing the sovereign debt crisis, it is an indisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare. Wolfgang Schäuble, German Finance Minister, 20111 Greece was the Eurozone's Lehman. While the worst of the post-Lehman crisis was both severe and relatively brief, the aftermath of the Greek crisis was less severe but longer lasting. It triggered what turned out to be a long-running crisis, as fundamental weaknesses in the Eurozone's economies and institutional structure were laid bare. Far from bringing Europeans together, the euro caused division, disarray and despair. The Eurozone has turned out to be an unhappy monetary marriage from which divorce is almost unthinkable. Since the Eurozone is the world's second-largest economy after the US, its crisis has also endangered global stability. The existence of this fragile structure helped turn a significant financial crisis into an economic disaster. THE ROLLING CRISES The moment of truth for the Eurozone came in October 2009, when George Papandreou, the incoming Socialist prime minister of Greece, told the world - and, above all, his country's long-suffering Eurozone partners - that its budget deficit for that year would be 10 per cent of GDP. This was well above the 6 to 8 per cent of GDP predicted only weeks earlier by the outgoing Conservative government.2 It was still more dramatically above the draft target for 2009 reported by the European Commission in June 2008, which was for a deficit of only 1.8 per cent of GDP (although that did include 0.75 percentage points in one-off deficit-reducing measures).3 In response, Jean-Claude Juncker, chairman of the finance ministers of the then sixteen-nation Eurozone group, said: 'The game is over. We need serious statistics.'4 In the end, the deficit reached 15.6 per cent of GDP.5 What made the Greek fiscal position so bad was not that its spending was extraordinarily high by Eurozone standards, but rather that its revenue was so low, given the country's high spending. Thus, in 2009, the ratio of Greek public spending to GDP was 54 per cent, according to the IMF. This put Greece into third position among Eurozone members, after France and Finland. But seven Eurozone members had spending above 50 per cent of GDP. Apart from the three already mentioned, these high-spending countries included Belgium, Austria, Italy and the Netherlands. Out of the seven only two (Greece and Italy) subsequently fell into crises. Yet the ratio of total revenue to GDP in Greece was a mere 38 per cent, ahead only of Spain, Ireland and the Slovak Republic, and far below the ratios achieved by the other high-spending countries: Finland, for example, raised 53 per cent of GDP in revenue and France 49 per cent. It was the gulf between the Greek embrace of high public spending (much of it relatively wasteful) and the country's inability or unwillingness to raise taxes that lay at the root of its fiscal difficulties. This was ultimately a political failure more than an economic one, though a failure that membership of the Eurozone helped. Until the Greek moment of truth, continental European leaders tended to view the crisis as largely 'Anglo-Saxon', with epicentres in New York and London. Yes, their banks had been sucked into the maelstrom: this was, after all, a global financial system. But it was, they were sure, the sloppy regulation and incompetent responses of others that had caused the meltdown. They confidently criticized the actions of US policymakers in September 2008, particularly the decision to let Lehman fail. They knew that they, too, would be affected by this crisis: how could they not be? They knew very well that they had to respond. But it was, they were sure, not their fault. They did protest too much. True, the ideas that had led to trust in financial liberalization had, as argued by the Nobel laureate Joseph Stiglitz of Columbia University in his book Freefall, largely originated in the US and the UK.6 But European institutions, in both their US and their European activities, had fully shared the misbehaviour by banking institutions. Inside the Eurozone, Ireland and Spain had experienced huge housing bubbles and associated credit booms. Above all, the institutional defects of the Eurozone had nothing to do with the US or the UK. The euro was a continental invention for whose frailties not only the Eurozone but the wider world was about to suffer. In 2009 and 2010, the epicentre of the crisis moved inside the Eurozone, where it subsequently remained. Prior to the crisis, investors had viewed all Eurozone government bonds as equally risky or, rather, as equally safe. Why anybody should have imagined that Greek and German government debts were equivalent is not easy to comprehend. This was partly another of the follies of private investors. But it was also partly the result of the regulatory rules established by the Basel Committee on Banking Supervision (an international committee of banking supervisors). Basel I, the first of these regulations, was published in 1988.7 It allowed banks to treat government debt as risk free and therefore to fund such debt with zero equity. The view that government debt should be risk free has a certain validity for countries that borrow only in money they create: at least the risk of outright default is very low in such cases, though not the risk of inflation. But it was certainly inapplicable to countries borrowing in euros created by a central bank over which they had next to no influence. That is something investors started to understand as soon as they became reacquainted with the temporarily forgotten idea of risk during 2007 and 2008. Increases in spreads started to emerge between German 'bunds' (the German word for bonds) and yields on weaker countries' bonds, this being a measure of perceptions of riskiness of the latter. By late January 2009, spreads of Greek government bonds over German bunds had hit 280 basis points (2.8 percentage points). Two years before, they had been less than a tenth of that level (see Figure 6). Market aversion to Greek debt continued to increase: by early April 2010 spreads over bunds reached close to 4 percentage points. Effectively unable to fund itself in the market, the Greek government then asked for help, including, on the instructions of its Eurozone partners, from the International Monetary Fund.8 On 9 May 2010 the IMF agreed to provide a €30bn 'stand-by arrangement' (the name for a standard loan from the Fund), while Eurozone members offered another €80bn.9 In response to the agreement, Dominique Strauss-Kahn, the subsequently disgraced IMF managing director,10 remarked: 'We are confident that the economy will emerge more dynamic and robust from this crisis - and able to deliver the growth, jobs, and prosperity that the country needs for the future.'11 If Mr Strauss-Kahn believed what he said, he was either unreasonably optimistic or the future he was contemplating must have been very distant. Greek spreads remained above - generally, far above - where they had been before the programme was launched up to and including January 2014. This was despite a large restructuring of private-sector loans outstanding in February 2012, whose effects can be seen in Figure 6.12 Over the period covered in Figure 6, Greek spreads over German bunds remained quite high, though down hugely from their peaks. Excerpted from The Shifts and the Shocks: What We've Learned-And Have Still to Learn-From the Financial Crisis by Martin Wolf All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.

Table of Contents

Acknowledgementsp. ix
List of Figuresp. xiii
Preface: Why I Wrote this Bookp. xv
Introduction: 'We're not in Kansas any more'p. 1
Part 1 The Shocks
Prologuep. 15
1 From Crisis to Austerityp. 17
2 The Crisis in the Eurozonep. 45
3 Brave New Worldp. 89
Part 2 The Shifts
Prologuep. 113
4 How Finance Became Fragilep. 117
5 How the World Economy Shiftedp. 149
Part 3 The Solutions
Prologuep. 191
6 Orthodoxy Overthrownp. 193
7 Fixing Financep. 223
8 Long Journey Aheadp. 257
9 Mending a Bad Marriagep. 289
Conclusion: Fire Next Timep. 318
Notesp. 354
Referencesp. 401
Indexp. 427