Coping with a Still-Fragile Global Finance System

Martin Wolf, chief economics commentator at the Financial Times, is one of the world’s most informed and astute observers of the global economy. In his recently published book, The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis, he argues that economic policy makers and central bankers are far from having solved the problems that led to the 2007–2008 financial crisis and subsequent Great Recession. The Economist has called the book a “fierce indictment of the global economy and a call for radical reform.” In early November 2014, BCG chairman Hans-Paul Bürkner sat down with Wolf (who was wearing a poppy in commemoration of the lives lost in World War I) in Barcelona to discuss the dangers still facing the world economy. Perhaps appropriately given the topic, their conversation was accompanied by a crashing thunderstorm.

Martin, thanks very much for taking the time to be with us today. In your book, you point out that the world has suffered six significant financial crises since 1980, each one bigger and more globally devastating than the last. And you believe that despite a flurry of new rules and regulations for banking, the global financial system remains extremely fragile. What's driving the fragility, and what should we do about it?

I think there are two central aspects to the fragility. The first is that the financial sector that we have developed is, in the core institutions, extraordinarily highly leveraged. It operates now after the excesses of the precrisis years with leverage in the range of 25 to 1, so it has very little true loss-bearing capacity. We hope that the banks offset this by their intelligent risk management, but of course, if all the institutions use essentially the same risk-management models and all end up with similar sorts of portfolios, they’re very exposed ultimately to the same sorts of risks. If something goes wrong, people who have lent money to them realize they have very little capital, and you can recreate panics of the kind we've seen before with extreme speed.

In addition to that, we continue to have very high leverage in our economies, not just in the financial sector. Governments, for instance, have got more indebted as a consequence of the crisis. So, we continue to have both a very fragile financial sector and substantial fragility in the whole economy.

At the moment, there is an enormous effort under way to increase capital requirements for banks. But doesn’t forcing banks to fund themselves with equity to a much greater degree than at present represent a major challenge to the traditional banking model? And doesn’t that also mean that the banks will be providing a lot less credit to the real economy?

Actually, banks haven’t been providing much capital to the real economy. If you look at what the banks have been doing, they’ve predominantly been lending to leverage up property assets. Most of it has been collateralized by property, mortgages of various kinds. They have been doing very little lending to small and medium-sized enterprises, while the big corporates are all dependent on the bond market. So, actually, the link between bank lending and growth has become incredibly weak. Indeed, that is one of the biggest problems—that we can have such huge expansions of bank balance sheets without actually affecting investment and growth at all. It’s a tremendous problem.

The second point I would make is that the traditional banking model is not that traditional. The leverage we're seeing now—25 to1—is quite new. It’s not the way banks used to run in the UK and the U.S., which I know best, 60, 70, 80 years ago. They used to have leverage of, at most, 10 to1, often even just 5 to1. So, moving to such extreme leverage as we see today, where the sound institutions have leverage of around 20 to 1, is actually relatively new. Having such undercapitalized banks, in my view, is one of the reasons why they give us so little in terms of growth and development.

It's clearly a tremendous adjustment we've got to make, but moving away from the financial sector we have today could be safer and better in terms of providing capital lending to the economy.

I was struck by your estimate that in the U.S., the cumulative present value of the lost GDP due to the Great Recession over the next century would be 17 times the GDP of 2013--quite an amazing number! What will it take to get the developed economies back on the path of strong growth?

I think the evidence from the only time we have anything like this, the 1930s, is that, in that case, of course, the shattering catastrophe of war led to extraordinary reforms in the economy—not exactly a policy proposal! But there were immense changes in the economy. They all became much more dynamic after the Second World War, particularly in continental Europe, but also elsewhere.

After the war, there was also a backlog of technological innovation to be implemented. That might be true too now—not as much, but still quite a bit; that might prove helpful. You also need, in my view, growth of demand which will encourage investment, encourage entrepreneurs to take risks, and put new businesses in place well beyond just the IT sector. I think there is a tremendous opportunity to do something equivalent to what the Americans did in the 1950s, when they built the highway program, to do large-scale public-infrastructure investment.

Let’s turn to the weakest spot in the world economy: the Eurozone. You liken it to “a bad marriage but one from which it is immensely costly to escape!” How to turn a bad marriage into a good one?

The short-run problem, in essence, is that you need substantial adjustments in competitiveness. There’s no doubt about that. And if they’re going to be positive sum, there also has to be some process which generates adequate demand in the Eurozone as a whole. The problem in Europe, I would say, is that if we leave aside Spain which has genuinely done some reforms, in most of the weak countries there’s no reform, and there’s absolutely no demand growth. So, the Eurozone is stagnant in all. This is even affecting Germany, after all, and that is creating very big political dangers, because you get very high unemployment, you are attracting populist politics.

So, my view is the deal has to be “reform for demand.” The problem is, on the latter there is no agreement at all, and because there's no agreement on that, there’s no agreement on the former either—and there might not be anyway, even if you could get agreement on the former. So, it looks to me like an impasse, and the impasse is very, very frightening.

That's why you’re also so critical of the German austerity push--although, of course, the Germans also make this quid pro quo that you also just made: “demand increase but also accompanied by reforms.”

One of the big dilemmas with these structural reforms is that they tend to worsen the demand picture for very obvious reasons. They involve a fairly significant compression of real wages and a shift from wages to profits. We saw this when Germany pursued a similar policy for its own economy in the late 1990s: the German corporate sector actually stopped investing in Germany; it invested mostly outside Germany. But it was very, very profitable. Consumer demand in Germany was rather weak. There were a number of reasons for this, but I think one of the reasons was the decline in earnings shares.

Now, if that happens across the Eurozone as a whole, then the Eurozone as a whole will need external demand to pull it. I've argued many, many times that the Eurozone as a whole, which is three times as big as Germany, is simply too big to be pulled by external demand. So, I think that the policies that Germany followed in the late ’90s are only half relevant to the Eurozone today. The reforms are relevant, but then you have to ask yourself, How do we deal with the demand-suppressing effects of these reforms? This is not a question that the German policy-making machinery wants to address.

I regard the success of the European Union and the success of the Eurozone, since they’re the same thing, as one of the unbelievably important issues for the future of the world, and the future of Europe, and the future of my country. These things really matter, and the burden of making them work has fallen on Germany, and Germany is going to have to make it work. There is no alternative.

Let’s turn, finally, to the emerging markets. They have been quite a bright spot in the growth story of the world economy. Will that growth be sufficient to help the overall global economy get back on track?

There’s no doubt—without that growth in the emerging markets, we would have had a complete catastrophe. It is very, very important that, for the first time ever in the modern economic world—say, since the Second World War—the developed countries hit an enormous crisis, very slow growth, but the emerging countries continued to grow. So, it’s a real shift in the whole balance of the world economy.

However, it now appears that the extraordinary growth of the emerging world in the mid-to-late 2000s was a bit of an illusion, and there is now a slowdown. This slowdown is occurring for a number of reasons. First, a number of economies, quite important economies, stopped reforms, and they still have a very large reform agenda. They still have many, many more problems than in the developed countries.

Then, in dealing with the crisis, many of the developing economies started huge credit expansions—particularly, China—which were not sustainable. So, they have some very big challenges ahead, particularly in China as it deals with the aftermath of its huge investment boom and credit boom, getting growth going again in India, reforming Brazil and all the other smaller economies.

Are you optimistic that the emerging markets will undertake the reforms that are necessary?

It seems to me that, in the end, the pressures from below in countries where people have perceived the possibility of living better, those pressures will force the governments to reform. But it can be a long-term process, and a lot can go wrong along the way.

Martin, thank you very much for this tour d’horizon.

My pleasure.