Martin Wolf - The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis

Can It a Great Depression happen again? And if It can happen why didnt It occur in the years since World War II? These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years. To answer these questions it is necessary to have an economic theory which makes great depressions one of the possible states in which our type of capitalist economy can find itself.

Hyman Minsky, 1982

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 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. 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 worlds 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 Minskys 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

Minskys 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. 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 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. 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, Keyness 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.