Fixing Global Finance: An Interview with Martin Wolf

Martin Wolf, Chief Economics Commentator and Associate Editor for the Financial Times, talks about his new book “Fixing Global Finance,” and the current financial crisis. In this interview with Nayan Chanda, editor of YaleGlobal, Wolf explains why global imbalances caused the financial crises, outlines the steps for ending this destructive cycle, and offers suggestions on how to help ensure global financial stability in the future. – YaleGlobal

Fixing Global Finance: An Interview with Martin Wolf

What can be done to ensure global financial stability in the future
Thursday, March 5, 2009

Nayan Chanda: I am Nayan Chanda, editor of YaleGlobal Online, and we have returning to our studio, Martin Wolf, chief economics writer for the Financial Times. Martin, welcome back.


Martin Wolf: Pleasure to be here again.


Chanda: Martin, I'm very pleased to have in my hand your latest book, Fixing Global Finance. No other title could be more appropriate for these days. So, it's very nice to have you with us. I thought since we have you here, the worlds foremost expert on the financial crisis, we might actually use this opportunity to have you give us a primer on the crisis that is roiling the world. To start with, first of all, how does one explain that American mortgage holders' failure to pay their mortgages could create such havoc in the world, leading to banks failing, and, including a government like in Iceland toppled over because of that, how do you explain that?


Wolf: Well, it is in a way quite difficult to explain. It is important to stress that I at least, and there were others that did much better, did not foresee a catastrophe of this scale and, even now, there are immense debates among serious observers, economists and financial experts, on what precisely has caused such enormous havoc. I think we have some sense of what led up to it and some sense of how it worked but there are some real uncertainties which I will come to in a moment. Let us first start with what led up to it. My view is somewhat developed from what was in the book, which was finished more than a year ago. There were really two principle underlying drivers, deep underlying forces. The first has been really quite long-term: three decades of expansion of the financial sector, and particularly, growth of credit and debt and of the balance sheet of the financial sector, its total assets, all at a completely unprecedented rate. So if you take, for example, the balance sheet of the US financial sector, it's been growing on average about six times faster than US GDP since the early 1980's and that was actually accelerating in this last decade.


Chanda: What happened, why did this acceleration take place?


Wolf: This is related to the second thing. Most of this expansion, at least up until the late 1990's, was because after the 1970's, which had been a big era of inflation. Inflation really wipes out debt, so in the early 1980's there was very little debt in the economy, we liberalized finance, there was a new environment of low inflation and stability, people borrowed more, and merely by the act of borrowing more, they created credit. That's how it works: the banking balance sheet expands, they find new credit-worthy borrowers. The only real constraint on expanding the balance sheet for the financial system is its solvencies underlie perceived solvency, so it was perceived to be very solvent so it expanded steadily. But I think in the late 1990's and the early 2000's something changed and this is the second cause which I really focus on: the global imbalances issue. For a number of reasons that are quite complicated, the emerging economies of the world, particularly in East Asia, emerged as vast surplus savings countries. They ran huge current account surpluses, which means they had an excessive savings looking for a home. First that drove down real interest rates worldwide, they got down very low, secondly, that home turned out to be principally the US. The US emerged—it had been a small deficit country before that —as a huge deficit country in this decade, as the surpluses in China and the other Asian countries, and later the oil exporters, exploded.


So when this capital came into the US it was invested largely in foreign currency reserves—very liquid assets—which were invested essentially in the US market. A lot of it went to buy the liabilities of Fanny Mae and Freddie Mac as it happens, which were part of this. They provided an extraordinary liquidity base for lending and also provided an environment of very low real interest rates which made it very attractive for people to create what I think of as “pseudo” high-yielding safe assets. Because of these background conditions, the very low interests, the flood of money availability, there began to be a series of housing bubbles across much of the developed world, and there was a very big one here. In the context of a housing bubble, to go back to my story about credit, well... house prices are rising all the time, so it seems completely safe: you borrow against the house, and if you don't have much money, it's quite safe because next year the house will be worth more. If you have difficulty in servicing the debt, you can always sell the house, no problem. In fact it began to become obvious, not just in the US, but in the UK and Spain, that you couldn't lose money borrowing for a house. And then that led to the final stage, the capstone of this combination, this housing bubble linked to these two phenomena. They started creating all these very clever securitized assets, very complicated assets, bundling together mortgages which seemed to provide safe, high-yielding assets, just what everybody wanted, and they started selling them all over the world. About half of the US assets related to this bubble ended up all over the world. If you look, now, in retrospect, it seems to me pretty clear that it was this combination of events which by 2006, roughly the peak of the housing bubble, had primed the situation for disaster. And the disaster of course happened when house prices started to fall, when everything basically unwound, and they suddenly discovered they had all these bad assets.


Chanda: So the whole borrowing spree was based on the assumption that housing prices are always going to go up and when that gave away, the whole thing came tumbling down?


Wolf: Yes, well, the fact of course that there was simply so much credit. I mean household debt in the US and the UK doubled over 10 years to levels that have never been seen before. So you have a hugely over-indebted household sector, you have a hugely expanded financial sector with very little equity because no one thought it was needed because it was all safe and a lot of it was pinned against these complicated securities, based on the assumption that house prices could only rise. And lots of American economists, Bob Shiller here at Yale was an exception, but lots of economists I spoke to said that it was impossible for house prices to fall across the country, because they'd never fallen. It was a quite normal view, sensible people thought this. Of course it turned out they were utterly wrong, and then of course, you suddenly get a vast quantity of impaired assets, and nobody knows how these new securities, which have very opaque structures, are actually going to work or what they're going to be worth, once the underlying assumption about house prices and therefore the ability to resell houses without difficulty turned out to be wrong. We also discovered of course and we know that in a late bubble phase, completely normal, lending standards were lowered, that's not new, and as a result a lot of people received houses, again not just in the US, but also in the UK, who really couldn't afford the loans, so once the housing prices fell, they were insolvent.


Chanda: So again, this bubble was also partly fueled by the savings of the East Asian countries.


Wolf: That is my view, yes, absolutely.


Chanda: …putting their money in the US, buying treasuries, and resulting in lower interest rates.


Wolf: This is what Ben Benanke described in a very famous speech he gave I think about five years ago: the savings glut hypothesis of what was going on in the world. My book explained, actually I was thinking about this before him, I wrote about it even earlier in the 2000's. I had been very concerned about the effect of this savings glut for a long period, and the main reason I was so concerned, I didn't expect the complete collapse of the financial system, but was, if you looked at the us economy, it turned out that the counterpart of the excess savings in the rest of the world was excess borrowing particularly by the household sector. The US household sector in the middle of this decade was running an unprecedented financial deficit, as it was spending more than its income by an unprecedentedly large amount, and borrowing vast amounts both to finance that and to finance the assets they were purchasing whose prices were clearly in the bubble mode. This, I thought was a huge source of fragility. I stress that in my book as one of the sources of fragility associated with the imbalances, and that turned out to be correct.


Chanda: And the other side of the same coin is the Chinese huge trade surplus. When the US household is going into debt, what they're buying is often products from China. And so the Chinese became the deliverer of sellers' credit. They are giving money to the US so the US can then go and splurge.


Wolf: Yes, that is correct, vendor finance, you might call it. That was part of the mechanism, they bought US treasuries, and the counterpart of that was that they were financing, in a way, their own exports, a lot of which were going to the US.


Chanda: So, now explain to us how did this housing bubble burst in the US spread so fast to the rest of the world. What’s the mechanism?


Wolf: Well, this is interesting and it's where it’s also become so disturbing. I think there were two aspects of this. First, as I've already mentioned, about half of the securitized obligations, the CDOs, collateralized debt obligations, and the CDOs squared, these very complicated obligations had actually been sold abroad, a lot of them to European banks. The European banks were also looking for high-yielding safe assets and they ended up all over the world. Some European banks actually bought US subsidiaries which were actively engaged in household lending. The very big British-based bank HSBC, is an example of a European bank that had bought a US mortgage lender, but others just bought all of these securities, about half of them ended up abroad. So that was one reason why this became global almost at once, it became obvious that these assets were everywhere. One of the worst hit banks in the world by this was UBS, the Swiss bank which had a very active American subsidiary which was deeply involved in this, and ended up with an enormous exposure, which is why the Swiss government has had to rescue it. But that's only one thing. The second thing that you have to remember, and this point I stress quite frequently, is that the financial system of the world in the last ten to fifteen years did truly become global. The big players of the world, the big financial institutions, particularly of the West, all operate globally. They all have American subsidiaries and European subsidiaries and they're all interconnected. Very closely interconnected.


Chanda: So total globalization of the financial system.


Wolf: Globalization of the financial system was extreme. So once any significant institution gets into trouble, and the most famous such case is of course Lehman, the third largest of the investment banks in the world got into trouble. Although Lehman is a global firm, it did business all over the world and did business with everybody. It did business with any major banking institution you can imagine, and with hedge funds everywhere. So of course once Lehman, to take this very salient and important example, went under in mid-September of last year, it affected the confidence in counter-parties everywhere because everybody was dealing with everybody else. So there was no longer a national financial system, the US did not have a national financial system, neither did the British. Indeed, very much not, well over half of the assets of our banking systems are foreign assets and liabilities. You talked about Iceland, well Iceland was an extreme example of that, most of Iceland is a tiny country with a few hundred thousand people, so nearly all the assets and liabilities of the Icelandic banking system, which exploded in size to almost 10 times GDP its assets and liabilities, and all of these were abroad, they were part of the global system. The Icelandic people couldn't rescue this. Once the assets went down, these institutions were insolvent and no government could save them. So one of the things that we've learned, in fact, is that a significant crisis affecting an important class of assets, like housing-related securities, immediately becomes global because all the institutions have invested in them and all the institutions are dealing with all the others. So I don't think you can possibly imagine anymore a national financial crisis, it’s one of the most important lessons of the whole mess.


There's a final thing, of course, once the financial system is impaired, it doesn't lend anymore, it's too frightened to lend to anybody, and that was particularly severe in September and thereafter. And of course, it affects the rest of the economy, nobody can borrow, businesses can't borrow, governments can't borrow, corporations, big, even the safest corporations can't borrow, so you then have a crisis in credit which affects, in fact, the entire world. The emerging economies are affected; consumers are affected, so they don't spend. And that’s of course why, in the last few months we've moved into a global recession, which some people think of as a depression simply because recently, the decline in GDP for some countries has been so very, very severe. Japan for example has, the last quarter as I understand it, has had a negative growth at an annualized rate of 10%. And similar things are being seen in other East Asian countries, in fact they’re particularly bad, China's growth in the last quarter was probably zero which for China is a depression. It is certainly worse than a conventional recession and unless it turns around fairly soon, it’s going to feel worse than anything since the 30's. And I think this is how we got here. It's a global system, which was built on global causes, but with very large regulatory and other mistakes in various countries, and particularly the US.


Chanda: So one of the basic issues is the high savings in China, and high indebtedness in the United States. How can one resolve that, or at least narrow the gap in the current situation? You wrote yesterday or last week that Chinese growth should be 10% a year and China’s domestic expenditure should be 12% in order for this gap to be narrowed. Is this realistic?


Wolf: Well, I think this is a huge question now, because it comes to the issue of how we get out of this. I mean this is very scary where we are now, this is a very severe global recession, and we want to get out of it as quickly as possible. So, how do we do that? Well, we all recognize that we’re not doing a very good job that we have to fix the financial system, we have to recapitalize it or make it sound in some way. Governments are struggling with that, I would say no one has been fully successful yet, including, unfortunately, the United States, but nobody has. So that's one thing we have to do. We're going to have to help hugely over-indebted households, because there are lots of bankrupt people and we're going to have to fix that. But there's also this very big issue as you rightly say about the demand expansion in the world in the future.


Now if we think about it, if we assume there is no change in the surplus countries, if we continue with the sort of world we had before, well you think about the US, a point I've made in previous columns, the UK is essentially the same, you've got a large current account deficit because the structure of your economy after many years of specialization, you don't have production of much tradable goods in particular, so once you get to full employment you tend to have a very large current account deficit— as excess demand. So the question you have to ask yourself is, what could generate excess demand in the United States on that scale again? Well it's not going to be the household sector which is very badly indebted and needs to save. It's very unlikely to be the corporate sector in this situation. So what's going to happen, it's clear what’s going to happen, is the US is going to run, to sustain demand, enormous fiscal deficit: 10%, perhaps even 12% of GDP, unimaginable numbers. Now, for a short period of time, of course the US can run deficits of that scale but it's very risky. You're going to pile up enormous amounts of fiscal debt. So to stop this from going on, either there has to be a huge pickup in domestic demand in the US going back to the bubbles, and I don't see how you could do that easily. This was I think the last big private sector bubble. Or the US external balance has to improve. It's a matter of definition. The US, the UK, and all these other countries are going to have to have better external balances.


Or somebody else. If we have dynamic growth in the world, we don't want to compete in a depression that would be “begging my neighbor” policy that used to be called. You want expanded demand in the rest of the world. Well, who are the best position to expand demand? Obviously countries with very strong balancer payment positions, with very strong current account surpluses and reserves: countries like Germany, Japan, and China. They don't expand demand relative to supply, then I think we have the danger of chronic excess capacity in the world, chronic deflationary pressure. In other words, the whole world starts looking like Japan in the 1990's: that's sort of my worry. Even with printing all the money, that is my worry of what might happen. The Japanese have printed money like mad and they still remain like this. So we do have to expand demand. Now understand completely, we take the case of China, which is simply the most important single country, that they can't change the structure of their economy, the structure of demand, overnight, except through a massive fiscal boost, which is what they're now doing, they're engaged in a huge investment program, and in the short-run that’s the right thing to do. In the long-run, however, it is right for the Chinese to try and absorb more of their production at home and rebalance their economy with more service production which would generate actually many more jobs. They have not done a good job of generating jobs recently, because their development path has been quite capital-intensive, much too much dependent on investment and household disposable income is only 40% of GDP which is why they're not benefitting fully. So what I suggested in the piece you mentioned which I produced as a blog during the World Economic Forum in Davos, is China should forget having a GDP target, instead of having an 8% growth GDP target, it should have a real domestic demand target. It should think of its policy in terms of generating real domestic demand, GDP will follow.


And I suggested, if you'd said they should try to grow real domestic demand at 12% a year for five years, that would solve the problem, it would help the world, and it would make the Chinese themselves better off. Now I recognize this is a huge challenge, but the first step to meeting the challenge is to define the problem and I think that's the right way to define the problem. I think there are similar difficulties in Japan: they have allowed domestic demand to languish for 19 years, since 1990, and they've got to fix that. Germany has a similar problem; there are a number of other smaller countries. If this problem is not fixed, I don't really see how we get out of this, at least in the near term, without these monstrous fiscal deficits in the US and the UK and a number of other developed countries as the source of demand. And that's going to be politically very difficult and ultimately I think unsustainable. So the thing that worries me most is not the clearing up of the financial mess, though that's a big issue, or even the clearing up of the over-indebtedness of the households, the thing that worries me most is as it were, where is the demand going to come from to sustain rapid growth in the world economy in the next ten years or so. And for that to happen, I don't think we can repeat a pattern in which we've been so dependent on excess demand from the households of a limited number of rich countries.


Chanda: Especially since what we've seen in the United States that the tax credit, as stimulus for spending didn’t work. People are hanging onto their money because they want to retire their debt rather than go and splurge in the shopping mall. The same thing is happening, though, in China. I gather that Chinese city governments are giving out consumer coupons and people are trying to turn that into cash and hang onto them.


Wolf: I'm sure that's true. Risk aversion.


Chanda: Yes. So, people are afraid to go to the shopping mall. And the second thing of course is that there’s so many dead banks still walking. So, how do you retire those banks and actually create the possibility of people getting credit from the banks at a reasonable rate?


Wolf: Now, my view on the first of these questions: I don't think the fact that people are saving a lot is so bad. Because people have to reduce their debts, I mean, it's quite reasonable. And if we help them to do that without inflation then that's not such a bad thing. But there's no doubt in my mind, and there's been a huge, almost religious debate here in the United States, that in the short run, in these conditions, it makes most sense to expand the forms of spending by the government which are immediate. Some of that goes to people, I mean unemployment compensation, of course, you're going to need a lot more of that to sustain people's demand. In this country, giving money directly to state and local governments so they continue to employ teachers and firefighters and all the rest of it. So, there are things that you can do which will sustain spending and if necessary, under the present circumstances, the government can simply borrow from the central bank and there's no problem about inflation, to support this form of spending. So in the short run, that's I think what you want to do. If you provide tax cuts in the present conditions, I would expect most of it to be saved. I mean, that seems to me inevitable. That wouldn't be the worst thing, the way I put it, it just means that if that’s going to happen, the stimulus bill, the total deficit, has to be even bigger because you'll want to offset the fact that so much of it is going to be saved. That is, I think, an inevitable part of this story.


Now, on the banks: this is a very controversial issue too. And I've written about it very very recently. You have to start I think, with the first thing is to figure out is what is really the problem. And the truth is, we are still disagreeing on this. There are some people, quite a lot of people, who would say that the very low prices of the assets that the banks are holding, which is what's driving their insolvency, is largely the result of panic. If people understood the true underlying value of these assets, they wouldn't be so cautious, they wouldn't be so frightened, the prices of these assets would rise and the banks would appear quite solvent. And those people are the people who suggest that the real job is to find some way of being able to market these toxic assets again. Mr Geihtner's plan is very much directed at that, though how it would work is quite obscure.


There are other people, and I'm one of them, who say: assume the worst. It's very likely that the banks are insolvent because these assets are just bad. And certainly, the other people, the investors, think they're insolvent, so they have to be recapitalized. There has to be a recapitalization program. It's very very difficult to persuade the private sector to recapitalize institutions that have no idea what they're worth. And because they have no idea what their assets are worth, all their experiences so far have been very bad, so, unless you can find a real price for these assets, pretty soon it's going to be very difficult to get the private sector to recapitalize; and we're talking hundreds of billions, possibly even a trillion dollars or more, so enormous sums. So that means that they're essentially only two other ways of dealing with this. Both involve a sort of bankruptcy process. But the bankruptcy process can be done

either by injecting government capital, you nationalize them, you take out the bad assets,

and put them in a bad bank, you nationalize, you put in public capital, and you re-float the institutions. This is very much what the Swedes did in the early 1990's. There is a variant of that in which you leave the bad assets in the old bank where it sort of dies, and you create a good bank with the good assets, so a new institution. There's the question of whether you move assets into a good bank, or move assets into a bad bank, that’s a sort if a secondary question, it's quite interesting, but it’s a secondary question.


The alternative way of recapitalizing, is an absolutely standard bankruptcy process, but here for a lot of institutions simultaneously, and that would essentially be you put them into bankruptcy, you would eliminate the shareholders' equity because it's worthless, and you would transform some portion of the bonds held against the banks into equity. So the bond holders end up owning the bank. That's a very common bankruptcy process. And then again, you would have a recapitalized bank, and it would be off and free. Those are, it seems to me, essentially the alternative. At the moment, nobody around the world has been prepared to do either of these things on a suitable scale because it seems to me that nobody has been prepared to recognize how big the losses actually are.


Chanda: And also, these old shibboleths about nationalization are still so strong that you cannot use that word and hope to be reelected.


Wolf: But what is so strange is, people, well, they’re not very happy, but people are prepared to accept large public subsidies to private institutions, I would call some of them even bribes to private institutions, which have been misused and in some cases, abused, but they are very unwilling to actually just say, well, we own it, because we are providing the risk capital. The reality, though, is that at the moment, the taxpayer is bearing the risk. It's clear. So whatever you call it, the risk capital is being provided by the taxpayer. My view is that if the taxpayer provides the risk capital then the taxpayer or his representative has to exercise managerial control, otherwise you will know that the private sector will exploit this, as indeed they clearly did in the last quarter of last year, when you look at these grotesque bonuses which were earned at loss-making institutions using, basically, government money. Now, the crucial thing to say, this isn’t nationalizing in the long-run, we're not going to have nationalized banks, it's just a nationally-imposed debt restructuring, that's all it is. The aim is to provide enough money. It’s a short-term.


Now if you were really concerned about this and it's difficult to re-float the institutions back into the capital markets quickly, I made a suggestion which I’ve seen was picked up this morning by Nicholas Kristof in the New York Times, which is just give the shares to all the American people, if you want, and then it's not nationalized. The aim is definitely not to have nationalized banking system. I share fully the view that that would be a terrible thing. The question is, how do you restructure bad banks, all the experience we've had with banking crises around the world, which I do discuss in this book, and there have been more than a hundred really big banking crises in the last thirty years, though this is of course much the biggest, it's a global one, is you mustn't leave zombie banks in existence. Zombie banks kill the economy. Either they take unreasonable risks or, worse, they don't dispose of their assets, and come clean on their balance sheets, and they don't expand credit, they don't do anything with their money. The zombie banks and the assets they have have to be liberated, and that's an essential policy task.


Chanda: OK, last question: About four years ago when you came to your studio, we discussed your book Why Globalization Works. Now, it looks like it doesn't work. So what went wrong?


Wolf: Well, the only thing I can say in my favor is the chapter on finance which I much developed in this book, was the most skeptical. Of all the chapters, it's the one in which I said very clearly, finance is something that has clearly gone wrong, we've had a lot of financial crises, we have to learn from this some of the lessons. And I also discussed, very briefly, the possibility of a major global crisis. Now I have to admit that at that time, I wrote the book in 2002 and 2003, I did not, that’s probably a lack of imagination, foresee a bubble on this scale leading essentially to the demolition, or at least an immense crisis of a type I haven't seen in my lifetime, since the second world war, affecting the core financial systems of the world. I'd assumed that these would continue to be predominately emerging market financial crises, and I focus as I do here very much on what you do with emerging market financial crises. Now, of course, it has become something global. And I thought then that it was more likely that we'd be threatened by some geopolitical or military event. We were concerned about terrorism, nuclear terrorism, war, that was something I discussed at great length, though I did also talk about a financial danger. Now what we've learned is that the financial system is even more unstable, more dangerous, more fragile on the global level than I thought. I don't think it undermines the case for globalization in trade and foreign direct investment, and for the big, huge gains that have been made for countries like China and India, containing billions of people, as a result of globalization. It seems quite clear that the gains are huge and if we look right now at the de-globalization, it's all very frightening. And it could go really wrong, we could have terrible protectionism and hundreds of millions of people will lose hope for the future. It would be a tragedy if that happened. But all that shows is that my concern about the financial system should have been even stronger than it was, and that's why I wrote this book. And the issue now is one, reconstructing the global financial system so that it works better, so we don't have a crisis like this again, soon, and I discuss that in this book though I've had more ideas since then, and that we deal with this big domestic demand balance problem, the problems of capital flowing uphill, which I have been concerned about for many years. These are really even more important. Now, the big policymakers of the world, President Obama and others, and developing countries too, that's why the G20 has become so important. Countries like India and China are also involved. We have to construct, together, a system that works better in this respect. It's an incredible priority. If we do that, then I think we can keep globalization going, but if not, we may revert to the most terrible disaster which we saw in the 1930's.


Chanda: “Buy American” or “British jobs for British workers”


Wolf: And it could get much worse than that, that's just pretty mild. But, it could get much worse if a year or two from now the world economy is still sinking and unemployment is over 10% and in China the economy is very weak and unemployment is very weak everywhere. Governments will become populist, and populist governments will become nationalist, and we could have terrible global conflicts. So this is very, very dangerous and we have to deal with it now. That’s why, I feel, by my standards, and in my writing, I've been almost hysterical. And I try to be very reasonable and very calm in what I write, I think one should be, but I do think the situation we have been in since last September is a critical situation in all the respects we've talked about. Policymakers have to deal with it. If they deal with it quickly and urgently and cooperatively, very important, it's a global problem and we need global solutions, then I think we can get through this in the next few years. And if not, it will be a different world but it won't be a better one.


Chanda: Well, on that note, Martin Wolf, thank you very much.


Wolf: It's a pleasure.

© 2009 Yale Center for the Study of Globalization

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