Is the current crisis a watershed, with market-led globalisation, financial capitalism and western domination on the one side and protectionism, regulation and Asian predominance on the other? Or will historians judge it, instead, as an event caused by fools, signifying little? My own guess is that it will end up in between. It is neither a Great Depression, because the policy response has been so determined, nor capitalism’s 1989. Continue reading "This crisis is a moment, but is it a defining one?"

The following is Martin Wolf’s testimony to the Senate Committee on Foreign Relations in the US, March 25, 2009

We are experiencing the most dangerous financial and economic crisis since the 1930s. But it is also a crisis for foreign policy: a deep recession will shake political stability a across the globe; and it threatens the long-standing US goal of an open and dynamic global economy. Perhaps most important, the US is currently seen as the source of the problem rather than the solution.

This crisis is, therefore, a devastating blow to US credibility and legitimacy across the world. If the US cannot manage free-market capitalism, who can? If free-market capitalism can bring such damage, why adopt it? If openness to the world economy brings such dangers, why risk it? As the shock turns to anger, not just in the US, but across the world, these questions are being asked. If the US wishes to obtain the right answers, it must address the crisis at home, and do what it can to rescue innocent victims abroad. This is not a matter of charity. It is a matter of enlightened self-interest.
Continue reading "US foreign policy and the global financial crisis"

Lord Turner is the UK’s man for all seasons. A few years ago, he fixed pensions. Today, it is finance. The report by the new chairman of the UK’s Financial Services Authority is a turning point. The authorities of a country that used to boast of its light financial regulation have changed their minds: the UK has lost confidence in its financial sector.

“Over the last 18 months, and with increasing intensity over the last six, the world’s financial system has gone through its greatest crisis for at least half a century, indeed arguably the greatest crisis in the history of finance capitalism.” This is the report’s starting point. It advances two explanations for this disaster: exceptional macroeconomic conditions – particularly the emergence of excess savings in large parts of the world – and reliance on “the theory of efficient and rational markets”. As the report notes, “the predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational”. So regulators were expected to stay out of the way. In the report’s new view, they should be in the way, instead. The financial sector no longer enjoys the benefit of the doubt: it may burn up the world.

The most important analytical points are that individual rationality does not ensure collective rationality, that individual behaviour is frequently less than rational and that, in consequence, markets can overshoot, in both directions. Above all, such failings create systemic risks: if everybody believes in the same (faulty) risk models, the system will become far more dangerous than any individual player appreciates; and if everybody relies on their ability to get out of the door before anybody else, many will die in the inferno. Continue reading "Why the Turner report is a watershed for finance"

Another ideological god has failed. The assumptions that ruled policy and politics over three decades suddenly look as outdated as revolutionary socialism.

“The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’” Thus quipped Ronald Reagan, hero of US conservatism. The remark seems ancient history now that governments are pouring trillions of dollars, euros and pounds into financial systems. Continue reading "Seeds of its own destruction"

By Gerard Caprio

The lack of clarity in the US Treasury’s plan to deal with the financial system is hardly unexpected. The administration is just one-month-old, and the specifics of this crisis, like many of its antecedents, are unique. As the plan becomes more specific, we can hope that the administration will be able to educate the public, including the supposed friends of free enterprise, that any plan for dealing with the banks must include the failure of those that are truly and deeply insolvent. Continue reading "US bad banks and bad plans: why capitalism requires “nationalisation”"

by Laurence Kotlikoff, Perry Mehrling and Alistair Milne

The infusions of equity in a score or so of major banks will help prevent a deep and prolonged world-wide recession. So will the Fed’s new Money Market Investor Funding facility, and similar guarantees provided in some other countries, which support unsecured short-term borrowing by top-rated financial institutions.

But these steps won’t help most banks to get back to their main job – lending to households and businesses. For banks to lend, they must borrow and doing so, on any scale, requires collateral. Collateral today is in terribly short supply because trillions of dollars in AAA or better senior structured credit securities, including top-tranche mortgage-backed securities, are no longer being accepted. Continue reading "Recapitalising the banks is not enough"

by Laurence Kotlikoff  and Edward Leamer

The demise of financial titans and the incessant warnings of economic Armageddon have unleashed a tidal wave of asset sales across the globe, eviscerating trillions in personal wealth. Stock prices are now low enough to bring back some buyers, but the contest between fear and greed remains undecided.

The same defensive mentality that allowed the sale of equities at fire sale prices threatens to cause a sharp drop in consumer spending, which accounts for 72 per cent of US GDP.  If this happens, the economy will slide into deep recession. Continue reading "Buy now: why Uncle Sam must put everything on sale"

By Maurice Obstfeld, Jay C. Shambaugh and Alan M. Taylor

Since the early 1990s, central banks in many emerging markets and developing countries have accumulated foreign reserves at an unprecedented rate. The macroeconomic impact of these official flows has been profound and they have contributed significantly to global imbalances. Providing an explanation for these trends remains a major puzzle in international macroeconomics, and prevailing theories based on trade or debt deliver poor empirical performance. We argue that part of this great reserve accumulation is a response to the threat of financial instability in the context of rapidly expanding financial systems, increasingly mobile capital, and exchange rate objectives. The recent turbulence in global financial markets supports this view. Continue reading "Reserve accumulation and financial stability"