Iceland was the first country devastated by the financial crisis. Lehman Brothers failed on September 15 2008. By October 9, its three big banks – Glitnir, Landesbanki and Kaupthing – had collapsed. The UK government seized Landesbanki UK under anti-terror laws, while Gordon Brown, the prime minister, threatened to seize Icelandic assets in the UK. On October 24, Iceland agreed a deal with the International Monetary Fund.

On October 27 2011, I attended a conference jointly organised by the IMF and the government of Iceland to celebrate Iceland’s graduation from the programme and evaluate the outcome of the rescue. I also moderated the final panel.

The programme remains controversial. Jón Daníelsson of the London School of Economics presented a critique during the conference. Others presented critiques from outside.

What happened to Iceland is clear: its banks ran amuck. Read more

Steve Jobs

Image by Getty.

I am a member of a cult. That cult is Apple. Its prophet was Steve Jobs. I am not a shareholder of the company. But I am – and have been for 31 years – a devotee of its products.

This started in 1980, with purchase of the Apple II for a World Bank research project I had promoted. I did not myself use the machine. But I could see the immense advantages of having such a computer for our own use rather than relying on remote access to a mainframe computer under someone else’s control. Read more

According to a FT article last week, Lloyds’ bank has a target return on equity of 14.5 per cent. Banks like to argue that this is the level of return on equity they need to earn, in order to gain funding from the markets. Naturally, remuneration is linked to achieving such objectives. The question, however, is whether such objectives make any sense. The brief answer is: no.

Forget banks, for the moment. What would you say if someone offered you an investment with a promised real return of close to 15 per cent? You might say: “How much can I buy?” Alternatively, you might say: “What is the catch?” Sensible people must take the latter view. If you thought that you were being offered a reliable real return at such an exalted level, you would buy as much as you could. This must be particularly true now when real returns on the bonds of relatively safe governments are close to zero.

So what is the catch? The obvious answer has to be that the real return in question is extremely risky, because it is volatile and offers a significant chance of total wipe-out. Read more

Anniversaries are a time to take stock, to ask where we have been and where we might be going. 2011 offers three remarkable anniversaries: the economic reform of India and the fall of the Soviet Union, both in 1991; and the terrorist attack on the US on 9/11/2001. What should we think about these three events, today? Here are a few tentative answers.

Is it too soon to tell? Yes. It always is. Each generation changes its view of the past in light of the present. That will continue, if not forever, at least indefinitely. We might well disagree about the significance of events that took place centuries ago. It is far too early to tell what these events might mean. Today, for example, 9/11 looks far less significant than it did at the time. One significant act of nuclear terrorism would transform that judgement.

Which of these events might posterity view as the most important? My guess is that it will be the economic reforms in India. The decision of the Indian government, under prime minister P. V. Narasimha Rao and his then finance minister Manmohan Singh (the present prime minister of India) to launch fundamental economic reforms on July 24 1991, in response to a severe balance of payments crisis, was a world-transforming event, in at least five respects. Read more

The Wolf Exchange will now restart. During the year I spent working on the UK government’s Independent Commission on Banking, whose report will appear on Monday 12th September, I could not continue with this venture. I hope to do so now.

My plan is to produce a substantial piece every two weeks, starting now. I hope also to write shorter pieces in between. The topics will be mostly, but not exclusively, about economics. I expect to respond relatively briefly to comments before the next big post. But I will not respond as actively as I did before. That way, I have discovered, madness lies. I will not respond at all to abusive, irrelevant or foolish comments. I will try to respond to comments that are courteous, relevant and thoughtful.

During any period of monetary disorder – the 1970s, for example, or today – a host of people calls for a return to the gold standard. This is not the only free-market response to the current system of fiat (or government-made) money. Other proposals are for privatising the creation of money altogether. (See, on this, Leland Yeager, professor emeritus at the University of Virginia and Auburn University, in the latest issue of the Cato Journal.) But the gold standard is the classic alternative to fiat money. Read more

Last week, I posted a section of a speech I delivered in Seoul at a conference organised by the government of the Republic of Korea on “Financial Reform: An Emerging Market Perspective”. This conference was part of the preparation by the South Korean government for the summit of the Group of 20 leading countries, which will take place in Korea in November. This week, I am posting the most important section, on reform. This looks at the twin aspects of the global challenge: macroeconomics and so the global imbalances; and microeconomics and so the regulation of finance. Read more

The conservative economic counter-revolution associated with the names of Ronald Reagan and Margaret Thatcher began some three decades ago. The Great Recession almost certainly marks its end. What follows will be something different, though how different it will is still unclear. This is a good opportunity to assess the broad economic consequences of that revolution.

For the sake of simplicity, I focus on gross domestic product per head in the six biggest high-income economies: the US; Japan; Germany; the UK; France; and Italy. (I also use the Conference Board database. These data are in purchasing power parity (Elteto-Koves-Szulc (EKS) method).)

There is much more to performance than GDP per head. These data ignore the distribution of income, which is of crucial importance, especially for the US, where a very large proportion of additional income seems to have accrued to the wealthiest. The data also ignore the underlying causes of changes in GDP per head: changes in output per hour, in hours per worker and in employment. Even so, they are revealing.

The single most important point from the chart on relative GDP per head is that the US remains where it has been for over a century: the most productive large economy in the world. At its peak, in 1991, Japan’s GDP per head reached 89 per cent of US levels. It then fell substantially in the 1990s. United Germany, France and Italy also experienced substantial relative declines in GDP per head over this period. The UK was the only one of these five countries to have achieved rising GDP per head, relative to the US, since 1990. This surely suggests that reforms led by American and British policymakers did bear some fruit.

The chart on growth of GDP per head elaborates this picture somewhat. The UK and US had the highest trend growth of GDP per head between 1980 and 2009. (All-German data are unavailable for the entire period.) But there are other interesting events: first, there is a progressive deceleration in trend growth: only Japan achieved faster trend growth in GDP per head between 2000-07 (that is, before the recent deep recession) than it did in the 1990s; second, the US growth deceleration in the most recent periods is marked, with growth in GDP per head only at the same rate as Japan between 2000 and 2007 – so much for the magic of the Bush-era tax cuts – and also between 2000 and 2009; third, GDP per head grew at less than 1 per cent a year in Germany, France and Italy in the most recent decade.

At first glance, then, the conservative revolution seems to have achieved some improvements in the previously lagging US and UK economies. But the magic potion started to lose effectiveness in the 2000s, particularly in the US.

The more interesting question, however, is how far this improved performance of the US and UK will turn out to have been a blip. There are two reasons for believing this. Read more

Update: Read Martin Wolf’s response to readers’ comments

It is summer – a good time to ask a big question. So I intend to ask the biggest question in political economy: what is the role of the state?

This question has concerned western thinkers at least since Plato (5th-4th century BCE). It has also concerned thinkers in other cultural traditions: Confucius (6th-5th century BCE); China’s legalist tradition; and India’s Kautilya (4th-3rd century BCE). The perspective here is that of the contemporary democratic west.

The core purpose of the state is protection. This view would be shared by everybody, except anarchists, who believe that the protective role of the state is unnecessary or, more precisely, that people can rely on purely voluntary arrangements. Most people accept that protection against predators, both external and internal, is a natural monopoly: the presence of more than one such organisation within a given territory is a recipe for unbridled lawlessness, civil war, or both.

Contemporary Somalia shows the horrors that can befall a stateless society. Yet horrors can also befall a society with an over-mighty state. It is evident, because it is the story of post-tribal humanity that the powers of the state can be abused for the benefit of those who control it.

In his final book, Power and Prosperity, the late Mancur Olson argued that the state was a “stationary bandit”. A stationary bandit is better than a “roving bandit”, because the latter has no interest in developing the economy, while the former does. But it may not be much better, because those who control the state will seek to extract the surplus over subsistence generated by those under their control.

In the contemporary west, there are three protections against undue exploitation by the stationary bandit: exit, voice (on the first two of these, see this on Albert Hirschman) and restraint. By “exit”, I mean the possibility of escaping from the control of a given jurisdiction, by emigration, capital flight or some form of market exchange. By “voice”, I mean a degree of control over, the state, most obviously by voting. By “restraint”, I mean independent courts, division of powers, federalism and entrenched rights.

This, then, is a brief background to what I consider to be the problem, which is defining what a democratic state, viewed precisely as such a constrained protective arrangement, is entitled to do. My short answer is that this is precisely what politics must be about. Read more

Update: Read Martin Wolf’s conclusions on the debate

Something strange happened to economics about a century ago. In moving from classical to neo-classical economics — the dominant academic school today — economists expunged land — or natural resources. Neo-classical value theory — based on marginalism and subjective valuation — still makes a great deal of sense. Expunging natural resources from the way economists think about the world does not.

In classical economics, land, labour and capital were the three factors of production. With neo-classical economics, the standard production function had just two factors of production: capital and labour. Land — by which we mean the totality of natural resources — was then incorporated into capital.

All thinking about the world involves a degree of abstraction. Economics has taken this principle further than any other social science. This is a fruitful intellectual procedure. But it is also risky. The necessary process of abstraction may end up leaving essential aspects of the world out of the analysis. That can be intellectually crippling. I believe that that is exactly what has happened, in this case. Read more

The conventional wisdom in both Japan itself and the west is that the country has an unmanageable public debt problem. I find this quite unpersuasive. All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. But the longer it waits the bigger the ultimate adjustment will need to be.

In 2010, according to the Organisation for Economic Co-operation and Development, Japan will pay net interest of 1.1 per cent of gross domestic product on net financial liabilities of 105 per cent of GDP. Since 2000, Japan’s average rate of deflation (on the GDP deflator, the widest measure of inflation) was 1.2 per cent. So let’s treat the expected real rate of interest on Japanese government borrowing at 2 per cent. Read more

First comes financial crisis; then comes sovereign debt crisis; then comes financial repression. This is the view of Carmen Reinhart, co-author of This Time is Different, the masterly study of financial crises through the ages. I recently had a fascinating conversation on this topic with her, here in New York, where I have been living since the beginning of April.

So the question for the exchange is: how likely is financial repression? What forms might it take? Might this even be the end of the era of globalised finance? Read more

Update: Read Martin’s final response to readers’ comments.

The question I wish to pose for the next two weeks is whether it is possible for countries to accept large net inflows of capital from abroad, without ending up in crisis. If not, how do we manage a world of capital mobility? Read more