Martin Wolf’s not so shocking shocks

Martin Wolf, FT’s chief economist, recently published a new book, The Shifts and the Shocks. The book reads like a massive Financial Times article. The style is quite ‘heavy’ and not always easy to read: Wolf throws at us numbers and numbers within sentences rather than displaying them in tables. This format is more adapted to newspaper articles.

Overall, it’s typical Martin Wolf, and FT readers surely already know most of the content of the book. I won’t come back to his economic policy advices here, as I wish to focus on a topic more adapted to my blog: his views on banking.

And unfortunately his arguments in this area are rather poor. And poorly researched.

Wolf is a fervent admirer of Hyman Minsky. As a result, he believes that the financial system is inherently unstable and that financial imbalances are endogenously generated. In Minsky’s opinion, crises happen. It’s just the way it is. There is no underlying factor/trigger. This belief is both cynical and wrong, as proved by the stability of both the numerous periods of free banking throughout history (see the track record here) and of the least regulated modern banking systems (which don’t even have lenders of last resort or deposit insurance). But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems are unstable; it’s just the way it is.

Wolf identifies several points that led to the 2000s banking failure. In particular, liberalisation stands out (as you would have guessed) as the main culprit. According to him “by the 1980s and 1990s, a veritable bonfire of regulations was under way, along with a general culture of laissez-faire.” What’s interesting is that Wolf never ever bothers actually providing any evidence of his claims throughout the book (which is surprising given the number of figures included in the 350+ pages). What/how many regulations were scrapped and where? He merely repeats the convenient myth that the banking system was liberalised since the 1980s. We know this is wrong as, while high profile and almost useless rules like Glass-Steagall or the prohibition of interest payment on demand deposits were repealed in the US, the whole banking sector has been re-regulated since Basel 1 by numerous much more subtle and insidious rules, which now govern most banking activities. On a net basis, banking has been more regulated since the 1980s. But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems were liberalised; it’s just the way it is.

Financial innovation was also to blame. Nevermind that those innovations, among them shadow banking, mostly arose from or grew because of Basel incentives. Basel rules provided lower risk-weight on securitized products, helping banks improve their return on regulatory capital. But it doesn’t fit Wolf’s story so let’s just forget about it: greedy bankers always come up with innovations; it’s just the way it is.

The worst is: Wolf does come close to understanding the issue. He rightly blames Basel risk-weights for underweighting sovereign debt. He also rightly blames banks’ risk management models (which are based on Basel guidance and validated by regulators). Still, he never makes the link between real estate booms throughout the world and low RE lending/RE securitized risk-weights (and US housing agencies)*. Housing booms happened as a consequence of inequality and savings gluts; it’s just the way it is.

All this leads Wolf to attack the new classical assumptions of efficient (and self-correcting) markets and rational expectations. While he may have a point, the reasoning that led to this conclusion couldn’t be further from the truth: markets have never been free in the pre-crisis era. Rational expectations indeed deserve to be questioned, but in no way does this cast doubt on the free market dynamic price-researching process. He also rightly criticises inflation targeting, but his remedy, higher inflation targets and government deficits financed through money printing, entirely miss the point.

What are Wolf other solutions? He first discusses alternative economic theoretical frameworks. He discusses the view of Austrians and agrees with them about banking but dismisses them outright as ‘liquidationists’ (the usual straw man argument being something like ‘look what happened when Hoover’s Treasury Secretary Mellon recommended liquidations during the Depression: a catastrophe’; sorry Martin, but Hoover never implemented Mellon’s measures…). He also only relies on a certain Rothbardian view of the Austrian tradition and quotes Jesus Huerta de Soto. It would have been interesting to discuss other Austrian schools of thought and writers, such as Selgin, White and Horwitz, who have an entirely different perception of what to do during a crisis. But he probably has never heard of them. He once again completely misunderstands Austrian arguments when he wonders how business people could so easily be misled by wrong monetary policy (and he, incredibly, believes this questions the very Austrian belief in laissez-faire), and when he cannot see that Austrians’ goals is to prevent the boom phase of the cycle, not ‘liquidate’ once the bust strikes…

Unsurprisingly, post-Keynesian Minsky is his school of choice. But he also partly endorses Modern Monetary Theory, and in particular its banking view:

banks do not lend out their reserves at the central bank. Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible.

I have already written at length why this view (the ‘endogenous money’ theory) is inaccurate (see here, here, here, here and here).

He then takes on finance and banking reform. He doubts of the effectiveness of Basel 3 (which he judges ‘astonishingly complex’) and macro-prudential measures, and I won’t disagree with him. But what he proposes is unclear. He seems to endorse a form of 100% reserve banking (the so-called Chicago Plan). As I have written on this blog before, I am really unsure that such form of banking, which cannot respond to fluctuations in the demand for money and potentially create monetary disequilibrium, would work well. Alternatively, he suggests almost getting rid of risk-weighted assets and hybrid capital instruments (he doesn’t understand their use… shareholder dilution anyone?) and force banks to build thicker equity buffers and report a simple leverage ratio. He dismisses the fact that higher capital requirements would impact economic activity by saying:

Nobody knows whether higher equity would mean a (or even any) significant loss of economic opportunities, though lobbyists for banks suggest that much higher equity ratios would mean the end of our economy. This is widely exaggerated. After all, banks are for the most part not funding new business activities, but rather the purchase of existing assets. The economic value of that is open to question.

Apart from the fact that he exaggerates banking lobbyists’ claims to in turn accuse them of… exaggerating, he here again demonstrates his ignorance of banking history. Before Basel rules, banks’ lending flows were mostly oriented towards productive commercial activities (strikingly, real estate lending only represented 3 to 8% of US banks’ balance sheets before the Great Depression). ‘Unproductive’ real estate lending only took over after the Basel ruleset was passed.

The case for higher capital requirements is not very convincing and primarily depends on the way rules are enforced. Moreover, there is too much focus on ‘equity’. Wolf got part of his inspiration from Admati and Hellwig’s book, The Bankers’ New Clothes. But after a rather awkward exchange I had with Admati on Twitter, I question their actual understanding of bank accounting:

While his discussion of the Eurozone problems is quite interesting, his description of the Eurozone crisis still partly rests on false assumptions about the banking system. Unfortunately, it is sad to see that an experienced economist such as Martin Wolf can write a whole book attacking a straw man.

* In a rather comical moment, Wolf finds ‘unconvincing’ that US government housing policy could seriously inflate a housing bubble. To justify his opinion, he quotes three US Republican politicians who said that this view “largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate.” Let’s just not tell them that ‘Real Estate’ comprises both residential housing and CRE…