Three Things Very Much Worth Reading From Martin Wolf
On the fallout from Lehman:
Do not learn wrong lessons from Lehman’s fall: “If the price of oil stabilises, I believe we can weather the financial crisis at limited cost in terms of real activity.” Thus did Olivier Blanchard, newly appointed head of the International Monetary Fund’s research department, describe the prospects ahead on September 2 2008. He was swiftly proved wrong.... Few economists then realised how fragile the global financial system had become. The failure of Lehman Brothers just under two weeks later and the ensuing crisis at AIG, the insurance giant, turned complacency into terror. The financial system plunged into an abyss, dragging the economy behind it.
What lessons are we to learn from this shock, a year later?... When finance ministers and central bank governors of the Group of Seven leading developed countries met in Washington last October, they decided to “take decisive action and use all available tools to support systemically important financial institutions and prevent their failure”. Desperate times; desperate measures. Since large financial institutions are most likely to fail during a crisis, this amounted to an open-ended government guarantee. What makes the decision quite unbearable is that it was, in my view, also correct. The risk of a cascading failure of the good, the bad and the ugly among financial institutions was apparent. Given what had happened after Lehman’s failure, only fools would have run this experiment. We were not that foolish. Thus, the lesson learnt from Lehman’s failure was the precise opposite of what many had hoped on the day it was announced: it is that every systemically significant institution must be rescued in a crisis. That lesson is reinforced by Wednesday’s agreement that the rescue, buttressed by unprecedented monetary and fiscal stimulus, has worked: the panic is over and the world economy is on the mend....
If these are indeed the sorts of lessons we draw, we are making huge mistakes. First, we cannot let stand the doctrine that systemically significant institutions are too big or interconnected to be allowed to fail in a crisis. No normal profit-seeking business can operate without a credible threat of bankruptcy.... The second big potential mistake is to return to the old doctrine that it is better to clean up after a crisis than to take any pre-emptive action.... The third big mistake is more immediate: it is to assume that we are already well on the way to a healthy recovery....
Letting Lehman go was not our biggest mistake. That was letting the economy and financial system become so vulnerable. Equally, the past year has restored neither the financial system nor the economy to health. We have avoided the worst. That is good. It is not enough.
On China's recovery:
Wheel of fortune turns as China outdoes west: China has emerged as the most significant winner from the global financial and economic crisis. At the end of 2008, many questioned whether China would achieve its growth target of 8 per cent in 2009. Who now dares to do so? Cushioned by its more than $2,100bn (€1,440bn, £1,260bn) of foreign currency reserves, huge trade and current account surpluses and a robust fiscal position, Beijing has been able to deploy all its levers over the financial system and the economy. Meanwhile, as one senior Chinese participant at the World Economic Forum’s annual meeting of “the new champions”, in Dalian, noted, “the teachers have made big mistakes”. Indeed, any visitor to Asia will recognise the west’s reputation for financial and economic competence is in tatters, while that of China has soared. The wheel of fortune is turning....
[H]owever successful China is in promoting domestic demand, it will not be the locomotive for the world economy. True, China’s merchandise trade surplus has indeed been narrowing: it was $35bn in the second quarter, 40 per cent lower than a year earlier. China’s current account surplus is also shrinking: it may be down to 6 per cent of gross domestic product this year, from 11 per cent in 2007. Yet, since it still only generates some 7 per cent of world output, China is too small to act as the world’s locomotive. Even halving its external surplus would add only 0.4 per cent to aggregate demand in the rest of the world...
On financial regulation::
Turner is asking the right questions on finance: Lord Turner is right to argue that... the fundamental issue is not structure, but philosophy. The UK authorities adopted the same view as the US: market forces guaranteed both efficiency and stability. They were wrong. Now that the view has changed, the upheaval caused by transforming the regulatory structure is unnecessary....
Now turn to whether the financial sector is “too large”.... [T]he sector enjoys subsidies from the state, via access to the lender-of-last-resort function of the central bank and explicit and implicit guarantees against insolvency. These need to be offset....
[H]igher capital requirements are far from a panacea. One danger is that banks may take on even more risk, to sustain high returns on equity. Another is that banks would again find a way around higher capital requirements....
That leads naturally to the “Tobin tax”. Obviously, it would have to operate in all significant financial centres. So the chance of its happening is zero....
Finally, how far are changes in the structure and levels of pay the answer? I agree with Lord Turner that “the honest truth is that bad remuneration policies, though relevant, were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies”....
[T]he more one analyses both the debate and what is happening, the more difficult it is to believe that a safer and more responsible industry is emerging. I love Lord Turner’s willingness to raise difficult questions. But I am not persuaded that he, or anybody else, offers convincing answers.
I confess I do not understand in what way "bad remuneration policies... were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies." I had thought that bad remuneration strategies produced the outsized risky trading strategies.
