January 2015
For professional investors and advisers only.
Schroders – Secular Market Forum
by Martin Wolf
The shifts and the shocks: What we’ve learned - and have still to learn – from the financial crisis
In his latest book, Martin Wolf explores the way in which the financial and
economic crises – which struck high income economies after August 2007 –
have altered our world. Discussing the book in Schroders’ head office in the
winter of 2014, Mr Wolf provided a summary of the positive changes made,
but also the worrying number of issues yet to be fully addressed.
Economists
have not caught
up with the new
world economy
Despite spending his professional life analysing the world economy, Wolf is candid in admitting
that he did not foresee the magnitude of the crisis which unfolded from 2007. He was not alone
in this. The consensus amongst even the most learned market observers was that a crisis on the
scale of the 2007 to 2012 collapse was inconceivable.
However, Wolf is keen to express that a failure to forecast the crisis – or the scale thereof – is
not what should be taken away from any analysis of the global meltdown. By aligning what Wolf
terms the “old orthodoxy” – the old economic rules – with the current state of affairs, it becomes
apparent that our understanding of the world’s major institutions and economies is nowhere near
as comprehensive as previously thought. Fighting a persistent threat of deflation, for example, is
not a challenge which a lengthy period of historically low interest rates was expected to pose.
Wolf believes that this indicates that economists have not yet adapted to the new economic terrain
we are on. Furthermore, he suggests that in studying the lead up to the economic crisis with this
realisation in mind, we may be better able to analyse the past and avert the same mistakes in the
future.
A brief history of
catastrophe
The financial crisis was the result of a number of inputs, each of which contributed to the problem
sitting at its core: the ‘sub-prime’ market. The errors were a result of using endogenous or inwardlooking central bank policy approaches, and a poor understanding of risk measures.
Prior to 2007 the global economy was in the midst of a ‘savings glut’, while corporate profits
were extremely high. Income levels rose for top earners while the impact on those in lower wage
brackets was limited. The result of the high savings levels was a dramatic fall in real interest rates,
while there was a huge increase in credit growth centred on those in lower wage brackets. In
Wolf’s words this was “dramatically true in the US” where a destructive feedback loop formed.
The credit facilities were secured against property which, rising in value due to low interest rates,
allowed for further credit to be extended.
Global Imbalances (% of world GDP) – Excess savings by country
4
3
2
1
0
-1
-2
-3
1996
1998
2000
2002
US
Oil Exporters
China & Emerging Asia
2004
2006
Germany & Japan
Rest of World
2008
2010
2012
Peripheral Europe
Discrepancy
2014
2016
Schroders – Secular Market Forum – The shifts and the shocks
The response to readily-available credit and rising real estate prices was an overdevelopment in
property projects, particularly in the US. With interest rates at relative lows, savers began turning to
the burgeoning asset class to provide them with returns. The following explosion in collateralised debt
securities looked like it could fill this gap.
However, when interest rates began to increase, it became apparent that credit levels were not
sustainable. Institutions which thought they were very safe were shocked at the scale of liabilities they
could not cover. The extant methods of quantifying balance sheet strength or leverage levels fell apart,
reliant on risk-weighted models which used backward-looking valuations.
Where we
are now?
The financial crisis brought a number of the world’s largest companies to their knees. For some, the
outcome was worse, with a number of full blown collapses. Lehmann Brothers’ bankruptcy filing is
the largest in US history, and the firm has become a byword for catastrophic failure through hubris. As
a result of drastic levels of intervention by major central banks – and in particular the Federal Reserve
– a global depression was averted, but Wolf is at pains to express that this does not indicate a global
economy in good repair. In his view, the biggest problems facing us have been resolved in the short
term, but have not been removed from the equation. They may arguably have been replaced by new
impediments.
To avert disaster, regulation in finance has expanded by a dizzying amount. The Dodd-Frank Wall
Street Reform and Consumer Protection Act, signed into federal law by President Obama in 2010,
was constructed with the aim of insulating the US economy from a repeat of the excesses that
demolished trust in financial markets. Wolf is an advocate of the increased scrutiny that banks face,
and sees both the expansion of regulatory intervention and drastically lower leverage levels as a
bedrock on which trust levels may be rebuilt. Wolf’s scepticism of banks even calls into question
the relevance of a privatised financial sector at all, if it is unable to function successfully without
government backing and a rulebook which may stretch, when complete, to 30,000 pages. But such
stringent regulation, however necessary, causes its own issues. With stifling levels of process to
adhere with, Wolf is aware that growth may not materialise as quickly as it needs to.
And one way or another, productivity does need to improve. US GDP is currently 18% below its
long-term trend, running from 1950-to-date. The eurozone, which Wolf believes represents the
world economy in miniature, is suffering from the same below-trend GDP growth; at 13% below
average. But unlike the US, the eurozone is teetering on the brink of deflation. Where US demand
has recovered from 2011 to date, demand in the eurozone remains below its 2008 levels.The spectre
of a Japan style economy now threatens Europe. 10-year bond yields in Germany are closing in on
Japanese equivalents at below 1%. The European Central Bank has been too timid in expanding
its balance sheet – falling a long way behind the UK and the US in the process – and inflation has
evaporated.
What are the
solutions?
Wolf’s primary concern is that the “new orthodoxy” is not different enough from the old version to be
able to resolve the current lack of global growth. We retain the same inflation targeting policies, with
the same inflation targets. There is still no coordination of fiscal policy with central banks. Leverage
levels remain extremely high at private and public levels and on top of all this, trust is still in tatters.
Levels of economic welfare in developed markets have dropped startlingly in the past decade, as
indicated by how far below the long-term average productivity now runs in both the US and the
eurozone. In spite of bold monetary measures from Shinzo Abe to reignite the Japanese economy,
there have been few lasting signs that the quantitative easing has been effective there either. To
resolve these issues, Wolf attempts to outline the changes which now need to be made.
Schroders – Secular Market Forum – The shifts and the shocks
$25,000
15.0%
10.0%
$20,000
GDP (bn)
5.0%
$15,000
0.0%
-5.0%
$10,000
-10.0%
$5,000
-15.0%
$0
1950
-20.0%
1956
1962
1968
Gross domestic product
1974
1980
1986
1950-2007 Trend
1992
1998
2004
Deviation from trend (percent)
US GDP – (Actual, trend and deviation from trend)
2010
Deviation from trend (percent)
The challenges of making long-term improvements in the health of the world economy does not,
in Wolf’s eyes, lie in preventing periods of recession or even depression. These are normal states
which an economy can find itself in, and cyclical deteriorations in productivity are to be expected.
Instead, Wolf’s focus is on how capable economies are overall at coping with future shocks; not
trying to kill all viruses, but strengthening the immune system. Wolf believes we need to focus on
the principal problems of productivity, and the health of global financial institutions.
The key to protecting the financial sector is expected to be macro-prudential policy. This is a way
of protecting the financial sector from the economic cycle, and also the economic cycle from
the financial sector itself. The essence of macro-prudential policy is to ensure we have a firmer
grasp of how vulnerable financial institutions are to economic shocks and vice versa. However,
interventions will be difficult to judge, politically unpopular and are likely at times to conflict with
monetary policy. The challenges for the demand problem are more clear cut in Wolf’s mind, but no
less difficult to overcome.
At a global level, Wolf believes that a much higher level of public investment is needed, as well as a
closer integration of fiscal policy and monetary policy. Governments should take advantage of the
low level of interest rates to borrow and invest in projects which will provide a long-run return to the
economy; investments such as infrastructure, health and climate change.
At a regional level, the eurozone and its ongoing stagnation represents a major headwind to
sustainable global demand levels. Inflation, which currently lingers far too close to 0% for the bloc
overall, needs to be far higher. In Germany, Wolf believes inflation should be as high as 4.0%.
At a domestic level, Wolf encourages us to focus on the structural difficulties posed by public
and private balance sheets. He believes that the level of capital on bank balance sheets needs to
drastically rise, while a drastic deleveraging of economies is essential.
Economic
score: ‘could
do better’
Wolf concluded his presentation by confirming that the financial crisis was “a major disaster, by any
standards”. A lot of the initial reaction was summarised by Her Majesty Queen Elizabeth II, on her
visit to London School of Economics in 2008. Her majesty asked what many were thinking: “Why
did nobody notice it?”Wolf’s view is that we should focus on a different question; “Why was it so
bad?”In exploring the question, he provides many of the solutions. Some vital and positive steps
have been made in saving the financial system. What Wolf has found is that if the financial sector,
at a global level, is more structurally sound and factors in the world it lives in, the impact of the
inevitable ‘shifts and shocks’ need not be so painful.
Important information: The views and opinions contained herein are those of Martin Wolf, and may not necessarily represent views expressed or reflected in other Schroders
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decisions. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the
amount originally invested. Schroders has expressed its own views in this document and these may change (to be used if the 1st statement above is not being used). For
your security, communications may be taped or monitored. The forecasts stated in the document are the result of statistical modelling, based on a number of assumptions.
Forecasts are subject to a high level of uncertainty regarding future economic and market factors that may affect actual future performance. The forecasts are provided to
you for information purposes as at today’s date. Our assumptions may change materially with changes in underlying assumptions that may occur, among other things,
as economic and market conditions change. We assume no obligation to provide you with updates or changes to this data as assumptions, economic and market conditions,
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