Has the financial crisis changed the world? Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

John Weatherall Public Lecture

October 2 2013

Queen’s University, Kingston, Ontario

2

Panic

3

Has the financial crisis changed the world?

• It is too soon to know. But I do hope it has.• In this lecture, I intend to address the following four

issues:– Where we are.– How we got here.– Where we go.– What we learn.

4

1. Where we are

• The high-income countries have been stuck in a “contained depression” for six years.

• What are the symptoms of this malady?• The answer is the combination of:

– Weak economies; – aggressive monetary and (to a lesser degree) fiscal policies; – and low inflation.

• Meanwhile crisis-hit eurozone members have fallen into deep slumps.

5

1. Where we are – the slump

THE LONG RECESSION

Q1 2008

Q2 2008

Q3 2008

Q4 2008

Q1 2009

Q2 200

9

Q3 2009

Q4 2009

Q1 2010

Q2 2010

Q3 2010

Q4 2010

Q1 2011

Q2 2011

Q3 2011

Q4 2011

Q1 2012

Q2 201

2

Q3 2012

Q4 2012

Q1 2013

Q2 2013

90.0

92.0

94.0

96.0

98.0

100.0

102.0

104.0

106.0

GDP IN THE "GREAT RECESSION"

Eurozone Germany France US UK Italy

6

1. Where we are – fiscal deficits

United States United Kingdom

Japan France Italy Canada Germany-16-14-12-10

-8-6-4-2024

GENERAL GOVERNMENT BORROWING(per cent of GDP)

2006 2007 2008 2009 2010 2011 2012 2013

EXPLODING FISCAL DEFICITS

7

1. Where we are – public debt

Canada Germany France United States

United Kingdom

Italy Japan0

20

40

60

80

100

120

140

160

NET PUBLIC DEBT (over GDP)

2007 2010 2013 2016

LEAD TO SOARING PUBLIC DEBT

8

1. Where we are – monetary policy

1/1/99

6/1/99

11/1/

994/1

/009/1

/002/1

/017/1

/01

12/1/

015/1

/02

10/1/

023/1

/038/1

/031/1

/046/1

/04

11/1/

044/1

/059/1

/052/1

/067/1

/06

12/1/

065/1

/07

10/1/

073/1

/088/1

/081/1

/096/1

/09

11/1/

094/1

/109/1

/102/1

/117/1

/11

12/1/

115/1

/12

10/1/

123/1

/138/1

/130

1

2

3

4

5

6

7

CENTRAL BANK POLICY RATES

Federal Reserve Bank of JapanBank of England European Central Bank

A WORLD OF FREE MONEY

9

1. Where we are – monetary policy

AND EXPANDING MONETARY BASE

May-06

Nov-06

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

Nov-10

May-11

Nov-11

May-12

Nov-12

May-13

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

450.0

500.0

BALANCE SHEET OF THREE CENTRAL BANKS

Federal Reserve ECB Bank of England

1. Where we are – monetary policy

10

YET MONETARY GROWTH CEASES

1/1/99 1/1/00 1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 1/1/13100.0

150.0

200.0

250.0

300.0

350.0

MONEY SUPPLY IN THE GREAT RECESSION

US M2 Euro M3 UK M3

11

1. Where we are – long-term interest rates

Jan-9

5

Jan-9

6

Jan-9

7

Jan-9

8

Jan-9

9

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

30

1

2

3

4

5

6

7

8

9

10

YIELDS ON 10-YEAR GOVERNMENT BONDS

Germany UK US Japan Canada

BOND YIELDS FALL TO VERY LOW LEVELS

12

1. Where we are – eurozone depressions

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-1370.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

GDP SINCE THE CRISIS

Italy Spain Greece Ireland Portugal

SLUMPS IN CRISIS-HIT EUROZONE COUNTRIES

13

1. Where we are – eurozone depressions

1/1/07 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 1/1/130

5

10

15

20

25

30

STANDARDISED UNEMPLOYMENT RATES

Germany Italy Spain Greece Portugal Ireland

UNEMPLOYMENT IN CRISIS-HIT COUNTRIES

14

2. How we got here

• The crisis is the result of a complex interaction between two forces:– A global saving glut; and– A fragile financial system

• When the “Minsky moment” came in 2007-08, the results were:– A huge financial crisis;– State-backing of the core financial system; and – The hyper-aggressive monetary and fiscal policies.

15

2. How we got here – asset bubbles

Q1 199

5

Q4 199

5

Q3 199

6

Q2 199

7

Q1 199

8

Q4 199

8

Q3 199

9

Q2 200

0

Q1 200

1

Q4 200

1

Q3 200

2

Q2 200

3

Q1 200

4

Q4 200

4

Q3 200

5

Q2 200

6

Q1 200

7

Q4 200

7

Q3 200

8

Q2 200

9

Q1 201

0

Q4 201

0

Q3 201

1

Q2 201

2

Q1 201

30.00

50.00

100.00

150.00

200.00

250.00

300.00

350.00

-2

-1

0

1

2

3

4

5

REAL HOUSE PRICES AND REAL INDEX-LINKED YIELDS

US real (S&P Case Shiller National) UK real NationwideSpain real UK 10-year IL gilts

Rea

l Hou

se P

rices

Index-linked Yield

BEGINNING AND END OF HOUSING BUBBLES

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2. How we got here – global imbalances

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016-3

-2

-1

0

1

2

3

4

GLOBAL IMBALANCES (as per cent of world GDP)

US Oil exporters Germany and JapanPeripheral Europe China and Emerging Asia Rest of worldDiscrepancy

WHERE EXCESS SAVINGS CAME FROM

17

2. How we got here – global reserves

Jan-9

7

Aug-97

Mar-98

Oct-98

May-99

Dec-99

Jul-0

0

Feb-01

Sep-01

Apr-02

Nov-02

Jun-0

3

Jan-0

4

Aug-04

Mar-05

Oct-05

May-06

Dec-06

Jul-0

7

Feb-08

Sep-08

Apr-09

Nov-09

Jun-1

0

Jan-1

1

Aug-11

Mar-12

Oct-12

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

FOREIGN CURRENCY RESERVES ($bn)

China Rest of AsiaRest of developing countries Industrial countries

THE ROLE OF GOVERNMENTS

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2. How we got here – asset bubbles

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

350.0%

US CUMULATIVE PRIVATE SECTOR DEBT OVER GDP

Households Non-financial Business Financial Sectors

THE RISE OF THE LEVERAGED ECONOMY

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2. How we got here – financial leverage

LEVERAGE IN PRE-CRISIS UK BANKING

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2. How we got here – eurozone

• The core of the eurozone financial crisis is not fiscal• The fiscal crisis is more a symptom of the financial

crisis than a cause of that crisis• The crisis is largely the result of divergences

accumulated in the years of excess: what made everything seem so good was in fact creating an acute long-term crisis

• External imbalances played a far bigger role than fiscal imbalances: it mattered less whether the private or public sectors were being financed than how big the external finance was

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2. How we got here – eurozone imbalances

THE ROAD TO THE EUROZONE CRISES

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

EUROZONE IMBALANCES ON CURRENT ACCOUNT(as per cent of Eurozone GDP)

Germany Other persistent surplus FranceVulnerable countries Others Eurozone

Axis Title

2222

2. How we got here – eurozone imbalances

THE ROAD TO THE EUROZONE CRISES

Finland

Netherla

nds

German

y

Belgium

Austria

France Ita

ly

Irelan

dSpain

Greec

e

Portuga

l-12.0-10.0

-8.0-6.0-4.0-2.00.02.04.06.08.0

5.6 5.43.5

2.5 2.00.2

-0.9-2.3

-6.2

-9.2 -9.7

AVERAGE CURRENT ACCOUNT BALANCES 2000-08

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2. How we got here – eurozone debt

NOT THE ROAD TO THE EUROZONE CRISES

Greec

eIta

ly

Belgium

Portuga

l

Franc

e

German

y

Austria

Spain

Netherla

nds

Irelan

d

Finland

-100.0

-50.0

0.0

50.0

100.0

150.0

GOVERNMENT NET DEBT OVER GDP (per cent)

242424

2. How we got here – eurozone debt

CRISIS-HIT COUNTRIES SUFFER

Greece Italy Portugal Spain Ireland0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

180.0

200.0

NET GOVERNMENT DEBT OVER GDP (per cent)

2007 2010 2013

252525

2. How we got here – eurozone yields

CRISIS-HIT COUNTRIES SUFFER AND RECOVER

12/30

/05

3/31/0

6

6/30/0

6

9/29/0

6

12/29

/06

3/30/0

7

6/29/0

7

9/28/0

7

12/28

/07

3/28/0

8

6/27/0

8

9/26/0

8

12/26

/08

3/27/0

9

6/26/0

9

9/25/0

9

12/25

/09

3/26/1

0

6/25/1

0

9/24/1

0

12/24

/10

3/25/1

1

6/24/1

1

9/23/1

1

12/23

/11

3/23/1

2

6/22/1

2

9/21/1

2

12/21

/12

3/22/1

3

6/21/1

3

9/20/1

3-2

0

2

4

6

8

10

12

14

16

SPREADS OVER GERMAN BUNDS

Portugal IrelandItaly Spain3-year Long-term refinancing operation "Whatever it takes"

26

3. Where we go

• Does this crisis mark a permanent slowdown in the growth dynamic of the high-income countries

• How does a growth slowdown affect debt management? Remember debts can be managed by:– Fast growth;– Inflation;– Low interest rates; and– Outright default

• If growth is slow, it is the other three that must happen

2727

3. Where we go

THE LONG SLUMP

Q1 1980 Q2 1983 Q3 1986 Q4 1989 Q1 1993 Q2 1996 Q3 1999 Q4 2002 Q1 2006 Q2 2009 Q3 2012$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

$20,000

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

US GDP AGAINST TREND TO 2007 IV ($bn)

US GDP annualised (bn) Trend to 2007 IVDeviation

2828

3. Where we go

THE LONG SLUMP

Q1 1995

Q1 1996

Q1 199

7

Q1 1998

Q1 1999

Q1 200

0

Q1 2001

Q1 2002

Q1 2003

Q1 2004

Q1 2005

Q1 2006

Q1 2007

Q1 2008

Q1 200

9

Q1 2010

Q1 2011

Q1 2012

Q1 2013

€ 0

€ 500

€ 1,000

€ 1,500

€ 2,000

€ 2,500

€ 3,000

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

EUROZONE GDP AGAINST TREND TO Q4 2007 (euro bn)

Eurozone (at 2000 Constant Prices) TrendDeviation

2929

3. Where we go

THE LONG SLUMP

Q1 1980 Q2 1983 Q3 1986 Q4 1989 Q1 1993 Q2 1996 Q3 1999 Q4 2002 Q1 2006 Q2 2009 Q3 2012£0

£50

£100

£150

£200

£250

£300

£350

£400

£450

£500

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

UK GDP AGAINST TREND TO 2007 Q IV (£bn)

UK GDP quarterly (bn) Trend to 2007 IV Deviation

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3. Where we go - potential

• Economies have responded in two ways to the crisis:– Productivity collapse and strong employment (e.g.

Germany and the UK)– Rising productivity and weaker employment (e.g. US and

Spain)

• Which of these indicates the best supply potential?• Answer: we do not know. Will productivity rebound

or will employment rebound?

3. Where we go - employment

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Germany United Kingdom United States France Italy Spain50.0

55.0

60.0

65.0

70.0

75.0

EMPLOYMENT OVER POPULATION RATIOS (AGED 15-65)

2007 2012

DIVERGENT EMPLOYMENT PERFORMANCE

32

3. Where we go - productivity

Spain United States

Canada Japan France Germany United Kingdom

Italy-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0% 11.0%

5.6%

1.5% 0.9%0.2%

-0.7%

-3.0%-4.2%

CHANGES IN OUTPUT PER WORKER 2007-12 (PPP $s)

PRODUCTIVITY GROWTH COLLAPSE

3. Where we go - recovery

• Whatever the potential for supply may be, where is the demand going to come from?

• With fiscal policy contractionary, it must come from private spending.

• In practice, rising consumption driven by credit growth is a necessary condition for a sustained recovery.

• So monetary policy is likely to remain ultra-easy.• But such an expansion might prove unsustainable.

33

34

4. What we learn

• First, our economic ideas have been discredited:– Back to Wicksell, Hayek and Keynes– End of market utopianism.

35

4. What we learn

• Second, the financial system is crisis prone:– We have allowed private institutions to serve a fundamental

public function – the creation of money. – The result, in a fiat money system, in which bank reserves

can be created without limit, is an explosive system.– The financial system is always part of the state. It is not fully

private.– We need to make the financial system much more robust. – The three most important reforms are higher capital ratios

and workable macro-prudential policies.

36

4. What we learn

• Third, we may be moving into secular stagnation in the high-income countries:– Slowing trend productivity growth;– Deteriorating demographics; – Debt overhangs; and – Financial repression.

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4. What we learn

• Fourth, large current account imbalances (i.e. external imbalances) always suggest a crisis is on the way:– The concern over imbalances felt by Keynes at Bretton

Woods remains valid.– But there is no mechanism to ensure global balance.– Indeed, the role of the dollar seems to make balance almost

impossible to achieve.

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4. What we learn

• Fifth, management of the world economy has become more difficult as the economic and political weight of the West has declined.– We are in another period of difficult transition between

hegemonic powers, as in the 1920s and 1930s.– The relationship between the US and China will be far more

difficult than between the US and the UK.– China cannot be the hegemon of a global market economy.

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4. What we learn

• Sixth, the eurozone is a bad marriage, but divorce is very costly. Can it be made a good marriage?

• For that it needs:– Debt restructuring – debt overhangs are now large.– Financing – largely supplied by the European Central Bank– Adjustment – symmetrical adjustment of income and

spending– Fundamental reform – a banking union and a minimum

fiscal union.

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5. Conclusion

• Here are my four main conclusions:– We are in a contained depression. It will not end until we

have sustained growth at “normal” interest rates and without unsustainable debt build-ups.

– We got here because of the interaction of macroeconomic imbalances with an inherently unstable financial system.

– It is not clear what sort of “normal” the high-income countries can get back to. That will, in turn, determine how the post-crisis debt overhang is handled and where we end up.

– We need to learn some big lessons about how to understand and handle our economies and financial systems, including not least in the eurozone.