Martin Wolf on the Financial Crisis: The Fire Next Time

November 4, 2014

by Michael Edesess

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If you think the global financial crisis of 2007-2009 was a one-time event caused by lax regulation and a financial industry run riot, then Financial Times chief economics commentator Martin Wolf has some bad news for you. Wolf, one of the world’s most respected economists, says these circumstances were only part of its proximate cause and that the financial crisis was the inevitable product of the global economic system. If that system does not undergo radical change, says Wolf, financial crises may keep on recurring until the world economic order collapses.

In the course of a long and extraordinarily erudite tutorial on the macroeconomic origins of the financial crisis, Wolf states: “The kernel of the story, then, is one of the interaction between global macroeconomic forces and an increasingly fragile, liberalized financial system.”

Let us explore why he believes that and what he thinks can be done about it.

The savings glut and the investment dearth

For Wolf, among others, the story really began with the Asian financial crisis of 1997-98. That crisis was sometimes dubbed the “Asian flu” because of its viral spread to neighboring countries. Short-term lending in nonlocal currencies, principally U.S. dollars, in what were perceived to be vibrant economies like Thailand’s were suddenly curtailed – i.e., not rolled over – when whiffs of economic problems arose. This curtailment both resulted in and was exacerbated by runs on those countries’ currencies. Dollar loans could only be repaid with debased local currency at high costs, if at all. Economic collapse ensued.

The crisis had serious detrimental impacts on the economies of Indonesia, Malaysia, South Korea and the Philippines, as well as Thailand. Those countries required emergency loans from the International Monetary Fund (IMF). The IMF imposed draconian conditions in exchange for the loans, reducing the countries’ internal spending and driving many people into extreme poverty.

Asian countries, especially China, learned a lesson from this. The lesson was never to be short of U.S. dollar reserves again.

Furthermore, stocking up on dollar investments by creating local currency to purchase dollar-denominated assets like U.S. Treasury bonds had a depressive effect on the local currency’s value relative to the dollar. This made the country’s exports cheaper. Hence, the same policy that inured the country against runs on its currency also fueled export-driven growth.

As is well known now, that policy worked wonders, particularly for China’s economy. China amassed a vast repository of foreign currency reserves, accompanying high levels of export-driven economic growth. At the same time, commodity prices soared in the 2000s, partly due to China’s growth, so that commodity-exporting countries also amassed savings.

The result was a “savings glut” – which Wolf says is the same thing as an “investment dearth.” In other words, there were more funds looking for a place to be invested than there were investments. Savings have to equal investments in the end. The way to tell that there’s a savings glut is that interest rates are low. Otherwise the demand for investment would exceed the supply.

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