Fixing Global Finance

An interview with Martin Wolf
Associate editor and chief economics commentator, Financial Times

“If global finance does little more than bring catastrophe in its wake, it becomes almost impossible to defend existing, let alone increased, levels of financial integration,” explains Martin Wolf, associate editor and chief economics commentator for the Financial Times. In an interview with Norbert Jorek, head of A.T. Kearney’s Global Business Policy Council, Mr. Wolf discusses the global impact of today’s financial crisis.

Norbert Jorek: The abandonment of the Bretton Woods system of fixed, but adjustable, exchange rates in the 1970s marked the beginning of a new global economy and an era of unstable exchange rates. As global leaders contemplate the future of the global financial system, what are the most important lessons to reflect upon?

Martin Wolf: Finance is the brain of the market economy. Unfortunately, as the world has been reminded too frequently over the past three decades—not least in the credit squeeze that began in the summer of 2007—this brain is susceptible to a variety of infirmities. In particular, it is prone to wild swings of mood, from euphoria to panic. The history of global finance since 1980 has, as a result, been one of the frighteningly expensive financial crises—expensive not just in terms of the costs to the taxpayer or of output forgone, but in terms of the shattered lives of innocent victims.

These disasters have turned global finance into the biggest economic challenge for those who support the integration of the world economy, a process now almost universally known as globalization. It is far from the only such challenge: international conflict, terrorism, and environmental catastrophe may ultimately prove far more important. But these challenges are not for economic policy alone. The workings of the financial system fall squarely within the economist’s domain. If global finance does little more than bring catastrophe in its wake, it becomes almost impossible to defend existing, let alone increased, levels of financial integration.

Norbert Jorek: As late as fall 2007, the world had had no sizable emerging market crises since 2001 (when Argentina defaulted), and the last global wave of crises ended by 1999. Had the world become more stable?

Martin Wolf: That would be a premature judgment. Since emerging market economies are unable or unwilling to absorb surplus savings generated in the world economy and, on the contrary, are generating surpluses themselves, some high-income countries must instead absorb those funds. Thus the net flows of capital were from the rest of the world to a few creditworthy high-income countries and, above all, to the United States, which has become the superpower of global borrowing. This has been far from the worst result of the experiment that is global financial liberalization. The emergence of America as an enormous borrower did indeed generate a welcome degree of economic and financial stability. Having the largest economy and the world’s most important currency, the United States is far better able to borrow abroad on a large scale than any other economy or even group of economies. But even there, the domestic counterpart of the external borrowing generated what ultimately proved to be unsustainable increases in household indebtedness. These led to the “subprime” crisis—a wider crisis that had its roots in U.S. mortgage lending practices—and to a financial shock that began to ripple across the high-income countries in 2007. The U.S. external deficit then started shrinking, as demand weakened and the dollar tumbled.

Norbert Jorek: What led to the United States’ role as this “superpower of global borrowing”?

Martin Wolf: It is the outcome of obvious failures: the failure to understand properly the inherent risks of all liberalized financial markets, where decisions are made by competing market-oriented institutions; the failure to appreciate the greater risks when finance crosses frontiers, particularly for fragile emerging market economies; the failure of debtor countries to understand the risks inherent in borrowing in foreign currencies and the consequent need for greater fiscal and monetary discipline; the failure to understand the exchange rate risk by both creditors and debtors and, in particular, the vulnerability of adjustable peg exchange rates in a world of liberalized capital movements; more broadly, the failure to understand what it means to live with the exchange rate instability of today’s multicurrency world, instead of the high predictability of the gold standard of the late nineteenth and early twentieth centuries; and the failure to modernize global institutions in time.

Norbert Jorek: Is this pattern of global net capital flows sustainable? And is the flow of capital from poor to rich countries desirable?

Martin Wolf: The former question is the more controversial. While the course on which U.S. external liabilities were launched looked unsustainable in the long term, because it implied an explosive rise in the country’s net liability position, it might have endured for a long time. But the domestic counterparts of that external borrowing became problematic far sooner.

The undesirability of this reaction to the prior instability of capital flows to emerging market economies is evident. A large-scale flow of capital from poor countries to the world’s richest is perverse. What makes it even more perverse is that strong political forces within the beneficiary country—the United States—resent the generosity of their creditors. Adding to this incendiary situation is the likelihood that the suppliers of finance will ultimately suffer large losses when the United States is called upon to repay—or at least to service—the capital it has received. Indeed, many are experiencing such losses as the dollar tumbles.

Norbert Jorek: Considering how much we have learned about how financial markets work in the past 30 years, why have there been so many financial crises?

Martin Wolf: All too often, the policymaking world was struggling to understand what was happening. Now the underlying economic forces are becoming a bit clearer. Unfortunately they are also rather depressing. It is hard, it turns out, to generate a sustained and stable net transfer of resources to emerging market economies. Every time this has happened, a severe crisis has resulted. The U.S. current account deficits of today are, I have concluded, the direct consequence of that failure. The United States has become the world’s spender and borrower of last resort, precisely because the world of globalized finance has proved so unstable.

Norbert Jorek: Are there advantages to liberal global financial markets? And if so, are they worth the subsequent risks?

Martin Wolf: Pointing to these waves of crises, some eminent economists have condemned financial integration outright. Among them have been the Nobel laureate Joseph Stiglitz of Columbia and Manchester universities, and Jagdish Bhagwati, also of Columbia, the most distinguished contemporary proponent of liberal trade. These two economists agree on few things, but they do agree on this. While almost all economists concur on the benefits of free trade, the same is decidedly not true for liberal finance. On this topic, opinions in the profession are far more evenly divided. George Soros, the contemporary world’s best example of a financial poacher turned would-be gamekeeper, has also been a persistent critic of the financial markets. And the financial disasters have had direct and dire consequences on the politics of emerging economies. Because of a wave of devastating financial crises, the public mood in Latin America has swung sharply against what is widely condemned as “neoliberalism” on that continent.

I am not quite so pessimistic. There are potential advantages to liberal financial markets. But exploiting those advantages, while minimizing the risks, poses an enormous challenge. The experience of the past three decades has demonstrated that conclusively. Even in the mid-1980s, few economists understood the potential for disaster in the interplay between liberalized finance, global financial integration, and the international monetary system. A notable exception was the late Carlos Díaz-Alejandro, wisest of all Latin American economists, in a prescient article published in 1985. We all know better now, but only after a long series of brutal lessons.

Norbert Jorek: How can financial markets function better?

Martin Wolf: We need to understand both the advantages and the dangers of liberal global finance. Even today, a harvest failure or a huge shift in the price of a particular commodity may have a significant impact on a developing country. The price of oil is an obvious example. Yet in high-income countries, and in most larger developing countries, no single productive sector has an economy-wide effect. But a financial crisis can have a huge impact on an entire economy, and indeed, on many economies at once. To understand the nature of these risks and the policy challenges they pose, we need to understand both the microeconomics of finance and the macroeconomics of exchange rates, public finance and monetary policy. It is in finance that microeconomics and macroeconomics meet. It has always been so.

Martin Wolf is the associate editor and chief economics commentator for the Financial Times and a professor of economics at the University of Nottingham. He is the author of several books, most recently Fixing Global Finance (Johns Hopkins University Press, 2008), and was named among the “Top 100 Public Intellectuals” by Foreign Policy and Prospect magazines.

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