Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Unregulated Financial Systems Make Unstable Economies

June 20, 2012

In the years since the global crisis of 2008, the economics profession has been in turmoil.

Unregulated Financial Systems Make Unstable Economies

Financial district of London, United Kingdom. Financial bubbles are created by perverse incentives, says columnist Martin Wolf (photo: Image Source/Corbis)


Many have written about the mistakes that were made but also about the challenges and the reforms needed to sustain the global economic system.

One of these voices is Martin Wolf. In The Occupy Handbook published recently, Financial Times columnist Wolf explained what he sees as the biggest challenges to the current economic system.

In an interview with IMF Survey, Wolf presented a blueprint for the reform of the economic system.

IMF Survey: What is the biggest challenge to the current economic system?

Wolf: One of the biggest issues, really for centuries, but certainly over the last 80 years or so, in economics has been stabilizing the economy itself. How do you stabilize the economy? That was the main issue in the ’30s, then it became a huge issue again in the ’70s, and economists have given a number of answers to that.

I think this recent experience has underlined the thesis that there are deep, inherent instabilities in a market economy with an open, unregulated financial system. At the level of straight macroeconomic policy, the experience has made it very clear that we need a very full weaponry of stabilization policy.

The crisis has meant quite extraordinary monetary policy actions but it is absolutely clear to my mind that in circumstances like this one needs to use fiscal policy as well, very aggressively.

In addition to the fact that although the financial sector and its inherent fragility is crucial—both at the macroeconomic and the microeconomic levels—without a more stable financial system, it is basically impossible to achieve a greater stability in the economy as a whole.

The consensus that was reached in the last 20 years—that one just lets monetary policies stabilize inflation, does not need to use fiscal policy at all—has turned out to be really quite profoundly false.

IMF Survey: Despite its flaws, the financial system is an essential part of the market economy. What kind of policies would you advocate for its fixing?

Wolf: Most economies look at these questions in terms of incentives and, when something goes wrong, they immediately say it is because of perverse incentives of some kind.

There’s no doubt in the case of our financial sector they’re extremely perverse incentives. They come from the role of limited liability companies with very, very high leverage and with management rewarded for raising the returns on equity, which they can achieve by taking risks and by, among other things, by leveraging their banks, their financial institutions to an extraordinary degree. So these incentives all have to be dealt with.

But in addition to that, I became convinced that, quite simply, in these sorts of bubbles we’ve seen, people make mistakes. Human beings are enormously influenced by recent experience—they’re influenced by herd movement. They all convince themselves that everything’s fine. That means that you actually need policies—it’s very difficult to do because the regulators get captured, too—but you do need policies that lean against the wind of conventional opinion at any particular moment. And that’s, I think, what good macroprudential policy is about.

Now, beyond this there’s a big issue I haven’t touched, which is the system is global, it’s very highly globally integrated, and it’s become very, very difficult for regulators to control. I believe that this is actually an area where we’re going to have to deglobalize finance in some ways.

IMF Survey: Two issues that really have come in the forefront in the past year or so are those of inequality and unemployment. These have come forward in the form of data and also as the prime concern of people. So what could be done to address them?

Wolf: Well, I focus in this discussion on inequality. In the case on the unemployment issue, I think the core issue now is inadequate aggregate demand. The macroeconomic response to the crisis has been inadequate in many countries, including the U.S., the U.K., many others. The inequality issue is a structural one. I think what’s happened is partly for profound economic reasons to do with the changes in the demand for skills in globalization, but also because of institutional changes which have shifted the balance in favor of management in a profound way, and shareholders in the corporate sector. We’ve seen enormous increases in inequality.

Now, I think this is proving politically as well as socially destabilizing. And in an ideal world—again, this may be very naïve—something has to be done about it. We have to look at the institutions of corporate governance. We have to look at the way the labor market is regulated. I think that’s a relatively small issue. We have to start thinking about tax policy as being a mechanism for redistribution. I think it’s particularly important that there be massive assistance given to, as it were, the children of the poor. We want to prevent this sort of generation after generation of disadvantage being inherited, creating a permanent underclass, as it were, a permanent class of very poor people.

This obviously is incredibly ambitious, but I think in a number of developed countries—I think the U.S. is a prime example, but also my own, the U.K.—the concern that we are creating a highly stratified society is very profound and I think it’s ultimately incompatible with the survival of what I think of as a working democracy.

IMF Survey: So in the face of all these challenges, do you have any hopes or does it look incredibly dangerous?

Wolf: Honestly, I am pretty depressed, but I’m mainly depressed about the political responses. The agenda I put forward is what I think of as an intelligent centrist response. Now, some of these things are happening to a limited degree: reregulation of finance to some degree, things like that. But politicians have been extraordinarily timid.

And the agenda has changed, in my view, in terms of running corporate governance, running the financial sector—surprisingly little, given the scale of the crisis. I don’t know whether that’s because the power distribution just got completely out of whack or whether it’s because actually the technocrats did a reasonable job of preventing a total depression, which I think was the risk. So people now think that wasn’t a terribly important event at all, so they don’t think big changes are needed.

But what I’m disappointed by is the level of political discussion. What is coming forward where there is complaints, as in France, is incredibly naïve and simpleminded, I think. And in a number of countries there’s really no intelligent debate about these issues at all. If we can’t address problems when they’re obviously in front of us, then, of course, one fails. That’s how states and societies fail.