The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—From the Financial Crisis -- Martin Wolf
In the world of ideas, metaphors rule—a continually underestimated fact. In economics, the metaphor of equilibrium has prevailed for over a century. It's perhaps the most antiquated and dangerous of myths, but it's seared into the brains of virtually every economist in the world. Understanding this can help investors see through the euphemistic arguments for and against post-crisis financial regulations—and come to terms with the fact that crisis-proof economies are a fantasy.
The idea that there is a point where supply meets demand is fine enough—we call that a price. But equilibrium is a biological and physical metaphor—it denotes a kind of balance to be sought everywhere. That prices want to reach a "balance" point, a homeostasis as it were. That's the myth—there is no such thing as a "balance" I can find in any economic system. Prices never, ever, find a resting point—they roil, turn, churn, react and adapt at every second of every day to new information, new opinions, new developments. Markets are a flow, not an equilibrium.
Said differently, equilibrium is a metaphorical abstraction—an abstraction the entire edifice of economic mathematics is built upon. It's the metaphor that makes the math models work. Those math models are what every student in Econ 101 has been taught for over a hundred years and what today’s elite economists still operate on.
I'd go so far as to call balance an obsession with today's macroeconomists. To their eyes, economic and market problems come from "imbalances": crises come from things like savings gluts (savings should always be balanced with investment), or imbalances in current accounts (trade should always be as balanced as possible). Modern accounting is mostly based on it—balance sheets, debits and credits.
From this balance obsession spawns an obsession with "stabilizing" and "destabilizing" the economy. It's pretty much all economic policy makers ever talk about. Bull markets end up being bad because they ultimately imbalance, and thus cause destabilization ... leading to bear markets and the need to re-stabilize. History gets interpreted this way, and thus prognostication about the future is thought in terms of preserving balance. And then, right on cue, come the bevy of new policies and regulations aiming to ensure balance.
Most or all of this, from the mouths of today's macroprudential high priesthood, will sound like the most sensible nonsense you've ever heard. After all, who doesn't want balance and stability?
Enter Martin Wolf's (most commonly known for his Financial Times editorials) The Shifts and the Shocks, a book about the global economics of the last six years, focused mostly on the US and Europe. The book functions as a great synopsis of economic events, but it is obsessed with balance. I'd wager some version of that word appears no less than 1,000 times in its 500 pages.
"Shifts and shocks" is the title, but also the central problem. In the world of mathematical "equilibrium," there is no room for novelty or new things. It's a closed system. Anything new must instantaneously return the system to equilibrium. (That’s the sneaky dirty secret of macroeconomics as a discipline.) In reality, that’s impossible because capitalism is all about dynamism and growth—new things like technology, new financial instruments and so on. Thus, there is never equilibrium, only flow and adaptation. The theoretical math of equilibrium is just plain bunk. Shifts and shocks are what capitalism is all about. Today's policy makers want to wish—or rather, seek to regulate—that feature away. But when you do, all you end up with is a vicious cycle of stagnation that, guess what, requires even more regulation to fix things!
None of this is to overly chide Mr. Wolf—this book is cogent and well-argued. And his scathing report card for the Euro is well worth the read. For those wonks willing to wade in, it’s a stimulating one-stop shop for all prevailing economic ideas of the day.
Revealed in this book is policy makers’ perverse incentive, which amounts to wanting their cake and eating it too. Of course governments want perennial stability and dynamic growth—they keep power that way. But capitalism simply doesn’t permit them both—it’s a blatant contradiction. (It is similar to an investor wanting growth and capital preservation—an impossible ideal.) Thus, though the book doesn’t explicitly say so, many of its solutions feel a lot like what China does: effectively making the biggest banks public utilities and regulating their capital ratios to levels elites deem “balanced.” But China is as susceptible to banking cycles as anywhere—lending simply is more politicized there than elsewhere.
That we should have new rules as capitalism evolves and flows is not necessarily a scandal. The idea proactive regulation can keep things in perpetual balance, however, is a farce and harms more than it protects in the long run.
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