Guest Post: “Martin Wolf, the FT’s rebel with a cause, and the future of finance

By Swedish Lex, an expert and advisor on EU regulatory and political affairs:

If you belong to those who believe that the debate on how to fix finance is mightily underwhelming when compared to the latter’s monumental failure, then I suggest reading Martin Wolf’s latest column in the Financial Times.

Wolf essentially trashes the financial system and the remedial actions taken thus far, Michael Moore-style:

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.

In Wolf’s view, the separation of utility banking from casino activities would be insufficient as there still would be a risk of the temptations of shadow banking leading to new bubbles and collapses. It seems that Wolf has taken the points made by Carmen Reinhart and Kenneth Rogoff in their recent book “This Time Is Different: Eight Centuries of Financial Folly” to heart. Wolf’s review of the book was published in the FT a couple of days ago. A few notable quotes from Wolf:

Cycles of confidence and panic are inevitable in our world of debt, be that debt public or private, domestic or foreign. Credit is extended freely and then withdrawn brutally.

Financial systems are accidents waiting to happen.

The final lesson is that financial liberalisation and financial crises go together like a horse and carriage. It is no surprise, therefore, that the last 30 years have seen waves of financial crises, of which the latest one is merely the biggest.

Importantly, Wolf concludes that regulation thus far has not been the answer but rather part of the problem. He seems to be recommending that large parts of financial activity may have to be outlawed altogether and that status quo is not an option:

The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go. At present, the official sector believes tighter regulation, particularly higher capital requirements, can contain these risks. But this is likely to fail. If it does, we will need to be radical. Yet narrow banking would still not be enough. We would need to rule out quasi-banking. Otherwise, we would soon return to the world of fragility and bail-outs. Funds that replace banks would have to pass the risks directly on to the outside investors. The authorities will not entertain such radical ideas right now. But the financial system is so inherently fragile that radical reform cannot be pronounced dead. It is only dormant.

So, to conclude, Wolf proposes changes to society that would be truly revolutionary, not as a means to achieve lofty and utopian ideals, but rather as a strategy for economic survival. Interestingly, the IMF yesterday published its new Global Financial Stability Report which contains an analysis of the inadequate policy responses by governments thus far and recommendations for future action. The parallels with Wolf’s thinking are striking, although the IMF obviously uses a different language:

A clear vision of future financial system regulation is needed to provide clarity and boost confidence.

In addition to a well-defined strategy for unwinding unconventional policies, confidence in the financial system will be bolstered by clarity over future regulatory reforms needed to address systemic risks. The recent easing of tail risks should not prompt authorities to relax their efforts to map out the path to a more robust financial system. A holistic, understandable approach needs to be formulated so that the private sector can plan appropriately. The priority should be to reform the regulatory environment so that the probability of a recurrence of a systemic crisis is significantly reduced. This includes not only defining the extent to which capital, provisions, and liquidity buffers are to rise, but also how market discipline is to be reestablished following extensive public sector support of systemic institutions in many countries.

There are already proposals that will go some way toward removing procyclicality in the financial system and increasing buffers against losses and liquidity dislocations. But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.

So, if we accept that the existing system is deeply flawed and that the necessary and desirable reforms are seriously lagging, the next question is; who is going to do the lifting? Wolf is entirely mute on this point but one has to assume that since the theme of his column is finance as such, unilateral UK action is not what he has on his mind. If Wolf’s thinking is limited to the UK alone then the City as we know it would be transformed into a museum. In order for Wolf’s vision for a new financial order to be effective, action would have to cover as many jurisdictions as possible. In fact the IMF Report discusses what it views as a need for globally coordinated policymaking and warns against regional solutions:

A macroprudential approach to global policymaking is needed to restore market discipline and ensure that the benefits of financial integration are preserved.
The further challenge is to place these reforms in the context of an integrated macroprudential policy framework in which both domestic and cross-border institutions can operate securely. There is now recognition that a combination of microprudential and macroeconomic policies operated procyclically and led to a buildup of leverage and systemic risk. Policymakers will need to address ways in which their own actions exacerbate systemic risks, regardless of whether they oversee monetary, fiscal, or financial policy. Cooperation and consistency in the policy field must extend across borders. Cross-border relationships between institutions and markets have made it impossible for policymakers to act unilaterally without consequences for others. Following the crisis, however, there is a danger that some countries will want to ring-fence their institutions and withdraw from global markets to protect their domestic economies from external shocks. What is needed instead is a way to benefit from increasing financial integration, while ensuring that potential negative spillovers are contained and clarity exists about the roles of home and host authorities. As policymakers move forward on this difficult task, the IMF can play a catalytic role through its surveillance activities and work on global macrofinancial linkages.

While I would agree with the IMF on the principle, I think it is wholly unrealistic to think that the Fund would be in a position to develop and broker the type of fundamental change that Wolf and, as it seems, the IMF, at least to some degree, are advocating. I furthermore have no expectations at all that the U.S. would be in a position to introduce the kind of reforms Wolf are suggesting, even if it, miraculously, wanted to.

This leaves us with the EU. The EU’s response to the crisis thus far clearly falls short of what Wolf is suggesting although a thorough analysis and reform program of EU policy for the financial sector is under way. The EU however possess the legal competence, the scope and the clout to undertake the kind of reforms that Wolf is suggesting although such a program would be as comprehensive and far-reaching as the introduction of the Euro and would entail a clear break with existing policies. Impetus for a grand projet to re-design the EU’s approach to finance would have to come from the highest political level with the full support of Germany and France. With Merkel re-elected on a platform of financial reform, Sarkozy unthreatened on the domestic political scene and with support from the European Parliament and Commission, such a development could not be ruled out entirely. Since the IMF now estimates that we still have a 1,5 trillion in writedowns ahead of us, at least, politicians might soon have to consider all options, including Wolf’s revolutionary ideas.

It would be interesting to hear what Wolf has to say on how his ideas for radical reform should be implemented and by whom. Perhaps for his next FT column?

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  1. Jon Livesey

    It’s the usual stuff, isn’t it. Only the EU can do the job. One immensely long guest editorial after another from Swedish Lex, and they all end up the same way: more power for the EU.

    After enough of these, I start to wonder if the “financial analysis”, which is just extended quotes from other people, is simply an excuse to post yet another push to concentrate power in Brussels.

    I’ll go and read Wolf in the original. That way I can see what he is really saying without the spin.

    1. M.G. in Progress

      Yesterday I was reading that Swedish Lex is “not knowledgeable enough on the issue itself” that was about taxation, regulatory and Commission’s consultation processes. Here we read Swedish Lex being “an expert and advisor on EU regulatory and political affairs”. I think it’s not realistic that EU or US can do things alone on regulation while everybody is afraid of free riding and competition issues in the financial industry.

  2. soulmatic09

    Wow @ this:

    “The answer to the second dilemma is to make banking illegal…The great game of short-term borrowing, used to purchase longer-term and risky assets, on wafer-thin equity, would be ruled out. The equity risk would be borne by the funds’ investors. Trading entities would exist. But they would need equity funding.”

    Talk about a radical solution.

  3. Fu

    To me, it’s not looking likely that the financial system will be reformed this time around. What it will take is complete economic collapse for real change to occur.

  4. Hugh

    There seems to be a kind of schizophrenia involved here. On the one hand, we know that European banks were involved in the same kind of crap investments as their American counterparts, that they were often even more leveraged, and that German banks in particular had all sorts of exposure in Eastern Europe. On the other, we have the assertion that European institutions and regulators have their act much more together than we do.

    Now maybe I missed it but I haven’t heard a lot about how the Europeans aired the problems of their banks, investigated them, and changed their way of doing business on even an interim basis. If the EU was going to take on the role of regional and/or world leader, I would have expected to have heard some of this. I haven’t.

    Rather I see the same kinds of political problems that beset all of these trans-national approaches whether it is the member states of Europe only or the world generally. The only country that could have led is the US but this didn’t and won’t happen because such leadership is as anathema to the Democrats as it is to Republicans.

    We desperately need real leadership but from what I have seen Asian, European, and American elites all appear equally clueless.

  5. tgmac

    The Europeans, and Germany especially, have been very quiet about their own failings. Merkel never leaves her hobby high horse far behind when talking about the financial situation by laying blame squarely upon the Anglo-US banking model while ignorinng the ‘quantitative easing’ policies of the ECB used to shore up a variety of reckless European banking institutions. However, after Ireland approves the Lisbon Treaty tomorrow, the Euro elites will have the impetus to reform banking. There is a will and now a vision attached to reform policy. While I cannot say with certainty what scope the reforms will encompass, they will be created to ensure an advantage to European Institutions. Anyone who thinks that the people of Brussels (political capitol) and Frankfurt (financial capitol) are guided by some lofty impulses is deluded.

    No doubt in Europe we’ll be fed the line that banking must become servants of industry, supposedly as is the case in Germany, but with an inflation doctrine inherent in the ECB remit we’ll still be exposed to risk and warped rewards. Financial reform will probably be used to create strong pan-European institutions that create barriers to entry and competition while driving prices up for consumers. We Europeans love nothing better than to take the high moral ground but arrive at solutions or reforms that are little better than the problems they addressed. Money is power and the EU cadres want to exercise global power.

    There will be a titanic struggle between London and Frankfurt but the political will to coral the London cowboys is tilted favourably towards Frankfurt, and there are some British financial officials who are favourably disposed to the European vision of reforms. The best London can do is fight a rear guard action and create favourable conditions for their super banks within the EU.

  6. Swedish Lex

    @ Jon Livesey

    You are reading things into my text that are not there, which is not the first time. I do not argue for “more power for the EU”, as you claim. The EU already has the legal authority and the power to act under the treaties that are in force, which is stated clearly in my text. The question I raise is whether it is likely or not that the EU actually will do so.
    Bearing in mind that if the IMF’s estimates for bank losses are at 3,4 trillion and, as Yves pointed out; “tier 1 capital of the top thousand banks in the world is a bit north of $4 trillion and most of the losses were replenished by governments”, it does not take a whole lot of imagination to come to the conclusion that governments in a couple of years might have gone from underwriting the financial system to actually owning and controlling it. Whether you love, hate or do not care about the EU, it is clear that the Union will be part of the process of redesigning the financial system, whether the EU actually wants to do that or not.

    @ MG in progress

    I yesterday commented that I am not knowledgeable enough about derivatives to have an opinion on whether the EC Commission’s public consultation on the issue makes sense or not on the substance. I do, on the other hand, have a bit of experience in regulatory affairs, including on public consultations and on matters relating to taxation. That the EU has competence to legislate on direct and indirect taxation is common knowledge. It is also common knowledge that the Commission only rarely and reluctantly puts forward proposals on taxation in view of the fact that the in most cases unanimity is required among the 27 Member States, which is hard to achieve in practice.

    @ Fu

    I hope that you are wrong and that a “complete economic collapse”, as you put it, will not be necessary to trigger reform. I have the impression though that Wolf and you may be on the same page here.


    According to the IMF, European banks lag those in the U.S. in accounting for losses. The future bad news on the financial side will thus have a European emphasis with significant economic impact in the European countries. This will in turn increase the chances, or risks, of a political response, depending on your views. Whether that response will be coordinated, significant and successful, we will have to see.

    @ tgmac

    You are in my view probably not far off the mark. Your scenario has an increasing degree of probability attached to it, looking a number of years into the future. Wolf’s column that completely beheads existing philosophies and models strengthens the case for those with other agendas.

  7. dearieme

    The EU, which cannot even present accounts that the auditors will sign off, is the answer? Bah, humbug. Just another sleazy power-grab.

  8. ian

    The governments of the world have no motivation to reform the system. They’ve already been bought. What they’re angling for is a bigger cut.

    There will be no reform until the next crash and after the next few crashes, it’s not likely to matter much what governments do.

  9. Ina Pickle

    Lex, the American government has the existing power and regulation in place to ban a great deal of the shenanigans – there is presently a call for regulatory reform, but aside from some obvious repeals of long-standing laws (Glass Stiegel, for example) the regs are in place if they were just enforced.

    For the past 15 years at least, they have not been enforced. The power has been abdicated. What is required is that we once again have regulators who BELIEVE in the laws that they are supposed to be enforcing and who are diligent to that end.

    As for the EU, it won’t really matter at all what they do to reign in banking if they do it in isolation. Surely you understand that. While there are a few pockets of genuinely different practices, the lowest common denominator is almost always exported in this world of ours. Money is notoriously fungible and mobile.

    We all need to recognize that the status quo impoverishes the populace for the benefit of a very few because the “down side” is covered by the many and the upside is captured privately (and shared with those few who could stop the casino – a house cut, if you will, for not ending the fun). That needs to stop – worldwide. I doubt that it will.

  10. John Merryman

    After reading the article by Martin Wolf, I sent some thoughts on how to rethink the financial system:

    Mr. Wolf,

    What will be left when the dust finally settles? Given that virtually every aspect of the financial and monetary system is being sacrificed in order to perpetuate the status quo, we will be left with as close to a clean slate as can be imagined. At least Hoover left Roosevelt with a solid currency.

    Money functions as both a store of value and a medium of exchange. As a store of value it is a form of private property, while as a medium of exchange it is a form of public utility, similar to a road system. While most people think of it as private property, the reality is that the system belongs to whomever guarantees its value. Render unto Caesar. We do possess the money we hold, in the same way we possess the section of road we are driving on. You own your car, house, business, etc, but not the roads connecting them. Money is a similar medium. It is a drawing right on community productivity for which we exchange our surplus resources.

    Believing money is private property encourages people to hoard it. The problem is that capital is subject to the laws of supply and demand, with the lender as supply and the borrower as demand. Since supply is potentially infinite, it is the amount of prudent borrowing which determines how much wealth can be saved. Unfortunately political power is on the side of those with money, rather than those borrowing it and this results in factors which swell the supply of money, while depleting the resources of borrowers. To create and store more notational wealth, the financial industry resorts to lowering loan standards and manufacturing excess circulation. Now this bubble is popping and much of that notational wealth is evaporating.

    Consider how it would change public perception of monetary wealth, if we were to come to the realization that the monetary system really is a form of public commons? The practice of hoarding excessive amounts would lack logical justification, so savings would be taxed progressively. This is not to discourage individual effort, but a necessary recognition of the effect of excess savings on a functioning monetary system. If people understood monetary value constituted public property, than they would be far more reluctant to drain value out of their social networks and environment to put in a bank in the first place. We all like having roads, but there is little inclination to pave more than we need. In this situation, the same would apply to monetizing our lives. Other avenues of trust and reciprocation would have the space to develop, which would strengthen communities and their relationship to the environment. Money is a powerful tool of society, but it cannot be made a god.

    When the Rothschilds developed private banking three hundred years ago, they were taking over the management of money from monarchs who were profligate. In doing so, they were responsible for maintaining the value of the gold certificates that were their currency. With central banking, the stability of the currency has become a government responsibility, while private banks maintain the profits of loaning it out. This is the foundation of the socialization of risk and the privatization of reward.

    Political power started as private initiative and eventually grew into monarchy. Monarchists railed against mob rule, but we eventually learned how to make politics a public trust by allocating power where it was most responsive. Why not do the same with the banking system? As the currency is a public utility, so profits from its administration could be public income. A public banking system would not be one huge behemoth, but consist of institutions incorporated at every level of governance, so individuals could bank with the ones which funded the services they are most likely to use. Different communities would seek to provide the best services with these funds, otherwise they would lose business and citizens to other communities. It may not be as globalized a system as we have now, at least to start with, but it would provide a solid economic foundation for a more sustainable global economy to develop.

    The problem in developing an successful monetary system is that while bankers are inclined to over-extend credit to increase profits, politicians are inclined to inflate the money supply to pay for public works. So banking would have to be a separate branch of government, similar to the judiciary.

    Another large problem is the system of public financing, where enormous bills, stuffed with enough goodies to gain sufficient support, are rammed through the system. That’s not budgeting. The process of budgeting is to prioritize needs and desires, then decide where to draw the line between what can be afforded and what cannot. In the US, some years ago, there was a discussion about the “line item veto,” where the president could delete any item he wished from spending bills. Obviously this would remove all power of the purse from the legislature and likely be unconstitutional. In the spirit of actual budgeting, a possible solution would be to break these bills down to their constituent lines and then have every legislator assign a percentage value to each line and then re-assemble them in order of preference. The president would then draw the line at what would be funded. This would divide responsibility, allowing the legislature to prioritize, while giving the president final authority over total spending. Since making the cut would be graded on a curve, there would be much less incentive to trade favors and the percentage system would allow legislators to fine tune their granting of favors to other legislators and lobbyists.

    Thank you for your time,

    John Merryman
    Sparks, Maryland

      1. John Merryman

        Thanks. We seem to be somewhere between the window and the sidewalk. As they say, it’s only the landing that hurts.

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