John Weatherall Public Lecture October 2 2013 Queen’s University, Kingston, Ontario

1. Has the financial crisis changed the world? Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times John Weatherall Public Lecture October 2 2013 Queen’s University, Kingston, Ontario

2. Panic

3. Has the financial crisis changed the world? • It is too soon to know. But I do hope it has. • In this lecture, I intend to address the following four issues: • Where we are. • How we got here. • Where we go. • What we learn.

4. 1. Where we are • The high-income countries have been stuck in a “contained depression” for six years. • What are the symptoms of this malady? • The answer is the combination of: • Weak economies; • aggressive monetary and (to a lesser degree) fiscal policies; • and low inflation. • Meanwhile crisis-hit eurozone members have fallen into deep slumps.

5. 1. Where we are – the slump THE LONG RECESSION

6. 1. Where we are – fiscal deficits EXPLODING FISCAL DEFICITS

7. 1. Where we are – public debt LEAD TO SOARING PUBLIC DEBT

8. 1. Where we are – monetary policy A WORLD OF FREE MONEY

9. 1. Where we are – monetary policy AND EXPANDING MONETARY BASE

10. 1. Where we are – monetary policy YET MONETARY GROWTH CEASES

11. 1. Where we are – long-term interest rates BOND YIELDS FALL TO VERY LOW LEVELS

12. 1. Where we are – eurozone depressions SLUMPS IN CRISIS-HIT EUROZONE COUNTRIES

13. 1. Where we are – eurozone depressions UNEMPLOYMENT IN CRISIS-HIT COUNTRIES

14. 2. How we got here • The crisis is the result of a complex interaction between two forces: • A global saving glut; and • A fragile financial system • When the “Minsky moment” came in 2007-08, the results were: • A huge financial crisis; • State-backing of the core financial system; and • The hyper-aggressive monetary and fiscal policies.

15. 2. How we got here – asset bubbles BEGINNING AND END OF HOUSING BUBBLES

16. 2. How we got here – global imbalances WHERE EXCESS SAVINGS CAME FROM

17. 2. How we got here – global reserves THE ROLE OF GOVERNMENTS

18. 2. How we got here – asset bubbles THE RISE OF THE LEVERAGED ECONOMY

19. 2. How we got here – financial leverage LEVERAGE IN PRE-CRISIS UK BANKING

20. 2. How we got here – eurozone • The core of the eurozone financial crisis is not fiscal • The fiscal crisis is more a symptom of the financial crisis than a cause of that crisis • The crisis is largely the result of divergences accumulated in the years of excess: what made everything seem so good was in fact creating an acute long-term crisis • External imbalances played a far bigger role than fiscal imbalances: it mattered less whether the private or public sectors were being financed than how big the external finance was

21. 2. How we got here – eurozone imbalances THE ROAD TO THE EUROZONE CRISES

22. 2. How we got here – eurozone imbalances THE ROAD TO THE EUROZONE CRISES 22

23. 2. How we got here – eurozone debt NOT THE ROAD TO THE EUROZONE CRISES

24. 2. How we got here – eurozone debt CRISIS-HIT COUNTRIES SUFFER 24 24

25. 2. How we got here – eurozone yields CRISIS-HIT COUNTRIES SUFFER AND RECOVER 25 25

26. 3. Where we go • Does this crisis mark a permanent slowdown in the growth dynamic of the high-income countries • How does a growth slowdown affect debt management? Remember debts can be managed by: • Fast growth; • Inflation; • Low interest rates; and • Outright default • If growth is slow, it is the other three that must happen

27. 3. Where we go THE LONG SLUMP 27

28. 3. Where we go THE LONG SLUMP 28

29. 3. Where we go THE LONG SLUMP 29

30. 3. Where we go - potential • Economies have responded in two ways to the crisis: • Productivity collapse and strong employment (e.g. Germany and the UK) • Rising productivity and weaker employment (e.g. US and Spain) • Which of these indicates the best supply potential? • Answer: we do not know. Will productivity rebound or will employment rebound?

31. 3. Where we go - employment DIVERGENT EMPLOYMENT PERFORMANCE

32. 3. Where we go - productivity PRODUCTIVITY GROWTH COLLAPSE

33. 3. Where we go - recovery • Whatever the potential for supply may be, where is the demand going to come from? • With fiscal policy contractionary, it must come from private spending. • In practice, rising consumption driven by credit growth is a necessary condition for a sustained recovery. • So monetary policy is likely to remain ultra-easy. • But such an expansion might prove unsustainable.

34. 4. What we learn • First, our economic ideas have been discredited: • Back to Wicksell, Hayek and Keynes • End of market utopianism.

35. 4. What we learn • Second, the financial system is crisis prone: • We have allowed private institutions to serve a fundamental public function – the creation of money. • The result, in a fiat money system, in which bank reserves can be created without limit, is an explosive system. • The financial system is always part of the state. It is not fully private. • We need to make the financial system much more robust. • The three most important reforms are higher capital ratios and workable macro-prudential policies.

36. 4. What we learn • Third, we may be moving into secular stagnation in the high-income countries: • Slowing trend productivity growth; • Deteriorating demographics; • Debt overhangs; and • Financial repression.

37. 4. What we learn • Fourth, large current account imbalances (i.e. external imbalances) always suggest a crisis is on the way: • The concern over imbalances felt by Keynes at Bretton Woods remains valid. • But there is no mechanism to ensure global balance. • Indeed, the role of the dollar seems to make balance almost impossible to achieve.

38. 4. What we learn • Fifth, management of the world economy has become more difficult as the economic and political weight of the West has declined. • We are in another period of difficult transition between hegemonic powers, as in the 1920s and 1930s. • The relationship between the US and China will be far more difficult than between the US and the UK. • China cannot be the hegemon of a global market economy.

39. 4. What we learn • Sixth, the eurozone is a bad marriage, but divorce is very costly. Can it be made a good marriage? • For that it needs: • Debt restructuring – debt overhangs are now large. • Financing – largely supplied by the European Central Bank • Adjustment – symmetrical adjustment of income and spending • Fundamental reform – a banking union and a minimum fiscal union.

40. 5. Conclusion • Here are my four main conclusions: • We are in a contained depression. It will not end until we have sustained growth at “normal” interest rates and without unsustainable debt build-ups. • We got here because of the interaction of macroeconomic imbalances with an inherently unstable financial system. • It is not clear what sort of “normal” the high-income countries can get back to. That will, in turn, determine how the post-crisis debt overhang is handled and where we end up. • We need to learn some big lessons about how to understand and handle our economies and financial systems, including not least in the eurozone.