J Evol Econ (2012) 22:401406

DOI 10.1007/s00191-011-0252-2
BOOK REVIEW

Stephany Griffith-Jones, Jos Antonio Ocampo

and Joseph E. Stiglitz (eds): Time for a visible
hand-lessons from the 2008 world financial crisis
Oxford University Press, Oxford and New York, 2010, 358 pp
Peter Spahn

Published online: 15 November 2011

Springer-Verlag 2012

For decades after the Great Depression of the 1930s, the economic profession
was at issue on its causes: did it came about by an unfortunate concurrence
of various flaws and shocks, or was there one single systemic reasonand
if so, which one? Finally, the debate seemed to have settled. The Federal
Reserve failed by letting many banks go bankrupt, thereby allowing broad
money to shrink substantially (of course, there was more than just one reason
for this decision). Today, after the deep, but fortunately short depression
that grew out of the Great World Financial Crisis, we are still in the infancy of
an understanding of this event. Again, the media and the journals are flooded
with more than a dozen of arguments that purport to give prudential answers.
It was unavoidable, yet annoying, that the choir of commentators was joined
by those observers who share a certain prejudice against the field of money
and finance in a capitalistic society.
It is one of the virtues of the book that none of its chapters gives support
to the popular saying that greed and fraud in the banking system were the
driving factors of the financial crisis. True, the editors cannot resist to state
(p. 1) that the financial crash also shattered into pieces the hollow premise of
self-regulating markets. Here they should have added that (in the European
meaning of the word) liberal economists and ardent believers in the freemarket philosophy never ignored the importance of the markets institutional and legal framework. The practice of American yuppie bankerswhich
already had its antecedent in the late 1920sof extending subprime loans to
persons who could not offer any collateral ignored that private liability is the
indispensable flipside of striving for economic benefits in a market order.

P. Spahn (B)
Economic Policy, University of Hohenheim, Stuttgart, Germany
e-mail: peter.spahn@uni-hohenheim.de

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P. Spahn

The books 17 chapters contribute in a serious and professional way to the

still unfinished analytical image of the World Financial Crisiseach from a
specific point of view, but the rough division of these chapters suggests that
peculiarities of the modern banking system and macroeconomic imbalances on
a world scale are to be held responsible for the emergence of a financial meltdown that could only be prevented by incurring large costs on the part of the
public. Parts I and II focus the (American) financial system and proposals for
regulative reform, whereas Parts III and IV take a world-wide macroeconomic
perspective, with special emphasis on the position of developing countries, and
make a plea for a reform of the global monetary system.
The introductory chapter by the editors gives a preview on each contribution, but does not offer a comprehensive and logically structured image of the
crisis as a whole, which could have integrated all the pieces contributed by the
authors into a coherent story of explanation; this task is left to the reader.
Moreover, looking at the chapters separately, not every argument can be
readily understood by the reader if she is not equipped with some appropriate
stock of knowledge in the field at issue beforehand. Surely the book does not
provide a guide through the abyss of financial-market contracts and practices.
Many of its chapters build on contributions to a July 2008 conference organized
by the Initiative for Policy Dialogue of Columbia University New York and the
Brooks World Poverty Institute of the University of Manchester. Therefore,
the reader cannot expect a discussion of the latest news on market data
and market reform (most manuscripts were finished in April 2009). But as
the agents in the political sphere hardly have managed to reach substantial
progress on the latter issue, the book is still up-to-dateunfortunately so, one
is tempted to add.
The key topic of the book is the search for structural, longer-term explanations of the occurrence of the crisis and for basic policy reforms that might
preclude its recurrence. Thus, Chapter 5 (by Stiglitz) on the more short-term
macro policy responses to the unfolding crisis in the US is somewhat besides
the main agenda. It is nevertheless instructive as it highlights policy decisions
with possible long-term distributional and social costs. One is that governments
(not only) in the US came to rescue commercial banks in a way that puts
the risks on tax payers, but helped to protect the interests of bank owners
and creditors (in the meanwhile however, US data show that effective fiscal
costs will turn out to be surprisingly low). Also in Europe, policy makers did
not manage to preclude large contractual bonus payments to bank managers,
although their firms only survived with help from governments. The second
point is that US authorities missed the chance of establishing a kind of social
housing policy which would have been easily possible by buying up the excess
supply of newly built houses and letting it to the poor.
The third decision refers to the burden sharing between monetary and fiscal
policy. Stiglitz agrees to the widely held opinion that monetary policy was
indispensable and helpful in restoring commercial banks liquidity (on this
Turners Chapter 6 provides a more detailed account), but given the zerobound of nominal interest rates monetary policy appeared not to be useful

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for supporting macro demand. The burden must shift to fiscal policy (p. 77).
With the benefit of hindsight, we now see that governments in US and Europe
succeeded in the stabilization of the macro economy, but by incurring the huge
cost of heavily increased public debt, which has to be serviced for many years.
Keeping in mind that the only aim of this operation was to increase spending,
the much cheaper solution would have been the organization of a money
rain, i.e. a gift from the Fed to the private sector.
Turning now to the main message of the book, the first 200 pages say that
there is something deeply wrong with financial markets. Stiglitz (in Chapter 1)
puts these problems under the headlines of wrong incentives and asymmetric
information. After reading the books relevant chapters, one might reach a
conclusion like the following: the evolution of financial markets (including the
banking system) entailed a series of gradual changes that, if taken separately,
appear as a more or less rational improvement of a given technique or
behaviour, but as a whole they made up for a highly explosive mixture
that disclosed its systemic-risk content after a major shock. One example is
the now much complained short-term bias of financial-markets behaviour.
Basically, establishing creditor-debtor relations and keeping assets is a longterm business (at least, this is what investment advisers tell you in your bank
office). But then this very businessfollowing the idea of efficient division
of labouris handed over to professional agents who promise to optimize
transactions and portfolios permanently. Soon they are paid on a 3-month
basis for realized arbitrage profits, and cannot be prosecuted any further if the
whole investment gets sour after five years and/or tax payers have to rescue
the financial firm (p. 142). The lesson is that financial markets have to re-learn
that long-term aspects of asset management should be mirrored in bank agents
earning schemes, in order to put incentives right.
A second example is diversification. It promises to lower the overall risk
of a portfolio and to distribute risks among markets agents in a way that it
is borne by those who are willing and able to do so. Actually however, the
spreading practice of packing and selling real estate loans (asset-backed securities) created information asymmetries and deficiencies: banks were mislead
to reduce efforts of screening debtors and their projects, knowing that these
credit claims would be sold anyway to the market. Surprisingly, the potential
reputation problem of selling bad securities did not bring about a halt
a fool (i.e. a ready buyer) is born every minute, enough to create a market
(p. 26). In the end, no one knew which private and institutional portfolios were
burdened with hidden risks. Diversification by securitization had poisoned the
whole market; rising counterparty risk let banks stop lending to each other.
The finding that marketization was just regulatory arbitragebanks escaped the obligation to keep sufficient capitalmoves the issue of regulation
into the centre stage of the book. Chapter 7 (by DArista and GriffithJones) establishes two principles. One is that regulation should work in a
counter-cyclical manner, aiming to put the brakes on the dynamics of financial
markets just when banking business expands, seemingly with low risk, but
actually heading for the next crash; thus capital ratios should not be constant

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parameters. The second is that regulation should be comprehensive, covering

all parts of the banking industry. It appears straightforward to call for a
regulation that is also international in its scope. But as this principle also
hints to the difficulty of reaching an agreement among numerous political
bodies one should remember Spain that maintained a deviating, restrictive
regulation on securitization within EMU. Chapter 8 (by Persaud) provides a
deeper insight into the matter by stating that regulation not only has to be
comprehensive, but also differentiated across the financial industry as different
types of firms (banks, hedge funds, pension funds etc.) incur different types of
risk. Keeping in mind that market agents in that industry vary the scope of their
activities in an evolutionary way one cannot but get a rather worried outlook
on the prospects of a future efficient regulation.
One important aspect of the structural, long-term change in bank behaviour
can be seen from the fact that, in the US, the ratio of liquid reserves to
deposits fell from 11.3% in 1951 to 0.2% in 2001 (p. 145). This remarkable
trend rests on the belief that base money is available from the central bank
upon request without quantitative restrictions. It corresponds to the modern
practice of monetary policy making, which abstains from any rationing in the
provision of base money to the commercial banking sector and relies only
on price-theoretic impulses by changing short-term interest rates. There is a
large debate on the advantages of this pattern of control technique from the
point of view of macroeconomic stabilization, but a large neglected by-product
of the removal of money supply constraints was that financial intermediaries
abandoned liquid-reserve keeping and increased their leverage (p. 134).
This provides a clue for the understanding of the World Financial Crisis,
which emerged as a liquidity crisis that unavoidably turned into a solvency
crisis. In a world where professional financial agents do not hold substantial
amounts of base money, liquidity cannot reasonably be seen as a given stock
of that money. Rather, it is the ability of markets to absorb transactions of
a particular asset without much effect on its price, and the ability of agents
to tap additional funds, if need be, from other agents. This in turn implies
that all agents may not pursue a similarly directed policy at the same time;
some have to go short, while others go long. Otherwise, if all agents are
demanding liquidity, we have suddenly a thin marketor no market at all
(p. 156). The financial market consists of a network of mutual claims and
debts. If, after a major shock, counterparty risk suddenly increases, lending
(rolling-over of maturing debt) stops and the market is on the verge of collapse,
irrespective of the superficial impression that the world is awash with liquidity.
The venerable Bagehot Principle called for a monetary policy emergency
initiative that precluded a run on commercial banks by the public. Mehrling
(in Chapter 10) argues that we need a much broader insurance principle: in
times of distress central banks must absorb all kinds of assets as collateral in
their money-creating repos or governments must provide a last insurance of
financial assets value.
The crossing point to the second big question of the bookexploring the
influence of macroeconomic imbalancesis somewhat hidden. In Chapter 1,

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it is mentioned that an insatiable demand for dollar bonds helped the process
of securitization (p. 32). But only in the final chapters the reader learns that this
excess demand originated from foreign capital flows to the US, more precisely:
foreign private and institutional investors, including central banks, bought ever
more low-risk dollar securities (US Treasury bonds), thereby lowering their
rates of return, which then set in motion a search for yield among other
agents. Thus, asset-backed securities found a ready market. A pattern of global
imbalance was sustained by sending the supposedly best dollar assets [. . . ] to
Asia, leaving a vacuum on the balance sheets of American and European intermediaries that was filled by the new untested products of structured finance
(pp. 1856). It is important to recognize that US capital import was able to
finance the trade deficit and US foreign investment in roughly equal shares
(p. 131), highlighting the much debated American excess consumption as
well as the international banking function of the US financial market.
This constellation cannot be captured adequately with the widely quoted
notion of a saving glut. Chapters 12 (by Akyz) and 15 (by de Carvalho)
convincingly argue that foreign demand for safe dollar assets was meant
for reserve-keeping purposes. Asian countries in particular had found an
appropriate response to the catastrophic failure of the former development
strategy of trade deficits cum capital import, where the latter suddenly fell off
in 1997 after having caused an over-investment bubble. Now large amounts of
low-yield dollar papers are hold, representing the predominant international
means of paymentthe euro has shown its incapacity to offer an adequate
supply of safe assets (p. 296). They serve as a cushion against the risk of
balance-of-payments crises triggered by emerging trade deficits or large swings
of capital movements. The authors express concern about a low profitability of
reserve keeping, due to higher interest payments on capital inflows compared
to interest income accruing from reserves, but this is relevant, if at all, in the
case of borrowed reserves that originate from capital import, not in the case of
earned reserves that reflect proceeds from an export surplus. In the latter case,
the true yield of reserves is not their interest income but the gain of additional
production and employment by means of exchange rate undervaluation.
By embarking on an export-led growth strategy, Asian countries, and China
in particular, have turned away from the traditional neoclassical doctrine
that developing countries due to lack of resources need an import surplus
(which then necessitates capital import or financial aid). Frenkel and Rapetti
(in Chapter 14) stand up for the Keynesian view that growth also in these
countries is demand-constrained; therefore an agreement on real exchange
rates that allow export-led development would be much more useful than
paying development aid! As long as this agreement is not reached on a
supranational political level, it appears understandable that emerging market
economies pursue flexible exchange rate policies, i.e. discretionary managed
floating that serves their macroeconomic interests. The saying of (net) capital
flowing from poor to rich countries (p. 257) is misleading however: (1) If
China accumulates financial claims against the USwho builds the capital,
who goes into debt? (2) Looking at gross flows, China receives much foreign

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direct investment, which helps to enlarge and improve its capital stock. (3)
Looking at resource flows, exporting consumption goods in no way impedes
massive industrial investment at home, because Chinas labour force is still not
fully employed.
So, whats wrong with Asian export surpluses? Ocampo (in Chapter 16)
holds, first, that the scenario is unfair to poor countries as they are led to
transfer resources to rich countries. This contrasts to Chapter 14, which shows
that the former countries take advantage of this constellation, and they can
redirect resource flows towards a domestic use by stopping to pile up dollars.
Second, the system is said to be unstable as the rest of the world can only
accumulate dollars through a US trade deficit. This statement is incorrect: the
same result can formally also ensue from American excess capital export (as it
was the case in the first half of the Bretton Woods system in the 1960s).
The third argument comes in two versions. (1) The international monetary
system is said to exhibit a deflationary bias because it is tilted against (trade)
deficit countries that have to bear all adjustment costs (by imposing restrictions
on spending), whereas surplus countries are not forced to increase their
spending (which would help deficit countries). In general, this is true, but it
is no good idea to weaken the budget constraint of deficit countries (look
at Greece!). Moreover, in the current situation, the deficit country is the US,
where surely no restrictions are felt due to the world money status of the dollar.
(2) Greenwald and Stiglitz (in Chapter 17) argue that the system is deflationary
because of the accumulation of dollar reserves in emerging countries. This line
of reasoning seems to be linked to Keyness liquidity preference theory: a rise
in money demand encountering a given supply of money increases interest
rates. But actually the Feds dollar supply adjusts endogenously to dollar
demand; moreover, foreign central banks dollar purchases on the foreign
exchange increases domestic money supply in these countries, so that an
inflationary bias may ensuewhich is admitted also in the book (p. 305).
Chapter 17 makes a speech for a world currency reform that substitutes
Special Drawing Rights for the dollar as the key international means of
payment, a proposal that goes back to the 1944 Keynes Plan. It is hard to
envisage the supranational agreement necessary to establish such a reform.
It is also hard to believe that an international monetary order where reserves
are allocated on account of political reasoning (pp. 272, 307) will bring about
sound macroeconomic results in the long run.
After reading all chapters, the reader is left with the basic question: are
distortions in financial markets or balance-of-payments imbalances the main
cause for the emergence of the World Financial Crisis? Does it help to mend
one complex of problems without the other? The scientific community is still
searching for answers. The book anyway is extremely helpful for discovering
and weighing facets and argumentsirrespective of whether the reader agrees
with the authors or not.

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