In This Review

The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—From the Financial Crisis
The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—From the Financial Crisis
By Martin Wolf
Penguin Press, 2014, 465 pp

Crises are an inevitable outgrowth of the modern capitalist economy. So argues Martin Wolf, chief economics commentator for the Financial Times, in his authoritative account of the 2008 financial crisis. Instability reveals itself in the form of shocks; even a seemingly small deviation from the norm can set off a major crisis. Consider the decline in U.S. housing prices, which began in 2006 and hit its nadir in 2012. In isolation, the trend appeared manageable. After a period of exceptionally high housing prices, U.S. policymakers initially welcomed the drop, which they saw as a much-needed correction to the market, a gradual unwinding of excess. They did not expect a crisis of the magnitude that eventually arrived; nearly no one did.

With characteristic thoroughness and clarity, Wolf identifies a number of culprits for this failure. At the broadest level, it was a failure of imagination. Bankers, regulators, and policymakers assumed that a long period of macroeconomic stability had made the economy invulnerable to shocks. In the United States and the United Kingdom, it had been many decades since the last major busts. Unfamiliarity, Wolf writes, bred complacency. “Why did the world’s leading economies fall into such a mess?” Wolf asks. “The answer, in part, is that the people in charge did not believe that they could fall into it.”

Wolf walks through developments in the United States, Europe, and the developing world, identifying key events and policies that collectively made the crisis the biggest, baddest, and costliest in a century. He pinpoints a host of troubling trends, including the global savings glut, an unsustainable credit boom, and an increase in the level of fraud. In the final chapters of the book, Wolf sketches a road map for the future, offering his vision for a more stable financial system.

Wolf’s book contains a wealth of illuminating details and sharp analysis. Two subjects, in particular, stand out: his critique of the mainstream economic ideas that held sway prior to the crisis and his analysis of the disaster in the eurozone. Wolf highlights a number of weaknesses in economic theory and practice that spurred the collapse, among them faulty modeling and shortsighted monetary policy. But his focus on economics comes at the expense of an equally important part of the story: politics. Political maneuvering, rather than flawed economic thinking and policymaking, is the key to understanding why financial regulations were so weak before the crisis—and also helps explain why, even now, relatively little has been done to strengthen them. But that narrative does not take center stage in his telling, even when it arguably should.

A woman carrying an umbrella passes Fannie Mae headquarters in Washington, D.C., February 2014. 


Prior to the slump, most economists—including Wolf himself—did not conceive of the possibility of a global financial meltdown. As Wolf writes, it was “partly because the economic models of the mainstream rendered [a crisis] ostensibly so unlikely in theory that they ended up making it far more likely in practice.” Regulators and investors blithely assumed, among other things, that people tend to make rational economic choices and that market prices reflect the true value of assets. This false sense of security made them careless: more willing to take risks and less concerned when warning signs arose. “Stability destabilizes,” Wolf writes, paraphrasing the American economist Hyman Minsky.

But the failures of economic theory alone cannot fully account for the crisis. After all, it is not unusual for economic models to contain simplifications. Most rely heavily on assumptions that do not wholly correspond to reality: frictionless markets, individuals who optimize with perfect accuracy, contracts that are enforced fully and without cost. Such assumptions are par for the course in economics, as they are in other fields of scientific inquiry.

Political maneuvering, rather than flawed economic thinking and policymaking, is the key to understanding why financial regulations were so weak before the crisis.

When used correctly, economic models can be useful guides for policy; in the wrong hands, they can spell disaster. Before the crisis, some models did include the possibility of bank failures and financial collapse, but they did not focus on how to minimize fluctuations in the economy. The economy is simply too complex to be captured in a single model; every model has limits. Still, policymakers should not dismiss economic orthodoxy as irrelevant, even if some mistakes are inevitable. They should be at once familiar with its tools and respectful of its limits.

In Wolf’s telling, bad economic theory manifested itself in poor regulatory and monetary policy. When it comes to financial regulation, his case is convincing. In the run-up to the crisis, many mainstream economists insisted that self-interest acted as an invisible hand, guiding the market toward efficiency, stability, and dynamism. Reviews of the pre-crisis regulatory and supervisory approach in the United Kingdom and the United States have identified that part of the problem was a philosophy that markets are generally self-correcting and that market discipline is a more effective tool than regulation—a mindset that led to excessive deregulation.

Wolf singles out two especially harmful regulatory errors. First, under the Basel Accords, the global framework for banking regulation, banks have been allowed to classify government bonds as risk free. When a bank acquires a risky asset, it must have enough capital to hedge against the possibility of default. The Basel rules meant that banks holding sovereign debt did not need to accumulate extra capital. “The assumption,” Wolf writes, “was that governments would not default,” a belief that appeared less and less secure as the crisis unfolded in the eurozone. Second, governments, most notably in the United States, strongly encouraged firms to make it easier for people to borrow money to purchase homes, which led to a frenzy of mortgage lending—including to borrowers with little ability to pay their debts—and contributed to the unsustainable housing bubble.

Wolf’s critique of pre-2008 monetary policy is less convincing. He finds fault primarily with the practice of inflation targeting, whereby central banks identify a particular low target inflation rate and then attempt to steer actual inflation toward it. Prior to the crisis, central banks did this by raising or lowering interest rates, a transparent and predictable process that was believed to make the economy more stable. Quite the contrary, says Wolf. “Central banks did deliver stable inflation,” he writes, but that predictability led people to underestimate the amount of risk that nevertheless existed in the markets, which made the financial system more fragile. But crisis prevention is not the main purpose of monetary policy. Monetary policy should aim to achieve low and stable inflation and milder business cycles, which inflation targeting has done. The robustness of the financial system should be safeguarded not by monetary policy but by tighter regulations.


In his analysis, Wolf tends to depict economic policy as the practical implementation of economic theory. The reality is more complicated. Crafting policy is not merely an economic act but also a highly political one. Regulatory policies, for example, can reflect the whims of politicians, the pressures of the public, and the influence of lobbyists.

But Wolf keeps politics behind the scenes, even when they should be front and center. Regulatory policy failed not because of shoddy economic theory but mainly because societies have been unable to remove banking and finance from the orbit of political manipulation. Consider the decision to allow banks to treat sovereign debt as risk free. Eurozone governments benefited from this policy, as calling their debt risk free made it cheaper to borrow, facilitating greater levels of government spending. Banks, eager to lower their capital requirements, were all too happy to play along. This is one example of the symbiotic relationship between governments and banks that permeates banking around the globe.

Politics also played a defining role 
in the U.S. government’s decision to promote lending for home purchases, particularly through government-sponsored enterprises (GSEs), such 
as Fannie Mae and Freddie Mac. The regulatory failures surrounding GSEs cannot be blamed on faulty economic theory. In fact, in testimony before the Senate Committee on Banking, Housing, and Urban Affairs in 2005, Federal Reserve Chair Alan Greenspan identified the risk GSEs posed to the country’s financial system and pleaded for more regulation. He said:

In the Federal Reserve’s judgment, a GSE regulator must have as free a hand as a bank regulator in determining the minimum and risk-based capital standards for these institutions. . . . We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at [Fannie and Freddie] and makes our financial system dependent on their ability to manage these risks. . . . To fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.

The same year, a bill was introduced in the U.S. Congress that would have tightened the regulation of GSEs along the lines Greenspan suggested, but support for the bill proved weak. In a 2008 op-ed for The Wall Street Journal, the economist Charles Calomiris and the lawyer and financial policy analyst Peter Wallison blamed the bill’s failure on political maneuvering by Fannie Mae and Freddie Mac. To curry favor on Capitol Hill, the companies presented themselves as champions of affordable housing. As a result, wrote Calomiris and Wallison, “Fannie and Freddie retained the support of many in Congress, particularly Democrats, and they were allowed to continue unrestrained.”

Former Federal Reserve Chairman Alan Greenspan testifies before the Senate Banking, Housing and Urban Affairs Committee in Washington, D.C., February 2004. 

To his credit, Wolf does recognize the corrosive influence of politics, taking issue, in particular, with the ways in which the financial industry uses its money and lobbying clout to shape policy. The pushback against postcrisis regulation reveals that such meddling remains alive and well. “This is one of the reasons why crises will recur,” Wolf writes. “Regulation will be eroded, both overtly and covertly, under the remorseless pressure and unfailing imagination of a huge, well-organized and highly motivated industry. This is not about fraud narrowly defined. It is more about the corruption of a political process in which organized interests outweigh the public interest.” Instead of dwelling on this point, however, Wolf diverts attention away from it, making flawed economic thinking the focal point of his story.


When it comes to Europe, Wolf identifies the political challenges inherent in creating a single currency across the continent, but he is less attuned to the ways in which politics also inform crisis management. Wolf describes the eurozone as a “polygamous monetary marriage entered into by people who should have known better, in haste and with insufficient forethought, without any mechanism for divorce.” The wedding was followed by an irresponsible honeymoon: debtor countries, such as Greece and Portugal, borrowed freely and spent recklessly, while Germany, the creditor spouse, built up a competitive export sector and an external surplus “matched by growing claims on the debtors.” When the crisis hit, the marriage turned bad: Germany blamed the debtor countries for wasting its money, and they blamed Germany for forcing them into destitution.

Wolf tends to depict economic policy as the practical implementation of economic theory. The reality is more complicated.

“The euro has been a disaster,” Wolf concludes. “No other word will do.” He justifiably reminds readers that he foresaw this outcome as far back as 1991, when the negotiations that led to the single currency were just concluding. He quotes from a Financial Times column he wrote that year, in which he judged the venture “in words used by the ancient Greeks of the path taken by a tragic play: hubris (arrogance); atē (folly); nemesis (retribution).” A day of reckoning appeared inevitable, even in the absence of the massive shock imported from overseas.

Wolf recognizes that the eurozone has always been more than an economic project. From the beginning, politics constrained its efficacy. Its design was flawed and incomplete. Seeking to avoid political resistance, European leaders intentionally designed the euro without building in a way for the currency union to deal with crises or correct macroeconomic imbalances. The misplaced hope was that if a crisis erupted, future leaders would find a way to handle it. In creating an imperfect union, European leaders acted irresponsibly; believing that it could succeed in spite of its shortcomings was nothing short of hubris.

If a poorly constructed eurozone explains why the continent was vulnerable to the crisis in the first place, policy blunders after the crash explain why it had trouble recovering. Many countries adopted austerity measures, slashing budgets and reducing their own borrowing, which turned out to be misguided. Economic growth slowed, “given that post-crisis private demand was so weak.” On the monetary side, Wolf pinpoints a number of missteps by the European Central Bank, including its failure “to ensure liquidity in debt markets.”

But again, the larger problems were political. The eurozone governments found themselves unable to work together to manage the crisis. Speaking in 2011 at a farewell event for Jean-Claude Trichet, the departing president of the European Central Bank, the former West German chancellor Helmut Schmidt highlighted the continent’s impotence. “All the talk of a so-called ‘euro crisis’ is just the idle chatter of politicians and journalists,” he said. “What we have, in fact, is a crisis of the ability of the European Union’s political bodies to act. This glaring weakness of action is a much greater threat to the future of Europe than the excessive debt levels of individual euro area countries.” Schmidt’s remarks, delivered in German at the old opera house in Frankfurt, were directed at Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president. Schmidt hoped to galvanize at least one of the two most powerful nations in Europe, but he failed to move either. At this critical moment, Europe’s economy was leaderless.


Wolf provides a relatively charitable explanation for why political considerations guided crisis management in the eurozone:

In a financial crisis, creditors rule. In the Eurozone crisis, the creditor that mattered was Germany, because it was much the largest. The aims of any plausible German government, and certainly of one headed by Angela Merkel, the country’s popular, cautious and self-disciplined chancellor, have been relatively simple to understand: these are to preserve the Eurozone, but on Germany’s terms.

Like most creditor nations, Wolf writes, Germany saw the suffering of debtor countries as their own fault. To exculpate itself, Germany argued that the crisis was a product not of current account imbalances—in which it was complicit—but of fiscal deficits. And because Germany “believes in tough love,” according to Wolf, it did not want to provide generous aid to countries, such as Greece, that it blamed for excessive borrowing.

A less charitable explanation is that Germany did whatever it could to avoid responsibility. Every crisis generates losses that someone must assume. In theory, the losses from a collective failure, such as the one in the eurozone, should be a collective responsibility. But without a common government to manage a fair and efficient distribution of the costs, countries acted in their own self-interest, guarding themselves against losses wherever and however they could. Stronger countries, such as Germany, exploited their leverage to avoid their share of the costs and impose losses on the constituents of less powerful countries.

Greek Finance Minister Yanis Varoufakis and German Finance Minister Wolfgang Schaeuble address a news conference following talks at the finance ministry in Berlin, February 2015. 
Fabrizio Bensch / REUTERS

Two episodes, largely absent from Wolf’s narrative, clarify the extent of the loss-shifting game. The first occurred in early 2010, when Greece, buckling under years of unsustainable debt accumulation and overconsumption, turned to the International Monetary Fund for help. According to leaked IMF documents, however, a decision to write off Greece’s debt, which the country badly needed, was delayed due to resistance from countries whose banks held Greek bonds. As Karl Otto Pöhl, former president of the Bundesbank, Germany’s central bank, said in an interview in Der Spiegel, the resultant IMF program “was about protecting German banks, but especially the French banks, from debt write-offs.” According to an internal IMF account of the May 2010 meeting of the IMF’s Executive Board, to gain support for a plan that would delay a debt restructuring and thus shield their banks from losses, the Dutch, French, and German chairs “conveyed to the Board the commitments of their commercial banks to support Greece and broadly maintain their exposures.”

Merkel did eventually force losses on selected holders of Greek sovereign bonds, but only after allowing German banks the opportunity to sell their holdings—a violation of the 2010 promise. The loser in all of this was Greece. According to the IMF, Greece’s debt-to-GDP ratio skyrocketed, from 126 percent in 2009 to 177 percent in 2014. Real GDP per person sharply declined, falling by 25 percent between 2007 and 2014.

If a poorly constructed eurozone explains why the continent was vulnerable to the crisis in the first place, policy blunders after the crash explain why it had trouble recovering.

The second episode took place in October 2010. At a summit in the French commune of Deauville, Merkel and Sarkozy decided to use their countries’ veto power in the euro area to block temporary assistance programs to eurozone member states—unless France and Germany could first impose losses on the private creditors of those states. This policy, known as private-sector involvement, was a serious misstep. The realization that the French and the Germans could force losses on private lenders alarmed those who held sovereign debt, which led to the deepening of the crisis throughout the eurozone, beginning with the collapse of the Irish economy. Germany, of course, came out on top. By making euro-denominated sovereign debt of peripheral states less attractive, Merkel masterfully created an implicit subsidy for Germany from the euro area periphery.

Throughout the crisis, Merkel has faced the same choice again and again: act to diffuse the crisis and avert catastrophe in the eurozone at the risk of losing support at home or enact policies that are sure to be popular in Germany but that will spread misery elsewhere. Put this way, Merkel’s decisions seem understandable—even inevitable. As Jean-Claude Juncker, the president of the European Commission, has said about the euro crisis, “We all know what to do, we just don’t know how to get reelected after we’ve done it.”


Outside Europe, the global economy is on the mend. But inside the eurozone, the outlook remains bleak. The eurozone, in its current form, cannot last. Wolf succinctly identifies the separation that has emerged between “the national level of accountability and the Eurozone level of power,” which has allowed Germany to wield outsized control over other nations. “This structure cannot hold,” Wolf writes, “and, if it can, it should not.”

In his final chapter, Wolf suggests several ways to mend the rocky marriage, including creating a proper banking union; converting some existing government debt into eurobonds, which could serve as a safe common asset; and giving the European Central Bank more freedom to intervene in government bond markets. But Wolf recognizes the large obstacle in the way: Germany is currently powerful enough to impose its views on the rest of the eurozone, blocking such reforms.

The eurozone needs a European solution. But politics are national, and no political body exists to protect the eurozone from individual countries that would rather pursue their own narrow interests. Europe needs leaders who are willing to risk short-term political costs to advance the common good, despite the misalignment of political incentives. Judging from the record of the past five years, however, the eurozone’s Greek tragedy may remain just that.

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  • ATHANASIOS ORPHANIDES is Professor of the Practice of Global Economics and Management at the MIT Sloan School of Management. From 2007 to 2012, he served as Governor of the Central Bank of Cyprus, and from 2008 to 2012, he was a member of the Governing Council of the European Central Bank.
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