Fixing Global Finance, By Martin Wolf

It might seem at first glance that the latest book by the eminent Financial Times commentator Martin Wolf was completed too early. The sub-prime crisis, those big losses on mortgage loans to low-income borrowers in the US, had got under way; but not the collapse of Lehman Brothers followed by much of the world's banking system. He knew that we were in trouble, but not how much. However, it soon becomes clear that the drama of bank rescues and tumbling share prices is just one facet of the underlying tensions and imbalances in the world economy. It is this analysis of global power, economic and ultimately geo-political power, which forms the subject of the book.

Wolf makes it clear that simply retreating from financial markets is not a policy option, a useful reminder at a time when many pundits see government management of the economy as the only solution. As he writes, financial claims "do not merely help the economy. They are the economy." But "The willingness to buy and hold these promises – and so the ability to sell them – depends on confidence, or in short, trust." The growth in the global economy in the decade to 2007 meant extending trust over long distances, between nations as different as China and the US. The economic relationship between the US and China is at the heart of Wolf's account of the development of a massive imbalance which ultimately brought the financial structure tumbling down. Since the market reforms begun by Deng Xiaoping in 1981, China has grown rapidly, fast enough to double real incomes every 10 years or so. The base was small, so even now the living standards of most Chinese people are low. Even so, rather than using growth mainly to improve living conditions and create a welfare system, the country has built up massive savings. It is not individuals saving this money, but state-owned companies and the government itself. China's national saving rate has reached close to 50 per cent of the total annual output. This is astonishing.

The Chinese economy is unbalanced between consumption and investment. Too much money is going into unproductive investments, not enough into improving life for the majority. Without a large rise in the exchange rate, the government has accumulated a mountain of foreign assets in its reserves. It has prevented an appreciation of the Chinese renmimbi against the dollar and invested its hoard in US government debt. The enormous US balance of payments deficit, the build-up of government debt and the running-down of savings by American households are the inevitable mirror images of Chinese savings. The US is the hero in this account, stepping forward to absorb the impact of China's unbalanced growth to an extent unmatched by other advanced economies (although the UK gets an honourable mention).

Some economists dispute this version of what went wrong. In particular, some pin the blame on the spendthrift habits of Americans rather than the excess thrift of the Chinese. The book spends some time rebutting alternative accounts, giving it a flavour of those clever novels which narrate the same events from multiple perspectives. Whatever the cause, though, it is clear from the scale of the imbalance between the two economies that an adjustment will be needed – one which is scarcely under way despite the traumas in the financial markets and banking system.

The final chapter on possible solutions is the least persuasive. Here, events have overtaken Wolf, making his suggestions seem too incremental to deal with the scale of what has happened. Nor does he tackle the geopolitical questions which arise from his account. For if the source of the funds sloshed around global markets was policy decisions by the Chinese government, then ultimately the solution has to lie in China too. What does that imply for China's internal stability and for the global balance of power? Perhaps that is the next big crisis in store for us.

Diane Coyle runs the "Enlightened Economist" blog at http://www.enlightenmenteconomics.com

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