One year after the collapse of Lehman, the controversial “rescue” of AIG, and the ensuing collapse of world financial markets there are two questions: what have we learned, and what good will it do us?
The second question is essential, because we have learned so much about the functioning of our financial system – and the three main lessons are all rather scary.
First, our financial system has become dangerous on a massive scale. We knew that the banks were playing games, e.g., with their so-called off-balance sheet activities, but we previously had no idea that these huge corporations were so badly run or so close to potential collapse.
Second, we also learned the hard way – after many revelations – that pervasive mismanagement in our financial system was not a series of random accidents. Rather it was the result of perverse incentives – bank executives felt competitive pressure to behave as they did and they were well-compensated on the basis of short-term performance. No one in the financial sector worries too much, if at all, about risks they create for society as a whole – despite the fact that these now prove to be enormous (i.e., jobs lost, incomes lowered, and fiscal subsidies provided).
Third, weak government regulation undoubtedly made financial mismanagement possible. But poorly designed regulations and weak enforcement of even the sensible rules were in turn not a “mistake”. This was the outcome of a political process through which regulators – and their superiors in the legislative and executive branches – were captured intellectually by the financial system. People with power really believed that what was good for Wall Street was great for the country.
But how much good does all this new knowledge now do for us? There is very little real reform underway or on the table. We can argue about whether this is due to lack of intestinal fortitude on the part of the administration or the continued overweening power of the financial system, but the facts on the ground are simple: our banks and their “financial innovation” have not been defanged.
In fact, they are becoming more dangerous. The “Greenspan put” has morphed into the “Bernanke put”, to use the jargon of financial markets, where “put” means the option to sell something at a fixed price (and therefore to limit your losses). The Greenspan version was always a bit vague, involving lower interest rates when a speculative bubble ran into trouble; the Bernanke version is huge, involving massive cheap credits of many kinds (as well as interest rates set essentially at zero).
Bernanke’s Federal Reserve has shown that, when the chips are down, it can save the financial system even in the face of unprecedented global panic. But this will now just encourage more reckless risk-taking going forward. In the absence of full re-regulation of the financial system, the Fed’s policies are asking for trouble.
Lou Jiwei, the chairman of China’s large sovereign wealth fund, summed up the view of big international financial players last week, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”
We have lived through a massive crisis – and learned how close we came to a Second Great Depression – yet nothing is now happening to prevent a repeat of something similar in the near future.
By Simon Johnson
This is a slightly edited version of a post that appeared first on the NYT’s Economix blog. It is reproduced here with permission.
By Philip Augar and John McFallPublished: September 10 2009 21:56 | Last updated: September 10 2009 21:59
In coming up with solutions that address the immediate crisis but fail to tackle dangerous systemic issues, the Group of 20’s emerging ideas on the banking industry bear a striking resemblance to the Americans’ response to the dotcom crash of 2001-02. Back then, the burst bubble exposed biased research and stock price manipulation on Wall Street and dubious accounting practices in US companies. Out came a new set of rules cleaning up the links between research analysts and investment bankers and laying a heavy hand on corporate chief executives.
These measures extinguished the fire but neglected more fundamental problems. By the time the regulations were in place, the investment banks and elements of the corporate sector were already deeply involved in new and even more dangerous practices. We speak, of course, of the derivatives-based leverage of banks’ balance sheets that brought down a range of previously sound institutions, dragged the global economy into recession and ripped up accepted economic theories.
We see exactly the same mistakes being made this time around. If effectively implemented (not the only possible outcome), the G20 finance ministers’ steer towards more and better capital, constraints on leverage and contingency plans for banking failures would help to avoid a repetition of the current crisis. But they are barely sufficient to give the financial services system the kind of radical overhaul it needs.
That would entail tackling a defective business model. Banks are allowed to mix plain vanilla deposit-taking and lending with high-risk investment banking. They are allowed to act for clients on both sides of a trade and take a proprietary turn out of the middle. In capital markets transactions they are able to act for those seeking capital and those providing it. Conflict of interest is embedded and this is unfair on other market users. It is “heads we win, tails you lose” as the banks make off like bandits in the good times and become pious onlookers as the taxpayer foots the bill when it all goes wrong.
Fixing the system requires this business model to be broken up and we would go beyond conventional Glass-Steagall type solutions. Activities such as corporate finance, providing advice for investors and proprietary trading should be separated from each other as well as being split off from deposit-taking. This would create smaller, less profitable institutions and solve a number of problems, many of which have been caused by financial institutions over-trading. The system we advocate would restore the balance of economic power towards industries other than finance. It would stem the flow of capital that goes into bankers’ bonuses (a problem that the proposals coming out of G20 seem unlikely to solve) and would rid the world of financial institutions that were too big to be allowed to fail.
Many heavyweight thinkers have dismissed narrow banking (a less radical option than the one we advocate) as, to quote Lord Turner, chairman of the UK’s Financial Services Authority, “not feasible”. They point out that although Northern Rock was not an investment bank and Lehman was not a deposit-taking bank, both failed. This is another example of fighting the last war. The real problems are not the specific causes of the crises of 2008 (banks) or 2001 (dotcom) or 1998 (Long-Term Capital Management) or 1989 (US Savings and Loans), but the enduring power of finance to be socially and economically disruptive.
We do not expect politicians and regulators to restructure the global financial services industry at what is still a critical moment for the economy. But it is regrettable that they appear to have shut the door on even having such a conversation. A starting point, as we have argued before, would be to set up a banking commission informed but not dominated by people from outside the industry. Its remit would be to consider structural change and how the financial services industry can serve the wider social and productive needs of the economy.
This crisis has offended people’s basic notions of fairness. The connection between effort and reward must be proportionate and the playing field needs to be level if we are to secure a fully functioning market economy underpinned by political stability. That is why there is no option but to start the discussion we advocate.
John McFall is chairman of the Commons Treasury committee. Philip Augar is a former investment banker and the author of Chasing Alpha
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By Dirk Bezemer
Published: September 7 2009 19:34 | Last updated: September 7 2009 19:34
From the beginning of the credit crisis and ensuing recession, it has become conventional wisdom that “no one saw this coming”. Anatole Kaletsky wrote in The Times of “those who failed to foresee the gravity of this crisis” – a group that included “almost every leading economist and financier in the world”. Glenn Stevens, governor of the Reserve Bank of Australia, said: “I do not know anyone who predicted this course of events. But it has occurred, it has implications, and so we must reflect on it.” We must indeed.Because, in fact, many had seen it coming for years. They were ignored by an establishment that, as the former Federal Reserve chairman Alan Greenspan professed in his October 2008 testimony to Congress, watched with “shocked disbelief” as its “whole intellectual edifice collapsed in the summer [of 2007]”. Official models missed the crisis not because the conditions were so unusual, as we are often told. They missed it by design. It is impossible to warn against a debt deflation recession in a model world where debt does not exist. This is the world our policymakers have been living in. They urgently need to change habitat.
I undertook a study of the models used by those who did see it coming. They include
- Kurt Richebächer, an investment newsletter writer, who wrote in 2001 that “the new housing bubble – together with the bond and stock bubbles – will [inevitably] implode in the foreseeable future, plunging the US economy into a protracted, deep recession”; and in 2006, when the housing market turned, that “all remaining questions pertain solely to [the] speed, depth and duration of the economy’s downturn”.
- Wynne Godley of the Levy Economics Institute wrote in 2006 that “the small slowdown in the rate at which US household debt levels are rising resulting from the house price decline, will immediately lead to a sustained growth recession before 2010”.
- Michael Hudson of the University of Missouri wrote in 2006 that “debt deflation will shrink the ‘real’ economy, drive down real wages, and push our debt-ridden economy into Japan-style stagnation or worse”. Importantly, these and other analysts not only foresaw and timed the end of the credit boom, but also perceived this would inevitably produce recession in the US. How did they do it?
Central to the contrarians’ thinking is an accounting of financial flows (of credit, interest, profit and wages) and stocks (debt and wealth) in the economy, as well as a sharp distinction between the real economy and the financial sector (including property). In these “flow-of-funds” models, liquidity generated in the financial sector flows to companies, households and the government as they borrow. This may facilitate fixed-capital investment, production and consumption, but also asset-price inflation and debt growth. Liquidity returns to the financial sector as investment or in debt service and fees.
It follows that there is a trade-off in the use of credit, so that financial investment may crowd out the financing of production. A second key insight is that, since the economy’s assets and liabilities must balance, growing financial asset markets find their counterpart in a growing debt burden. They also swell payment flows of debt service and financial fees. Flow-of-funds models quantify the sustainability of the debt burden and the financial sector’s drain on the real economy. This allows their users to foresee when finance’s relation to the real economy turns from supportive to extractive, and when a breaking point will be reached.
Such calculations are conspicuous by their absence in official forecasters’ models in the US, the UK and the Organisation for Economic Co-operation and Development. In line with mainstream economic theory, balance sheet variables are assumed to adapt automatically to changes in the real economy, and can thus be safely omitted. This practice ignores the fact that in most advanced economies, financial sector turnover is many times larger than total gross domestic product; or that growth in the US and UK has been finance-driven since the turn of the millennium.
Perhaps because of this omission, the OECD commented in August 2007 that “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign: a soft landing in the United States [and] a strong and sustained recovery in Europe.” Official US forecasters could tell Reuters as late as September 2007 that the recession in the US was “not a dominant risk”. This was well after the Levy Economics Institute, for example, predicted in April of that year that output growth would slow “almost to zero sometime between now and 2008”.
Policymakers have resisted inclusion of balance sheets and the flow of funds in their models by arguing that bubbles cannot be easily identified, nor their effects reliably anticipated. The above analysts have shown that this is, in fact, feasible, and indeed essential if we are to “see it coming” next time. The financial sector is just as real as the real economy. Our policymakers, and the analysts they rely on, ignore balance sheets and the flow of funds at their peril – and ours.
*‘No One Saw This Coming’: Understanding Financial Crisis Through Accounting Models, MPRA
The writer is a fellow at the economics and business department of the University of Groningen in the Netherlands
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