A good crisis gone to waste


“You never want a serious crisis to go to waste,” Rahm Emanuel, then chief of staff to President-elect Obama, said in November 2008, describing the opportunities for reform presented by the financial meltdown. The day of financial market hegemony and market fundamentalism was over. Since the convulsions triggered by Lehmans, everything had changed, we were told.

      But three years later, very little has changed. . Not only are financial institutions back to business as usual, they have successfully transferred most of the consequences of their own failure to governments and the non-financial economy. Private sector debts and deficits have been effectively shifted to governments.  So if three years ago the mortgage marked seemed to be the source of the problem, today’s crisis is perceived as originating in sovereign debt. Europe and the United States both suffer from a continuing economic malaise, in which issues originating in the financial sector overshadow the activities of ordinary businesses. If the 2008 crisis was an opportunity for fundamental reform of the financial system, as Emanuel suggested, it did indeed go to waste

      Three years ago, the political right initially floundered, as free market ideologues struggled to rationalise the public subsidy of capitalism’s most aggressive institutions. Only later did they find an explanation:  events which superficially appeared to be the fault of greedy bankers and market dysfunction were, of course, the fault of government: the result of negligent regulation, social engineering in the housing market, and loose monetary and credit policies. The public at large, not entirely convinced by this explanation, remains bemused and angry. 

      In Europe, in 2008 and 2009, Chancellor Merkel and President Sarkozy  excoriated the excesses of the free market as they rushed to the support of their over-indebted large banks. The left offered no diagnosis, no new ideas and gained no electoral advantage.  The parties which had waited a century for capitalism to collapse under its own contradictions congratulated themselves that such collapse had been averted by the injection of simply incredible amounts—trillions of dollars—of taxpayer funds into the banking system.   

      The specific events of 2007-8 were unanticipated. But the underlying problems that led to that crisis had been evident for some time. Their origins lie in the financial innovation that followed the development of derivative markets in the 1970s, in the deregulation of the financial services industry—and particularly the removal of restrictions on the creation of financial conglomerates—and in the rapid growth of the financial sector that followed these changes.

      In both Britain and the United States, the principal functions of the financial services industry had traditionally been performed by specialist institutions: banks provided payment services,  deposit taking, and corporate lending; investment banks undertook securities issuance; insurance companies promoted risk cover and managed long-term savings; and securities trading was handled by brokers and jobbers or specialists. Wide ranging structural reform of the financial system, which strongly reinforced this separation, had followed the Wall Street crash of 1929 and the banking failures that followed.  The period from then until the 1970s was one of historically exceptional stability in the financial system.

      Financial institutions in continental Europe had always been diversified, but Europe’s universal banks had been conservatively structured and managed. Indeed that inward looking culture is part of the reason why Paris and Frankfurt never became global financial centres. In the light of developments in New York and London, many European banks reinvented themselves on Anglo-American lines and established substantial presences in the Anglo American cities.

      These new financial conglomerates posed acute management issues from inception. In “Big Bang”—the structural deregulation of the City in 1986—retail banks acquired broking and trading operations. These purchases were unsuccessful. Retail bankers had been groomed in larger bureaucracies, whose performance depended principally on the accurate routine processing of millions of daily transactions, and they could not handle the more entrepreneurial cultures they had acquired. In time, however, the traders and corporate advisers, who were  smarter and greedier, took control of the much-enlarged businesses. Although the principal activities, and the vast majority of the employees, of the large conglomerate banks are still in traditional retail banking, the most senior positions are mostly taken by individuals whose background has been in investment banking.

      These organisational changes put a transaction-oriented trading culture at the centre of the global financial system. There were early indications of the possible instability that might result: the first emerging market debt crisis in the early 1980s; the stock market crash of 1987; and the Japanese asset price bubble which peaked at the end of that decade. Demonstrations of fragility grew in scale and consequence. A second emerging market debt crisis occurred in 1997-8 and the new economy bubble followed soon after.

      The immediate cause of the events of 2007-8 was the collapse of a pyramid of complex securitisation based on the packaging and repackaging of loans, especially mortgages.  Debt securities offer returns which are differentiated according to the perceived risk attached to them, so that trading books in which institutions which are able to borrow relatively cheaply –  because of their perceived size and stability and an expectation that their obligations are underwritten by government – make loans to riskier borrowers and derive a steady stream of profit.

      These profits are likely to be fully offset  by large losses from occasional defaults.  But if the risk of such default are underestimated – either because of miscalculation or because holders believe they will be protected from the consequences – the immediate result will be (ultimately illusory) profits for the financial institutions involved and inappropriately cheap credit for the borrowers.  This is precisely what happened in the markets for mortgage backed securities and sovereign debt within the Eurozone.  Crisis is inevitable  but can be long postponed or delayed.  It is too easy to be deflected by the particularities of securitisation or the mechanics of the creation and maintenance of a single currency in Europe, and to seek solutions in the capital requirements and the operations of the European Central Bank.  The recurrent crises of modern finance are not associated with any particular set of financial instruments but are endemic features of modern financial markets and the structure of the financial services industry.

      The proximate causes of these various booms and busts have been very different, but a basic mechanism is common to all. Asset prices are bid up  in some market or other. The underlying cause is often some genuine economic, political or technological trend such as the commercialisation of the internet, growth in East Asia or Latin America, or the creation of a common European currency. Consultants and journalists, gurus and financiers, have a common interest in exaggerating the significance and extent of these developments.

      The resulting herd behaviour in and around financial markets creates cumulative mispricing, and immediate profits. Overvaluationsfeed on themselves. A substantial proportion of the apparent gains is paid to individuals associated with the process, and to their bosses. The mispricing is eventually corrected. The resulting market dislocation imposes collateral losses on investors and institutions. Governments intervene to mitigate these losses, pumping large amounts of money into general support of asset prices. These actions provide fuel for a new crisis in another asset class.

      The assertion that financial innovation led to risk mitigation was simply absurd. Asked whether the world he or she experienced had become more or less risky over the last two decades as a result of such financial innovation, the person in the street would think you were joking. The main impact of financial innovation on everyday risk has been the transfer of much of the risk associated with pension provision from the corporate sector to the individual. The risks which innovation supposedly enabled financial institutions to manage more effectively were, overwhelmingly, risks generated within the financial system itself: and in the end even the claim that they enabled the financial sector to manage its own risks more effectively was dramatically refuted by the most severe financial crisis in eighty years—or perhaps longer.

      The rise of financial conglomerates might have enabled financial institutions to reduce risk by diversification, and indeed such benefits are still asserted by industry spokespeople; but the reality was that the resulting interdependences aggravated risk. Essentially well-run institutions such as AIG and Royal Bank of Scotland were brought down by activities that were very small relative to their overall operations.  Retail deposits, government guaranteed, provided collateral for speculative activities in other markets. 

      Many diversified financial conglomerates were simply unmanageable. The organisations resembled collections of unruly barons who would depose any king who imposed restrictions on the aggrandisement of their wealth and power. The risk exposures concealed in increasingly convoluted  corporate structures and bewilderingly complex instruments were generally beyond the comprehension of their senior management.

      To understand why the political response to the events of 2008 was so feeble, it is necessary to begin with the intellectual and political background. The consensus on the mixed economy fell apart in the 1970s and 1980s. The decisive events occurred in the two largest centrally planned economies, with the collapse of the Soviet Union and the abandonment of its empire, and the opening of China to the market. At the same time, reaction in the US and Britain against what was seen as increasingly sclerotic corporatism led to the rise of the radical right under Reagan and Thatcher. In the developing world, success in achieving economic growth was broadly correlated with enthusiasm for capitalist models of economic development.

      And so the right, which had often dominated the levers of economic policy, came for the first time in a century to dominate the terms of economic debate. A market fundamentalism, which had only a short time before been advocated only by an extremist fringe, became a mainstream ideology. The terms globalisation and privatisation were central the language of those who resisted these developments as well as those who welcomed them. 

      Market fundamentalism rests on a range of assumptions. Greed is the dominant motivation in economic affairs. Markets populated by self-interested individuals are the only efficient form of economic organisation, and interference with markets is justified only to accommodate a limited class of defined market failures. The role of the state is appropriately limited to the enforcement of contracts and property rights, and perhaps the provision of a minimal welfare safety net.      

      Market fundamentalism as practical doctrine meant that more markets were better than fewer markets: and the more trade that occurred in these markets, the more prosperous the economy, or at least the advocates of this philosophy, would be. The policy response towards the financial sector was to encourage the proliferation of new securities instruments and markets and to promote, in the name of increasing liquidity, an explosion of trading volumes.

      Market fundamentalism is a travesty of how market economies, of which there are many varieties, really operate. Markets function only because they are embedded in  context. Property rights and contracts are social constructions. The pursuit of greed destroys both the organisations that exemplify it and the legitimacy of the system that supports it, as the events of 2008 proved. The organisation that “Makes nothing but money” (Bear Stearns’s notorious self-description), proved in the long run not even to make that. Most important risks in society—including, we now see, the risk of dislocation in risk markets themselves—are handled not through markets, but by social institutions. Complex modern economies require far more cooperative activity than a market fundamentalist account would allow.

      True believers in market fundamentalism were never more than a small minority thoughbusiness interests were ready to espouse its convenient  rhetoric. The subtle but important distinction between policies that support a market economy  that support the interests of established large firms  was not widely appreciated by policy makers on either right or left. Free market policies could therefore be interpreted as the promotion of a wish list for corporate lobbyists. And no group of corporate lobbyists was better-funded, or more assiduous, than that representing the financial services industry.

      In 2008 the market fundamentalist doctrine, which implied failing businesses should be allowed to collapse, conflicted with the practical fact that these failing businesses included the largest and most politically well connected corporations in Europe and America. Doctrine did not last long: at most, the forty-eight hours from the collapse of Lehman to the bailout of AIG. The most strident business advocates of market fundamentalism made clear that the principle of survival of the fittest had never been intended to apply to them. Government support for free markets meant government support of markets. If they seized up, the responsibility of government was to support these markets by providing the liquidity that would enable them to trade freely. In this intellectual milieu the notion of putting a $700bn slush fund for failed businesses at the discretion of a Secretary of the US Treasury who was himself the former CEO of the largest investment bank,  seemed entirely natural and coherent. It is difficult to exaggerate the sense of entitlement felt, and still felt, in the City of London and on Wall Street.      

      Market fundamentalism set the political left on the back foot in economic argument for three decades, and it completely failed to come to terms with the triumph of the market. There had been—and remains—an opportunity for the left to explain that effectively functioning markets are the product of a social context. But attempts by Clinton and Blair to point to a “Third Way” collapsed in vacuity and derision. The pragmatic but intellectually incoherent response was to accept the primacy of the market with bad grace.

      So when the banking system collapsed in 2008, the political left, bereft of ideas or analytic framework, readily acquiesced in the process by which the governments provided much of the capital and underwrote all the liabilities of major banks. Frightened of the word “nationalisation”, far less its reality, a Labour government in Britain would not countenance discussion of the issue: although the moment was one at which many people on the political right would have been easily convinced that such measures provided the best means of reorganising banks and securing continuation of their essential functions during the necessary and inevitable restructuring process. But simply writing large cheques saved thought, and averted a confrontation for which politicians were, and continue to be, completely unprepared.

      The statement “there should be more regulation” is a hopelessly inadequate response to the problems the modern financial sector poses for the real economy. There is no point in saying there should be regulation unless there is clarity about objectives and the questions that such regulation might address. Despite the plain evidence not so much of the past failure of regulation, but of its continuing irrelevance, ludicrously exaggerated expectations of what regulation might achieve remain widespread. If the CEOs and boards of large financial institutions had difficulty in both understanding and controlling what was happening within them, that was a fortiori true of external regulators. The issue was not, and never has been, that regulators lacked powers. The capacity to apprehend Bernie Madoff, to block the acquisition of ABN-Amro by RBS, or to prohibit the establishment of off-balance sheet vehicles with huge liabilities that banks would be expected to underwrite, has always been there. The issue is that regulators lacked political authority and technical competence to intervene. They still do.

      At present, the principal objective of regulation appears to be to stabilise the existing structure of financial institutions.  The declared purposes of the new regulatory institutions in Britain are to promote stability and maintain confidence.   This approach is not surprising, since the institutions of financial services regulation are mostly captured by the industry.In some cases they are directly controlled by it;more often, they are manned by people who see the industry through its own eyes because they have no other perspective. The regulatory goal is the health of the industry, which is in turn interpreted as the health of the particular firms from which it is today composed. The purpose is the achievement, not of financial stability, but of industry stability, as if these were the same thing: but since the sources of instability are to be found in the structure of the industry, accomplishment of this goal is in fact a guarantee of further, and potentially more damaging, crises.

      Although poorly organised to manage their own affairs, large financial institutions were, and are, well organised to manage their external relations. Investment bankers are generally politically adroit if not managerially skilled. Policy makers recognised the intelligence and the range of contacts of investment bankers, overestimated their importance in business and the economy, and had little appreciation of what they did, beyond the fact that it was very difficult to understand.

      In the United States, the regulatory process has been corrupted by the mechanisms of political funding. In Europe, policies and politicians cannot be bought in the same crude way. But the instinctive corporatism of much of continental Europe leads to a natural equation between the interests of Germany and the interests of Deutsche Bank. Britain has neither American corruption, nor the extremes of German or French industrial policy. And yet political and regulatory capture is equally powerful here. There is an element of awe, almost intimidation, of politics by finance: the global leadership of the City of London is seen as a valuable asset, its activities complex, and the assertion that any action might damage City interests perceived as a powerful objection to any proposed course of action. Few politicians or officials have the knowledge, or inclination, to challenge such assertions or to examine the precise nature of the alleged damage or its consequences for the economy as a whole.

      And so financial institutions in general, and investment banks in particular, became the most powerful industrial lobbies in the western world. Simon Johnson has drawn the analogy between Wall Street and the Russian oligarchs—or mediaeval barons—who operated in a self-reinforcing style in which political power enhanced economic power and vice versa. It is, he suggests, a cycle capable of being broken only by revolution or external intervention.

      Rahm Emanuel’s desire not to let a crisis go to waste did not last long:  President-elect Obama’s economic appointments signalled clearly that serious financial reform was not part of his agenda, and the Dodd-Frank legislation has been steadily eroded by industry lobbying and Republican gains in Congress.

      The establishment in Britain last year of a commission on banking represented a belated recognition that the issues were structural ones, and the commission will recommend steps to encourage competition and to reduce the ability of banks to use their retail deposits and taxpayer guarantees to support their investment banking operations.  There is little Britain can do to prevent recurrent financial crises:  but there is much that can be done to protect the British economy from the consequences.  That should be the focus of our policies.

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