| Various authors, LSE, 2010, 288 pages, £14.99. |
| Just over two years ago, the post-Lehman financial
crisis precipitated a global bailout of banks, fully revealing how the
previous period’s carnival of greed had led to pervasive and extravagant
blunders, frequently verging on fraud and in major cases actually
fraudulent. Alongside this bailout, interest rates in most major
currencies were reduced virtually to nil, both as a general monetary
stimulus and to permit banks to be recapitalised by wide interest rate
spreads. With a hefty fiscal stimulus in parallel, financial markets
have recovered sharply. Bankers had stripped out huge bonuses up to 2007
on what turned out to be false profit statements, denuding their banks
of needed reserves in the process. Over the past 12-18 months they have
renewed their bonus-paying habit on the back of strong revenue
recoveries arising from cheap money – while ordinary savers get little
or no interest, and the economic recovery remains feeble, at least in
the developed world. |
| Conditions could hardly be better for the reception
of a book by a distinguished group of commentators recommending major
reforms of the financial system. The Future of Finance, ten essays
published by the London School of Economics, is mostly focussed on
proposing such reforms. All the essays are interesting, several
brilliant. The excesses of the financial system in the years to 2007 are
outlined effectively, and a variety of proposals laid out for creating a
better financial system. Yet in a strange way the book lacks structure,
specifically: |
• A ‘What went wrong?’ framework – the default
assumption that it was all caused by bad banker behaviour pervades the
essays, and is incorrect;
• In what way are current regulations most inadequate? – reforms being
hard to achieve, especially as international agreement is needed for
them to be successful;
• Would the proposals being made have prevented the crisis, or made it
much less severe? |
| An unduly easy monetary policy almost invariably
expresses itself in credit excesses. And the lenders are mostly bankers.
Sushil Wadhwani, in a limpid essay, stands back from the blame game
better than the others; and Andrew Smithers, who (like this reviewer)
forecast the debacle well in advance, here argues (rightly) that bubbles
can be forecast. But two brilliant early essays in the book – by Andrew
Haldane analysing the contribution of the financial sector to the
economy, and by Paul Woolley, using the ‘principal versus agent’ concept
to explain the momentum trading that features in all bubbles – both
effectively claim that the banking crisis was exclusively caused by
banks. Other essays proposing ‘ways forward’ mostly accept this claim. |
| Haldane’s essay attributes to bank excesses all of
some hypothetical (and improbably large) future loss of income
subsequent to, and implicitly caused by, the crisis. He ignores
Wadhwani’s points on the benefits from the ‘financial revolution’ of the
past 30 years. His outstanding and witty analysis of the accounting for
banks’ contribution to GDP is marred by the assertion that the taking of
risk is not part of their value added, as the risk (of a loan) is there
anyway. But, of course, it is not. Depositors want deposits, not
businessmen’s or householders’ promises to pay. Otherwise, the whole
financial system could be handled in the public securities’ markets. The
assumption of risk with depositors’ money is precisely the contribution
of bankers, and loans would in many cases not happen without bankers’
intermediation – a point recognised at least as long ago as Bagehot.
Paul Woolley’s elegant essay explains much that is wrong in capital
markets, and stands apart from the rest of the book in its concern
chiefly with how investors and their asset-manager agents should handle
themselves: the ‘future of finance’ indeed, rather than of regulation.
|
| If bankers take the entirety of blame for a crisis
arising from a vertiginous expansion of debt, then no monetary policy
can be too easy. The oddity of the run-up to the 2007-8 crisis is that
monetary policy was clearly too easy in provoking debt that would
certainly exceed the capacity of income to justify it – yet it was just
about right in relation to normal criteria, eg, the US Federal Reserve’s
mandate to aim for low inflation and reasonable growth. In the six good
years of the last cycle, from end-2001 to end-2007, the US real growth
rate was 2¾%, well below the long-run average of 3-3¼%, which covers
recessions as well as growth periods in the cycle. Inflation was less
than 3%, little over 2% excluding food and energy. Although a housing
bubble was evidently blowing up, a stricter monetary policy would have
been highly controversial, possibly leading the Fed to be over-ruled by
the Congress. |
| Why did it require such a massive run-up of debt
ratios to provoke such modest growth? The answer lies in the Eurasian
savings glut. The long-standing excess of private savings over
investment in Japan was compounded by mercantilist policies of Asian
Tigers, traumatised by their treatment in the Asian crisis; repression
of growth and incomes in Germany and other countries of north-central
Europe, reinforcing demographic effects, as in Japan; and, finally in
2005-7, a massive build-up of net exports from China. Wadhwani alludes
to the savings-glut idea, but is agnostic as to its role in making US
policy too easy. But the evidence is virtually incontrovertible to an
economist: the huge expansion of financial activity and debt saw the
real cost of money go down, at least until 2006, by when the die was
cast. This can only mean that supply was driving up demand – not the
reverse. This theory was first proposed by the present reviewer in 2004,
then, independently, by present Fed Chairman Ben Bernanke in 2005, and
is accepted widely, including by Martin Wolf, whose contribution to this
book is a succinct look at the specific issue of how to reduce abuses in
bankers’ pay. |
| Supporting the ease of US and other countries’
policies was a lax Zeitgeist. If the US regulations in place had been
properly enforced, most of the disgraceful ‘Ninja’ loans (‘No income, no
job or assets’ – not to mention documentation!) would have been
prevented. The proposals here, notably a lucid exposition of possible
reforms by Charles Goodhart, could well improve the financial system.
Clearly, as Lord Turner demonstrates, stronger equity and other capital
ratios, and explicit vulnerability of subordinated debt, should be
required. Martin Wolf’s desire for all loan-making institutions to be
regulated makes sense – but could prove unattainable in a globally
competitive context. The question of how to deal with the cat’s cradle
of derivative contracts that tied all the banks together, and made it
likely that failure of one could drag multiple other institutions
under-water, is not fully addressed in this book, though it was a
primary source of the crisis, both in the Bear Stearns collapse of
March, 2008 and the Lehman bankruptcy that September. |
| The true danger is that in some future boom and
bubble, if the Zeitgeist is again as absurdly laissez-faire as in the
run-up to 2007, new regulations, however well conceived, will do little
good. Meanwhile, the problem for now – and at least the next ten years –
is highly unlikely to be wildly extravagant risk-taking by bankers. It
is, rather, the refusal of the savings-glut countries to accept any
responsibility for what went wrong, and the consequent dependence on
unacceptable government deficits for recovery in the deficit countries.
This dilemma is, and has always been, an economic and also political
crisis. Excessive government debt may indeed provoke a new banking
crisis – but it will not, this time, be the bankers’ fault. It would
have been better if this book had framed its useful analysis with these
broader issues. |
Charles Dumas
Chairman, Lombard Street Research |
|