June 28, 2009
Vince Cable (the UK Liberal Democrat “shadow” finance minister) has written a superb book on the world economic crisis and what it means, entitled The Storm (Atlantic Books, 2009). In only around 160 pages, he writes clearly and with considerable economic authority. Cable was one of the few who anticipated the current crisis. The book was finished in autumn 2008.
In November 2003, the author questioned the then finance minister, Gordon Brown, in the House of Commons, on the dangerous state of the British economy. Brown replied that the questioner had been writing articles in the newspapers that spread alarm, without substance, about the state of the British economy.
Below are a selection of points made by the author:
· History teaches us that individual and collective stupidity, greed and complacency act as powerful countervailing forces to what seems like unstoppable progress.
· In the last two decades, the pendulum swung, particularly in the Anglo-Saxon world, towards deregulation.
· Two important issues of principle are: the need to strike the right balance between the perceived risk of creating a damaging shock to the whole banking system, if one bank were allowed to go bust, and the danger of moral hazard, if foolish and dangerous behaviour were to be rewarded by a bail-out; and how to strike a balance between public sector and private sector reward as a result of the rescue operation.
· The trigger for the global financial crisis was the US mortgage market. The reason this was transmitted to wider financial markets was that US mortgage lenders raise money for new loans by selling on their debt to other institutions.
· The total US mortgage market was worth roughly $12 trillion in July 2008, but the original debt was leveraged. Debt default could be insured against but the insurers depended in turn on borrowed capital. Derivatives markets also made it possible to hedge (or speculate) against the risk of default. The credit default swap market, for example, which grew on the back of the growth of these debt instruments, achieved a notional value of over $60 trillion. This in turn represented about one tenth of the overall size of derivatives markets, which Warren Buffet warned us was the H-bomb to follow the sub-prime A-bomb.
· The sums involved were still relatively small. Sub-prime lending did not cause he crisis. It was merely the fuse that lit the bomb. The explosive was non-traditional lending outside the banking system, centring on securitization (ie mortage-backed securities.
· The genius of securitization is also its central weakness. Debt is so widely and skilfully diffused that it becomes impossible to trace it. No-one really owns the loans. So institutions have struggled to identify how much their own financial assets, backed by sub-prime mortgages, are actually worth.
· A yet more serious problem are the “amplifiers”, multiplying losses (and gains) and adding to uncertainty. Amplification comes from several sources, the most important being excessive leverage, particularly by investment banks. Leverage of 30:1 (ie borrowing in relation to equity/share capital).
· Taking all the amplification into account, US losses from the current crisis were estimated by the IMF in autumn 2008 at around $1.4 trillion, 7% of GDP and 50 or more times larger than the sub-prime losses. But these estimates of losses are but a fraction of the losses which will eventually take place as the recession takes further toll.
· The impact on the world outside banking has been felt through the slow, quiet strangulation of bank lending to those institutions or markets that are now seen as excessively risky.
· After a series of bank failures and lender crises, the US administration took the crucial and very risky decision to let Lehmann Brothers, a venerable 158 year-old institution and the fourth largest investment bank in the US, go bankrupt.
· An even more dramatic intervention led to the state takeover of AIG, the world’s largest insurer, which had taken on $450 billion of credit default swaps.
· It soon became clear that the financial markets were in a state of blind, uncontrolled panic. Contagion set in.
· The key step was to recognise that banks should have whatever liquidity is necessary from the central bank (a practice which has operated since the 19th century). But the crucial step was to recognise that, if the banks were to return to their central role as financial intermediaries, they would need help in adjusting to the large losses that they had made. Writing off losses required capital. Only state intervention could solve this problem. Different countries used different remedies.
· There is as yet no sign of a reversal of the contraction in lending.
· The financial crisis has thrown up two major, related sets of controversies, which expose fundamental fault lines in economic and political thinking.
· The first is whether, and if so how far, governments should intervene. The theory of moral hazard is often invoked.
· The second is whether there should be a reversion to tighter regulation of the markets, and if so, in what form.
· Banking is an Alice in Wonderland world, in which financiers earn high salaries for taking and covering risks, and see themselves as pillars of a competitive but responsible private enterprise system. Yet, when crises and panics occur, governments are expected to step in.
· A system which allows banks and other institutions to make profits and fat salaries from questionable and foolish practices, while the public picks up the bill, should simply be unacceptable.
· The increase in oil prices to $140 per barrel was a major ingredient in the witches’ brew of economic toxins that contributed to the crisis of 2008.
· At the beginning of 2008, food prices overall were 150% higher than in the same period in 2000, and 40% up on the previous year. The economic and social consequences of the food price shock, however, have been proportionately much greater in poor countries than in rich ones.
· The rapid growth of China and other emerging economies has been generating demand for raw materials and food and pushing up prices.
· The dependence of these countries on export-led growth also supplied the world with cheap manufactures, creating a non-inflationary environment which made it possible for the US, UK and other western countries to grow so rapidly, without triggering overt inflation, over the last decade. But it also led to a large accumulation of cost account surpluses, and these translated into large foreign exchange reserves which, combined with the surpluses and reserves of the raw material exporters, created a vast pool of liquidity which has flowed back into western economies.
· When historians look back on the current period, what they will find most odd and different both from previous historical experience and from the predictions of theory, is the massive flow of savings from relatively poor countries such as China into rich countries, particularly the US.
· The complaint about China’s ‘unfair’ exchange rate is wrong on a basic point of economics. What matters for the ‘competitiveness’ of exchange rates is not the nominal value, but the real effective value when relative rates of inflation and the exchange rates of trading partners are taken into account. Chinese inflation is difficult to measure but it is undeniably more rapid than in the US, causing a real appreciation against the dollar.
· The world resembles an Alice in Wonderland tea party in that everything is the opposite of what it should be. Poor countries provide foreign aid to rich countries to help them live a riotous lifestyle. Rich countries then become angry and argue that this state of affairs is desperately unfair – not to the poor countries, but to themselves. Poor countries complain, in turn, about being bullied into stopping this flow of foreign aid from their own people who need it to the foreigners who don’t.
· The economic crisis has provoked a questioning not just of international integration – globalisation – but of the whole private enterprise system.
· The current debate is often characterised by the use of the word Keynesianism. Keynes is often invoked, but he said a lot of different things. He was, however, unambiguously a liberal (and Liberal), who wanted to save capitalism from itself. He wanted the market economy to work, and was dismissive of Marxist or highly interventionist idea such as are being advanced by some of those now using his name.
· Few now question that the Anglo-Saxon model of finance was deeply flawed, unstable and unsustainable. It will have to be remade in ways that greatly reduce the systemic risk from large volumes of excessively leveraged transactions, but that hopefully, preserve the capacity for innovation. There is a balance to be struck.
· We will not return to a simpler, purer world in which there is genuinely competitive banking, no state involvement and no moral hazard. The political will would fail at the first major crisis.
· A better approach is to say that since key firms cannot be allowed to fail, they must be more effectively regulated. The rejoinder has been that more regulation will never work. But the alternative that the financial sector must be allowed to lurch from boom to bust, generating vast profits in the booms and liabilities for the taxpayer in the busts, is rejected.
· Three areas in particular where a reformed regulatory regime focused on systematic risk would make a difference are: first, to use the regulatory instruments available to reverse the pro-cyclical bias of current rules; second, macroeconomic policy, particularly monetary policy, should operate to deal with asset prices as well as inflation ; third, remuneration and incentives based on bonuses encourages excessive and dangerous risk-taking, which adds to systemic instability, and regulation should insist upon systems with bonuses paid in stock that is not redeemable for some years.
· One of the trickiest but most important areas ripe for reform is the structure of the banking system itself. Nothing has caused more damage in the UK and US than the involvement of what used to be localised and specialised retail banks in global investment banking. Investment banking has, in recent years, resembled a casino. There are several kinds of banking structure which could emerge from this crisis.
· Financial markets are complex and entangled, and do not operate within national frontiers. So any meaningful regulatory response has to involve cooperation between the main regulatory authorities in the US, Eurozone, UK, Japan, China and perhaps more widely.
· The centre of gravity of the world economy has moved to the east, particularly to China. Hitherto the Chinese official reading of the crisis has been in terms of US economic weakness and lack of financial discipline, rather than a recognition of shared responsibility and mutual weaknesses.
· A new multilateralism is needed that recognises the changing balance in the world economy and has Asia at its heart, not at the edge of it.
· Unless the key players can demonstrate a capacity to make serious headway on the resultant issues, the existing structures could quickly unravel, to be replaced by confrontation and conflict. Four such issues are set out below.
· First, the left-over business from the old Bretton Woods – exchange rates, economic imbalances, and macroeconomic stability.
· Second, man-made climate change.
· Third, the revival of the stalled Doha development round of trade talks.
· Fourth, the development agenda – to eliminate hunger, poverty and disease.
· The financial and economic crash has also exposed the weakening of social cohesion that has followed in the wake of Britain becoming an international financial centre. The amoral, cynical financial dealings which, we were assured, created wealth have contributed not just to instability but to a weakening of the wider ‘social contract’.
· While there is crucial, urgent work to be done on the blocked financial plumbing and dangerous economic wiring, it is the job of the political class to redesign the home so that it is better able to withstand future disasters.Author : Stanley Crossick