Extreme versions of the financial crisis

There are two versions of events leading up to the financial crisis that seem to be emerging. The first is based on the assumption that capitalism, as a system, is not at fault. What happened is that banks became lazy in their risk management, overextended themselves through excessive lending and investment in assets that they did not understand, and ran into problems as a result. Advocates of this viewpoint suggest that banks that made these mistakes should be punished – they should have had their assets taken over by other banks, even if this meant that they were sold off at low market values due to the ‘fire sale’ nature of their problems. There are arguments that the banking sector did not go through a lack of liquidity, but particular banks became insolvent, and as a result, they should have allowed to go bust. Having a central bank as a lender of last resort results in banks believing that they can behave recklessly, leading to moral hazard, and be bailed out if they make mistakes on the assumption that they are ‘too big to fail’. What is therefore required, then, is not more regulation of international financial markets, but less, but with banks being allowed to fail and be taken over by more successful banks if they mess up.

A second version of the crisis looks at it from the politically opposite end. In it banks, once again, failed in terms of their risk management, and over-borrowed and over-lent because of low interest rates. However, this view suggests that this is an inevitable feature of capitalism, where speculation runs riot and where, because the public sector must pick up the tab when things to wrong, profits are privatised and risk socialised. In this view of the world, banks must be heavily regulated, with their capital holding requirements increased significantly (the Canadian banks came out of the crisis relatively unscathed, goes the argument, because of their capitalisation) and with banking playing a much smaller role in the economy after the crisis as the gains and profits made from it over the last twenty years have been largely written down. Some writers suggest that capitalism as a whole is now stagnating, so that any growth is illusory, and down to bubbles emerging which are largely illusory, and which do not result in growth for the real economy at all.

So, even in the extreme views of both accounts, there is a shared recognition that the banks failed comprehensively in terms of risk management. There is a longer story here about the creation of abstract financial instruments that I’ll deal with another time, but the central problem seems to be that banks created financial instruments based on assets that aren’t particularly liquid (houses), and then proceeded to treat these assets as if they could be traded effectively as money, even though there was no marketplace for the assets (which were traded between institutions rather than through an exchange), and when the underlying asset (the houses) was found to be falling in value, the risk management systems the banks has put in place completely failed to foresee the possibility that the market for housing, as a whole, could fall. This is because the models underpinning these assets were based on data that only included time periods in which house prices had been rising, and also possibly because they used the wrong kind of mathematics – they were based on Gaussian systems (normal distributions) rather than non-linear (complex) modelling. This is because, for most everyday events, the Gaussian systems were good approximations, and because it seemed to the managers running the banks that the assumption that house prices would continue to rise was a reasonable one.

The accounts differ in terms of what happens next. The first version is based on banks being allowed to fail, assets prices going through a short sharp shock to correct markets, after which things should pick up. There is certainly a kind of natural justice in this. If banks are going to be responsible, it does seem odd that we should bail them out in the bad times and allow them to make huge profits and pay out massive bonuses in the good. The problem comes in whether the banking system, as a whole, was so swept up the purchase and sale of the illiquid assets that there were no good banks left to bail out the troubled ones, and the financial system as a whole would have collapsed. We still don’t really know how big the losses from the financial crisis will be. Charles Morris’ great book ‘The Trillian Dollar Meltdown’ was changed to ‘The Two Trillian Dollar Meltdown’ for the paperback edition, and Morris freely admits the losses could be far greater even than that. When a collapse occurs on this scale, there is certainly the danger of a systematic failure.

The second version of the crisis suggests that what is needed now, following Hyman Minsky, is for banking to be socialised, taken over by governments, and given a role of supporting the real economy instead of engaging in speculation. This seems both unlikely and rather incredible. Just because we may find speculation and the bonuses that go with it rather repugnant doesn’t mean that it doesn’t fulfil a useful function. Speculation, short-selling and overnight money markets might appear to be bizarre constructs, and in many ways they are, but all provide liquidity to the financial systems of the world. Indeed there is a good argument to suggest that the world economy’s problems come from financial flows being interfered with, especially from budget surplus countries like China, Russia and the oil producing nations, international currencies being held down artificially low, and a surplus of cheap money circulating that flooded to assets producing returns above those that government debt could promise – particular in financial instruments attached to housing. Had those surpluses been reinvested back into the nation states from which they originated, the standard of living for people living with them might have been improved, and the world economy been in a more stable situation.

It seems to me that we’ve got ourselves into a bizarre situation. On the one hand, we underwrite banks by saying that they are too big to fail, but on the other, say that they aren’t subject to much in the way of regulation in good times that might mitigate against a repeat of the crisis of 2007/8 in the future. Governments across the globe are presently tinkering with regulation systems, apparently on the assumption that they can fix this. However, while central banks are prepared to bail out banks, then they will always have an incentive to take on more risk than we might like. Banks aren’t being held accountable for their actions, which is odd considering that they have been presented as the paradigm of competitive success for so long. Perhaps it’s time to rethink what the role of central banks is – the present situation seems rather untenable. It is not reasonable for banks to expected to be bailed out through public money, and be making huge profits a mere year later, and this seems to where we have got to.

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