Archive for the ‘Financial crisis’ Category

Responsible capitalism

January 20, 2012

There’s been a lot of talk this week from the two main political parties about responsible capitalism. Sadly, so far, it has all been rather content-free – a few isolated points about how we shouldn’t allow bankers to claim bonuses where the performance of their banks is actually getting worse, and how we ought to strip knighthoods from ex-bankers whose governance appears, with hindsight, to have been less than great.

What is absent from these discussions is any idea of the principles of what responsible capitalism might look like. Aside from homilies about wanting to reward good performance and not bad, and to remind business about its duties to wider society, it’s all a bit empty. What follows is some ideas on what we might do if we were to actually try and achieve some kind of responsible capitalism.

First, we need to recognise that is unlikely that any of us, in ourselves, contribute a great deal to productivity or growth or our firm’s performance. We are either fortunate to work in an economy where existing infrastructure (including public services) and business relationships allow us to make our mark, or less-than-fortunate and be born somewhere where we don’t get access to education, or opportunities, or businesses, and so have a great deal more barriers to overcome even to survive. To imagine somehow that it is our own brilliance that makes for good business performance is rather delusional. Some of us make better fists of the hands we are given than others, and some worse. But none of us educates ourselves from scratch, makes the economy from nothing, and builds a business context where we can be successful.

I’m not minimising the brilliance of entrepreneurs and great social figures who have done real good. What I am saying is that, in order for the them to be brilliant, a great number of other things had to happen first. Neither am I saying we aren’t responsible for our lives – we are. To paraphrase Marx, we all make choices, but not in conditions of our own choosing.

Recognising we are all products to some extent of our own environments (even if it is by opposing them) means that we should recognise those that have achieved a great deal, but also that there have to be limits on those rewards. JP Morgan (the banker, not the firm that bears his name today) use to have limits on the multiples allowable between the lowest and highest-paid worker in his firm. This seems entirely sensible to me. Let’s reward those who do well, but also recognise (in Cameron’s words) that we are in this together. Would it really hurt us to have a maximum difference of ten times salary between lowest and highest paid worker (which is actually more than Morgan allowed)? It might focus our attention on the lowest paid as well as the highest, and recognise that everyone in the firm has the potential to make a difference.

A second point is that we have to recognise the perverse effects of allowing corporate lobbying on the scale we now have. Robert Reich argues in ‘Supercapitalism’ that we should throw the lobbyists out of Washington and even goes as far as saying we should abolish corporation tax on the argument that this would remove the right of representation (no taxation without representation, and vice versa). He might well have a point. We need to remember that our representatives are not there to represent businesses, but communities. Sometimes their interests will overlap – many other times not. Governments should be selectively drawing on the expertise they need – not being lobbied by those with the most money and power.

A related point to this is that we should set a maximum size on what we allow corporations to reach. Once corporations reach a particular scale, they have power and influence so great that any idea about free markets goes out of the window. There’s a reason Roosevelt took on the massive corporations of the US a hundred years ago – he believed markets should be free from the dead-hand of massive corporate power, challenging them through anti-trust laws. Sadly, we seem to have forgotten his insights – if there was ever a time we needed to re-establish competitive markets which will work to the benefit of consumers rather than businesses it is now. Once businesses reach a certain scale, they should be split up and forced to compete with one another. The alternative is to see the depressing oligopolies that dominate our high streets and economies. Markets don’t work well unless we make sure those within them are following some basic rules – in order to be free, markets need to have some strong ground rules.

All of this isn’t rocket science. Asking firms to narrow the gaps between the best and worst-off, getting rid of corporate lobbying and limiting the size and power of business is all designed to make markets work better, and to recognise that we all deserve credit for firm’s successes. That’s what responsible capitalism looks like to me – harnessing markets for the benefit of us all, rather than for those who are lucky and privileged enough to work for massive banks, exploiting their monopoly positions and paying a select group obscene amounts as a result. That has nothing to do with free markets, and everything to with protecting the interests of those who already have money, interest and power.


Financial illiteracy, responsibility and the financial crisis

January 17, 2012

Over at Stephen Dubner’s website ( (and thanks to Tim Harford for pointing this out on Twitter) there’s a piece with two short interviews about responsibility for the financial crisis. The first is from Alan Krueger (who is on the White House Council of Economic Advisors) where he suggests that Americans need to become more financially literature so that they save more. At one point he admits that the middle classes might look to have their incomes improved, but fundamentally, if US citizens were to become more financially literate, they would learn to save more.

The second quote is from Krueger’s predecessor, who makes similar points about saving, but also points to the 2000s as being a period in which the financial rulebook was thrown away, and so financially illiterate people got themselves into mortgages they didn’t understand, which in turn magnified the effect of the crisis.

Now there’s nothing too much factually wrong with these statements. It would be good if people in the US saved more, as they’d have a cushion against unemployment and illness and the expected generally. And it would be good if people hadn’t got themselves into such awful mortgages in the 2000s. The problem is that this grossly over-simplifies ideas about responsibility and financial illiteracy.

First, and in contrast to most economic theories, firms don’t make good profits from operating in competitive markets – they make money by deliberately making their markets less competitive. They launch brands to differentiate their products and massive marketing campaigns to persuade us that very similar goods are, in fact, not substitutes. This allows them to raise their prices and achieve brand loyalty. This is Marketing 101.

In the financial services industry, the situation is even worse. What are intrinsically bland products such as savings accounts and mortgages suffered from massive financial innovation (to give it a charitable name) from the 1980s onwards, reaching a point of sophistication where it was not only those buying the products that did not understand them, but also those selling them (Michael Lewis is good on this in The Big Short, as is Gillian Tett in Fool’s Gold). Now ideally, people would have laughed at the mortgages they were being sold as they were often incomprehensible, and demanded simple, straightforward products, but they were quite often not even offered the vanilla form products because greater profits could be made from selling the more complex versions (or so it seemed). Those who bought products they did not understand have to take some of the blame, but when those who sold them did so in bad faith (as very often appears to have been the case) then their liability is somewhat reduced.

Equally it seems utter madness to blame most Americans for not having any savings. Income inequality has grown massively since the 1980s, with most blue-collar workers seeing their wages stagnate in real terms. Little wonder that the fancy mortgages which promised them new wealth seemed to attractive – what are you meant to do when the world is getting more expensive and your pay is stagnant? Where exactly where these savings meant to come from? Blaming the poor for not saving and grasping what was sold to them as a chance to improve their lot is disingenuous to say the least.

There is one thing that would result from US citizens being more financially literature. They’d be a lot more angry about the lack of financial reform we’ve seen, and a lot less accepting of the ridiculous justifications that have come out of Wall Street for the financial crisis. There would almost certainly be bankers in jail, and a rather different economic plan in place to take the nation forward that regulated financial services more tightly for the future. Equally, some difficult questions about the riches made by financiers in the last thirty years would require answering when the majority of Americans have seen their incomes stagnate. Greater financial literacy would be a good thing – but not for the reasons Dubner seems to be suggesting.

On the wisdom and foolishness of crowds in riots and stockmarkets

August 10, 2011

Crowds are strange. In certain circumstances they can demonstrate extraordinary behaviour. James Surowiecki wrote a book (The Wisdom of Crowds) exploring this, with the classic example being one where people are asked to guess the weight of a hog. Rather amazingly, the mean answer (when people are asked to guess independently) tends to turn out right. As it does when you ask them to guess the number of sweets in a jar. In situations where you ask people to make a judgement about something they have some basic ability in, on average, they are right. Kind of spooky, but it does seem to be the case.

Stock markets depend on traders being, on average, right. They are there to make sure that assets are valued correctly (easy to forget when things seem to be going wrong), and on average, most of the time, they seem to work okay. Traders buy and sell, and come to some average agreement on what prices ought to be. So long as there are reasonably liquid markets, with lots of buyers and sellers, and where judgements are being made independently of other traders, things tend to be okay.

Then we have riots and stock market panics. It seems to me that there is a basic difference between these situations and what most of us experience in everyday life. When people stop thinking independently of one another, and start going with what everyone else is doing, things don’t work out well. In riots local protests can gradually escalate in self-reinforcing loops where things get nasty. A shooting in London resulting in a peaceful protest can end up in a riot where people get angry and start driving one another on to things they wouldn’t do by themselves. Other people in other parts of the country see it on television, and start behaving that way too. Some of those rioting will have more justification than others – they will feel that they are excluded, hated, maginalised. Others will regard rioting as a chance to take things. In either case, people are engaging in behaviour they wouldn’t normally consider. They are doing it because everyone else is.

Stock market panics also go that way too. Stock markets work well when traders are making independent evaluations of whether to buy and sell. They work badly when everyone else is panicking and they feel obliged to join in, even if they don’t know what the source of panic actually is. Do you think traders are all coming to the same view about US or Spanish or Italian (or French) debts? Hell no. They are copying one another, waiting to see where the next crowd is running to. As David Smith blogged yesterday ‘Crazy bourses – booming one day, slumping the next – if they’re not careful they’ll give financial markets a bad name.’ @dsmitheconomics.

What this seems to point to is that we need, in riots and stock market frenzies, a way of getting people to stop copying one another and start thinking for themselves again. We all have it in ourselves to cause mischief of one kind or another if we get carried sufficiently away. Stock markets tend to rebound after falls and everyone recognises that they’ve gone too far. When they do get carried away traders are generally looking for credible reasons to stop behaving like mindless selling machines, and the turning point is probably less about specific plans for governments may announce about austerity or buying debt than an event that breaks the mind-state of everyone to get them to think again. My main worry is that on financial markets no-one gets fired for following crowds, but people do lose their jobs for trying to work against them – ask fund managers. If we rewarded the first people to start buying (or the first to start selling at the height of a boom) rather than those who are simply profiting from copying crowds (over 90% of financial traded is correlated across the industry), then we might begin to get traders to think for themselves, and for momentum that isn’t helping anyone or doing the job financial markets are meant to do – value assets – to be taken away. Another route into this is the Tobin tax – a tax on financial transactions that asks a constant question before someone buys or sells an asset that asks them – are you sure?

In riots we need to find ways of getting people to start thinking as individuals again. If we can bring it people’s attention they are being filmed or traced via their phones that might make them think again, even though I don’t like the civil liberty breaches that entails. Once we forget that our actions have consequences then we are on the way to very bad behaviour. Where we have people who have very little to lose by engaging in a riot – they have no job, little hope – then the urge to stop thinking might come more quickly. That’s not an excuse, but it might be a reason. We need to find ways of reminding those engaging in riots that they will have to face the consequences of their actions tomorrow – when they will see they’ve wrecked the place where they themselves live, destroyed people’s homes and wrecked local businesses who provided much-needed jobs. I saw a tweet yesterday that said ‘Manager of one store recognised people coming in to store to commiserate today as also appearing on CCTV as looters on Monday. Incredible’ @peterjohn6. Yes it is. But it’s a reminder that those people now know what they did was wrong, and probably wish that they’d stopped and thought about things at the time rather than following the crowd.

Crowds are great when the individuals within them function independently of one another, and their action is co-ordinated to bring out differences of opinion that keep extremes in check. When everyone starts copying one another, however, extremes can result in bad things really quickly. We need ways of putting a brake on the extremes by finding creative ways to ask ‘are you sure you want to do that?’ before things get out of hand. None of us is immune to doing deeply stupid things in a crowd in the wrong situation if we don’t stop and think again. Britain isn’t ‘broken’ or ‘sick’, but it does have people and communities where there is little sense of people thinking for themselves, and acting in unhealthy groups. We need to help people in finding their own voices, so they can learn that their actions have consequences. Part of that is punishment, but a bigger part is surely helping those that feel they have nothing to lose by joining in with a riot a feeling that they are a part of this country too.

Why the financial crisis hasn’t led to significant financial reform

August 3, 2011

Three years on from the financial crisis, why haven’t we seen significant reform to the way that financial markets work (or don’t work, to be accurate)? We’ve seen the biggest financial disaster of my generation. Depending on who you believe, losses are around $3 trillion, and governments supporting banks to the tune of at least $14 trillion in 2010 (the figure, I suspect, now would be even higher).

Perhaps more importantly, we are now seeing the consequences of this level of state support for the banks. The biggest economy in the world, driven by what look like from the UK to be a bunch of barking-mad religious fundamentalists who know no history, has come pretty close to defaulting on its massive debts, a significant cause of which is the effects of the crisis on the economy. In the UK a coalition partner has been made a liar by tripling Higher Education tuition fees directly against pretty clear election promises, and supporting government policy hell-bent on incoherent reforms to the public sector, probably putting itself into the political wilderness as a result.

In March this year, the governor of the Bank of England expressed surprise there had not been more popular protest at the results of the crisis, and has made it clear that those that are bearing its burden are in no way responsible for it ( After the Wall Street crash we saw the US government separate investment banking from deposit holding institutions, as well as imposing a range of other systemic banking reforms. Given the consequences of the financial crisis have been so huge, why haven’t we seen significant reform to the banks?

A number of explanations come to mind, none of them particularly flattering to the state of debate, or to our political systems.

One view, made very clear by Colin Crouch ( is based on misunderstandings that surround financial markets. Because they are portrayed as being dynamic, profit driven and profitable, we’ve lost sight of the fact that banking is in fact dominated by a few, effectively state-backed corporations with surprisingly little competition between them. Because we use the language of the market and the state, we forget the power that massive corporations like banks can achieve – they are a third form of organisation that are able to portray themselves as dynamic, entrepreneurial and market-based, when in fact they are in receipt of massive government underwriting, and lobby on a truly terrifying scale to get the laws they need to continue to make their profits. Instead of assuming banks are in a competitive marketplace where the best firms win, we should look a little closer. Banks have become massive lobbying operations – supporting politicians, and making it very difficult for them should they dare to pass reforms that go against bank wishes. The extent of this lobbying is perhaps made clearest in Robert Reich’s book ‘Supercapitalism’ where he goes as far as to claim we should abolish corporation tax and deny corporations any lobbying rights in Washington at all.

A second reason, related to the first, is the revolving door that has appeared in the last twenty years between politics and finance. Prominent bankers have become increasingly close to prominent politicians, often with a good deal of job movement following. In his wonderful book ‘Them and Us’ Will Hutton suggests that this has resulted in governments effectively becoming ‘captured’ by the financial services industry. Even if lobbying fails (the point above), finance can depend upon their former employees in government, especially in the US, not to work against banks’ interests. We don’t have to believe in a conspiracy to see how this might have happened – if you’re trained as a banker, you see the world in banking terms, and even if you subsequently end up in government for the most altruistic of reasons, you are likely to be heavily influenced by your training and background.

A third reason, and perhaps the one I believe most in, is that we are reluctant to pass laws restricting the behaviour of the banks specifically because of the mess they’ve caused. The problem is that the economies of countries such as the US and UK have become dependent on the financial sector to make profits, and to generate tax revenues as a result. We’ve become so dependent in fact, that we find it hard to come up with an alternative view. Think back to the 2000s – how many bankers were brought into advise government how to better to its job? Given the problems with debt we now face, and a certain lack of courage and imagination from our governments, they have been unable to think differently. They need the financial sector to generate profits to pay off the debts that the collapse in the financial services industry caused in the first place. If I were Chinese, I’d find this funny. I’m not Chinese.

Related to this is the argument that our deregulated financial sector has now got the poorest in society into so much debt that, if we re-regulated it, it would lead to widespread default, as well as preventing debt from driving the consumer-led growth which our economies now depend upon. It seems that we want to hold the real incomes of the poorest paid down at the same level as they were in the 1970s, but still expect this group to consume more goods and services to get us out of low growth. Regulating the financial industry would mean that getting the poor into debt wasn’t an option. So we’re not doing it.

Finally (for now), there is the complexity of the whole issue. This comes into play in lots of ways. I don’t think our regulators are fools – they are just trying to come up with rules to govern a banking system that is truly out of control. But one of the reasons its out of control is that we’ve allowed banks to lend ridiculous multiples of their capital in a bull market, and leave themselves all bankrupt when things went bad. I appreciate that to go in too hard with rules after the crisis would have probably brought even more banks down, but frankly, they’ve had long enough now to sort themselves out, and the evidence seems to be that they would much rather continue to invest in speculative financial assets – backed by government guarantees and based on quantitative easing – than invest in businesses trying to dig us out of the hole we are in. I understand that investing in business in a slow-growth economy is risky, but I’d much rather our banks do that than allow them to build us a new financial bubble in gold, oil or whatever other nonsense speculative money is running into that generates no good for anyone else.

The problem is that the financial services industry is so complex no-one really understands it in its entirety, and this means it is difficult to come up with good regulations. It also means that it is hard to have a public debate about this stuff. Whenever I start on how you move from a CDO to a CDS and then to a synthetic CDO people’s eyes glaze over. But these assets were a significant cause of the mess we are now in, and we need to take the time to understand the sheer bloody incompetence of the people who caused it.

Regulating against such nonsense will be difficult, but it’s crucial that we do. The consequences of the financial crisis will be with us for a generation because of the debt they’ve brought us, and that’s assuming the lack of adequate regulatory response doesn’t drag us all down again in a recurrence.

Why the financial crisis is worse than you think

August 3, 2010

Now that banks are beginning to declare big profits again, and stock markets are in reasonably good shape, there is the possibility of thinking that the financial crisis is in some way over. But it really, really isn’t.

For a start, we seem to have learned very little in terms of re-regulating the banks that nearly brought the entire Western economy down two years ago. This week the Basle group published proposed changes to regulative structures that are so mild, and so limited, that they will make very little difference to bank behaviour. We are told that, within the Bank of England, briefing papers are being prepared to show that the economy, if the banks remain unregulated, is as vulnerable as it was in 2007/8. And yet we don’t do anything about it. This is really scary.

One of the reasons we don’t do anything about the banks is that re-regulating them would be, in the short term, a hugely deflationary act. Banks remain massively over-leveraged, with their profits coming from speculative activity and lending to individuals, mostly the form of mortgages. There is very little lending to business. This should come as no surprise – banks in the UK don’t lend to business as it’s far to messy and unreliable for them when they can instead be making highly leveraged bets on esoteric financial instruments instead. Banking likes to present itself as being a great friend to small and medium-sized business when only a tiny proportion of bank activity goes in that direction.

If we were to apply even moderate banking regulation, forcing that banks deleverage down to, say, a ratio of eight to one, that would result in massive amounts of financial assets having to be sold and a possibly even greater reduction in the paltry amount of lending to business that banks presently offer. But it would make the financial system far more stable down the line. A great deal of pain now, but at the avoidance of future crises.

One thing we ought to have learnt is that the boom times of the 2000s were largely illusory – the profits upon which public services were expanded and banks could claim to be masters of the Universe, were almost entirely the result of accounting illusion and increased amounts of leveraged debt. We are going to have to contract the system back down to a sensible level at some point, or face another crisis down the line when we haven’t paid for the last one yet.

Several accounts of the crisis suggest that what we need is to find a new ‘long wave’ of economic activity that will save us. So, as the post-war boom was based on something called Fordism which entailed mass production and a huge expansion of consumer goods, we now need a new wave of economic activity to take us forward. But this is hugely mistaken – if we expand world production on a massive scale again, can you imagine what the environmental consequences would be? Some accounts suggest the environmentalism can provide us with a new world boom, but that is surely to miss the whole point of environmentalism in the first place – it is not about ever-expanding economic activity but about making do better with what we have and making a sustainable future.

So unless we are really going to buy into the idea that free markets can save us (because that worked so well in the 2000s), we are facing a future where we have to deleverage banks, reduce our own holdings of debt, and work within a lower level of GDP. The alternative is to be forever looking for a new bubble to invest our debt into in the hope it will somehow put off the moment when we have to face up to the mess we are in.

Instead it is time to grasp the moment and realise that economic growth is not the be-all and end-all. We know that our well-being doesn’t actually improve above a certain level of GDP which most industrial nations are now well beyond. We know that the planet needs us to adopt a more sustainable future. We know that we can’t go on with the levels of debt that we have. All this adds up to us looking to a different future, and having to take the pain of the consequences in the present.

Government needs to be far harder with the banks, forcing them to deleverage, but also demanding that they go back to their old role of lending to businesses again. I’d even go with Minsky and suggest that government could become the retail banker of the nation – let the existing banks continue to engage in highly risky speculative activity and see how many people choose to leave their money with them. We need new visions of what the future might look like – not to keep repeating the errors of the last twenty years.

The financial crisis, social policy, methodology and spurious precision

October 23, 2009

One of the most important aspects of the financial crisis, but one that is often at risk over getting over-looked, is its consequences in relation to research and knowledge.

To try and explain what I mean by this, we need to start by thinking about economics. Economics has presented itself as the ‘hardest’ of the social sciences, favouring quantification above qualitative data, and prizing its version of scientific rigour that is organised around statistical modelling in various forms. It claims to follow a hypothetico-deductive model in that it tries to test theories through the use of empirical data. It follows the positivistic mantra of variables not being real unless they can be measured.

Economics, as a discipline, receives very large amounts of funding from research councils, and even now is marked as a priority area for further research. This seems to me to be a huge mistake.

This isn’t because we don’t need to understand economics better, its because the discipline of economic has failed on a colossal level to meet its own demands for methodological rigour and relevance, and the wider societal need to contribute to our understanding of the economy.

Economics is still largely based on Newtonian, normal distribution-driven models of mathematical modelling. Writers such as Ormerod, Mandelbrot and most recently Taleb have shown the mess this results in. Economists confidently predict outcomes based on models that bear little or no resemblance to anything anyone experiences in the world, are shown to be wrong again and again, but continue as if their methodology remains sound and sensible. Every time there is a financial crisis, you might have noticed how economists label it as a one in a hundred year event. But these events keep coming. Economic models assume away the reflexivity of humans (which Soros damns them for in his work), presents financial outcomes in a Gaussian, normal distribution (which Mandelbrot has shown is entirely inappropriate) and gives predictions that are wrong over and over again.

In a time when the economy is booming, it doesn’t tend to matter that the predictions of economists aren’t entirely accurate, as basing what you think will happen tomorrow on what happened yesterday won’t result in a problem. The problem occurs when the economy goes through a turning point – the most important time to be able to predict – and economists fail to predict it, or to be able to provide any sense of why it happened or how long the particular downturn will last. And yet we keep going back to them, asking for more spurious predictions of when things will get better, as if they are able to get it right this time.

This has huge implications for the way we carry out social policy research. There are strong movements within social policy to utilise economic approaches because of the supposed rigour they will generate. I think this is absolutely bonkers. Economic approaches don’t work in economics, so why on earth should they work anywhere else? I have no problem with quantitative modelling provided it is based on sensible assumptions and it is careful in its recommendations. Economics has not done any of these things. It has failed us, and its about time that we started addressing that problem rather than trying to copy its methods in academic contexts where it is even less suited than its home area.

Social policy does need theoretical roots. But there is no reason why these can’t be pluralistic, so long as we can understand each other’s languages, and we make explicit our assumptions about the world when carrying out research. Social policy based on economics often fails to do any of these things – it presumes that, because it is based on economic principles, that it should be accepted on those terms. It’s about time we challenged that. The city economist Roger Bootle has just published a book showing the failure of academic economics to address real world problems. Economics (the discipline) doesn’t work when addressing the problems of economics. Advocates of its methods in other disciplines need to be challenged far more often than has so far been the case.

Banking pay

August 12, 2009

As I write this, the UK FSA are publishing decisions about guidelines and rules in respect of banker pay, issues which have come to the fore during the financial crisis after bubbling away in the background for a number of years.

The arguments in favour of bankers being paid substantial sums in terms of bonuses are well-worn ones. First, there is the argument that banks must pay the market rate for ‘talent’ or it will go somewhere else, and either that individual institution, or the economy as a whole, will lose out. We can call this the ‘market rate’ argument. Second, there is the argument that, in order to incentivise bankers to innovate and come up with new financial products and services, that we have to offer them lucrative bonuses to encourage them. We can call this the innovation argument. Third, there is the argument that certain bankers create incredible returns on their activities, and so it is only fair that they receive a share of that return. We can call that the ‘fair share’ argument. Do these arguments stand up to any scrutiny.

First the ‘market rate’ argument. This depends on labour markets working efficiently, and of money being a substantial incentive for those working in banks. If markets don’t work efficiently then rewards go to the wrong people, and if money doesn’t incentivise bankers then paying them more is a waste of money – they would have done the same work for less.

The argument about efficient labour markets in banking presumes we are able to identify good performers from bad ones, and that good performers should command a premium. However, there are disquieting claims that good financial performers might just be rather lucky rather than brilliant. Taleb’s ‘The Black Swan’ and ‘Fooled by Randomness’ are the most popular version of this claim, suggesting simply that, as there are a very large number of traders, some are going to be very successful period after period not because of their ability, but because of blind luck. It might well be that traders receiving extraordinary rewards are just extremely fortunate. Equally, if bankers pay is bid up in periods where high rewards are being made, what about in periods where losses occur. In such periods should bankers receive substantial cuts in pay, especially where their organisations have been bailed out by taxpayer’s money. In such times, we are told, it is more important than ever to pay high rates to make sure that the best bankers remain in firms to make good losses and to ensure public debts are repaid. This seems rather like trying to have the argument both ways to me – that in boom times bankers should be paid highly, and in bad times they should be too. This isn’t any kind of market logic – that would suggest that in bad economic times bankers take substantial pay cuts. Until such a time as this happens, it’s hard to take this argument seriously.

The second part of this logic is that money incentivises bankers. This seems, on the surface, to be an obvious thing – of course it does. However, I’m not sure how far it extends as bonuses get bigger and bigger. The law of diminishing returns would suggest that bonuses have a limit beyond which they achieve nothing. If you pay me a £2 million bonus rather than £1.5 million, am I going to work proportionately less? There may be a collective action problem here – that you pay me £2 million because you think I might leave if you don’t, and so everyone is forced to pay this much as a bonus. But this goes back to the first part of the market rate argument, and is less to do with the market than an inherent belief that labour markets in finance are inherently efficient. If there is good reason to doubt this is the case, then the argument doesn’t work. Equally, it seems to assume that bankers are only interested in financial incentives, and pay little regard for the quality of their experience at work, their colleagues, or any of the other reasons why we work for who we work for. This surely doesn’t stand up to much scrutiny.

Next, there is the innovation argument, that bankers need to be paid substantial bonuses in order to come up with brilliant new financial products and services. This seems to suggest that banking is such a terrible job to have that, only by incentivising people through the use of blunt cash can we get them to do their job well. Is this really the case? This would seem to make the case that bankers aren’t terribly professional, and don’t take much pride in what they do. I hope this isn’t the case – and if it is, the perhaps why ought to be thinking again about how we organise banking. Either way, I don’t think the argument works.

Next there is the ‘fair share’ argument. This one doesn’t really work either. This is because bonuses are often linked to performance, and what we’ve learned over the last couple of years is that bank ‘performance’ is a far from obvious concept. Banks seem to have exposed themselves to considerable risk, leveraging themselves far beyond any sensible level, with considerable implications for us all since the credit crunch of 2007. In the years prior to the ‘crunch’ bankers appeared to be generating substantial profits on opaque financial instruments, and paid themselves massive bonuses on that basis. But these profits have often proven to be rather illusory, paper-based rather than adding any long-term value to the economy as a whole. They may even have been wholly illusory – think of the trillions that have been wiped out over the last two years. Banking bonuses, it seems to me, should be linked to the long-term value of assets such as shares rather than short-term profits. This might also have the effect of making bankers more loyal to banks, and so giving them less of an incentive to want to change banks on the grounds that their bonus is only £2 million and not £3 million – it might bring an end to this kind of nonsensical thinking.

Equally, the ‘fair share’ argument should apply both ways if it is to apply at all. If bankers are to get shares of the profits they generate, should they also get shares in any losses? It seems unreasonable for them to gain only the upside of the risks they take without having to participate in any downside. Only by linking bonuses to long-term performance can both upside and downside be taken into account, and bankers encouraged to create tradable assets of real value rather than those designed only to achieve short-term gain.

Who is to blame for the financial crisis?

August 5, 2009

Given the complexity of the financial crisis, I suppose it’s no surprise that a wide range of candidates have been suggested as to who we ought to blame for it. Here are a few of them.

The market
A first generic response is to blame the market. All of it. This is a kind of backlash against the neocons or neoliberal dominance that has undoubtedly been present for the last thirty years or so. This is good in the sense that the blind faith in markets that has overtaken us, at least in the US and UK, hasn’t been terribly healthy. Our governments appear to have reached the conclusion that markets can solve everything, and that, if only markets were more widespread, more widely used in areas such as the public sector, things would be better.

However, this is also sloppy thinking. Markets, in themselves, don’t solve anything. Markets aren’t always competitive, and competition isn’t always a good thing is every setting. We need to think a bit more carefully in the future as to where competition can be used to make things better, and when marketplaces need to be more carefully regulated and controlled. Markets aren’t the solution to everything – they are social institutions that we make the rules for. They should serve us, not dominate our lives.

The government
A second obvious agent of blame is the government. First we can allow the government for allowing the financial crisis to happen. The US and UK governments have for several years been telling us that they’ve solved the problems of economic boom and bust through a combination of independent central banks, low interest rates, and in the UK prudent public spending. They staked a great deal on the financial sector being the dynamo of their respective economies.

This seems to have been a substantial mistake. It will be some time before we know whether the entire economic growth of the last ten year (or more) has been wiped out by the financial crisis, but it seems plausible to suggest this is the case. This puts the focus back on the so-called ‘real’ economy to deliver growth for us, but this carries with it substantial risks.

We are at the end of a long boom of activity that began in the 1950s (so called ‘Fordism’) and it’s not clear what goods and services might help us achieve a new one. IT is trotted out as the answer (but remember the tech-collapse of the late 90s?), but it is not clear how sustainable economic growth can be achieved in the same way from what is, in effect, a service technology to improve productivity rather than the potential source of a new growth period in itself. Perhaps it’s time to think about learning to live with what we have and accepting that economic growth year on year is no longer possible or desirable? It may be well that our environment requires this kind of thinking.

The regulators
Another obvious candidate is the regulators, who have been portrayed as being ‘asleep at the wheel’. In the UK, the complex three way split of regulation introduced by Gordon Brown, splitting control between the Bank of England, the FSA and the Treasury seems to have resulted in no-one wanting to take control, or responsibility, for what happened. In the US criticisms have been made that the initial response, the so-called TARP programme, was badly-thought through and may have made the crisis worse.

This is the toughest one to crack. My sense is that regulators became too focussed on individual banks and not enough on the system as a whole. Systemic risk was allowed to build up through the use of complex derivatives, with too much leverage building up and not enough capital to back it up. Any individual bank may have been able to make the case it was reasonably secure, but the system as a whole was far over-leveraged. Regulators should have seen this happening, but they didn’t. They also allowed the growth of a ‘shadow’ banking system where the real commitments of financial institutions were extensively hidden from shareholders, and even from some senior bankers themselves. Some serious lessons to be learned here.

The financial instruments
We can also, of course, blame the financial instruments that created the crisis. The growth of SDOs, CDFs etc, all within a relatively short period of time, has been extraordinary. The idea of securitization, in itself, however, does make sense. Making markets more liquid through their use has a logic. The argument Gillian Tett makes in her books (and columns) is that they were extensively mis-used. This makes a good deal of sense. CDOs and CDFs were transplanted from their original context into others where, perhaps because those designing them did not really understand the dangers involved, they were not appropriate.

The story Tett tells is of J P Morgan bankers who originated these financial instruments looking out at the marketplace wondering how other financial institutions using them with sub-prime mortgages are possibly making money from them. J P Morgan’s bankers couldn’t make the instruments work in that setting because to do so would require extraordinarily high insurance (CDFs) against the risk being taken on. It turns out that the other companies made CDOs in subprime products work by not adequately insuring them, and by credit rating agencies apparently not understanding the nature of the underlying asset.

The financial instruments themselves were not to blame. That is like saying knives are evil because they are used as murder weapons. It’s their mis-used that is the problem.

The bankers
At the beginning of the financial crisis it was popular to lame the bankers for the crisis. They had got us into a terrible mess through selling bogus financial instruments, claiming colossal bonuses, and requiring government bailouts. Things went quiet for a while, and we’re blaming them again now that banks on both sides of the Atlantic are beginning to make money again. Is this fair?

It is partly. Institutions that have required public bailouts, and so which would not exist unless taxpayer’s funds had been used to intervene, seem to have gone back to ‘business as normal’, paying huge bonuses and being rather bullish. It’s hard not to feel a touch resentful about this. At the same time, nationalised banks in the UK seem to be making massive losses, which we are having to pay for, but at the same time sometimes continuing to pay executives extraordinary amounts to work within them. It’s pretty ghastly.

A lot of the banking pay argument seems to me to rest on two ideas. The first is that, in order to get good people, you have to pay market rates. There’s something in this, but I can’t see that the rate for executive bankers was very high a year ago when the banks were going bankrupt left, right and centre. If we were paying market rates then, salaries would have been pretty close to zero. Market rates have to work in both directions.

Second, there seems to be an assumption that bankers need to be incentivised through huge bonuses. This seems pretty close to nonsense to me. Are you going to work significantly harder if offered a million pound bonus rather than a £500,000 one. Will you work twice as hard if there is potential for a £2 million bonus instead? What kind of logic is this? Is it so horrible being a banker that we need to pay this kind of money just to get people to do the job?

My view, as I’ve said in other entries here, is that bankers need to start behaving more like professional, and less like second-hand car salesmen. Perhaps we might respect them a bit more then.

Last, xenophobia gets an airing. The argument is that the Chinese/Arabs/whoever-else-you-don’t like caused this by buying up our assets and forcing them into a financial bubble that has now come crashing down. Their investment in our economies caused interest rates to be too low for too long, and they kept their own currencies from appreciating to keep selling us good cheaply so that they fuelled a boom from which we have now moved to bust.

Oh dear. Lots of nonsense here. Yes, the economies of the world have received substantial investment from China, petro-countries (including Russia) and yes, that investment has kept interest rates lower than they would have been, and yes, they have sold us an awful lots of goods. But I don’t remember us blaming these countries while the boom lasted. If you want to blame China, don’t buy Chinese goods, but I suspect you’ll have a hard time avoiding them. Blaming other countries for what we ourselves have done isn’t going to solve anything.

‘Is banking a profession?’ and other questions about banking accountability

July 24, 2009

There are at least four ways of holding someone to account; through the market; through democratic means; through law; or through peer censure (including family). Each can be applied to bankers embroiled in the crisis that we are in. Starting from the perspective that those responsible for events should be held accountable for them (which seems fair enough to me, and I’m sure to most people), then what can this kind of analysis show us?

Holding bankers to account through the market means letting insolvent banks fail, and encouraging consumers to move their accounts to banks that they believe are and have behaved responsibly. However, we haven’t let insolvent banks fail for fear of systemic failure of the banking system, and the extent to which most bank customers understand whether or not their banks have been responsible is probably questionable. This doesn’t mean that this system can’t work – banks can be allowed to fail, and customers can get better educated about their financial choices. But neither seems to be happening right now, which does ask questions about whether banks are being held to account through market choices.

Holding banks to account through democracy means working out a regulatory regime through open public debate (which could be minimal or very extensive, depending on the country involved), and making sure that public regulation system works through government scrutiny of it. I’m not particularly hopeful, again, that either is the case. I’m not sure there’s a great deal of public debate or understanding about banks, never mind how to regulate them. This might not matter if our elected politicians understood them, and could offer us worked out alternative schemes that we could debate and vote for, but that doesn’t seem to be the case either. The US and UK scrutiny of banking leaders often seemed more like public showboating than any attempt to understand what happened and to act appropriately. There are also substantial problems around banking regulation and government involvement including regulatory capture (especially when significant politicians often seem to leave politics and join banks), and through banks funding political parties and even individual politicians. Rather depressingly for those of us that want democracy to work better, it doesn’t seem to be working in relation to banks – something that is even more alarming now that the state has nationalised some of them.

Holding banks to account through law would mean either the state or private individuals taking legal action where they believe that bankers have acted illegally. There are certainly cases in the nineteen century where banking collapses were followed by widespread lawsuits, and I’m sure there are lawyers on both sides of the Atlantic looking for possible angles for filing law suits now. Suing bankers to hold them to account has an immediate appeal – justice is linked to law in lots of people’s minds, and it would mean that bankers or fraudulent mortgage brokers are held to account even when they have moved on to other firms. They wouldn’t be able to evade responsibility for their actions by moving onto another job. However, doing things through the law is incredibly slow, extremely expensive, and doesn’t deal with the problem that most of practices that led to the financial crisis were probably legal, even if they weren’t terribly ethical on many occasions, and may not have made a great deal of sense when viewed with the benefit of hindsight. The law can’t protect us from practices that are legal, but unethical, or just unprofessional. However, that doesn’t mean that we shouldn’t use the law from time to time to remind those in positions of responsibility, either inside or outside the financial sector, that they have to work within the law.

That takes us to the fourth option – holding banks to accountability through peer censure. I think this asks an interesting question. Is banking like professions like medicine? In many respects it is. We trust bankers to do things that we don’t really understand ourselves (creating what are often called principal-agent relationships where a party acts on our behalf). This is because bankers have (or are supposed to have) expertise in what they do. Now we wouldn’t trust a surgeon to operate on us if they hadn’t passed their medical exams and weren’t a registered doctor. So I wonder whether we should be trusting banker with our money, and in many respects with our financial future, if they aren’t qualified and accredited to deal with it. Bankers often argue that they should be self-regulating, but it’s hard to see how they can be self-regulating unless they are able to operate censure for those that choose to operate within the law, but unprofessionally and unethically. Banking is special – it isn’t just another business – because bankers can create money. That’s a significant responsibility, that at present, doesn’t seem to come with too much accountability in return. If other systems of accountability aren’t working terribly well, then perhaps we need to try something new.

Holding bankers to account through peer censure would mean treating it as a profession. It would mean that other bankers (and lay members) would be able to decide whether bankers about whom there were complaints or concerns should be allowed to continue to practice as a banker or not. If they are not, then they would have their licence to be a banker effectively removed. In turn, banks would not be allowed to employ those people in any kind of banking role. Banks themselves would be responsible for drawing up clear standard which they expected their members to operate within, and would be able to move closer to a self-regulation model as there would be clear penalties for bankers behaving unprofessionally – they would lose their livelihood. The medical profession manages to make this kind of system work at least moderately well.

Maybe it’s time to take bankers at their word in terms of self-regulation, but make them take full accountability for the remarkable profits and earnings they are able to make during the good economic times through a system that defines, amongst themselves, which practices are acceptable and which are not, and which clearly censures those that step outside the limits. This might also help consumers in making judgements about who they wish to trust their money with – if given a choice between an accredited banker and an unaccredited one, I know who I’m going to trust.

Regulation and the logic of the banking sector

July 24, 2009

What the events of the last two years have made clear is that the state is not just the lender of last resort to the banking sector, but is also effectively is guarantor. This is rather uncomfortable for many of us. In the economic good times, the banks make lots of money, pay lots of tax, give staff what, compared to what most of earn, are extraordinary bonuses, and, because of their importance and status in the economy, end up advising governments and becoming destinations for ex-politicians to move to once they leave politics (hence Tony Blair and Al Gore now being part of JP Morgan Chase). However, in bad times, then the government is expected to bail the banks out, whether the problem, to use Charles Morris’ key difference, is whether the banks have become illiquid, or insolvent. Banks are viewed as too big to fail, and too important to fail because of the potential implications should they collapse. The ghost of the Great Depression continues to haunt us.

So on the one hand the profits of banking are privatised, and although they are subject to tax, taxation is often avoided or at least reduced through banks, entirely rationally from their perspective, doing everything they can to reduce their liability. But on the hand, the risks of banks are socialised. It isn’t just banks that are now so big that the risks of their operations have become socialised, as governments have bailed out all manner of businesses since the recession began. But banks are still special, because unlike other types of business, they literally create money.

Banks create money by lending more money than they hold in terms of capital deposits at any moment in time. One of the joys of having taught first year economics in the past is the look of wonder on students’ faces when you show them how credit spreads throughout an economy, and how deposits expand and expand when lent over and over again. This means that banks are special – they can do things that other types of business can’t (at least not to the same extent).

So banks have a key social role – they provide liquidity and credit to both individuals and businesses. Allowing them to fail means that that whole system is subject potentially to systemic risk and potential collapse. So, on this logic, it makes sense for banks risks to be at least partially underwritten by the state. This is usually referred to as the lender of last resort function, where, if a bank gets itself into trouble and runs out of the everyday funds it needs to run things, its working capital, it can borrow from the central bank. Doing so, however, means that it has to pay a higher rate of interest than it would do than if it could simply borrow from its own sources or from other banks. Lending from the central bank is done at a premium, so is a last resort on the part of the banks (who have to pay more interest) and the state (which only wants to lend to banks on this basis when there is a danger of systemic collapse).

However what’s happened in 2008/9 is that banks have not just lent as a last resort, they’ve taken over banks, bought shares in them, provided them with liquidity, and allowed banks to lend against assets which the marketplace (such as it is for paper such as CDOs) have come to regard as so troubled as to be worth only a small percentage of its original value. They’ve also guaranteed bank loans and so face potentially massive exposure should those loans fail in the future. Central banks have done far more than the lender of last resort role – they’ve intervened to stop banks from failing. This is not temporary funding to deal with a liquidity problem, but medium and even long-term funding to deal with a solvency problem. Governments have taken the risk associated with banking into the public sector.

Banks are now beginning to make profits again. This is great as loans made to the government are being repaid, and banks will pay taxation on those profits, helping to at least partially fund the massive bail out. However, it does raise some rather difficult questions about what the role of banks exactly is.

If banks are bastions of free market capitalism, then what on earth is the state doing preventing them from becoming insolvent? If banks are too big to fail, then that would indicate a huge flaw in the way they’ve developed. If size is the problem, this would point to a policy of breaking banks up so that they can be allowed to individually fail safely in the future. Perhaps we need to look back to Theodore Roosevelt who understood that sometimes capitalism needs to be made more, well, capitalistic. In a free market firms need to be able to both enter and exit freely without disturbing the market as a whole. Banking is an awfully long way away from this. Regulation would be about breaking banks up into smaller units, and having a strong role in making sure that banking systems as a whole are adequately capitalised (Canadian banks seem to have got through the crisis rather less bruised than in other countries because of this). It would also mean that central banks are limited to being lenders of last resort and no more. Banks would be made to conform more to the capitalistic model of smaller organisations in fiercer competition with one another, with a regulator looking for systemic risks, and individual banks being allowed to fail.

On the other hand, if banks are going to depend on being bailed out by the state, then it not clear whether we gain from having private banks being bailed out publicly. This is probably the worst of all possible worlds. Banks can take what risks they like, ultimately, knowing that if they come off then they make huge profits, and if they don’t come off, then they can rely upon the government to help. This makes no kind of sense. Under these circumstances the government might as well nationalise the banking sector on the grounds that banking is a social function with a unique quality (the ability to create money) as this will at least cut down the risks to the taxpayer.

Neither of these options is particularly palatable. But we do begin to have to think about the role of banking in an economy, recognise that it is not like other kinds of business, and have some kind of debate about what we want to happen next. Resentment against banks and banking remains high and may be rising as redundancies and unemployment more generally rise. But it does seem to me that banks have to recognise the logic of either being competitive businesses, or being extensions of the state. They can’t be both.