The Crash of our era has not been characterised by the social pain of the kind we saw in the 1930s. Many people have lost their jobs. Many have seen public services cut back. Many others have lost trust in the financial services industry and the regulatory authorities. What there hasn't been, however, is mass unemployment. Yes, there has been a rise in food bank use and job insecurity but the "Want" of the 1930s hasn’t been repeated. This is partly because of the scale of the response from the global authorities.
Global governments didn’t repeat the Smoot-Hawley error described in the previous chapter. We haven’t seen trade wars. China and America, in particular, undertook large fiscal stimuli. Even those countries that announced “austerity” - like Britain - have not cut public spending dramatically. Borrowing £100 billion and more each and every year for seven years in a row - as Chancellor of the Exchequer George Osborne has done - adds up to a very cautious form of deficit reduction (the budget deficit is still equal to 4.9% of GDP at the time of writing). Britain's Chancellor borrowed £100bn plus in 2010/11, 2011/12, 2012/13 but £97.3bn in 2013/14 and £89.2bn in 2014/15. Despite the austere rhetoric most finance ministers are in some way Keynesian expansionists.
Moreover the fiscal expansionism has been modest compared to the monetary expansionism. Some estimates suggest that $12 trillion of quantitative easing has taken place since the crisis struck. That’s the equivalent of one sixth of world GDP. With interest rates at rock bottom levels for seven years indebted companies and households that might have struggled to survive in normal monetary conditions have not gone under. In many cases that is merciful but there are perhaps too many zombie companies out there who would have failed by now if they had been subject to normal market disciplines. Potentially storing up problems for the future, monetary abnormality also means that borrowers and lenders are not subject to conventional risk disciplines.
The policy response to the crisis raises two particularly important issues:
> First, if the world economy hits another market crash the same remedies (if they are remedies) won’t be available. The public finances of most governments don’t have the room for a stimulus that they had in 2008.
> The second great issue concerns whether we have fixed the financial system.... Have we got the right regulatory regime now? Are there still too many banks which are “too big to fail”? Are bankers reformed characters? Will the next episode of asset price inflation meet with a stronger response from the monetary authorities? Has the housing market been fixed?
Let’s briefly take each of those five questions in turn. In these subjects I’m straying beyond my intellectual comfort zone and therefore don’t pretend to have firm answers to any of the questions – but a paper on post-crash capitalism can't avoid raising them.
HAVE WE GOT THE RIGHT REGULATORY REGIME NOW?
Let’s start by knocking down a great myth that has been allowed to grow up since 2008. The banks were regulated before the financial crash and heavily. Here’s Mark Littlewood of the London-based Institute of Economic Affairs reflecting on pre-crisis regulation within Britain:
“Look at the financial services sector. Supposedly a hive of devil-may-care, Wild West, free market capitalism. The last time I looked at the [Financial Services Authority] regulatory handbook contains 10 sections. The section titled 'Prudential Standards’ is divided into 11 sub sections. The sub section ‘Prudential Source Book’ for banks, building societies and investment firms is made up of 14 sub sub sections. The sub sub section ‘Market Risk’ is divided into 11 sub sub sub sections. The sub sub sub section of ‘Interest Rates’ has 66 paragraphs. There are over a million paragraphs in the rule book. Until the late-1970s, bank supervision was performed by the Bank of England with a team of around 30 employees. When the Bank of England was given statutory responsibility over bank supervision in 1979, fewer than 80 people were engaged in the supervision of financial firms. Since, then the number of UK financial supervisors has increased dramatically, rising almost forty-fold to around 1,200. In 1980, there was one UK regulator for every 11,000 people employed in the UK financial sector. By 2011, there was one regulator for every 300 people employed in finance. Regulatory reporting requirements have risen too. In 1974 returns could have around 150 entries. Today, UK banks are required to fill in more than 7,500 separate cells of data - a fifty-fold rise. And forthcoming legislation could see that rise to between 30-50,000 data cells spread across 60 different regulatory forms. I don’t know how you’d describe such a legal framework. My description probably can’t be stated in polite company, but it certainly can’t be described as unregulated free market capitalism.”
The situation in America wasn’t much different. George Mason University’s Mercatus Center reported that regulatory restrictions on financial services grew every year between 1999-2008 and regulators reported themselves as content with what they saw. One year before the crash happened in the US, the Federal Deposit Insurance Corporation announced that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”. Regulatory authorities in all parts of the developed world were not short of powers or staff to make such conclusions.
One response to this massive regulatory failure is to call for even more red tape. Another is to call for it to be abolished. Regulatory complexity is certainly difficult for smaller banks to cope with – forcing them out of business and reducing the diversity and therefore the stability of the financial ecosphere. The IEA makes other arguments for slashing regulation. In a 2013 paper written by Forrest Capie and Geoffrey Wood it is argued “that capital regulation is not necessary if banks are not underwritten by the state”. It thinks banks simply game the system and everyone gets a false idea of security from an extensive regulatory regime. Investors and depositors stop taking personal responsibility for assessing the quality of a bank and assume that the regulators have it all covered. Regulation may not just be a false comfort blanket – it can also distort and make things worse. It happened with one of the Basle rules that govern how much capital banks must put aside for different types of lending. One required more capital provisions for lending to small business than for mortgage lending. This was a contributory factor to the property bubble and to the reduction in finance to the small businesses that are most likely to generate the jobs of tomorrow.
Whatever the intellectual merits of reducing regulation, the electorates of western democracies are not going to accept substantial deregulation. More likely to succeed is a policy that breaks up the banking sector into smaller entities. Compare Dodd-Frank with Glass-Steagall. Dodd-Frank was the 2010 law enacted by the US Congress in response to our era’s financial crisis. It is 849 pages long and contains 398 new rules. It does, in other words, add to the complexity of the pre-crash regulatory regime – and, arguably, the false comfort that that regime engendered. Glass-Steagall was the 1933 reform introduced by US legislators in response to the 1929 crash. Just 37 pages long it prevented the “undue diversion of funds into speculative operations” by banning retail banks from more dangerous speculative or investment operations. It was as wise a response to 1929 as Smoot-Hawley was a stupid one. It was as simple and reassuring as Dodd-Frank was complex and “more of the same”. The events of 2008 probably needed structural reform but structural reform hasn’t happened on a sufficient scale.
Regulation has introduced the “bail-in” so that the investments of shareholders and the money of creditors are extinguished before claims are made of the taxpayer, but whether for emergency liquidity lines or propping up the banks with capital injections, the taxpayer is still exposed. Moreover, the banks are even larger than they were before the crash. Which brings us to the too-big-to-fail question.
ARE THERE STILL TOO MANY BANKS THAT ARE TOO BIG TO FAIL?
Andy Haldane, chief economist at the Bank of England, wrote for the London Review of Books on the growth of “fat” banks:
“At the start of the 20th century, the assets of the UK’s three largest banks accounted for less than 10 per cent of GDP. By 2007, that figure had risen above 200 per cent of GDP. When these institutions hit problems, a bad situation can become catastrophic. In this crisis, as in past ones, catastrophe insurance was supplied not by private creditors but by taxpayers. Only they had pockets deep enough to refloat banks with such huge assets. This story has been repeated for the better part of a century and a half; in evolutionary terms, we have had survival not of the fittest but the fattest… Consider the effects of the too-big-to-fail problem on risk-taking incentives. If banks know they will be bailed out, those holding their debt will be less likely to price the risk of failure for themselves. Debtor discipline will therefore be weakest among those institutions where society would wish it to be strongest.”
This problem could be solved by forcing the break up of the larger banks. Alan Greenspan has proposed another solution. Although the former head of America’s Federal Reserve may not have covered himself in glory for his part in the financial crisis his idea of premium capital reserve ratios for larger banks has considerable merit. He set out his idea in an article for the FT:
“New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage.”
If these super-ratios are sufficiently punitive – and I mean punitive – they could take us back to an era of smaller, less systematically-dangerous banks.
HAS BANKING CULTURE CHANGED?
If you wanted motorists to stop tailgating you could mount a spike in the centre of the car’s steering wheel – directed towards the driver’s breast. It’s not clear which of two economics professors - Armen Alchian or Gordon Tullock - were the originators of this radical approach to road safety but you get the idea. We don’t want boring banks – it might be better that we get frightening banks.
The British Tory MP Steve Baker – of Cobden Partners, a specialist consultancy on banking crises - has recommended radical measures to reconnect risk and reward. His answer to Bank of England chief economist Andy Haldane’s desire that we “reshape risk-taking incentives on a durable basis” is to reassert the liability of bankers. He recommends unlimited personal liability for the board members of banks in the event that their institution becomes insolvent. He also recommends that bonus payments be deferred over five years – invested in escrow accounts until they are paid. Two gentlemen whose names might be familiar to you - Nathan Rothschild (1777 to 1836) and J P Morgan (1837 to 1913) operated under unlimited liability and such partnerships were not unusual – even up to the 1980s. “Banks are often quick to require small business directors to provide personal, secured guarantees,” continued Baker, and “what is sauce for the goose is sauce for the gander.” Have such liability reforms been dismissed because they would produce a haemorrhage of operations from financial centres that required them? Have they been dismissed because of lobbying by crony capitalists in the banking centre? Have they been dismissed because they really are not a good idea? I fear the first two explanations are most likely.
It should, nonetheless, be noted that up to 60% of bonuses in the City of London are now being deferred for seven years for bankers who exercise significant influence functions. Since 2011 when the new regime was introduced, £900 million of bonuses have been clawed back. More here.
WILL THE NEXT EPISODE OF ASSET PRICE INFLATION MEET WITH A STRONGER RESPONSE FROM THE MONETARY AUTHORITIES?
For the International Monetary Fund in Washington the major policy error in the years leading to the financial crisis was not excessively lax monetary policy but the lack of an effective regulatory framework to protect financial stability. For the Bank of International Settlements in Basle the key error was low interest rates which encouraged the growth of indebtedness in the world economy and the misallocation of capital. A problem we might be experiencing again now.
Jeremy Stein, a governor on the Federal Reserve Board, appears to have departed from the Greenspan-Bernanke consensus that monetary policymakers should not concern themselves with financial stability. He joined with a number of academic commentators – who worry at the dominant role that monetary policy plays in inflating and deflating credit bubbles. In a speech in February 2013 Mr Stein worried that “if the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behaviour.” His arguments were summarised on The Economist’s “Free Exchange” blog.
Personally I think we need the monetary rather than the regulatory authorities to take the lead responsibility in avoiding the next crisis. Or at least lessening its impact – crises of some kind have always occurred and always will. The policy we need is called “leaning against the wind” and was described by Jean-Claude Trichet, the former governor of the European Central Bank:
"The leaning against the wind principle describes a tendency to cautiously raise interest rates even beyond the level necessary to maintain price stability over the short to medium term when a potentially detrimental asset price boom is identified." It should be mentioned that leaning against the wind has the advantage that it can to some degree ameliorate the moral hazard problem of the purely reactive approach to asset price boom-bust cycles. By reacting more symmetrically – i.e. being tighter in booms as well as looser in busts – the central bank would discourage excessive risk-taking and thereby reduce over-investment already during the boom. This in turn would lead to a lower level of indebtedness and less severe consequences of a possible future bust."
Leaning against the wind dampens two things that are central to crises: excessive risk-taking and asset price inflation. We operate the other way round at the moment – or at least we did in the Greenspan era. At times of fragility central banks eased monetary conditions – putting a floor under asset prices. But when confidence was high – even giddy – the monetary authorities were slow to act. Other than Jamie Caruana at the Bank for International Settlements, no senior central bankers are proponents of “leaning”, however.
HAS THE HOUSING MARKET BEEN FIXED?
I have only one recommendation to add to the comments I have already made on housing throughout this paper and that is to quote the wisdom of one of the world’s richest people, Warren Buffet. This is what he wrote in one of his annual letters to investors:
“Home purchases should involve an honest-to-God down payment of at least 10 percent and monthly payments that can be comfortably handled by the borrower's income. That income should be carefully verified. "Putting people into homes, though a desirable goal, shouldn't be our country's primary objective. Keeping them in their homes should be the ambition."
Seven years after the crash all sorts of phenomena that were deemed to be part of the problem are back. Telephone number salary awards for bankers. Skyscraping house price inflation. Zero deposit mortgages. And a monetary policy that accommodates asset price inflation. We haven’t learnt enough lessons.
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