Six myths about the financial crisis07 September 2009
A comfortable, corporatist consensus is building up about how to deal with the financial crisis. Led by Alistair Darling and his French and German counterparts at the G20 finance ministers' summit on the weekend, this consensus is essentially that the financial crisis "proves" that global free market capitalism has "failed" and that everything is the fault of overpaid greedy bankers unshackled by morality or law-makers and egged on by mega bonuses to ever more spectacular risk-taking. The world apparently needs nothing more than to close down the "casino banks," ban dangerous speculative innovation and return to a sort of updated, over-regulated, post-war corporatism in order to recreate the happy days of the 1990s. The following six myths about the financial crisis demonstrate why this is the wrong approach.
MYTH 1: THE "EXPERIMENT" WITH FREE MARKETS HAS FAILED
The idea that the era of financial liberalisation is over seems to betray a rather dramatic failure of perspective. The last 18 months have certainly been painful. But the losses pale in comparison with the huge wealth creation of previous decades. World real GDP grew by around 145 per cent from 1980 to 2007.
By every conceivable measure the citizens of countries able to profit from this growth have higher life expectancy, cleaner water, better healthcare, higher standards of literacy and more freedom. The "experiment" with free markets has been an almost unqualified success.
The American Nobel laureate Gary Becker has calculated that even if the recession turns into a depression with a GDP fall of 10 per cent then the net growth in GDP from 1980 to 2010 would still be 120 per cent or about 2.7 per cent a year - a real per capita increase of nearly 40 per cent.
Even in this worst case, this is a "failure" that the citizens of the many countries unable fully to benefit from global capitalism would probably be happy to settle for.
MYTH 2: THE FINANCIAL CRISIS IS A FAILURE OF GLOBAL CAPITALISM
The enormous and novel factor in this crisis was not the globalisation of world markets. It was attempts by governments to direct the free movement of capital.
Some large emerging economies pursued fixed exchange rates and current account surpluses, buying Western debt and driving down their own currencies. This massively increased the supply of available debt and the confidence of banks in lending to high risks at low rates. The oversupply of debt also held down interest rates in Western economies, while ever cheaper imports meant that inflation was held under control. This "new paradigm" underwrote the rapid economic growth of the boom. The West was in a virtuous circle: a faster growth rate seemed possible without exciting inflation.
The US was also to blame. Its subprime mortgage market could not have existed in anything like the size it did if the Government had not been so determined that it should. For decades US Governments encouraged home ownership by poorer households, providing economically significant incentives to mortgage providers by underwriting mortgages and by underwriting risk with implicit government guarantees. This government intervention led directly to the creation of the securitisation market in the 1970s and the subprime mortgage market over the past decade.
MYTH 3: THERE HAS NOT BEEN ENOUGH GOVERNMENT INTERVENTION
Financial regulation has been more global, profound and far-reaching than ever before. This has had profound effects on the pressures on banks' management. Insurance for retail savers' deposits, for example, has grown and grown. This may reduce unnecessary bank runs and panics. However, with deposit insurance, savers have no fundamental interest that their bank should not invest their money in too many risky loans, bluntly allowing banks such as Northern Rock to run the risks that they did.
Other rules have been ineffective or even positively harmful. Capital adequacy rules require banks to keep a certain proportion of their assets "safe" in very low-risk investments. The current Basel II accords ask for 8 per cent of part of the asset base to be kept as capital. But a century ago, under market (not regulatory) pressures, European banks' average capital base ratio was around 25 per cent. Following the credit crunch we will, ironically, end up with regulations that require capital bases equivalent to those that were commonplace before the age of deposit insurance and capital regulation. Why the apparently perverse chain of events in which banks have become less secure as global bank regulation has increased? Because investors and depositors a century ago, unprotected by government guarantees and not distracted by arbitrary capital ratios, were more demanding of their banks. Regulation and government guarantees have not, in the historical long term, made banks any safer.
MYTH 4: REGULATORS WOULD HAVE STOPPED THE MADNESS IF ONLY THEY HAD HAD MORE POWER
Almost everyone - banks, funds, regulators and economists - thought they could measure risk more precisely and certainly than they could. This problem was compounded by international regulation which set up an overly precise and flawed framework for measuring risk as the international arbiter for evaluating balance sheet risk. Banks' and regulators' understanding of risk was incorrect. And they thought they could perfectly hedge and insure away their risks. They could not.
It is not that regulators would have stopped the madness if only they could have done. They could have. But they made the same error as the bankers. And by institutionalising the flawed approach to risk management through the Basel II accords they compounded the problem and further encouraged bankers in their over-confidence.
MYTH 5: BANKERS' SALARIES AND BONUSES ARE TO BLAME
Regulators and politicians intend to make bankers' bonuses both smaller and longer term. Clearly governments who have bailed out banks have every right to demand what they wish. And the public's anger as they see their taxes save institutions that have paid over billions in bonuses is entirely natural. But governments will not achieve much by micro-regulating the pay packages of bankers.
The real problem was the nature of banks' profits not the structure of their bonus schemes; to fix the bonus schemes, therefore, is to the cure the symptom not the illness. Some of the organisations that failed most spectacularly were quite sensible in their long term incentivisation: 30 per cent of Bear Stearns and Lehman Brothers employees held shares in those banks. Finally, any scheme is likely to be irrelevant because banks will find ways around the restrictions. And a cap implemented in just one country would merely drive banks to locate their staff elsewhere.
MYTH 6: REGULATIONS NEED TO BE MADE TOUGHER
Global financial regulation has clearly been going in the wrong direction. Rather than not doing enough, financial regulators were doing more and more and doing it badly. The solution is not tougher regulation per se, but more transparency, more flexible regulation and a simpler global financial architecture.
Banks must be allowed to fail, with clear international rules making it easier for cross-border banks to be wound down without the market panicking. Simple information on bank stability and safety should be more readily available: the risk, capital and information that banks file for their accounts and for their regulator should be clear, utterly transparent and available to all investors, depositors or commentators. Banks' insurance should be priced according to risk, with banks choosing their optimum business model - from retail banks collecting deposits and offering mortgages to banks competing in the full range of corporate and capital market operations - and the price of deposit insurance varying among models. Finally a more flexible, judgement-based approach to capital, liquidity and balance sheets must be introduced.
Judging by the weekend's summit, what the current response will achieve is an ongoing systemic reduction in world trade and capital flows, a diminution of the role of London as a financial centre and, bizarrely, a renaissance in the Swiss fund management industry.
Whether these are outcomes that the G20 finance ministers or the voters who put them there really desire seems highly debatable.