17 June 2011
The Future of Finance: The LSE Report
2010, LSE, 288 pages, £14.99
Reviewer: Charles Dumas, Chairman, Lombard Street Research
Just over two years ago, the post-Lehman financial crisis precipitated a global bailout of banks, fully revealing how the previous period’s carnival of greed had led to pervasive and extravagant blunders, frequently verging on fraud and in major cases actually fraudulent. Alongside this bailout, interest rates in most major currencies were reduced virtually to nil, both as a general monetary stimulus and to permit banks to be recapitalised by wide interest rate spreads. With a hefty fiscal stimulus in parallel, financial markets have recovered sharply. Bankers had stripped out huge bonuses up to 2007 on what turned out to be false profit statements, denuding their banks of needed reserves in the process. Over the past 12-18 months they have renewed their bonus-paying habit on the back of strong revenue recoveries arising from cheap money – while ordinary savers get little or no interest, and the economic recovery remains feeble, at least in the developed world.
Conditions could hardly be better for the reception of a book by a distinguished group of commentators recommending major reforms of the financial system. The Future of Finance, ten essays published by the London School of Economics, is mostly focussed on proposing such reforms. All the essays are interesting, several brilliant. The excesses of the financial system in the years to 2007 are outlined effectively, and a variety of proposals laid out for creating a better financial system. Yet in a strange way the book lacks structure, specifically:
• A ‘What went wrong?’ framework – the default assumption that it was all caused by bad banker behaviour pervades the essays, and is incorrect;
• In what way are current regulations most inadequate? – reforms being hard to achieve, especially as international agreement is needed for them to be successful;
• Would the proposals being made have prevented the crisis, or made it much less severe?
An unduly easy monetary policy almost invariably expresses itself in credit excesses. And the lenders are mostly bankers. Sushil Wadhwani, in a limpid essay, stands back from the blame game better than the others; and Andrew Smithers, who (like this reviewer) forecast the debacle well in advance, here argues (rightly) that bubbles can be forecast. But two brilliant early essays in the book – by Andrew Haldane analysing the contribution of the financial sector to the economy, and by Paul Woolley, using the ‘principal versus agent’ concept to explain the momentum trading that features in all bubbles – both effectively claim that the banking crisis was exclusively caused by banks. Other essays proposing ‘ways forward’ mostly accept this claim.
Haldane’s essay attributes to bank excesses all of some hypothetical (and improbably large) future loss of income subsequent to, and implicitly caused by, the crisis. He ignores Wadhwani’s points on the benefits from the ‘financial revolution’ of the past 30 years. His outstanding and witty analysis of the accounting for banks’ contribution to GDP is marred by the assertion that the taking of risk is not part of their value added, as the risk (of a loan) is there anyway. But, of course, it is not. Depositors want deposits, not businessmen’s or householders’ promises to pay. Otherwise, the whole financial system could be handled in the public securities’ markets. The assumption of risk with depositors’ money is precisely the contribution of bankers, and loans would in many cases not happen without bankers’ intermediation – a point recognised at least as long ago as Bagehot. Paul Woolley’s elegant essay explains much that is wrong in capital markets, and stands apart from the rest of the book in its concern chiefly with how investors and their asset-manager agents should handle themselves: the ‘future of finance’ indeed, rather than of regulation.
If bankers take the entirety of blame for a crisis arising from a vertiginous expansion of debt, then no monetary policy can be too easy. The oddity of the run-up to the 2007-8 crisis is that monetary policy was clearly too easy in provoking debt that would certainly exceed the capacity of income to justify it – yet it was just about right in relation to normal criteria, eg, the US Federal Reserve’s mandate to aim for low inflation and reasonable growth. In the six good years of the last cycle, from end-2001 to end-2007, the US real growth rate was 2¾%, well below the long-run average of 3-3¼%, which covers recessions as well as growth periods in the cycle. Inflation was less than 3%, little over 2% excluding food and energy. Although a housing bubble was evidently blowing up, a stricter monetary policy would have been highly controversial, possibly leading the Fed to be over-ruled by the Congress.
Why did it require such a massive run-up of debt ratios to provoke such modest growth? The answer lies in the Eurasian savings glut. The long-standing excess of private savings over investment in Japan was compounded by mercantilist policies of Asian Tigers, traumatised by their treatment in the Asian crisis; repression of growth and incomes in Germany and other countries of north-central Europe, reinforcing demographic effects, as in Japan; and, finally in 2005-7, a massive build-up of net exports from China. Wadhwani alludes to the savings-glut idea, but is agnostic as to its role in making US policy too easy. But the evidence is virtually incontrovertible to an economist: the huge expansion of financial activity and debt saw the real cost of money go down, at least until 2006, by when the die was cast. This can only mean that supply was driving up demand – not the reverse. This theory was first proposed by the present reviewer in 2004, then, independently, by present Fed Chairman Ben Bernanke in 2005, and is accepted widely, including by Martin Wolf, whose contribution to this book is a succinct look at the specific issue of how to reduce abuses in bankers’ pay.
Supporting the ease of US and other countries’ policies was a lax Zeitgeist. If the US regulations in place had been properly enforced, most of the disgraceful ‘Ninja’ loans (‘No income, no job or assets’ – not to mention documentation!) would have been prevented. The proposals here, notably a lucid exposition of possible reforms by Charles Goodhart, could well improve the financial system. Clearly, as Lord Turner demonstrates, stronger equity and other capital ratios, and explicit vulnerability of subordinated debt, should be required. Martin Wolf’s desire for all loan-making institutions to be regulated makes sense – but could prove unattainable in a globally competitive context. The question of how to deal with the cat’s cradle of derivative contracts that tied all the banks together, and made it likely that failure of one could drag multiple other institutions under-water, is not fully addressed in this book, though it was a primary source of the crisis, both in the Bear Stearns collapse of March, 2008 and the Lehman bankruptcy that September.
The true danger is that in some future boom and bubble, if the Zeitgeist is again as absurdly laissez-faire as in the run-up to 2007, new regulations, however well-conceived, will do little good. Meanwhile, the problem for now – and at least the next ten years – is highly unlikely to be wildly extravagant risk-taking by bankers. It is, rather, the refusal of the savings-glut countries to accept any responsibility for what went wrong, and the consequent dependence on unacceptable government deficits for recovery in the deficit countries. This dilemma is, and has always been, an economic and also political crisis. Excessive government debt may indeed provoke a new banking crisis – but it will not, this time, be the bankers’ fault. It would have been better if this book had framed its useful analysis with these broader issues.