The devil take the debt

Adair Turner’s – out this month – joins a select group of books that provide as clear an explanation of the financial crisis as one could hope for. It complements John Kay’s , with its emphasis on globalisation, financialisation and the switch from relationship to transactional finance. emphasises above all the inherent instability of banks’ ability to create credit, when not restrained by policy, especially given the scarce supply of that all-important asset, real estate. The growth of the shadow banking sector amplified this pre-existing source of volatility.

[amazon_image id=”0691169640″ link=”true” target=”_blank” size=”medium” ]Between Debt and the Devil: Money, Credit, and Fixing Global Finance[/amazon_image]

The book starts by pointing out that it was always foolish to think financial markets would satisfy the criteria for efficient (and stable) outcomes. The pre-crisis orthodoxy of liberalisation ignored the pervasive information asymmetries and non-rational choices in finance. features prominently here. As Turner points out, it isn’t as if there was any shortage of evidence from history that financial crises occur reasonably frequently. He adds the distinctive feature of the recent crisis, the increased inequality of incomes driving demand for easy credit, which banks were only too happy to meet. (Echoes of of Raghuram Rajan’s .)

The third part of the book covers the global dimensions of the crisis, in particular the China-US flows, and the role of the Euro. The financial flows not intended for direct investment were both immense and destabilizing, he writes. Among the high income countries, gross cross-border flows increased from less than 10 times GDP in the 1970s to 37 times GDP in the 2000s, with even larger proportionate increases for middle income countries. There is no evidence at all, he argues, that financial flows on this scale play any socially useful role at all.

And in this context of unsustainable credit growth at home and destabilizing flows across borders, only a minority of banks proved able to manage their balance sheet risks. To make matters worse, those that were good at risk management looked after themselves by offloading their bad risks onto other financial institutions, less well able to manage them. So the outcome for the system as a whole was even worse.

Given the difficulty of tackling the three drivers of the crisis – a limited supply of land and real estate, income inequality and global imbalances – what does Turner, a former head of the FSA, recommend? His answers are interventionist, suggesting a total rejection of the idea that finance can be left to ‘the market’. “To achieve a less credit-intensive and more stable economy, we must … deliberately manage and constrain lending against real estate assets,” he writes. He also advocates central bank monitoring of credit growth, constraining it when necessary; taxation of land values; taxation of debt to bring its treatment in line with taxation of equity; and raising bank equity ratios and minimum liquidity requirements (a step advocated by every, but every, economist who has given a moment’s thought to the crisis – shocking that the banks have lobbied their way out of this minimal step towards systemic stability).

Indeed, the book’s final chapter has some sympathy for even stronger measures: outlawing private money and credit creation; taxing credit creation funded by debt; and encouraging equity and hybrid instruments in place of debt.

However, the book concludes with a caution: “We face a choice of imperfections, and some of the imperfections are unfixable.” Financial markets are imperfect; so are policy-makers. Simple rules will never deliver stability, Turner argues. Far tougher constraints on the financial sector are needed. But policymakers will always have to make judgments as conditions change, and will get it wrong sometimes. Still, he suggests, not as wrong as in the mid-2000s.

Turner is at the tougher end of the spectrum in terms of his recommendations for constraints on the financial sector. But his calls for reforms join an honourable roll call of economists – as well as and , , , for example. As points out, millions of people are still suffering from the effects of the financial crisis. Yet the policy response has been minimal, and there is nothing to stop the whole thing from happening all over again. At least if it does, nobody will be able to blame the economists this time for not having sounded the warning.


Sharks and economists

I’m very much looking forward to hearing Joris Luyendijk talk about his book at the Festival of Economics in Bristol next month. It’s an excellent piece of reportage on the City and the ways in which it traps its workers into certain forms of behaviour.

[amazon_image id=”1783350644″ link=”true” target=”_blank” size=”medium” ]Swimming With Sharks: My Journey into the World of the Bankers[/amazon_image]

However, Joris’s attack on economics in The Observer this weekend is, unfortunately, stuffed with all the false old chestnuts critics of the subject always trot out: economics is not objective like physics (string theory? hello?!); modelling involves the assumption that there are ‘timeless truths’ in economic behaviour; GDP is not an objective temperature measurement of the economy (I can recommend him – by an economist – on that issue!)

[amazon_image id=”0691156794″ link=”true” target=”_blank” size=”medium” ]GDP: A Brief but Affectionate History[/amazon_image]

He writes: “Why should bankers ask themselves if a lucrative new complex financial product is safe when the models tell them it is? Why give regulators real power when models can do their work for them?” That question answers itself: because it was more profitable. Surely a sociologist of the City would find that almost nobody in banking gave much thought at all to the underlying economics of financial markets? Financial economists have much to answer for, but there is an odd tendency among critics of economics to attribute extraordinary power to  ‘the model’ rather than to politics or the sociology of financial institutions.

The article argues there should have been more research into the sociology and anthropology of the City. Quite right. But isn’t that what sociologists and anthropologists do? Economists like me have no training or experience in those research methods. I agree, too, that there are economists who disguise their politics as technocracy; I’d call them macroeconomists but some of them take umbrage when I do so. There is tons we don’t know about aggregate behaviour in actual economies. Neither that fact nor its acknowledgement make economics rubbish, or even unscientific. There is tons we don’t know about the natural world too. And by the way, physicists, biologists and chemists all use models. So do historians, just with words instead. Possibly even sociologists.

Don’t read me as saying economics has no criticisms to answer; it certainly does. But it is exasperating to read the same old same old nonsense from a critic who uses the misuse of one sub-field of economics by people in the financial markets to rubbish the whole subject, about which he seems to know very little. So I look forward to welcoming Joris to the Festival, where he’ll be able to hear a lot of economists engaging with the public, and talking about the environment, social mobility, immigration, the scope of government and many other issues.

Meanwhile, I agree with Dani Rodrik’s tweet:

One reason I wrote Economics Rules is commentary like this, which misleads more than it illuminates
11/10/2015 22:35

and recommend strongly his . I might buy a copy for Joris.

[amazon_image id=”0393246418″ link=”true” target=”_blank” size=”medium” ]Economics Rules: The Rights and Wrongs of the Dismal Science[/amazon_image]


Alone and together in the economy

There is an interesting new summary of the work of the Systemic Risk Centre, whose theme is the idea of endogenous risk: risk created by the interaction of participants in a market or economy, and amplified through feedback loops. The pamphlet opens with a statement from Milton Friedman: “The great mistake everyone makes is to confuse what is true for the individual with what is true for society as a whole…. Almost any interesting economic problem has the following characteristic: what is true for the individual is the opposite of what is true for everybody together.”

It also, of course, quotes : “Nobody can be a great economist who is only an economist – and I am even tempted to add that the economist who is only an economist is likely to become a nusiance if not a positive danger.”

The centre focuses on finance. The summary is particularly good on the paradoxes: that making each individual market participant behave prudently will destabilise the whole financial system, in a real fallacy of composition; that many regulations amplify pro-cyclical feedback loops; that the Tobin tax on transactions would amplify market volatility; and so on. The work sounds like a terrific addition to the points made in Ian Goldin’s book , which has a chapter on finance. Adair Turner’s forthcoming also looks at some of these issues.

[amazon_image id=”0691169640″ link=”true” target=”_blank” size=”medium” ]Between Debt and the Devil: Money, Credit, and Fixing Global Finance[/amazon_image]


Sorting out short-termism

Reforming finance and corporate governance have been a bit of a theme in my recent reading. There was John Kay’s outstanding , which I reviewed here a few days ago. I’ve read the proof copy of Adair Turner’s impressive new book, , although am not allowed to post a review until it’s out in November.

[amazon_image id=”1781254435″ link=”true” target=”_blank” size=”medium” ]Other People’s Money: Masters of the Universe or Servants of the People?[/amazon_image]  [amazon_image id=”0691169640″ link=”true” target=”_blank” size=”medium” ]Between Debt and the Devil: Money, Credit, and Fixing Global Finance[/amazon_image]

Meanwhile, I’ve read a short new book by Laurie Fitzjohn-Sykes, formerly a City analyst and now working for the think tank Tomorrow’s Company. It’s called , and is well worth a read.

[amazon_image id=”1845408349″ link=”true” target=”_blank” size=”medium” ]Playing the Long Game: How to Save the West from Short-Termism (Societas)[/amazon_image]

The book starts with a vignette of the annual general meeting of Softbank in Japan, in which Masayashi Son gave a 2 hour speech setting out his 30 year and 300 year vision. He must be doing something right. Softbank’s latest product, Pepper the companion robot, has sold out its first two batches of 1000 within a minute of launch.

Pepper, the robot Softbank proposes as your companion - photographed by Rory Cellan-Jones at Innorobo this year

Pepper, the robot Softbank proposes as your companion – photographed by Rory Cellan-Jones at Innorobo this year

The author contrasts this of course with the quarterly results obsession in UK and US business, with the under-investment in the west compared with Asia, and stockmarket churn. It touches on one issue I think is highly damaging, the link between executive remuneration and share prices – as does Andrew Smithers in his excellent book .

[amazon_image id=”B00EMVHKR4″ link=”true” target=”_blank” size=”medium” ]The Road to Recovery: How and Why Economic Policy Must Change[/amazon_image]

Fitzjohn-Sykes’ conclusions focus on exactly the need to change management incentives through corporate governance reform and taxation of the damaging pay structures. He also recommends using the tax system to link fund managers’ pay to the long term performance of their funds rather than quarterly outperformance, and introducing minimum stock holding periods for pension funds. In such a short book these recommendations are short on detail but surely in the right territory. Interestingly, he advocates requiring all market research to be conducted by 3rd parties – this focus on the problem of sell-side research is worth considering, along with putting the spotlight on the fund management industry as well as the investment banks and the companies themselves.

At 115 pages, this book is a concise introduction to the short-termism problem, and I’m sure some of the solutions it advocates will prove necessary. However, the problem is well-known and many people have suggested reforms; the question remains why they have so little political traction?


Other people’s money

Catching up with post-holiday stuff has slowed me down, but I finished John Kay’s new book, on a flight back from his native Edinburgh yesterday. It is characteristically excellent, drawing the main threads out of the complexities of modern financial history and the post-crisis consequences, and writing with beautiful clarity and style. It’s up there  with John Lanchester’s as a guide to understanding what has happened in finance. I agreed with every word. I don’t suppose he’d want the job, but it would be marvellous if we could put John in as Chancellor to sort things out.

[amazon_image id=”B00UJD8AS2″ link=”true” target=”_blank” size=”medium” ]Other People’s Money: Masters of the Universe or Servants of the People?[/amazon_image]

The book tells the story of the financialisation of the British and global economies in its first section, and the transition from relationship-based financial services focused on customers and the real economy to transactional and trading-based financial entities.This progressive shift in behaviour, values and institutions affected the whole of the corporate sector. The book offers a telling contrast between the 1987 and 1994 annual reports of ICI:

“ICI aims to be the world’s leading chemical company, servicing customers internationally through the innovative and responsible application of chemistry and related science. Through achievement of our aim we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate.”


“Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base.”

This has happened across the whole of the business sector throughout the west. It’s tragic. Risk taking at the expense of others, bonus culture, income inequality, short termism, declining business investment, overly-detailed regulation having utterly adverse consequences, and the taxpayer still in line to prop up the whole edifice if – or rather when – the financial sector gets hit by another tail risk it can’t cope with. As Kay underlines, and as pointed out so clearly, and even Alan Greenspan now admits, the banks have far, far too little equity capital and too much leverage. The summary here of Deutsche Bank’s balance sheet is terrifying.

The book is particularly clear about the inadequacy of banks’ current levels of shareholder capital vs debt on their balance sheets, and the nonsense of the Basel risk weightings, and banks’ claiming they can achieve 15% return on equity – always done by reducing the amount of equity in the denominator. Kay writes: “Return on equity is an inappropriate performance metric for any company, but especially for a bank; and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management.” Bizarre, or perhaps just cynical.

So what to do about it? Especially as financial markets start displaying the kind of declines that could, potentially, wipe out a frail bank’s mimimal equity? The book has good answers. Kay starts with a set of principles for reform, including shorter chains of intermediation before the final customers, more focused and specialist financial institutions, a prioritisation and demonstration that the financial institution has its clients’ interests at heart (hello, Goldman Sachs), criminal and civil penalities applied to individuals (not fines on institutions), simpler regulation. Above all, politicians should abandon the illusion that the finance sector is special compared to other sectors of business. After all, the numbers don’t make sense; it has certainly not contributed as much to the economy as is claimed, and is not financing industry or serving the needs of investors.

In detail, the book favours structural remedies, not more and more regulation of behaviour – that is an arms race between banks and regulators that the former, with their ability to extract vast rents and hire lawyers/lobbyists will always win. Kay sees ring fencing of retail activities from investment banking as a ‘first step’. I agree: the too-big-to-fail-subsidy will always be too big for as long as there are any links. There needs to be a structural separation, and deposit guarantees only for utility retail/small business banking. He also puts great weight on individual civil and criminal responsibility.

Towards the end of the book comes one of many eye-popping quotations from Goldmans executives:

Sen C Levin (D, Michigan): When you heard that your employees in these emails and looking at these deals said, “God, what a shitty deal!)… do you feel anything?

Mr D.A.Viniar (CFO, Goldman Sachs): I think that is very unfortunate to have on email.

No wonder Kay concludes: “The finance sector of modern western economies is too large.” Spot on. It takes too many of the best graduates, distorts pay across the corporate sector, fails to innovate on behalf of its customers, and exposes taxpayers to unsupportable risks. Financial conglomerates need to be broken up, banks need to hold much higher levels of equity capital.

Financialisation has even damaged unfairly the standing of the role of markets (and economics): “The intellectual misconception behind the thought that prosperity might be enhanced by trade in baseball cards has been associated with an economic model that misunderstands the (important) role that markets play in enabling complex modern economies to manage information,” Kay writes. Prices are important signals – just not the prices on the trading room screens.

Shrinking the finance sector takes the book in its final pages to the influence of money and lobbying on politics. Which politicians are going to serve the people instead of the masters of the universe? Unfortunately I haven’t heard even the Labour leadership candidate my Tory best friend has renamed “The Gift that Keeps on Giving” addressing this. As for the American system, utterly bought by big money, beyond hope.

Meanwhile, I hope lots of people will read and then send it on to their elected representative with suitable passages highlighted, saying – if you want my vote next time, act on this.