The de-leveraging crisis--or the sub-prime crisis or the debtonation crisis--came about through the interaction of wicked plutophiles, genuinely useful financial innovations and lax, cowardly and confused regulators. It is important to untangle these in order to destroy what was genuinely bad in our financial arrangements. The spread of cheap computing, the theoretical understanding of how to price flexibility--option pricing--and the globalisation of supply and demand for capital set the stage for the growth of the financial sector from the 1980s for the next 25 years. In a world of benevolent, professional bankers, these changes would have been welcomed. However, the world of finance became the global magnet for hordes of semi-quantitative plutomaniacs against whom the partially sighted, ideology-bound regulators had no chance of success.
Globalisation, financial innovation and computing have brought benefits that now, when blame is spread generously, should be remembered. The heart of every financial transaction is an exchange of financial risks. When you sell a house, you want an amount of cash in exchange with a known, certain value. When a bank offers a mortgage, it swaps a known value for the likelihood of a stream of payments. The seller of the house has become financially more secure; the seller of the mortgage has taken on the corresponding risk. Moving risk around has real social value. A manufacturing company in Senzhen with good commercial contacts to corporate America can borrow to expand; it wants to take on risk. A fifty year-old office worker in California, at the height of her earning powers and saving for retirement, may find that an investment in a Senzhen factory is attractive. Globalisation of capital markets--whatever abuse it also permitted--expanded the opportunities for these sorts of re-allocations of risk. There is real social value in doing this--as long as you do it right.
Financial intermediaries can often provide more attractive risk re-allocations than would be possible with direct contracting between lenders and borrowers because they can enjoy the statistical effects of pooling risks. This is the basis of insurance: because things tend not to all go wrong at the same time--because ``sod's law'' is not a law--two mortgages are less risky than one mortgage. Information technology expanded the scope for the discovery of offsetting risk of this sort, and so found ways to ``cancel-out'' uncertainty. There is real social value in doing this, as long as you really do it. Only inveterate gamblers prefer material uncertainty to stability, and they can always be served at the casino. The more material uncertainty can be destroyed through social aggregation of risk, the easier we ought to be able to sleep at night ...as long as we are really doing this. Computers trawling great databases of prices could identify opportunities for cancelling risk on an unprecedented scale.
The development of portfolio theory and option pricing theory by financial economists has opened the way for a greatly increased scope for pooling risks. Even once you have identified uncertainty that can be ``cancelled out'', you need to turn that aggregate into a product that those affected by the uncertainty can buy; and as long as you can assess the price of risk, these become products that those with a collective appetite for risk can supply. So, a retiree might want to swap her accumulated pension fund in exchange for a promise to have her medical care covered, her subsistence needs covered, and a small amount left over for her children. Financial theory now allows such products to be priced and supplied.
In the midst of all this potential to do good came the plutomaniacs and bad regulators. The three forces of good change in finance of the last 25 years--increased opportunities to trade, increased data-processing and increased understanding--could all in themselves justify some degree of increase in the level of leverage. For every pound, euro or dollar of certain value that a financial firm could count on, it could now transform those into more uncertain pounds, euros or dollars of value than in the past. The banking multiplier could increase. Its increase from a traditional value of about 6 to the current value of about 25 is the story of ``debtonation'' that Ann Pettifor has told so well. Even if the forces of good change could justify--an extreme suggestion--a doubling of the rate of leverage, the five-fold increase we have lived through in 20 years can only be explained by the monumental failure to properly guide an invisible hand made weak by the mendacity of many in the financial industries.
As globalisation allowed banks to run rings around national regulators, the Bank for International Settlements transformed itself in the 1980s into a world-wide regulator. All banking institutions need to show consolidated accounts and prove that taking all their operations together, they have sufficient capital to cover ordinary and even extraordinary risks. Banks are required to limit their lending to 8 times their capital, where the value of the capital base is cleverly adjusted for its riskiness. In a world of benevolent bankers, all of them following the rules, these constraints should have worked. The banking money multiplier would have stayed at 8X, a number apparently entirely justified by the good forces for change in finance.
But we know the reality ...Banking ``innovation'' became more concerned with hiding the lending that banks were extending in order to continue to lend a long way beyond the 8 times capital limit. The ``special investment vehicles'' like Granite--the Jersey-based company that Northern Rock set up--existed only to be the repositories of lending that would not be counted against capital by the Bank for International Settlements regulation. Bankers, bonuses based on the volumes of the transactions they performed, had found a way around the spirit of regulation to unconstrained personal gain. Asset price bubbles followed, as the money created by banks chased limited investments. Emerging markets, technology stocks, housing, stock markets, gold, commodities, contemporary art ...anything in vaguely fixed supply--or at least supply slightly more fixed than the unconstrained creation of money by the financial sector--rose in price to absorb the money being created in the cracks of international regulation by the plutomaniacs. We can tell that the crisis still has a way to run from the stellar results of Hirst's last auction.
The crisis we are now going through comes from the fact that the money-creation went into a largely virtual economy. This was not about factories in Senzhen or retirement packages ...most of the growth in money was going to casino chips on which rich-world middle classes became hooked; their appreciating housing assets gave them a sense of righteous enrichment, a reward for who knows what hidden moral virtue they could conjure. The retrenchment today will require de-leveraging from today's absurd 25X to a normal 8X. Two thirds of the debt in the system needs to be eased out.
The dilemma now is this: how do we de-leverage in such a way that the virtual economy is hit, not the real? and how do we protect the real forces for good while cutting off the most destructive tendencies of the plutomaniacs? Regulatory pragmatism is aimed at the first problem now. AIG is too close--or thought to be too close--to the real economy to be allowed to default, while Lehman is sufficiently virtual to need to go. HBOS has strong links to reality--its mortgage business in the UK is tightly related to household savings, and so to the UK economy as a whole--to get nod-through approval to join the stronger balance sheet of Lloyds-TSB. As banker to the real economy and bankrupter of the virtual economy, this regulatory pragmatism is the right approach to the immediate mess.
But what of the longer term problem of good regulation? Can we have our good financial cake without it being forced down our throats like geese prepared for their liver? A solution to a problem usually comes from choosing the right constraints: what is fixed? what can be assumed to be in our choice? It is important to assume that the plutomaniacs will always be with us: financial regulation must assume that the great magnet of money will always disproportionately attract the iron-like sharks. What was true of politics when David Hume recommended that we design constitutions on the assumption that every man be a knave should now, in a world where the market has become mightier than the sword, be applied to financial regulation. 75 years after Hume's advice, Benjamin Constant, in his essay on the Freedom of the Moderns as Compared to that of the Ancients, reminded us that we ought to continue, all of us, to stay involved in politics in order to prevent the return of tyranny:
we should [...never...] surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying!
Today, this advice holds for control over finance. This is where the holders of authority lie in wait for us. Politics today needs to be in the shareholder assembly, as activist investors, as savers and borrowers. We must take control of regulation from the demoralised public servant and help ourselves. Where is your pension invested? Who manages the money? How culpable am I for the use that my savings have been put to? In our pre-occupation for the freedom of the moderns, for our cherished ability to get along with our private concerns, we have left a gaping opportunity for plutomania to operate and create havoc. Regulation is too important to be left to the conflicted civill servants.
We need all to become our own regular regulators.
tony curzon price 2008-09-19
