Let's welcome the enmity of bankers

What caused Britain's and the USA's financial crash? What is its legacy? How to deal with the consequences? David Potter, who built the global, hi-tech company Psion, and then served on the Bank of England when the crash began, addresses these questions with the exceptional authority of a businessman amongst economists. 

David Potter
5 October 2012

The article started as an interview with Anthony Barnett and Will Davies and the first comment is a note by Barnett on how the interview came about and its autobiographical form. This exchange is also available to read as a PDF

What took you from being a scientist into business?

I was a young lecturer at Imperial College London where I had completed my doctorate in 1969. I worked on many-body, non-linear, physics. This deals with the laws of nature in complex phenomena such as fluid dynamics, the atmosphere or the structure of a galaxy. It leads to subjects such as turbulence, statistics in nature and it later spawned chaos theory. I became an early user of computers, simulating complex phenomena, and wrote an early work on the subject, Computational Physics. I was invited to teach and research at UCLA in Los Angeles in 1974. While there I reflected on the coming impact of the micro-processor.

These, together with memory chips and logic circuits, were pretty basic then but were developing with what is famously called Moore’s law. In one form, it projected that solid-state engineering would double the number of bits inside the chip and process them at higher speed every eighteen months. Over thirty years this means a compound of two, twenty fold, or 2 to the power 20, which is over a million. If right, solid-state engineering was about to change the world.  And it has, including the financial impact we will talk of later.

Two competencies informed the vision.  First, I had expertise in computer software and second an understanding of the significance of solid-state engineering. During the first half of the twentieth century, science created the framework of quantum mechanics to understand atoms, molecules and solids.  Now it was being applied to molecular biology and to fashioning solid-state matter that could engineer memory, computers, transmission cables and displays.  This is the technology that has revolutionised the world in the past 40 years, as mechanical engineering transformed the world of our great-grandparents. I was in California where it was happening.  A new economic and technology revolution was on the way and I wanted to be a part of it. I resigned my academic appointments and founded Psion.

Did you have the handheld computer in mind?

No. I started by asking where are the markets? In the first year I explored opportunities, raised some capital and started publishing the software of others in the UK.  This was on the computers of Clive Sinclair and Herman Hauser, founder of Acorn, who went on to build the BBC microcomputer. I recruited Charles Davies whose doctorate I had supervised at Imperial College.  Soon there were other able young people.  We formed a powerful team developing early software for a growing microcomputer market. That’s where we made our first real money. Our first profits funded a powerful VAX mini-computer, providing cross-compilers and professional tools that gave us advantage. We led the early computer games market in this country.

The trouble was that the market was growing extremely rapidly in many areas. Competition would multiply rapidly. I had doubts about the longevity and commercial wit of some of those with whom we were working. We searched for the wider markets of the future and identified hand-held devices and computers as a core long-term opportunity.

It was virgin territory.  We created it from nothing but the vision of the opportunity. People have large amounts of private information.  Most did not realise it then. Bits of personal information were kept in paper diaries, address books, odd notes, notebooks and in the attic. We identified the need and set out to create our own niche market.

You became a manufacturer?

Not initially. We did the research, the development, the core engineering, the market positioning and the selling. The need informed the functionality, but there was no predecessor to inform the design and delivery. This was exciting.  The team we assembled was led by another Imperial College alumnus, Andy Clegg, a gifted engineer with a lateral mind. We had to ask more and more questions. How do you store information permanently when you switch off the power? The machine would be too small to embed a disk-drive at that time. To solve this, we created a solid-state disk, and called it a data-pak; today it is a memory stick. We built that into the machine.

There were three core problems; one was the permanent storage or memory of information; the second, battery life; and the third - you had to make it very, very compact.

Making the machine small required a new type of electronics and mass manufacture not yet established in the West.  We turned to Japan where new processes and ideas in the art of electronics manufacturing were being mastered.  Our major component suppliers came from Japan, Korea and Taiwan and we worked with small, specialised manufacturers in the UK to employ the techniques.  Later we established our own facilities in the UK.

The ‘Organiser’ we launched in 1984 was the first of many models and indeed generations of products through seventeen years of engineering and market development.  In addition to the hardware the biggest, though virtual, machines Psion created were software systems that drove the hardware.  For all of us in the company it was exciting to participate in new markets.  There were financial rewards for many. But the greatest sense of achievement and reward was driven by providing new utility and benefit to the customer and driving new frontiers in the market.  

Solid-state engineering did indeed deliver a transformation in computers, communications, mobile phones, fibre-optic cables, and TV and displays.  But it has had an even wider effect than the creation of these great new industries. It has automated the making of goods. 

Through the nineties, the comment of the eminent economist, Robert Solow, “You can see the computer age everywhere except in the productivity statistics” roiled American economists. Perhaps at that time they were looking in the wrong place: not America, rather the East.

Since 1992 the world, and particularly the great consuming countries of The West, have benefited from a progressive reduction in the price of goods. Over the fifteen-year period between 1992 and 2007, the Consumer Price Index, (CPI) in the UK has hidden a compound reduction in the price of goods of 2% per annum while the cost of services has risen 4.5% per annum. The cost of our imports in Britain has fallen while price stability was maintained from the falling cost of goods and rising internal service incomes. It is not simply cheap Chinese labour that has driven the deflation of goods in the last 20 years. If you visit a Chinese factory today manufacturing say, iPads, great automated machines are working quietly assembling hundreds of components per device in seconds and with apparently little human aid. Over the last twenty years, one hundred million Chinese may have been added to world manufacturing as low-cost labour (The Economist, 29 July 2010). In the same period, some thirty billion microprocessors have been added to automate much of what we do, and many have automated the processes and machines that make the bulk of manufactured goods across most industries. It is the productivity gains from the automation of manufacturing that has delivered such a plenitude of goods at such low cost.

Manufacturing and engineering have become globally integrated. Your iPad says “Designed by Apple in California” and then, rather disparagingly, “Assembled in China”. Apple could not build or design it without 90 per cent of the components being engineered and designed across the world, in America, in Europe but particularly in the Far East.

It should say “Made in the World”.  As we recover from the Great Financial Crash and broaden our economy, perhaps Britain needs to find new opportunities for growth as part of “Made in The World” again.

Which took you to the Bank of England?

That was later. I was brought up in an old-fashioned way. Success in commercial life demanded some contribution in pro bono work. My earliest public contribution was in the Dearing Committee that reported on Higher Education in 1997. Its members were chosen in 1996 by both political parties because it was due to report after the election. I was brought in as someone with academic and new technology experience. It was a wide-ranging review of the future of higher education in Britain and we produced a report that informed the development of tertiary education.  

After Dearing I served on the Higher Education Funding Council and the Council of Science and Technology. I found that in British society you get to a stage where you become what I call “a balloon” - you find yourself floating up from one public role to another.

You become a ‘good chap’

Perhaps! No doubt it happens in other countries. In 2003, I was invited to join the Bank of England. As well as passing the ‘good chap’ test, I hope it was because I’d created a world class business, had experience of policy making under both Conservatives and Labour, and had an academic training too.

I became a non-executive director of what is called The Court. Later I became Chair of the Remuneration Committee which carried the nominal role of deputy chair of Court. Appointments are for three years at a time and I served the maximum of two terms. That was 2003-6 and 2006-9 - I was there in effect at the end of a long period of ‘peace’ and then in ‘war time’.

Could you talk us through those years, the period building up to 2007, and then how you explain the financial crisis?

When I joined in 2003 inflation-targeting was the established process for the setting of interest rates by the MPC. Between 1992 and 2007 Britain had a continuous period of economic expansion.  That growth appeared well-controlled with low inflation. Mervyn King called it NICE (Non-Inflationary Continuous Expansion).  I don’t think Britain has ever had such an extended period of growth, or at least for over a hundred years.   Monetary policy was centered on a target for inflation, to keep it at around 2 per cent (in the CPI measure).

This long period of growth seemed to give further empirical justification for using inflation targeting to control monetary policy and demand.  It seemed to have served us well. Two factors had come together: belief in a new rational economics and a new class of policy makers in the Bank. Eddie George became Governor (in 1993) and was a ‘commoner’, a gifted economist and public servant whose whole career was in service to the Bank of England. Before that and with some exceptions, patricians who had been heads of the big banks ran the Bank. He was followed by Mervyn King. To quote a colleague: the MPC didn’t have to leave it to patricians to make their arbitrary judgments in setting interest rates, it had a data machine for doing it. 

By the time I joined the Court this was a committed policy based on strong analytic foundations of the output gap and supported by deeply held beliefs.   Interestingly from 1992 our interest rates and those of the Euro after January 1999 tended to follow those of the Federal Reserve by about three months, as shown in the graph below. Although Europe with Britain has an economy as big as the US, we tended to follow the US, perhaps one of the factors in the ‘North Atlantic Great Recession’.

In my opinion, inflation targeting as a data machine was too narrow and theoretical a system to steer monetary policy, interest rates and credit. What many perceived as its great virtue, rigour based on data, disallowed wider perspectives that might allow judgment to be employed in ever-changing social and market behavior. It blinkered the risks to financial stability that were clearly developing through increasing debt, leverage and ‘animal spirits’. Whatever the judgment might be it is clear that in the period 1998 to 2007, monetary policy overshadowed the second core remit of the bank, systemic financial stability.

As important, when the 1998 Act formalised the role of the Bank of England in setting interest rates through an independent monetary policy committee it created the Financial Services Authority (FSA). The quid pro quo for granting the Bank of England independence in setting interest rates was to remove the Bank’s authority to oversee the balance sheets of the banks, through which monetary policy operated. This was odd. 

Historically the Bank of England had three core remits: the management of monetary conditions across the country with, of course, the banks as the Bank of England’s customers; second, oversight of the integrity of the banks individually as well as of the financial stability of the economy as a whole; third, supporting the interests of the financial sector in Britain. In the arrangements following the 1998 Act, the Bank of England was seen as responsible for the stability of the financial system as a whole, but not oversight of the banks that shaped it. This regulatory power was moved to the FSA. 

This separation of responsibilities was ill-conceived. How could the Bank of England be responsible for the banking system as a whole, if it was not responsible individually for the major banks with intimate and direct access to their core information?

Following the 1998 Act, the FSA was formed through the integration of a large number of separate regulatory bodies. In my opinion the FSA was derelict in its new key role of responsibility for the prudentiary regulation of the banks. The sheer scale of the financial crash that overwhelmed our country particularly is testimony enough. Many enquiries, books, articles and reviews have already provided the evidence of regulatory failure both in the UK and the USA, which we tragically mimicked. The message from the political classes was ‘light touch’.  Don’t challenge the prudence of the bank’s new innovative products or question their increasingly leveraged balance sheets. This charge applies to both the Labour Government and Conservative opposition who seldom failed to warn of over-regulation.

The same messages emanated from Alan Greenspan in Washington, a disciple of Ayn Rand and her philosophy of ‘Objectivism’. An important element of all this was that the world was changing rapidly. Wall Street and the City were selling new financial instruments that were really very, very new, had not been tested and weren’t being properly examined. There are all manner of ways of controlling credit. These were done away with on the basis that it was better to control credit simply through price, namely interest rates. Mr. Greenspan was doubtful that central bankers could even identify a boom when it was happening. Even if you knew what was happening you would probably do more damage taking control of the boom than you would by having a crash and picking up the pieces.

Such views were shared by people in the Bank. Well they were dead wrong about that. They stopped any crash occurring for 15 years but boy when it came, it came!

And when you were in the Bank of England, you saw this coming?

On the one hand, I was clear that there was an enormous credit expansion in progress likely to lead to a crash, but on the other it was not clear how this would be resolved. The issues were raised: very frisky spirits in the British economy with house prices going up, widespread credit available and rising everywhere and household indebtedness at 160% of incomes; in the corporate world the same. These are symptoms of a boom which is not likely to last. There were influential voices in the Bank who argued that the British have large assets and so the level of debt is not much higher than it has been historically. The problem with this is that in a crash the value of an asset goes down.  

Of course these were issues for the MPC. But they were also issues for the Court of the Bank and the wider executive in its core responsibility for systemic financial stability. The monetary role crowded out the stability responsibility.

I also agree with much of what Andy Haldane, who is still in the Bank of England, said in his OurKingdom interview with Will Davies.  It needs diversity of experience, not simply specialised academics, and I totally concur that it is fatal when economic policy makers and particularly financial economists adopt the methodology of physics.

It is the role of Government to use judgment to regulate industries and markets to meet the public interest, while allowing the hidden hand of competition to do its work within that framework. Adam Smith never suggested otherwise. Over many years regulation has necessarily been introduced in key industries such as airlines, the food industry or drugs, often after catastrophes such as thalidomide. Regulation must be powerful and unwavering. It was a terrible error in Britain’s case to take away prudentiary responsibility for the banks from the Bank of England and give it to the FSA. The siren voice of the British Bankers Association (the BBA) for light touch was that of self-interest and turned into forms of ‘capture’.

The public interest requires the commercial banks to be assessed for their prudence not their marketing activity. To encourage others in the future it is important to call to account the directors of Britain’s failed, bailed or nearly failed banks. No one has. The Queen’s Question was “Why did no one see it coming?”. For the establishment of politicians, policy makers, macro-economists and chatterati it was an appropriate question. More widely the question was based on a false premise. There were many people ‘who saw it coming’. We are social and herding animals and the naysayers were rejected and their voices not listened to. It was always thus, as J K Galbraith makes clear in “The Great Crash1929”.  A good party does not want party poopers.

The underlying issue for Britain has been the dominating influence of America in our own political and economic arrangements. We have been in the shadow of their hegemony, with disastrous results. In contrast, many countries including Australia, Canada and much of Asia were not and have not suffered the devastation we have.

Are we looking at a systemic crisis of capitalism as a whole, or just one of the North Atlantic model?

I would say that the epicentre was the North Atlantic culture of the last twenty five years. After the economic failures of the seventies, new economic thinking in America encouraged a necessary return to freer market-driven economies. The most important element of this transition during the Reagan-Thatcher era was our implicit acceptance of the American Way. This has affected our attitudes to debt, the often excessive expansion of our economy through debt-driven demand, and a value system that has more to do with a Virginian than a Quaker, a British banker or a member of The London Stock Exchange. 

Commentators in America or Western Europe described the Great Recession of the last five years as a world event. Certainly world trade dropped precipitously from the summer of 2008 but with stimulation across the world recovered just as rapidly within a year. But Asians describe the Great Recession as a North Atlantic phenomenon, where banks, governments and consumers have been mired in debt and GDP is flat or lower than in 2007. Much of Asia, Australia, Canada, Brazil and South Africa experienced a short downturn from the effect of world trade, but rapidly resumed growth. Australia, Canada, Singapore and Scandanavia, for example, had well regulated banks that avoided the North Atlantic contagion.

Across the world, capitalism has spread and is in robust health. Through the eyes of a real-world entrepreneur, the period 1980 to 2007 was one of the most creative and expansive periods in history. Harnessing quantum physics in chips, fibre and displays created new media, the mobile phone, and the automation of office, manufacture and retail. Our social and political lives have been changed.   Science, the development of new technologies that followed, and the striving of millions of people and thousands of companies produced better and cheaper goods and services. The nineteenth century was the era of the machine, the engine and mechanical engineering. We called it the industrial revolution. The last thirty years has been the age of automation, the virtual machine. The rewards to the creators, the firms, the employees were great products, new services, revolution in our society – the excitement and rewards of fulfilling needs in dramatically better ways.

The great progress of so many previously dispossessed regions of the world is testimony to that.

There was money to be made by de-regulated bankers in this vibrant technology revolution. The contribution of the financial sector was secondary. The goal, the reward, the return was money. If money alone is the raison d’être it is easy to lose the ethical direction or compass of one’s work.

And in case any banker is reading this with scorn, I ask him or her to review how banks managed their information in 1980. It is the technology I am describing that transformed the world of finance and banking. There is an irony in this, that the very technology that has had the greatest influence in transforming the world economy also provided the transformation of the banking world that has so damaged that new economy.

It was unsound, extremist, free-market ideology coupled to the powerful lobbies of Wall Street and the City that drove the banking collapse around the North Atlantic. So while I am sure that capitalism is alive and well, all industries that carry risk to the security of the public must be regulated. Thalidomide, air crashes, the loss of life-time savings are a few illustrations. Who today would suggest that pharmaceutical companies should be de-regulated to market drugs at their own discretion and in the interest of their “return on equity”? 

The effect of this ideology can be illustrated graphically in the growth of credit in the American economy (60 years) and British economy (25 years) as a proportion of GDP. It has risen largely monotonically, through various cycles, as more and more credit drives our economic system. The rate of growth is particularly dramatic over the twelve years to 2007. Government debts, personal and private debt, credit card debt and corporate debt, each increases as financing is driven by credit as opposed to more robust equity. This increases risk throughout the system. I’m a conservative business person who has survived through ups and downs and I was conscious of the risks being run with leverage and debt. In America, the morality of debt has changed so that the sense of personal or corporate responsibility has been eliminated. Private equity regularly defaults on its debts and householders often have no personal liability for their mortgage but can walk away if it suits them.

Traditionally equity was the shock absorber for risk. As it is replaced by greater and greater leverage it is little surprise that crashes occur.   

Is resuscitating financial institutions by pouring money into them making matters worse?

I fully supported the rescue of the banks. It was right at the time and it would be correct again, though I doubt that the nation has the capacity to address such a scale again. The Bank of England stopped the system from collapsing, but much remains to be done.

What to do about our banks? There are two things to be said. The obligations they hold are enormous in relation to our GDP but they are not that big themselves. In the year before the start of the crash (2006), their contribution to GDP was 4.5% and, if you take in financial services as a whole, about 9%. If I ask people how big are the banks a typical response is 25%-30% of the economy. The reason they loom so large is their giant loan sheets. In 2007 the UK’s GDP was about £1.4 trillion. The balance sheets of British banks being regulated by our government was about £9 trillion, seven times GDP. We have poured in vast quantities of money to keep these banks afloat.  It’s not the £46 billion used to buy the Royal Bank of Scotland (RBS) - it is the hundreds of billions of pounds RBS, HBOS, and other banks required to keep going. This is coming from the taxpayer. In October 2007, Government  assumed the responsibility for Northern Rock.  In October 2008, Government acquired a majority holding of RBS, assuming its assets and liabilities. How truthful or explicit are the banks being to us and to the authorities? If there is another crash I’m not sure what will happen.  Quite simply we will not be able to afford it. I have just shown a graph of UK debt to GDP excluding the bailout. According to the ONS, this is what it looks like now if you include the bailout:

Source: GDP (IMF), other:  ONS

The financial sector is the fourth wedge in the make-up of UK debt. It shows a rise in debt from 72% of GDP in 1995 to 210% of GDP in 2008. Then, through Autumn 2008, the rescue nationalisation of RBS and some mortgage banks  effectively transfers half of this crippling financial debt to the taxpayer (third wedge). This is the “bailout”. Much of the increase in public sector debt may be recovered as failed bank assets are sold, but the risks are transferred to the public sector. 

So I think the first action is to downsize the banking sector in the UK. I agree with the proposals of the Vickers Report that it is imperative to re-establish the core functions of financial intermediation. Because their contribution to GDP is in fact small we are not going to lose very much by doing so. But I do not think Vickers has gone far enough. Downsizing means smaller banks and less of them so that a collapse cannot threaten the economy. Their leverage on the British economy must be reduced. Commercial banks and investment banks should be separated.  Failed banks like RBS and Lloyds-HBOS should be divided and the parts sold. HSBC is different. It is mainly regulated in this country, but has huge assets across the world.  

So it would be no great loss if Barclays left Britain?

Yes, but let us not pick on Barclays. British banking has long been a key industry with a proud history. This should continue but a reduction in leverage and in scale is necessary for the long-term stability of the UK and so one way or another, by design or by calamity, it will happen. Why do we allow our banks to speculate for such a small and doubtful contribution to GDP? Before the financial collapse the bank lobby pointed to the contribution to tax revenues. If the published loans and support supplied by the taxpayer through the Bank of England and the Treasury are summed, the Banks are in the red over the last decade. The lobby of the banks, particularly through the British Bankers Association (the BBA), is out of proportion and it drives a great PR machine to press its case. Bankers should press the wider economic case. The UK’s total debt as a share of GDP is one of the largest and most daunting in the world. There is too much debt in every sector, but our position is greatly exacerbated by the huge liabilities of our oversized banking sector. This is shown starkly by comparison with the ten largest developed countries in the world:

These figures do not include the transfer cost of the bank bailouts to the public sector. The national cost of the British banking collapse has been huge. By way of illustration, the published balance sheet of the Bank of England between February 2007 and February 2011 rose from about £35 billion to about £220 billion to support illiquid and in some cases insolvent banks. Furthermore, the MPC has provided or committed £375 billion in Bank of England money in exchange for long-term bonds through quantitative easing in an attempt to support failing confidence. 

Which is due to the strange practice of quantitative easing where there is little understanding of how this works.

It is the exchange of one national liability (money) for long-term national liabilities (gilts).  Bank of England money buys gilts or other assets and in turn supplies money through the banks, in principle to the economy.

There will come a time when people say: “You’ve bought these £375billion in additional bonds, you had better sell them back to the market so that you can square the books!”  It’s a good question as to whether that will happen.

There seems to be a difference between your high-tech fortune made in a recognisable way creating a new business and the lavish money making exposed by the financial crash, which seems to reward those who have failed or who are certainly not involved in the creation of wealth.

Oh I agree. For most successful businesses and those employed in them, the reward is creating and delivering successful or even great products and services to the customer, the public. Everyone needs income to live a good life and support their families but pride comes from what we do. Banks should and do provide an important service. But if those engaged in banking see no greater purpose than the acquisition of money, then inevitably their workplaces will lack any ethical foundation. In short they have forgotten their customers.

The fundamental problem is the lobby, both in Washington and here in London.  The Guardian and Bureau of Investigative Journalism have recently researched and published an investigation into the effect and power of The City on our policy and politicians. It is disproportionate to other sectors. According to published reports the last US elections cost over $3 billion, much derived from financial interests. A series of senior CEO’s have made public statements claiming that the cause of the financial crash was the mortgagees who could not pay and committed fraud through misrepresentation of their incomes. It is a gross misrepresentation denying well-documented aggressive lending by the financial sector.  

What do we learn and what should we do?  The supply side of our economy must be re-created. Second, Reinhart and Rogoff in a study of debt and crashes over 800 years have shown that the issue of debt must be addressed before sound recovery develops. Impaired debt must be recognised and written down. The power of the monopolies must be broken. President Obama has been very weak in my view, compared to Franklin Roosevelt.  In a famous speech in Madison in 1936, President Roosevelt referred to “…monopolies in finance and business.  They are unanimous in their hate of me, and I welcome their hatred.” Why can’t Obama say that? Why can’t Cameron say that, or Ed Miliband for that matter? “I welcome their enmity”. 

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