Taking risks with the economy? It's time to throw caution to the wind

What do British banks and prisons have in common? They are both part of systems designed to manage risks and that are now part of the problem. We need to break the cycle by opening up policy-making to more experimental, less familiar forms of intervention and regulation. What is there to lose, that the financial status quo isn't already losing? There may be a lesson here for the rest of the West as well.

William Davies
28 April 2012

As an instrument for the deterrence and rehabilitation of criminals, the modern prison system is exceptionally bad value for money and woefully ineffective. While invented to ameliorate certain social risks of modern industrial societies, it has become clear that it is generating new risks all of its own, with prisons becoming schools for the teaching of crime. If policy-makers were to start again in tackling problems of crime and social exclusion, they would not start from where we are today.

But such is the nature of national risk management. Governments get locked in to certain dysfunctional paths, which then, it seems, become even riskier to abandon. No government will simply reverse existing incarceration policy without inviting far greater political and social costs. Or so it is believed.

This is all becoming true of government’s involvement in another 19th century risk management system: investment banking. As a basis on which to connect financial surpluses with productive opportunities, the banking system is proving to be a huge waste of money for British taxpayers, while delivering on scarcely any of its broader objectives. The sheer complexity and scale of the system means that is must now be viewed as a source of risk, and not a solution to it. If policy-makers were to start again in designing a risk management system for productive capitalism, they would certainly not start here.

Nearly five years after the dawning of the financial crisis, we can now identify one of its possible long-term legacies: the implicit association between the modern state and large financial institutions has become an explicit one. It is no longer possible to specify exactly where the state ends and the banking system begins.

Governments have long been silent facilitators of modern banking, through a number of 19th century risk management institutions. ‘Limited liability’, which enables shareholders to capitalise a firm (including a bank) without being liable for its losses, enabled banks to extend their lending way beyond the capital invested in them. As Andy Haldane of the Bank of England explained in a speech last year, ‘Control Rights (and wrongs)’, without this implicit state support, banks would have been incapable of taking anything like the risks that they did over the last hundred years, let alone the far higher risks taken over the last twenty.

Nationalised central banks, acting as ‘lender of last resort’, are a further way in which the safety net of state sovereignty is implicitly offered to the financial system. As with limited liability, the whole point of such a guarantee is that, in its simple existence, it then shouldn’t require implementing. As the founder of modern political theory, Thomas Hobbes, argued, so long as two individuals are both aware that an all-powerful state exists, it is reasonable for them to trust each other to behave peacefully and honestly without government having to do anything. States implicitly under-write certain forms of risk management, on the understanding that their bluff will not be called.

When financiers called the state’s bluff in the autumn of 2008, the result was that the boundary between the state and the banking system all but dissolved. The implicit under-writing has become an explicit one, thanks to government loans, guarantees, equity finance and quantitative easing, all of which offer a thoroughly Hobbesian solution to the chaos that would otherwise have engulfed the money economy. The National Audit Office calculated that, by the end of 2009, the public had already provided support to the financial sector totalling £850bn (around 60% of GDP), which was before a further £125bn of quantitative easing was introduced. One effect of this crisis is that central banks have become primary arms of economic policy-making, taking responsibility for areas of the economy (such as jobs and growth) with which many of them were never officially tasked.

Escaping financial lock-in

The critical question facing policy-makers today is how to avoid getting locked in to this path. It is not inconceivable that the banking system could still be a weight around the taxpayer’s neck in another twenty years time, unless new institutions and policy paths are tried out. The fact that nobody, other than a handful of individual bankers, would benefit from this strange form of public-private partnership is not enough to prevent it occurring.

Politicians speak repetitively about discovering a new economic path, and seem desperate to re-separate the state from the banking system, even if it means selling off tens of billions of pounds-worth of RBS and Northern Rock shares at a significant loss. A ‘rebalanced’ economy supported by a simpler financial system seems to be what all political parties want. If we take them at their word, we would expect to see the state shift its guarantees to alternative, more effective forms of investment and lending. This may involve the state becoming a more active force in banking, harnessing its stakes in RBS and Lloyds-TSB to creating a new type of investment culture, as Business Secretary Vince Cable’s recently leaked letter to the Prime Minister suggested.

Rhetorically, at least, a consensus is emerging regarding the types of economic institutions that would be preferable over those of the status quo. There has been considerable enthusiasm expressed across the political spectrum for mutual ownership and governance, which avoids the destabilising consequences of fast profit-chasing. The virtues of German ‘Mittelstand’ companies, often owned by trusts on behalf of families or employees, are now recited religiously at most economic policy seminars around Westminster and Whitehall. The report of the Ownership Commission makes a compelling argument for a less transactional business culture.

A more recent speech by Haldane argued that online peer-to-peer lending has innate qualities of simplicity and openness, that render it systemically superior to the esoteric world of complex derivatives. This, he argued, is the future. The suits and screens of Wall Street and Canary Wharf are now retrograde in comparison to new lending systems, such as Zopa, Abundance and Funding Circle.

Leaving aside the not insignificant issue of how the Conservative Party is funded, for the most part the state has become an unwilling accomplice in the City of London’s fortunes. But such is the danger of policy lock-in where risk management is concerned. Given the enthusiasm for the new, one would hope to see guarantees and regulatory endorsement offered to new market entrants and entirely new models of finance. But by virtue of their sheer newness, these firms appear as ‘unknown unknowns’ to routine-happy civil servants and regulators, who are more used to dealing with the ‘known unknowns’ of the status quo, no matter how dysfunctional and costly it becomes.

We are living with a situation in which billions of pounds of public money is still being effectively siphoned into the pockets of private individuals, via quantitative easing and other forms of support for the banking sector. The on-going hand-wringing over the 'fairness' of bankers' pay tends to ignore the graver public insult, that billions of pounds are being removed from the banking system in the form of bonuses, which the taxpayer will have to provide if the system collapses again. Gordon Brown cites figures showing that if bankers had reduced their pay by a mere 10 per cent between 2000-2007, the banks would have had £50bn more of capital available to them when the crisis struck, which is the same amount that the government injected into RBS and Lloyds-TSB in October 2008.

There is a structural problem here that has still not been dealt with. If this situation is to change, the government will need to take risks with its modus operandi of risk management. While regulators and policy-makers view the future via traditional risk management techniques, they will effectively endorse traditional risk management institutions of the City of London. Only with an ethos of experimentation can anything genuinely new be anticipated and valued.

Experimenting with responsible finance

During the 1980s and ‘90s, The Daily Mail would occasionally puke its outrage that another young offender had been sent on a ‘holiday’ in order to aid their rehabilitation. Sometimes, to make matters worse, the child had seized the opportunity to commit a further crime. And so, by the time New Labour entered office in 1997, politicians were fearful of straying too far from the line that ‘prison works’, in defiance of all policy intelligence on the matter. Experimentation and hope were stifled.

The state faces a similar challenge today in disentangling itself from the financial status quo. The Financial Services Authority is afraid of approving new models of retail investment business, for fear that one of them will blow up in unforeseeable ways. The Bank of England is striving to re-activate the real economy, but can only justify doing so via a re-activation of deadweight financial institutions. These agencies may be trying their best to protect the public, but innovation is being stymied by fear of failure. The result is that the old has died, but the new cannot be born. This is the fearful condition that Sigmund Freud defined as ‘melancholia’, in which a lost past is clung to, in blind defiance of its passing.

Two things in particular might help here, embracing the long-term future and the past respectively. Firstly, a parallel regulatory system needs developing for different forms of finance, based on a new type of financial intelligence, which is less mathematical and more attuned to innovation. A regulator that behaved more like a venture capitalist - researching new business opportunities, networking, engaging with technologists, imagining a new future – would be able to take a more considered view of what the future of finance might plausibly look like. At present, regulators and regulated fit together like a jigsaw, with a set of routinised compliance standards making new ventures or imaginative solutions almost impossible.

Secondly, there is a role for a much less modern approach to risk and liability. The governance of charities, mutuals and many employee-owned companies depends upon some very traditional notions of trusteeship, that are moral and reputational in character. These bring duties of care on the part of risk-takers that cannot simply be shirked if they turn out badly. Unlimited liability of partnerships brings a similar level of professional vocation to legal and accounting practices, given the personal consequences of bad decision-making. But the stock market flotation of investment banks in the 1990s, followed by the lobbied-for creation of ‘Limited Liability Partnerships’ in 2000, created conditions for a nihilistic risk management culture, in which gains could be privatised and losses socialised. Rebuilding the legal instruments of private liability, in both a moral and an economic sense, will be crucial if we are to move forward.

Amidst all of this, the state can use one of its perennial monopolies: the ability to define and punish crime. Finance is a profoundly moral issue, as it involves the creation of relationships of trust, often with very high stakes indeed. The state offers certain privileges to financial institutions, such as limited liability and a national currency. In return, senior individuals should potentially be criminally liable if they are not intending to act in the interests of their clients. A new bank, for example, may appear risky and may be risky; but if the founder is criminally liable for its activities, savers can at least know that they will not be intentionally ripped off. The same cannot be said of Goldman Sachs’ recent customers.

Ironically this brings us back to the question of prison. At a cost to the public of £41,000 a year per prisoner, there is peculiarly little economic rationality in housing young men who might gladly work legally for a third of that. But if Fred Goodwin had ever feared for his freedom, the British taxpayer might now be tens of billions of pounds better off.

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