How to let a good crisis go to waste

Last year’s financial crisis presented an opportunity for fundamental reform, argues Will Brown. It’s one that’s already gone to waste.

It’s now over a year since the world’s financial system went into meltdown in the wake of the collapse of Lehman Brothers in September 2008. At the time, there was much talk of a transformation of the financial system, of a revolution in state regulation of private finance, the end of neoliberalism, even a transformation of politics. Yet, as the crisis passes and the world economy starts to make its way up the long slope from recession, these bolder claims have been pushed to one side.

Instead, the political consensus among governments of the leading economies focuses on much more modest ideas: a tweak to the regulatory architecture here, a word or two against bank bonuses there, a broad but toothless declaration in favour of international stability over there. And, shamefully, the weasel words of the private financial sector, briefly silenced in shock at the scale of the crisis, now re-emerge warning against any actions that might restrict competitiveness, of the need handsomely to reward ‘world class talent’, of the need to be vigilant against burdensome regulation. The job of dealing with their past failings meanwhile falls to ordinary tax payers, public service users and the newly unemployed.

In the UK, with a Tory government waiting menacingly around the corner, the debate is all about the burdens of the public sector, the need to cut government expenditure and the failings of the political class. And in the USA, the shell-shocked political right, which looked down, if not quite out, after twin blows from the collapse of the American economic model and the Democratic triumph of November 2008, has now regained its feet and rails against the expansion of ‘big government’.

It is in this context that it is worth reflecting on what we have been through, the underlying dynamics of our financial system that lie at the heart of the crisis and the political challenges we are left with.

Financial crises old and new

Although, quite rightly, the recent financial crisis dominates our thoughts, it should be remembered that financial crises of one kind or another are recurrent features of the economic landscape. Since World War Two the dominant view has been that the problems underlying the 1930s bank crisis and Depression have been addressed, and that governments and central banks know how to avoid them.

Yet we’ve had a succession of crises over the last 20 years, including the stock market crash of 1987 and recession of the early 1990s; a prolonged economic slow-down in Japan, from the early 1990s onwards; a financial crisis in Mexico in 1995, and then in Argentina; the Asian crisis of 1997, spreading from Thailand to Malaysia, South Korea and Indonesia; a crisis in Russia in 1998; and, in 2001-2, another crisis in Argentina. In addition, we have seen recessions in the US and other leading countries in 1981-2 and 1990-2; the debt crisis in Latin America in the 1980s; and more recently the dot com bubble and burst at the turn of the century followed by another recession in the US in 2001.

Indeed, you could hardly say that financial stability has been a hallmark of recent economic history. And, as Barry Winter rightly points out in his article ‘Lies, Hubris and Neoliberalism‘, at every juncture before a financial crisis we have had displays of unguarded hubris – pronouncements on the underlying strength of the economy and assurances that market fundamentals are sound – not least, Gordon Brown’s too-often repeated claim that new Labour had abolished boom and bust.

Two views of financial markets

As the economist George Cooper argues in his excellent short book The Origin of Financial Crises, mainstream economics contains, broadly, two contrasting views about how financial markets work. Here, I am primarily referring to asset markets (stocks, shares, property, etc) and debt markets, and the relationship between them, albeit in very simplified terms.

First, we have to remember that in any sophisticated economy, and certainly any modern industrial economy, credit plays a crucial and central role in enabling a much higher level of economic activity than would be possible if people and businesses only spent and invested what they already owned. An economy without credit would provide a much lower standard of living than one with credit, but this also implies that an economy with a credit industry needs to be regulated in some way.

Traditionally, what banks are prepared to lend to individuals and firms is based on the collateral (assets) that the borrower owns and the borrower’s likely return on investments – less collateral and higher risk mean higher interest rates, and vice versa.

Recent problems centre around this process because it means lenders must estimate the value of assets held by borrowers, and the prospects for investments or purchases, which in turn are also based on expectations about asset prices in the future. This is particularly clear in the case of mortgages, which we’ll come back to.

The first view of this process, the dominant one in economics, policy making and banking for many years, is that asset prices – the prices of stocks, shares, property, etc – are a true reflection of their value; that is, that asset markets are ‘efficient’ mechanisms. If the stock market is going up, that is because businesses are worth more, will be generating more income for shareholders, and thus are a reflection of the underlying strength of the economy.

On this view stock and share prices, property prices and company balance sheets will all be taken by banks and other financial institutions as sound evidence that lending can be increased. Generalised across the economy, it supports the view that expanding levels of debt – held by businesses and individuals – are ok, if asset prices are going up, because they are taken as an indication of the underlying strength of the economy.

However, the alternative view, one held by Keynes and the economist Hyman Minsky (who I’ll come back to), among others, is that asset markets are not efficient, that they operate in a quite different way to markets in goods and services, and in particular that they generate self-reinforcing but alternating cycles of growth and contraction.

On this view, in the boom phase, an increase in asset prices leads to increased lending, which stimulates the asset market, which in turn justifies increased lending, and so on. However, in this kind of self-reinforcing cycle, asset price increases are not simply a reflection of the state of the economy. They are themselves inflated by increases in credit and as such become a cause of economic growth, generating a false picture of overall health in the economy and of the credit-worthiness of borrowers.

What inevitably happens is that a self-reinforcing boom becomes a self-reinforcing crisis. The economy ‘flips’ (the trigger varies in different crises), confidence in borrowers decreases leading to a contraction of lending, forcing sales of assets to pay off inflated loans, leading to a further decrease in asset prices, leading to further loss of confidence … and so on.

Minsky moments

Named after Hyman Minsky, a post-Keynesian American economist, Minsky moments are not an economist’s version of Perry Como, but the points at which economies turn from boom to bust. Minsky was relatively neglected by policy makers and bankers during the years of neoliberal dominance, as indeed was Keynes’ view about the inherent instability of financial markets. Yet, back in 1974 Minsky noted:

‘A fundamental characteristic of our economy, is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.’

It follows from this is that financial crises – even in the view of these fairly conventional economists – are not driven by individual misbehaviour, greed, exuberance, or the absence of enough women on the trading floors. Instead, they are, in George Cooper’s words, ‘hard wired into the system’. (It’s not that the behaviour of traders is unimportant just, in his view, that the problem is more fundamental than that.) ‘Let’s be honest,’ Cooper wrote, ‘a static stable equilibrium has never been observed anywhere in financial markets.’

Hype springs eternal

The other important thing to note is that most policy makers, central bankers, politicians and financiers have not held this latter view of inherent financial instability – which carries with it a necessity for financial authorities to closely monitor and control the expansion and contraction of credit. They have instead held the view that asset and debt markets are efficient and tending towards equilibrium.

It is only because of this that we can understand how, shortly before every single financial crisis, we hear those hubristic declarations of economic health. Thus, before the dot com bubble of the late 1990s turned to bust we were told that the boom was a sign of a fundamentally new kind of economy based on perpetual growth. Similarly, in 2005-07 we were told that houses weren’t over priced, and that record levels in stock market prices were a reflection of sound fundamentals (and sound management) of the economy. And, in August 2007, we were told by the US Treasury Secretary that problems in the housing market had ‘largely been contained’.

Even as late as summer 2008, Bill Emmot, former editor of The Economist, wrote in The Guardian that this wasn’t a crisis, ‘it’s just a kerfuffle’. As Nobel Prize-winning economist Paul Krugman noted dryly, in credit-fuelled booms, ‘hype springs eternal’.

The unfolding crisis

So how did the crisis unfold? As we know its roots lie in the sub-prime mortgage market in the US.

In the late 1990s, the US and other leading economies experienced a boom and then a crash in investment in internet-based businesses, the so-called ‘dot com bubble’. In response to the downturn which followed the dot com bust in 2000, and to limit the economic shockwaves from the 11 September 2001 attacks on New York, the US central bank, the Federal Reserve, aggressively cut interest rates to pull the US economy out of recession. On the face of it this seemed to work, as growth in the US economy quickly resumed.

However, the policy pursued by Federal Reserve chairman Alan Greenspan allowed large increases in the level of credit, most notably in the US housing market, and the dot com bust was followed by a housing boom. The end of the housing boom, from 2007 onwards, had a devastating impact – a world-wide ‘credit crunch’, a financial crisis which threatened the existence of some of the world’s biggest banks, and a deep recession. The reasons for this lie in the particular way banks handled lending.

Banks and other lending institutions had been lending increasing amounts to homebuyers, stimulating demand for houses and pushing up prices, leading to further lending – precisely the kind of asset boom described above. Low interest rates meant this lending spread from relatively lower-risk customers to ‘sub-prime’ borrowers, mainly people on lower incomes, many of whom were offered short-term, cut-price interest rates on mortgages as an incentive to sign up.

For banks and other lenders, such mortgages were inherently risky but this risk was mitigated by low interest rates and what seemed to be sustained economic growth. In addition, they protected themselves against this risk by selling mortgages on to other investors (banks, investment institutions, and so on). This process of ‘securitising’ loans, selling loans to other players in the financial sector, ensured that the risky loans were spread throughout the financial system.

In the face of increasing signs of inflation in the US, and concerns that some sectors such as housing were overheating, the Federal Reserve began to increase interest rates, from one per cent in 2004 to more than five per cent in 2006. This affected borrowers in many sectors but particularly those with sub-prime mortgages who saw their monthly payments rise rapidly. Many were forced to default, and because ownership of the loans was now spread so widely, the effects of mortgage defaults were felt by institutions that were, on the face of it, far removed from the US housing market.

Furthermore, because of the complexity of the financial instruments that had been created, no one was clear how much ‘bad debt’ was in the system as a whole and how much was held by each bank. Banks had to make provision to cover their own bad debts and were increasingly reluctant to lend to other banks because they weren’t sure how exposed they were. As a result credit rapidly dried up.

First effects

The first effects of the crisis began to show in summer 2007 when New Century Financial, one of the main sub-prime lenders in the USA, went bankrupt. The first effects outside the US showed when French bank ParisBas had problems. In response, central banks in Europe, USA, Canada and Japan began to pump more money into the system as banks became increasingly nervous about lending to each other.

In the UK, the run on Northern Rock in September 2007 exemplified some of the problems to come as uncertainty about the bank’s exposure to bad loans prompted savers to withdraw their money, fearful that the bank would collapse. At the same time, US banks started to reveal the extent of their exposure to bad debt – Merrill Lynch, for example, owned nearly $8bn in bad debt.

By winter 2007, the inter-bank lending rate (the interest rate at which banks lend to each other to fund their day to day transactions) reached then record levels, a particular problem in the UK economy given the UK banks’ reliance on wholesale lending markets (day to day borrowing from other banks) which grew from zero in 2001 to over £650bn in 2007. The end result for Northern Rock was nationalisation, in spring 2008, and in the USA the investment bank Bear Sterns was absorbed by JP Morgan Chase in a deal brokered by the Federal Reserve.

Despite these signs of restructuring, the underlying problems of the mortgage market remained. In summer 2008, UK house prices fell for the first time in 12 years and the US government was forced to bail out two of its biggest mortgage lenders, Fannie Mae and Freddie Mac, who together owned up to $5 trillion in home loans. In September 2008, amid increasing turmoil, Merrill Lynch was taken over by Bank of America and AIG Insurance was kept afloat by a rescue package from the US Federal Reserve.

However, that was also the month the US government declared it would not step in to save the investment bank Lehman Brothers which was forced to file for bankruptcy on September 15th  – the biggest casualty of the credit crunch so far. Shortly afterwards, the US government’s US$700bn package to rescue the financial system – its largest intervention in the markets since the 1930s – was held up by Congress, causing worldwide panic. The crisis spread rapidly to Europe, with a collapse in Iceland’s banking system and desperate efforts to shore up banks in other countries, including the UK, Germany and Ireland.

Throughout autumn 2008 we saw a succession of government and central bank interventions of increasing magnitude in the USA, UK, Iceland, Ireland, Germany, and elsewhere; a partial nationalisation of some of the UK’s leading banks; and interest rates slashed in an effort to stimulate inter-bank lending. By winter 2008, the US and Eurozone officially went into recession and the UK followed in January 2009. Even China saw a sharp decline in exports and growth.

Responses and lessons

The G20 meeting in April 2009 managed to reach some agreement about stimulating the world economy, and some commitments (largely lived up to so far) not to create further problems through trade protectionism and the like. However, more far-reaching proposals for financial regulation have been harder to achieve. Ongoing challenges to the USA’s world leadership (see my article, Superpower Headaches), divisions between Europe and the US, signs of recovery and a re-activated financial lobby have all curtailed some of the more far-flung rhetoric of March-April 2009.

Yet, the underlying risk of repeated boom-bust cycles has by no means gone away. The basic economic model, especially in the UK where the City has long dominated economic policy, remains susceptible to the dynamics of instability identified by Keynes and Minsky long ago. Most of the signals from the UK government point towards a reconstruction of the existing system, with limited changes, rather than fundamental reform. Even the nationalised banks are being packaged up to resume their former role, as if nothing had gone wrong.

Chancellor Alastair Darling even stated, in one of his more extraordinary moments, that nothing was fundamentally wrong with the system, we just need ‘better people’ in the boardrooms. If anything could demonstrate the paucity of vision, acquiescence with the status quo, and absence of radical ambition at the top of the Labour Party, this is it. ‘Never let a good crisis go to waste,’ Obama’s chief of staff, Rahm Emanuel is reported to have advised. It feels uncomfortably like we already have.

This is an updated version of Will Brown’s talk at the ILP’s round table seminar, Crunch Times: Politics and the Crisis. To read a report of that event and link to other contributions click here.
To read other articles on the economic crisis, click here.