The credit crunch, libertarians and smoking guns

 A few days ago Charlotte Gore wrote, “If Libertarians and free markets are to blame, please point to the regulation that was blocked by Libertarians that would have prevented the Credit Crunch.  The answer is simple: such regulation was never proposed.” 

Oh! Yes it was, and repeatedly – but for various reasons no-one wanted to know.  

I agree with her about Gordon Brown’s reason for not wanting to know (“Brown was thrilled with the ‘boom’ and enjoyed his reputation as the miracle chancellor, the one who had ended boom and bust.  He had no desire to highlight flaws in the system”).   But the wider context was the all-conquering neo-liberal world-view variously expressed as, for instance, ’government is not the answer – it’s the problem’ (Reagan), and that ‘the market is always right’ (Thatcher). 

After 1979 and the Winter of Discontent, socialism as a philosophy with anything useful to say about economics was washed-up so New Labour adopted the neo-liberal world-view to a large extent and it filtered down to the ‘great and the good’ and thence to much of the administrative hierarchy.  

Some people did know that there was a problem but by this point swimming against the tide became difficult for even the most determined individual and neo-liberalism become the ruling cognitive policy.  A better opposition might have evolved a coherent alternative but tragically, none did.  From there on, and in the absence of any rival world-view, the die was cast.  Of course, there were many brave and insightful individuals who did what they could but, as individuals, that is not much in the final analysis. 

Some of the ensuing missteps are documented in this recent piece from the New York Times on the Greenspan legacy.  As former Chaiman of the Federal Reserve, Alan Greenspan championed the ruling view that  any sort of regulation is bad, an unnecessary and unwarranted cost for business, that businesses including banks would naturally self-regulate in their own interest and that Wall Street had tamed risk.  A professed libertarian, Greenspan counted among his formative influences the novelist Ayn Rand who portrayed collective power as an evil force set against the enlightened self-interest of individuals.  

Just to summarize a few threads from the NYT article:

• In 1997 Brooksley Born, then head of the Commodity Futures and Trading Commission, a federal agency that regulates options and futures began exploring derivatives regulation – contracts like the now notorious credit default swops.  She was concerned that unfettered opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it”.  Prescient indeed!  However, she ran into fierce and concerted opposition from Greenspan and others who asserted that she didn’t know what she was doing and that too many rules would damage Wall Street, prompting traders to take their business elsewhere.  Despite the fact that the very next year the collapse of the massive hedge fund LTCM vindicated her view and almost caused a systemic crisis, she was sidelined and eventually forced out.
• Greenspan and allies persuaded Congress to repeal the Glass-Steagall Act - a depression era law that had kept commercial and investment banking separate – in effect creating a firebreak – to reduce the systemic risk of a failure in one part of the banking system spreading to the rest.
• As the size and importance of the derivatives market grew, Greenspan repeatedly rebuffed attempts to bring in even minimalist regulation.  For instance, congressman Ed Markey asked the General Accounting Office to study derivative risks as far back as 1992.  The GAO’s subsequent report identified “significant gaps and weaknesses” in derivative regulation.  They saw that the sudden failure of any large US dealers could pose risks to the financial system as a whole.   Despite this Markey’s subsequent bill was never passed.

Although not strictly part of the current financial collapse, the Enron debacle shares root causes and many of the same cast of characters as this posting by Public Citizen shows.  It documents how the Gramms – Senator Phil and wife Wendy – played a central role. 

In 2000 Gramm engineered a provision in a bill that exempted Enron’s energy trading from regulation and disclosure which enabled Enron to manipulate the electricity market, especially in California in such as way as to reap a vast profit immediately after the deregulation took effect – up 400% from the previous year in 2001 Q1.  The cost to Californians was in billions until regulators belatedly moved to restore some order in June 2001.  Subsequent investigations concluded that “power generators and power marketers intentionally withheld electricity, creating artificial shortages in order to increase the cost of power“.

Is it possible that market manipulations are in some way behind the soaring cost in energy in Britain compared with the Continent?  I think it likely.

More recently, in 2004 the SEC agreed to a plea by the big banks (including Goldman Sachs then led by Hank Paulson) to unshackle them from the traditional rules that limited the amount of debt they could take on in relation to their equity.  With little discussion the change was agreed.  This is hubris of the highest order; it flies in the face of all previous experience and was undoubtedly the proximate cause of the credit crunch – the smoking gun.  Its immediate result was to kick start the huge boom in debt that is now collapsing.

Traditionally, banks have been required to keep their capital ratios at around 10:1 yet by the time Bear Stearns collapsed its ratio had risen to 33:1.  The SEC had become aware of “numerous red flags” regarding Bear Stearns activities yet so great was the presumption against regulatory intervention that no action was taken (just as with Northern Rock).  (The significance of this ratio is that the higher it is, the more profitable the bank – provided markets are rising.  However, the risk increases in parallel so that even the slightest market fall can cause the whole house of cards to tumble). 

Moreover, with the development and growth of the hedge funds, governmental and regulatory negligence have allowed the emergence of a shadow banking system completely outside of the formal banking system and its associated regulatory control.  This again defies all historical experience and is now tottering under the weight of its greed and is about to collapse causing immense ‘collateral damage’.

I could go on, but no doubt there will soon be a tidal wave of books documenting the many and various ways in which warnings were dismissed, regulatory interventions stymied and existing regulations sidelined and not enforced.

However, despite all this sad history, I believe it would be wrong to frame this simply as a issue of libertarian vs non-libertarian or some such; to do so would be to throw the baby out with the bathwater.   There are problems with the extreme libertarian position which is why I do not describe myself as such.  Conversely, there are also great merits in a more nuanced semi-libertarian position which is where I place myself on the political spectrum.

I suggest that there are two common errors with the more extreme versions.

Firstly, the tendency to forget that anything involving human beings has to have a pretty huge behavioural element.  It is all very well for Greenspan and others to argue for instance that market participants would act responsibly (an absolutely fundamental part of his belief-system).  Unfortunately, this assumes that everyone involved is some sort of secular saint which is dead wrong.  There are a fair few spiv-bankers out there and the way that capitalism works is that those who make higher profits eat up those making lower profits.  No morals are involved so – absent imposed boundaries – the result is a race to the bottom and indeed that is precisely the term applied to recent events in several recent press reports.

The behavioural dimension is important in another way – the cock-eyed bonus culture in finance.  If people are paid huge amounts on the basis of short-term measures why would they care if the long-term consequence of their deal making is to bankrupt the firm?  They will be long gone when it unravels.  It’s just a twist on the classic Ponzi Scheme.  This problem completely short-circuits the libertarian logic of enlightened self-interest enforcing discipline.  It has been known about for just about ever – but no-one did anything.  (In contrast, note that the libertarian self-regulation meme can work well for self-employed people embedded in their local community, alert to the reputational dimension and thinking long-term for themselves and their families).

Secondly, some libertarian ideas can, with the slightest nudge, morph from being a benign and positive proposal into a cancerous travesty that is nevertheless so close to the original as to escape detection by the media or Parliament.  Dissenters can easily be dismissed as ’special pleading’, ’ill-informed’ etc.  This is just wonderful for powerful corporations who have the lobbying power to do all the nudging they want, especially when their ‘friends’ are in power.

Thus, deregulation – which can certainly be a good thing in many circumstances - can, in other instances, become cover for a power grab as in the Enron case.  I submit that one of the underlying trends that so disfigures contemporary society is the rise of the Corporate State seen in everything from clone towns to soaring energy prices to disenfranchised citizens. (There has to be a better term than ‘Corporate State’ - any suggestions?)  Carnivorous companies can and do see themselves as being above the law, not subject to it.

So I conclude that for liberals everywhere, it’s time to do some pretty serious thinking about the political economy of regulation, competition and consumer protection.  Somewhere in there is a new, exciting and immensely powerful narrative struggling to be free from the wreckage of the neo-liberal view.

Postscript: Since I roughed out most of the above Greenspan has recanted – sort of.  He has admitted that he made a “partially” wrong decision in thinking that relying on banks to use their self-interest would be enough to protect shareholders and their equity.  Hmm – not much ‘”partial” about it!

An open letter to Baroness Shriti Vadera

Dear Shriti,

Congratulations on your appointment earlier this month as Parliamentary Under-Secretary of State for Competitiveness and Small Business.  You take up the post at a crucial time.

Small businesses around the country are already being hit hard by the credit crunch and will be hit harder still in the near future as its consequences rip through the economy with dire consequences for employment, future tax revenues etc.  The whole country – and not just small business - needs you to be an effective and powerful voice at the heart of government for good sense and good finance.

As a former banker you will know that all business – large or small – depends on inputs of capital, labour and materials in varying proportions.  The credit crunch bears very directly on one of these – the cost of capital.  As you will also know, there is very rarely an absolute shortage of anything; more typically there is a shortage at an affordable price and that is why the question of price matters so much – and not just availability which is how the press mostly reports it.

In a posting I made yesterday I calculated (albeit in an approximate back-of-an-envelope sort of way) that the bailout plan would result in retail interest rates of around 16%.   Just a few hours later I settled down to watch the Channel 4 News only to see them carry an item about small businesses being trashed by – you guessed it - interest rates of 16%.   A small business owner rightly commented that this is, “almost a credit card rate”.  

To put this in context, I was able to get a loan at 7% to finance the purchase of a small business some years ago from the retiring owner.   At 16% it would not have happened and several people would now be unemployed.  It is no exaggeration to say that if the rate remains at anything like 16% businesses around the country will be decimated.  For this to happen at a time when sales revenues are down anyway will be a double whammy.  (Come to think of it double whammies are bit of a Labour speciality).

Moreover, many are now calling for interest rates to be slashed ASAP to stimulate the economy and there is little doubt that a cut, perhaps as much as 2% will be made soon.  However, Gordon Brown’s cunning bailout plan would prevent this feeding through to the real economy. 

In your Channel 4 interview yesterday you effectively conceded the point saying that, “as their [the banks] own cost of funding has increased a problem has emerged, that they are seeking to pass it on“.  Well, yes!   Go to the top of the class!  But, the banks cost of funding has increased because the government of which you are a part decided to increase it; this is the inevitable consequence of sticking the banks with a penal interest rate.  In the final analysis the banks will not pay this, business will and we will all be poorer for it.

It’s all very well for your boss to pose around like he’s some sort of economic genius, but it’s actually pretty obvious that he’s totally out of his depth (though to be fair, rather less so than Dave from PR). 

Unfortunately the civil service doesn’t help much either – as a body they have never had to engage fully with issues of cost or price (as opposed to temporary famines in departmental budgets which are quite different).  They need to learn that taxpayers are not a magic money tree.  In fact this also bears on the ‘competitiveness’ part of your brief; we need a government that understands that its role is, in part, to help individuals and businesses cut costs.  Not by subsidies obviously, but by doing things differently, better, more efficiently.

So we need a root and branch change, both in the leadership and the engine room.  In the meantime, please do what you can and explain to your boss that he should make some key changes to the bailout plan as it now stands.

Yours etc.

Liberal Eye

Green revolution

Amid the general gloom, here is a good news story from a few days ago about a green revolution in Malawi which, I believe, illustrates some important principles.

Malawi, a thin sliver of a country between Zambia, Tanzania and Mozambique is the thirteenth poorest country in the world. It has experienced six consecutive years of food shortage from 2000 resulting in widespread hardship and starvation.  Traditional farming techniques and seed strains could simply not produce enough food.  

The answer: give villagers vouchers exchangeable for fertilizers and improved higher-yielding seed varieties and help with crop diversification, irrigation (most of the country spreads out along the shores of Lake Malawi) and some basic science. 

The result has been rapid and dramatic.  Malawi has emerged as a regional food exporter sending maize all the way to Kenya even though the improved seed varieties are not particularly new and have been around for years. 

Inevitably, not everything in the garden is rosy.  High export prices means that there are still big pockets of food shortage among those Malawians who do not have access to suitable land (or alternative paid employment).  Yet the country is clearly far better off than it was only two years ago.  What was lacking was organisation and information.

So what lessons can we draw from Malawi?  I think there are two.

Firstly, a good analysis of the problem followed by iniatives that address the real isues gives a big return on effort.

Secondly, empowering ordinary people is the key.  Bottom-up, not top-down approaches work best. 

Needless to say both these principles are highly relevant to sorting out the credit crunch.

Some very murky corners

The devil is always in the detail, bank bailouts not excepted.  Now there is a row about the terms that illuminates some murky corners of government thinking.  BEWARE!  NEW STEALTH TAX COMING.

Under the current version of the plan most of the taxpayers’ money will be in the form of ordinary shares but some (£9bn out of £37bn) will be in the form of redeemable preference shares – effectively a loan with conditions.  Conditions include (a) interest set at a penal 12% and, (b) no dividends to be paid on ordinary shares until the preference shares are redeemed (i.e. until the loan is paid off).  The idea is allegedly to encourage the banks to pay back ASAP – which is fine as far as it goes, but …

Firstly, the larger object is to bail out the banks – not to punish them with a penal interest rate.  I don’t know what the govt’s cost of borrowing is currently, but I don’t think it’s anywhere near 12%.   I quite understand (and in fact agree with) the notion that someone should carry the can for this, but it’s spiv bankers that should be punished – not the institutions where they worked. 

The banks have been compared in recent days to the ‘financial plumbing’ of the economy.  Quite so, but if you are the victim of a cowboy plumber who wrecks your loo you don’t then go and take a sledge hammer to the boiler and pipework in a fit of rage.  Government should be mature about this.  The quickest way to ruin a bank is to increase the price it has to pay for its funding.

Secondly, it will be difficult for the banks to lend for mortgages or businesses if their marginal cost of capital is 12%.  Normally they would have to add a ‘retail markup’ onto their cost of capital so 12% wholesale becomes perhaps 16% retail.  How many will be able to afford this for their mortgage or business loan?  With inflation rates set to plummet on the back of falling commodity prices the real cost of loans will go through the roof.

Thirdly, bank dividends are very important to pension funds as a source of cash flow out of which to pay current pensioners.  If there is no dividend for up to five years pension funds will be decimated, probably doubly so.  If they keep their bank shares, the rest of their portfolio will have to take the strain at just the worst possible time; similarly if they sell, they do so at the worst possible time and make a massive capital loss.

It looks like Brown has homeowners, businesses and pensioners in his cross hairs for another whopping stealth tax.  And, as we all know, he has form on this; one of his first actions as Chancellor was a stealth tax on pension funds.  That the banks are the proximate target does not change the fact that the ordinary people are the ultimate victims.

Moreover, it turns out that the condition that preference share must be paid back before ordinary dividend payments are resumed was included at the instigation of the EU as confirmed on BBC R4’s ‘World at One’  (audio: the interview begins at approx 10.50 minutes in) today in an interview with Jonathan Todd, spokesman for the EU’s Competition Commissioner.

Apparently the Commission, “wanted to ensure that there was an incentive for the banks to repay the state as quickly as possible and we did not consider that applying a penal interest rate would be sufficient to achieve that“.  The UK government had considered it would be a sufficient incentive. 

This is all wrong - the Competition Commissioner should butt out.  I can concede than the EU has a role in ensuring that member countries don’t provide covert subsidies for national champions (or national basket cases) but it must be clear, even to them, that this is not the context here. This is the worst sort of bureaucracy – powerful, but without any ultimate responsibility or accountability when things screw up as a result of its intervention.

So what should the government do?

I suggest that the bailout: (a) should involve only preference shares (not ordinary shares – see this earlier post for reasons), (b) the interest rate should be as low as possible (e.g. 2% above the government’s own cost of capital),  (c) preference shareholders should get a deferred bonus at redemption of 1% for each year after the first two years that the shares remain outstanding (i.e. 1% on amounts redeemed in the third year, 2% in the fourth year, 3% in the fifth year etc.)  

This would mean that the banks could get healthy again ASAP, in the meantime they could make loans at affordable rates, they could pay dividends to pension funds and others that rely on them (although there seems to be general agreement that, this year at least, there will be no dividends anyway), and last but by no means least it is quite possible that private investors will put up much of the capital if the government gets its numbers right (those I’ve used above are purely illustrative).

After all, it is increasingly obvious that the government needs to keep its powder dry for the firestorm ahead.

Message to Tweedleother

An interesting thought from Prof David Byrne writing in yesterday’s (Newcastle upon Tyne) Journal.

He points out that hundreds of thousands of skilled jobs have been lost over the last few decades in the Greater Tyneside area.  Many of these are not just skilled manual jobs but the, “technical expertise of real engineers, which [means] that this was far more a knowledge based place 40 years ago than it is today for all the guff about Science City“.

He’s right about this.

He’s also right when he goes on to say, “… all the great and the good … have got it absolutely, magnificently, totally as wrong as they damned well could“.

Sadly, tragically, he’s also right when he later says, “… so far as the major parties go we have a choice among tweedledee, tweedledum and tweedleother“.

Ouch!

Could this view be fairly widespread?  Could it be why Lib Dems are flatlining in the polls?

You bet!

The Amazing Mr Ponzi

We had all better learn this simple definition of a Ponzi Scheme.

A Ponzi scheme offers a high return to investors using the funds of newcomers to make payments to earlier subscribers, and collapses when the supply of suckers runs out.

It is a succinct definition of how a large part of the UK (and indeed world) economy has worked over the last few years.

Seeds of the next crisis

It is said that the seeds of the next war are sown in the decisions made in at the end of the last one.  As with wars, so it seems with banking crises.

Last week I broadly welcomed the bailout approach adopted by Brown in contrast to the Paulson Plan in the US which was already failing.  Not that Brown can take a credit for inventing the approach; a very similar scheme was used in Sweden in the early 90s and very recently by Warren Buffet, the world’s most successful investor, to rescue Goldman Sachs so the precedents were clear.  Moreover, he had the experience of Northern Rock some months before giving him time to get his head round the concept (with Vince Cable calling it consistently right).  Now most EU countries and, to a limited extent, the US are moving to adopt schemes based on the ‘British Plan’ in some degree.

The background is, of course, an absolutely monumental failure of the banks themselves, the regulators and the government.  (Which is to say that Brown is doubly implicated in that he both heads the government and, as Chancellor, designed the regulatory framework that has failed so catastrophically).

But all that was last week and it seems that even a weekend is a long time in politics.  For the plan that was being discussed last week has mutated over the weekend in ways that are subtle yet important and fill me with foreboding.  Motives matter, and I am not convinced that the government is as pure as driven snow at this point.  It needs to be.

Firstly, the decision to let Lloyds TSB take over HBOS in flagrant breach of competition rules was just about (downhill and with a following wind!) justified when first mooted on the basis that Lloyds could rescue HBOS without recourse to the taxpayer.  But since it has emerged that both Lloyds TSB and HBOS will need taxpayer help this rationale entirely evaporates.  Labour is acting as midwife to the birth of a very dangerous offspring.  Moreover, the loss of an important plc head office to Edinburgh is no small matter.  The UK as a whole would be healthier if more public companies had head offices outside London.  I would like to see this deal stopped or, failing that, a Lib Dem commitment to break up Lloyds/HBOS.  Let it not be said at some later date that Lloyds/HBOS didn’t know the risk.

Secondly, the original rescue plan envisaged that government help would be in the form of preference shares with various conditions attached.  While these were not precisely spelled out it is clear that they would include restrictions on executive pay and bonuses.  What we are actually getting seems to have mutated to a small number of preference shares with most of the money injected in the form or ordinary stock with directors on the board to match.

Now this distinction matters, not so much because of the mechanism per se, but because it seems to herald a shift in government thinking over the weekend.  For, despite the name, ‘preference shares’ are nearer to loans than to ordinary shares.  Under the original proposals the government effectively gives the banks concerned a loan at an interest rate somewhat higher than the government itself pays (so making a profit on the difference), not taking management control as such except via the conditions linked to the purchase of the preference shares.  Under the revised proposals the government is very much involved as a ‘player’ – with ongoing involvement in day-to-day decision making. 

These two approaches are subtly but importantly different.  The first is rather similar to the way the Bank of England operates in setting exchange rate targets – government sets the target at the outset in the full glare of democratic accountability but then stays firmly hands off.  The second is, at first sight, more democratic but in reality it’s classic Labour, hands-on-the-levers-of-power.  However much Brown insists that the government-appointed non-exec directors are just that – not executive – they will have a disproportionate influence in transmitting Brownian wishes into routine management decisions at a level that stays far below any Parliamentary radar.  If Brown says (or even thinks), “jump” the board will have to be exceptionally strong-minded not to ask, “how high?”.  And Parliament will never know, not even that some issue was in play.

Under the preference share approach government has to make its mind up about conditions now then stick to them.  Key decisions are not difficult - the premium over the government’s cost of borrowing, director’s pay and bonus capped at, say, £250,000, until the preference shares are redeemed (Germany has imposed a cap of 500,000 Euros).  This would give directors a powerful interest in giving  taxpayers their money back ASAP so minimising risk.  This giving the money back ASAP is the approach taken with Northern Rock where over half has already been repaid.

Under the ordinary share purchase approach the government will find itself facing a ‘difficult’ election while enjoying massive de facto influence (if not outright control) of a huge pile of assets.  If Brown judges that a quick boom will improve Labour’s chances then a hint here and a nudge there will ensure that there is one by pouring these assets into schemes whose merit may be more political than financial.  And if these schemes can be spun to have wider social benefits then so much the better.  House building would seem to be the obvious way to tick all the boxes.

Already the government is showing its prediliction for political objectives in telling the banks that they must lend to house buyers and small businesses at the same rate as they lent to them in 2007 at near the height of the boom.   Government spokesman have been doing the rounds of the media trying to deflect criticism on this point by saying that they still expect the banks to be prudent lenders.  But that’s not what the government said earlier.  They could just as well have left this to the banks themselves; after all banks make their living my making loans to people and businesses so they can’t and won’t stop just like that.  There are still other banks out there who would be more than happy to pinch their best customers.

Brown needs to get this sorted quickly because, although necessary, this plan is not sufficient to get us out of this mess.  We need to be moving on fast to get ahead of events, and not trailing in their slipstream.

Banking rebooted – keep your fingers crossed

The banking and finance sector has just experienced the financial equivalent of the blue screen of death familiar to users of older versions of Windows. 

What Gordon Brown has done is the financial equivalent of a reboot involving part-nationalizing the major banks.  To give credit where it is due, this is undoubtedly the right approach.  This is a relief; as recently as last week Brown was talking only of liquidity issues (meaning roughly that banks had too much of their assets tied up in long-term loans etc leaving them short of ready cash for day to day operations) even as it was becoming increasingly obvious that (for some banks) there was also a solvency problem (meaning that they had lost so much on bad mortgages that they were bust).  

In such circumstances the only sensible option is to recapitalize the banks but how it is done also matters.  In the USA Paulson’s plan is to do it indirectly by buying bad assets off the banks for more than they are worth (as has the Spanish govt this week).  The banks’ profit on such deals gives them new capital, but the taxpayer gets nothing.  US taxpayers were right to be scandalized and to call this ’socialism for the rich’.  The alternative is to take preference shares (or equivalent) for direct injections of new capital which is what Brown has done.  It has the huge merit of giving taxpayers a big stake in any bank rescued, a big say over policy (including executive remuneration) and the very real possibility of a profit in due course when the govt eventually unwinds its position.

Will it work?  It should provided that global markets aren’t too spooked and panicky (which unfortunately may well be the case).  We will only know in a few days but the evidence will be that UK banks start lending to each other.   Keep praying, keep your fingers crossed or whatever you do; but don’t expect the stock market to recover any time soon – it’s falling in expectation of a pretty severe global recession, probably even depression. 

What if it doesn’t work?  Rinse and repeat, persuade others to do the same where necessary but don’t copy Paulson’s bad plan which already looks to be failing.

But, we should never have started from here.  While I am more than happy to give Brown his due for charting the best route out of this mess, he cannot escape responsibility for getting us into it in the first place.  It is the direct, and ultimately inevitable, result of the ‘market fundamentalist’ policies he and Blair have been following since 1997 and the Tories before that.

The basis of our political choices

From TED comes this lecture by psychologist Jonathan Haidt on the moral values that are the basis of our political choices (length about 19 mins).

Enjoy.