John Lanchester on the financial crisis

John Lanchester

The financial crash of 2008 was worldwide, and the failure of governments to address the causes of the crash also was worldwide.  Because the same thing happened in different countries under different leaders, the reasons for failure are systemic, not just the personal failings of particular leaders.  The solution must be systemic.  A mere change in leaders is not enough.

John Lanchester, writing in the London Review of Books, wrote an excellent article about the crash and its aftermath.  I hoped to call attention to it in my previous post, but, as of this writing, there has been only one click on the link.

I know people are busy and have many claims on their attention.  If you don’t want to bother reading the full LRB article, here are some highlights.  If you’re an American, bear in mind that, even though so much of what he wrote applies to the USA,  his focus is on British policy.

The immediate economic consequence was the bailout of the banks.  I’m not sure if it’s philosophically possible for an action to be both necessary and a disaster, but that in essence is what the bailouts were. 

They were necessary, I thought at the time and still think, because this really was a moment of existential crisis for the financial system, and we don’t know what the consequences would have been for our societies if everything had imploded.  But they turned into a disaster we are still living through.

The first and probably most consequential result of the bailouts was that governments across the developed world decided for political reasons that the only way to restore order to their finances was to resort to austerity measures.  The financial crisis led to a contraction of credit, which in turn led to economic shrinkage, which in turn led to declining tax receipts for governments, which were suddenly looking at sharply increasing annual deficits and dramatically increasing levels of overall government debt.

So now we had austerity, which meant that life got harder for a lot of people, but – this is where the negative consequences of the bailout start to be really apparent – life did not get harder for banks and for the financial system. In the popular imagination, the people who caused the crisis got away with it scot-free, and, as what scientists call a first-order approximation, that’s about right.

In addition, there were no successful prosecutions of anyone at the higher levels of the financial system.  Contrast that with the savings and loan scandal of the 1980s, basically a gigantic bust of the US equivalent of mortgage companies, in which 1100 executives were prosecuted.  What had changed since then was the increasing hegemony of finance in the political system, which brought the ability quite simply to rewrite the rules of what is and isn’t legal.

Ten years after the financial crisis

Canary Wharf financial district in London. Source: Quartz.

Ten years after the financial crisis of 2008, the U.S. government has failed to do anything necessary to avoid a new crisis.   I just read an article in the London Review of Books that says that the U.K. government’s policies are just as bad.

Like the U.S.-based banks, the British banks engaged in financial engineering that was supposed to create high profit on completely safe investments—which, as experience proved, couldn’t be done.

The British government had to bail out the banking system in order to save the economy.  There probably was no alternative to that.  But it then proceeded to put things back just the way they were before.

John Lanchester, the LRB writer, said there was no attempt at “ring fencing”—what we Americans call firewalls—to split up investment banks, which speculated on the financial markets, and retail banks, which granted small business loans, home mortgages and other services to the real economy.

The UK, like the US, engaged in “quantitative easing”—injection of money into the banking system through buying bonds.  The basic idea was that if banks and corporations had more money to invest, they would invest more, and the economy would grow.

This didn’t happen.  Instead banks and corporations bid up the prices of existing financial assets and real estate, which added to the wealth of the already rich.

Ordinary Britons faced austerity.  Their government cut back on the social safety net and public services.  British life expectancy, like American life expectancy, has actually fallen.

The British, like us Americans, had 10 years to fix their financial system.  Like us, they wasted the opportunity.  Now it may be too late to avert the next crash—even if the UK and US governments wanted to act.

LINK

After the Fall: Ten Years After the Crash by John Lanchester for the London Review of Books.  Well worth reading in detail.  Hat tip to Steve B.

Trump’s Fed protects banks from stress tests

Bill Black, an expert on banking and white-collar crime, described how Donald Trump’s appointees to the Federal Reserve Board are revising “stress tests” to free Goldman Sachs and Morgan Stanley from a requirement to prove they are solvent enough to weather the next recession.

To pass the “stress test,” they’d have to put a larger fraction of their profits into capital reserves.   Black said they could easily do this, but it would cut into bonuses and dividends.

He also noted that Germany’s Deutsche Bank in Germany can’t even pass the easier stress test.  Deutsche Bank is Germany’s largest bank and, according to Black, the only large bank willing to lend to Donald Trump’s businesses.

LINK

Fed Lets Goldman Sachs, Morgan Stanley Off Hook, Investors Profit Billions, a transcript of an interview of Bill Black for the Real News Network.

It’s not just Wall Street

It’s not just the USA that allows bankers and financiers to break the law and get away with it.   Or regards the largest financial institutions as “too big to fail”.

This goes back to Prime Minister Tony Blair, who thought he could make London the world’s financial hub by freeing banks from all regulation.

As in the USA, the government’s priority is to protect the financial institutions rather than to protect the public.

Banking regulation is even weaker in Europe than in the United States, and one of the goals of the proposed Transatlantic Trade and Investment Partnership, the next international agreement in the pipeline after the Trans Pacific Partnership, is to set limits on financial regulation.

That would make banking and finance un-reformable, either in the USA, the UK or other TTIP signatories.

Update 5/22/2015.  The five banks that pleaded guilty to rigging interest rates and the exchange rate for foreign currencies are Britain’s Barclays and the Royal Bank of Scotland, the USA’s Citicorp and JP Morgan Chase and Switzerland’s UBS.

Public Citizen on the Trans Pacific Partnership

Source: Public Citizen.

Top congressional leaders, including Senators Orrin Hatch, R-Utah, and Ron Wyden, D-Oregon, the chair and vice-chair of the Senate finance committee, and Rep. Paul Ryan, R-Wisconsin, chair of the House ways and means committee, announced their support for “fast track” approval of the Trans Pacific Partnership Agreement.

This would mean that the House would have 60 days to discuss this complicated agreement, and the Senate an additional 30 days, after which they would have to vote the agreement up or down, without amendment.

But the fact that the leaders support fast track doesn’t mean it’s a done deal.  The procedure still must go before the House and Senate as a whole.

I think the TPP is a bad idea, but, even it were a good idea, it deserves more discussion than fast track would allow.

Corporations don’t commit crimes

No, corporations do not commit crimes.  Corporate executives commit crimes.  There is a difference.

The U.S. Department of Justice charged JP Morgan Chase with various crimes, including fraudulent sale of mortgage-backed securities, covering up losses, rigging electricity prices and aiding and abetting Bernie Madoff’s Ponzi scheme.  Last September Attorney General Eric Holder announced a settlement of the case, in which JP Morgan Chase agreed to pay nearly $20 billion in fines.

The company responded by laying off 7,500 employees and freezing the pay of employees below the executive level.  But now the board of directors raised the pay of CEO Jamie Dimon, who had ultimate responsibility for the illegal actions, from $11.5 million a year to $20 million.

As Matt Taibbi of Rolling Stone pointed out in a recent post on his web log.

Eric Holder and Barack Obama … decided last year to make a big show of punishing JP Morgan Chase as a symbol of bank corruption, then forgot to punish the actual persons who oversaw the bank’s misdeeds.  This is a little like reining in a school bully by halving his school’s budget.  It doesn’t work.  Crimes are committed by people, and justice has to target people, too.  Otherwise the whole thing is a joke.

But from the board of directors’ point of view, the fine is less than the $25 billion in TARP funds that Dimon got from the federal government when the company was on the verge of collapse.

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Click on Jamie Dimon’s Raise Proves U.S. Regulatory Strategy Is a Joke for the whole article by Matt Taibbi for Rolling Stone.

Click on JP Morgan Chase, Penance and Fines for an account of JP Morgan Chase’s misdeeds by Christopher Brauchli for Huffington Post.

Click on Dimon Does Davos, and His Board Gives Him a Raise for more by Bill Black.

Those loaded words, “free markets”

The free exchange of goods and services is necessary for the functioning of a modern industrial economy.  It is not just because freedom is good in itself, although it is.  It is not just because free competition spurs companies to produce better goods at lower prices, although it does.

It is that in order to makes decisions within a modern economy, it is necessary to compare relative values.  You can’t do that unless you know the prices of things, and the only non-arbitrary way to set prices is through agreement of a willing buyer and a willing seller.

So the economics profession is perfectly right to start with the concept of free markets as a premise.  The problem is when that concept is taken to a self-defeating extreme.  Free markets are not the same thing as the absence of rules and regulations.  If that were so, Lebanon under the warlords or Haiti after the earthquake would be the greatest free market countries in the world.  The New York Stock Exchange draws investors from all over the world because they have confidence that a listed company’s financial report bears some semblance to reality, and that a broker is not trying to rip them off.

To say that rules and regulations as such are inconsistent with the free market is like saying traffic lights and speed limits are inconsistent with free driving.  You could make the argument that individual drivers are better able than traffic police to decide when to stop and start and how fast to go, but that is not a freedom that would be meaningful to me.

The test of a proposed law are regulation is (1) whether it is consistent with basic Constitutional rights, (2) whether it promotes the common good and (3) whether it can be enforced impartially.

For insight into what happens when decision-makers decide that “free markets” can function without law and regulation, I recommend Yves Smith’s book, ECONned: How Unenlightened Self-Interest Undermined Democracy and Corrupted Capitalism and her web log, naked capitalism.

Who is “more beholden” to Wall Street?

My fellow blogger Ben Hoffman made this comment to an earlier post.

Republicans appear to be more “beholden to Wall Street” than the Democrats since they’ve fought all efforts to rein in the abuses.

I think that’s a good way to put it.  The Democrats are beholden to Wall Street, but the Republicans may be more beholden to Wall Street.  But on questions of interest to Wall Street the parties are more alike than they are different.

Barack Obama and Joe Biden signed on to President Bush’s TARP bailout plan, as did John McCain and Sarah Palin.  Once in office, President Obama continued with President Bush’s economic team, reappointing Ben Bernanke as chair of the Federal Reserve Board, and moving Timothy Geither from the White House to Secretary of the Treasury.

Congressional Democrats did not consider legislation to break up the “too big to fail” banks.  They did not consider legislation to control risky speculation with federally-insured deposits, to restore the barriers between savings and investment banks, to put a minor tax on stock market transactions or to set requirements of bank reserves—any of which would have reined in the Wall Street speculators.

Instead they supported the Dodd-Frank bill, introduced by Senator Christopher Dodd of Connecticut, a center of the insurance industry, and Rep. Barney Frank of Massachusetts, a financial center, which creates a new layer of financial regulation under rules to be determined.

This could be good, if the regulators are wise and firm, and are not thwarted by Congress or the incumbent President.  How likely is that?  How likely is good policy to last from one administration to the next?  In the years prior to the financial crisis of 2007, the government did not use the regulatory authority it had.  A simple statement by Fed chairman Alan Greenspan that real estate prices and stock prices were overvalued might have burst the bubble before it grew too great.  Will a new regulatory body be any different?

The influence of Wall Street banks goes beyond Wall banking regulation.  The bi-partisan priority of financial austerity over fighting unemployment reflects the influence of bankers and financiers, which insists of financial probity in everyone except themselves.

It is true enough that there is a difference between the leadership of the two parties.  The Republican leadership is actively hostile to labor unions, minorities and the working poor; the Democratic leadership merely puts the interests of the big financial institutions first.

Bailouts and the risk premium

Click to view

Interest on some kinds of bonds is higher than on others.  That is because of the “risk premium.”  The higher the risk that the borrower will default, the higher the interest rate the lender will charge.  That is why high-yield bonds are called “junk bonds.”  High interest rates on certain corporate bonds offset the risk that the company that issued the bonds goes bankrupt.  High interest rates on certain government bonds offset the risk that the government defaults.

But the policy of the Federal Reserve Bank and the U.S. Treasury Department is that bondholders should be protected from risk, no matter what the cost to the public.  This goes against the principle of a free enterprise system, which is to reward success and punish failure.

These thoughts came to mind when I read a New York Times interview with Sheila Bair, outgoing chair of the Federal Deposit Insurance Corp., an Eisenhower-type Republican who found herself in the minority when she opposed the “too big to fail” mentality so prevalent in the government.  Here are some key paragraphs from the article.

The age of the kilo-page

I recently learned a new expression – “kilo-page” – which means a thousand pages, as in, “The financial reform bill is more than a kilo-page.”  My rule of thumb is that a kilo-page law is not understandable, and that a law that is not understandable defeats the whole purpose of the rule of law, which is to have impartial rules for the common good that everybody follows.  A kilo-page law is an open invitation to the powerful to manipulate the system for their own benefit.

I came across the expression in the comment thread on a web log post entitled Scandinavian Simplicity by an economist named Scott Sumner.  Sumner makes the point that Sweden recently issued a single-page regulation – that everyone who gets a mortgage loan must make a 15 percent down payment – that will do more for financial stability than the whole 1000-plus pages of the U.S. financial “reform” bill.  The actual expression “kilo-page” was coined by another economist, named Bryan Caplan.

Hat tip to Marginal Revolution.

Obama the establishmentarian

The key to Barack Obama is that he is an establishmentarian, not a populist.  Throughout his career he has worked for modest incremental changes by demonstrating his reasonableness and moderation.  He has never challenged the existing power structure, but always sought to work within that structure.  This is not weakness of character.  It is a reflection of his sincere convictions.

When you are dealing with reasonable people, this approach can produce good results.  When you are dealing with unconditional enemies, it does not.

President Obama and the Democratic congressional leaders were able to enact a health insurance bill only when they stopped pursuing the mirage of bipartisanship and made use of their constitutional powers.

Have they learned a lesson?  The test will be how President Obama and the Democrats approach financial reform.  Will they enact legislation that really prevents the big banks from putting the financial markets at risk, or will the legislation simply be a gesture?  Will Obama use his eloquence to bring the pressure of public opinion to bear on Congress, or will his energy be devoted to reassuring the financial establishment of his harmlessness.

We’ll see how it goes. There are encouraging signs that the Democrats are at last willing to use their constitutional powers.  But Obama is what he is. His approach has been consistent throughout his life.

A parable for our time

Charlie Munger, the long-time partner of Warren Buffett in his Berkshire-Hathaway investment fund, wrote a caustic parable which sums up very nicely the economic history and current economic plight of the United States. Click on this to read it.