Saturday, July 4, 2009


Talk to The New Institute, Merewether
July 14, 2009

I want to deal briefly with the origins of what we’ve come to call the global financial crisis and its consequences for economies around the world before I focus on the underlying causes of the crisis and the role of economics. Then I’ll look at what needs to be done to avoid another such monumental failure of economic management. I’ll be talking mainly about the global scene - particular the scene in America, where the crisis had its origins - and much of what I say won’t apply to Australia, though I will talk about how Australia managed to escape the worst of the madness.

The origins of the crisis can be found in America’s huge housing boom, in which house prices rose greatly, many hundreds of thousands of new homes were built and the rate of home-ownership rose significantly. One factor that made the boom so big was the issuing of loans to sub-prime borrowers - people with bad credit histories who had no hope of servicing their loans. This irresponsible lending was encouraged by the securitisation of loans - that is, because the banks that made these dubious loans didn’t retain them but converted them into mortgage-backed securities, which they then sold to investment banks, hedge funds and pension funds, not just in America but in Europe and even to some Australian local councils. Inevitably, the housing bubble burst and it was suddenly realised that many of the sub-prime loans would never be repaid. House prices fell dramatically - because the Americans had built far more houses than they actually needed - and a lot of big investment banks and other institutions found themselves holding possibly worthless mortgage-backed securities. But it wasn’t clear which banks were holding large amounts these securities and were thus in trouble. This uncertainly generated a great deal of fear and reluctance among the banks to continue dealing with each other.

This wouldn’t have been so bad - it would have led just to a housing-led recession in the US - were it not for the fact that it brought unstuck a huge and long-running expansion in the financial sectors of all the developed countries. The financial markets had been inventing complicated new financial contracts known as derivatives that supposedly shifted various forms of risk on to the shoulders of people more able and willing to bear that risk. Because this trading of risk was believed to have reduced the risks financial institutions were facing, they were emboldened to borrow heavily to buy more of these derivatives that were proving so profitable. As part of the globalisation of financial markets, financial institutions in Britain and Europe - and Australia to some extent - participated fully in this decade or two of frenzied trading and expansion.

The sub-prime problem acted as the bump that caused this whole house of cards to collapse. The crisis reached its culmination in mid-September last year, when the US authorities decided to allow one of America’s five big investment banks, Lehman Brothers, to collapse under the weight of its debts. This caused a wave of panic among financial institutions on both sides of the Atlantic. They refused to deal with each other, financial markets temporarily stopped functioning, and banks and insurance companies started falling over. For a period of several weeks governments had to step in to prop up these institutions, all of them granting government guarantees of their banks’ deposits and wholesale borrowings. The global financial system came perilously close to collapse. The whole world watched these frightening events unfolding on television every night, resulting in a synchronised blow to the confidence of consumers and business people in almost all the developed economies. The considerable losses faced by banks in the US and Europe greatly reduced their ability and willingness to continue lending to ordinary businesses. From that point it became clear that the world had entered its most severe recession since the Great Depression. Deep recessions in the US, Britain, Europe and Japan, plus sharp slowdowns in China and the other major developing economies, have seen a marked decline in world trade. Despite optimistic talk of ‘green shoots’, the likelihood is that unemployment in these economies will continue rising for some time before it begins a very slow fall.

Who’s to blame for all this? Well, you can blame it on the greed of bankers and other participants in the financial markets, but that doesn’t get us far. I’d prefer to say that the crisis was caused by the failures of human nature, compounded by the economic managers’ reliance on a model of human behaviour that fails to take account of many aspects of that human nature.

Human beings aren’t rational as the economists’ basic, neo-classical model assumes, but are highly emotional. Even economists themselves are more driven by their emotions than many of them realise. Particularly because people are so influenced by the behaviour of those around them, the people who make up an economy are prone to an alternating cycle of optimism and pessimism. So much so that this is now - and probably always has been - the main factor driving the business cycle of boom and bust. During the optimistic phase people happily take on ever-increasing risks and obligations. They spend rather than save, expanding their possessions and activities, pursuing status symbols, piling into the markets for property and shares, forcing prices up, then piling in some more just because prices are rising.

They do all this confident in the belief that the good times will roll on forever and prices will only go higher. But, of course, as we all know but keep forgetting, some event inevitably causes the boom to end and, when it does, the prevailing mood flicks from optimism to pessimism. People become afraid, they worry about all the commitments they’ve taken on, they abandon their plans for expansion and tighten their belts. In many asset markets (but probably not our housing market) prices go from being unrealistically high to being unrealistically low. The result is business failures, lay-offs and rapidly rising unemployment. This causes the fear to deepen into a pessimism which assumes the world will stay bad forever.

My first point is that, though economists know full well that the economy moves in cycles of optimism and pessimism, boom and bust, and a large branch of economics is devoted to studying the management of the business cycle - macro-economics - economists don’t have much of a handle on the factors that drive the cycle, especially those that derive from human psychology. They accept that ‘confidence’ is a major influence on the cycle, but they can’t get confidence into their mathematical equations, so they end up underrating its importance. A big part of the problem is that conventional micro-economics has no place for psychology or the business cycle, assuming the economy is always at full employment because it is self-equilibrating, self-correcting. Alan Greenspan admitted he’d made a mistake in believing the banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions. He had too much faith in the economy’s self-correcting powers because he assumed we’d behave rationally, not emotionally.

My second point is that this chronic underestimation of human failings tempted economists and regulators to run a partially deregulated financial system and not to worry about weaknesses in the remaining regulatory system, such as the US’s multiple regulatory agencies sharing responsibility for the system, and the operation of the hedge funds completely outside the regulatory regime. Here we have a fatal combination of model-blinded thinking on the part of the economics profession and blatant self-interest on the part of powerful vested interests in the financial markets. When they’re in optimism mode, business people always want to be completely free to do as they please in their push for profits.

But because the big banks and other players in the financial markets aren’t rational and are capable of getting carried away in a boom and doing stupid things they later come to regret, they do need fairly close supervision to protect them from themselves and to protect us from them. In the absence of that supervision it was inevitable the episode would end in disaster.

In Australia, our econocrats - particularly those at the Reserve Bank - have been an honourable exception to this naivety. They’ve been a lot more worldly wise, always being very conscious of the problem of asset bubbles. The former governor, Ian Macfarlane, was highly conscious of the risks involved in our long housing boom. He devoted much effort to studying and trying to talk down the boom, with some success. So we avoided making the same errors with our banking system, partly also because of two accidents: first, the four-pillars policy banned mergers between the big four banks because politicians fear the displeasure of the electorate more than the displeasure of the banks and, second, our Australian Prudential Regulation Authority was riding herd on the banks because it was still smarting from the caning it got over its inadequate supervision of the HIH insurance company.

In their drive for profits, people in the financial markets invented these ever more sophisticated and artificial - weird and wonderful - financial contracts known as derivatives. In theory, these synthetic contracts were about ‘risk management’ - spreading and shifting risk to those most able to bear it. In practice, the risk was spread to those least able to understand it. Even the inventors of these derivatives didn’t fully understand how they worked and the circumstances under which they could come unstuck. Individual financial institutions didn’t understand the extent of the risks they were taking on and no one - neither other institutions nor the regulators - knew where the risk was accumulating. So my third point is that derivatives were a case of the market being too smart by half and not nearly as smart as it imagined itself to be.

The story of the origins of the global financial crisis is littered with references to excessive gearing or leverage or plain old excessive borrowing. The reason booms go on for so long and get so big is that they’re fed by excessive borrowing. While everything is on the up and up, borrowing is a very easy way to magnify your gains from investment. Trouble is, once prices start falling, being highly geared is a way to magnify your losses and risk your own survival.

The thing about debt - or ‘credit’ as economists prefer to call it - is that it’s like fire: a wonderfully useful and beneficial thing, but also something that, if not understood and carefully controlled, can do immense harm. Yet economic theory focuses almost solely on the benefits of credit, hardly acknowledging how dangerous it can be if allowed to get out of hand. Why such a cavalier attitude towards debt? Because of the assumption that we’re all rational; because of the economic model’s unrealistic assumptions about human nature.

So my fourth point is that a primary cause of the crisis was the failure of regulators to understand the need to impose constraints against excessive gearing. The sudden discovery of all the trouble derivatives had got us into wouldn’t have caused nearly so much devastation had not the institutions that found themselves holding the parcel when the music stopped been so precariously geared. Indeed, some of the derivatives were themselves aimed at helping people gear up.

In the past 15 or 20 years, central banks have become proficient at controlling the former scourge of inflation by means of inflation targeting. What they have not managed is to find a way to prevent the build-up of speculative asset price bubbles. That’s because the instrument they use to fight inflation - the manipulation of interest rates - can’t simultaneously be used to fight asset bubbles. But all this means is that, as part of the move back to a more carefully regulated financial system, we need to revert to direct controls over borrowing levels.

It’s overly dramatic to imagine we’re facing the death of capitalism. We’re not because there is simply no practical alternative to the use of markets to coordinate the production and consumption of goods and services. Similarly, it’s a crude caricature to imagine that in the past 20 or 30 years we moved to ‘free markets’. No market has remotely approached the position of being entirely free of government intervention and regulation. What’s true is that - particularly in the case of the financial markets, and particularly in the US - we greatly reduced the degree of regulation and allowed much of the regulation that remained to be ineffective.

So the choice we face is the degree to which we regulate markets and the activities of businesses. And there’s little reason to doubt that the pendulum will now swing back in favour of more regulation of markets, particularly the financial markets. We’ll need to do more to limit excessive borrowing, more to regulate the use of derivatives, more to make their use more transparent to regulators and to other players in the financial markets, more to include hedge funds within the regulated framework. We need tax reform to eliminate the tax advantages of debt funding over equity funding, including the tax advantages of negatively geared property investments.

It’s important to remember, however, that regulation offers no easy answers. The very reason we dismantled regulation and gave up public ownership of businesses in the 1980s and 90s was that they weren’t working well, partly because they were being widely circumvented. It’s now clear we went too far in that direction, but the answer isn’t to go to the opposite extreme. Rather, it’s to find a mid-way position where carefully judged regulation can keep things under better control. And here, in the example of Australia, the world does have proof that sensible, less-than-onerous regulation can keep the banks out of trouble, to their own benefit as well as ours.

I think it’s a mistake, however, to see the curbing of excessive executive salaries as central to the need for reform. To some extent it’s true that these salary packages were structured in a way that encouraged executives to take excessive risks with other people’s money. Something needs to be done about that. But the fact that these obscene salaries were grossly unfair - that they greatly overestimated the value of those executives’ contribution to their company’s success; that they were the product of market failure rather than market forces - shouldn’t cause us to overestimate their importance in the scheme of things. Say we were able to magically reduce all executive salaries to quite modest levels. When that saving was distributed between all the company’s many customers, the reduction in the prices they were paying would be fairly minor.

I believe we’ve been living through an era of heightened materialism where a revival of faith in the near infallibility of markets - the benefits of deregulation - has contributed to a breakdown in the norms of acceptable business behaviour. Business leaders now feel free to behave in self-aggrandising ways - the ruthless treatment of employees, customers and shareholders - that formerly were regarded as beyond the pale.

I believe it’s possible for us to return to a period of less self-seeking, more principled, ethical behaviour by our business leaders. This not an area that economists know much about - it requires an understanding of the drivers of human behaviour that’s outside their field of study. But social attitudes aren’t fixed; if they can change for the worse they can also change for the better. The economic and social devastation wrought by the global financial crisis - of which we’ve so far seen only the start - may be sufficient to motivate such a change of direction. And carefully judged reregulation may have a valuable part to play in that change.

Economists’ faith in rationality leads them to believe that to change people’s behaviour you must first change their attitudes. But psychology teaches that, in reality, the process works the other way: if by changing regulation you can oblige business people to change their behaviour, they will adjust their attitudes to fit their behaviour.