Thursday 7 May 2009

Anatomy of the Crisis

On Tuesday evening Chris Giles, economics editor for the Financial Times paid Keele a visit to deliver a talk on the independence of the Bank of England. Thankfully, rather than concentrate on this topic (which, let's face it, was only ever going to float the boat of economics anoraks), he gave us a broad overview of the mess we find ourselves in and the prognosis for the future. In short, things are grim but anyone hoping for a re-run of the great depression are going to be disappointed.

Giles narrative begins in early 2007 when things started unravelling in the American sub-prime mortgage market, which through a series of domino effects and feedback loops spread the developing crisis to money markets, financial institutions, corporate credit and then to the wider economy. All told the crisis stayed out of sight for much of the 18 months, but when it did surface it was in a series of spectacular collapses. Most economists and central banks did not catch on to what was happening until it was too late. For example, they expected inflation would be the big problem of 2008. As we now know they were wrong. Badly wrong.

If there was a watershed moment it wasn't the reluctant nationalisation of Northern Rock nor the bailing out of Bear Stearns, but the collapse of Lehman Brothers. As far as the US government and financial authorities were concerned a line had to be drawn somewhere. Ideologically they could not countenance propping up every failing bank and politically they would have a hard time selling it to the American people. The consensus among economists was that if a bank should be allowed to go down, it should be Lehman's because it was not as central to the finance system as other institutions. This turned out to be a catastrophic mistake: it marked the exponential growth of the crisis. In a stroke not only did a widely-known investment bank plunge into the abyss, but with it went the regime of trust that underpinned the loans banks make to each other and the wider economy on a daily basis. Credit dried up and capital fled the so-called emerging economies for the comparative "safety" of home. The ultimate legacy of Lehman's is a financial climate where the only credit worthy borrowers are governments.

We are familiar with how this has played out up to now. According to the IMF world trade and industrial production has fallen off a cliff. The value of world trade has declined 30 per cent since the onset of the crisis. Production in the advanced metropolitan economies is down 15 per cent, with South Korea and Japan reporting 30-40 per cent shrinkage. Stock markets are back at 2003 levels. The Purchasing Managers' Index for manufacturing (which measures what companies say they are selling) is well down, but is showing signs of a very slight recovery. And then there are the social consequences. Official statistics show unemployment in the UK sailed through the two million barrier in March. Bankruptcies are at record levels and repossessions are up. Whatever progress was made in tackling poverty here and around the world is rapidly being rubbed out.

And the bad news goes on. Global output is expected to fall for the first time since the Second World War. World GDP growth has taken a massive hit - if it grows at all this year that will be thanks to China. For Britain the decline in output is equivalent to the 1979-82 recession, the difference being the pain being "shared" across all the regions of the UK and not just concentrated in the north. And of course government borrowing has had to mushroom to keep the show on the road. To put it into context, it stood at around seven per cent of national income during the 90s. When the government last went to the IMF for a loan the share was between seven and eight per cent. After the bail outs and recapitalisation of the banks public borrowing is equivalent to 12.5 per cent.

These have been the effects, so what were the causes? Giles made a distinction between immediate causes and underlying factors. The sparks that lit the tinder were:

* The bursting of the house price bubble, which was egged on by cheap credit.

* Excessive risk-taking by the banks, which infected the wider finance culture. As the (then) chief executive of Citigroup said in July 2007, "When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."

* Light touch regulation, which amplified the effects of the natural business cycle in conjunction with a complacent culture: Bank of England and IMF stability reports recognised the dangers but there were more or less ritualistic additions rather than calls to action.

* No distribution of risk - the bursting of the Dotcom bubble did not wreak havoc because risk was not concentrated. On the surface, prior to the collapse risk distribution appeared to be secured by financial instruments that sliced and diced mortgages. Problem was these "products" were concentrated in a few key firms and warehoused by the banks before they were widely distributed among investors. Furthermore when the crisis hit and brought down AIG, the insurance firm at the heart of global finance, this concentration of risk caused severe damage at the core of the system.

* The initial round of implosions precipitated more collapses as investors grew fearful and panic spread around the world.

These causes were conditioned by a precarious global economic climate. In the first place there was a serious imbalance in the economy. Since the IMF's intervention during the Asian crisis of 1997-8 and the attendant capital flight a strong domestic culture of saving developed, which sought increasingly profitable investment outlets. One of these was the US government itself via bonds, but also (mediated by US banks) its massive housing sector. It made cheap credit possible but also provided the financial backbone that allowed for riskier and riskier investment decisions.

Secondly economists had developed an irrational trust in their models. Because they appeared to be accurate more faith was placed in them and a models culture ruled the thinking of banks, central banks, regulatory debates and the academic discipline of economics itself. However, as Marx once noted, one should not confuse the things of logic for the logic of things. These models had two chief defects. They modeled individual banks and institutions in isolation from the rest of the economy. As such they were blind to the possibility of crisis that attends any complex system - a self-evident truth for ecology and network theorists for over a generation now (and, of course, far longer for sociologists and especially Marxists).

Third and fourth, the faith in the models reinforced a global culture of complacency that thought many of capitalism's problems had been solved, a culture best encapsulated by Gordon Brown's declaration that boom and bust had been abolished. All that remained were micro problems. As such the good times helped breed an anti-regulatory orthodoxy.

Finally there was a structural underestimation of risk. Society (or rather, the drivers of policy and the captains of finance) had forgotten banks are inherently risky institutions. Immediately there are intermediaries between savers and borrowers. The former provide the funds for lending, the latter the interest payments on loans. Therefore banks fulfill essential economic functions and are too important to allow for their wholesale failure. If anything's been learned from this crisis, that is the lesson.

How to get out of the crisis? Giles took a look at the measures being implemented across the world, which broadly follows those pursued by the government here. All the advanced economies have interest rates around zero, some have taken to 'quantitative easing' (the creation of electronic money rather than the printing of bank notes), the fiscal stimulus (many countries opting for bigger interventions than the UK, via tax cut and spending increases), recapitalisation of banks, a beefing up of the IMF, and automatic stabilisers such as falling prices have kicked in. In addition the UK has enforced lending by the banks (thanks to their part-nationalisation) and currency depreciation, which is significantly narrowing the gap between exports and imports. Taken together all these amount to a very strong economic stimulus and the IMF thinks things will begin moving again by 2010. But it is a big risk: if it doesn't work, what then?

In the questions Giles was asked more about the impact of Lehman's failure, the possibility of the British taxpayer getting their money back from saving the banks. There were two points Giles made that particularly interested me. The first was that in the UK the recession maybe sharp, but there is no crisis of consumer confidence. Spending has held up, all things considered. What has gone down in 'consumer investment' (i.e. small investments): it is this that has boomed over the last decade, not spending. He also added that if there was a collapse in consumer confidence the government are more than prepared to fire up the printing presses to stave off deflation. The second point was the future shape of the British economy. The crisis here is different to how it has taken hold of Germany and Japan, but strong manufacturing sectors hasn't stopped them from being hit very hard. Proportionately, they have been hit harder than British manufacturing. Giles forecast an economy less reliant on finance - London will retain its position as Europe's financial capital but it is likely to be less profitable, less sexy and smaller. Britain's economy will become more mixed, but it's hard to say now what this mix will be.

Concluding, he quipped that the next few years were going to be a "great time to be an economist" and said economists are learning, and will continue to learn after the next crisis has hit in another 20-30 years time. Considering he's a professional economist, there was little appreciation of the crisis tendencies inherent in the system - all that's needed is a bit of tinkering here, a bit of knowledge-gathering there and eventually economics will guarantee a capitalism with all the contradictions ironed out.

Credit where credit's due, Giles's account of the crisis was excellent and I've seen this analysis echoed and mirrored in the left press. But his vision of what comes next manages that rarest of feats; the marrying of utopianism with a politically impoverished outlook. Not only is a capitalism without contradictions impossible, it's not particularly desirable either.

1 comment:

JobSearchNinja said...

Recessions do not only bring about tough times financially. Sadly, they set men against men and raise moral issues that most of us would rather not have to consider.