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I have seen only the first programme in a three-part BBC documentary on the financial crisis, called The Love of Money. It was one of the productions that I watched last week for Newsnight Review, as are the other things mentioned in this post. This programme is about Lehman Brothers. I strongly recommend it (it's available to watch for another 11 days on the link that I've given). It's a riveting documentary about one of the most dramatic episodes in financial history. Also worth watching is a BBC drama called The Last Days of Lehman, concentrating on the three days in which the bank's fate was determined.
It is an extraordinary narrative about the ineptitude and vaingloriousness of Dick Fuld. Lehman's chief executive could have saved the bank if only he had been willing to acknowledge the destruction of value that he'd caused. He refused to acknowledge or even understand this till it was far too late, if he ever did. The documentary leaves as an open question whether the decision to let Lehman's fail was right. For reasons I explained last week, I believe it probably was the right decision, though it had momentous consequences.
Do not on any account waste your time with a book called A Colossal Failure of Common Sense, by Larry McDonald, a former trader at Lehman's. The quality of the (ghost) writing is remorselessly dreadful and the judgements either nugatory or fatuous. ("Dick [Fuld] and Joe [Gregory, Lehman's President] turned their backs all three times. It was probably the worst triple since St Peter denied Christ.")
The author claims to have known with the deregulation of the Glass-Steagall act, the Depression-era legislation separating commercial and investment banking, that it would all end like this. There are strong though not decisive arguments for breaking apart financial conglomerates. But if Glass-Steagall had still been in place last autumn, then Goldman Sachs and Morgan Stanley - two investment banks with quite small credit-related losses, but which still suffered a collapse in share price - would certainly have gone under. They managed to turn themselves into bank holding companies and thereby stabilise their position.
Finally, do try to see Enron, a play by Lucy Prebble, which is sold out at the Royal Court Theatre but will transfer to the West End. It's great theatre, depicting with wit and inventiveness the rise and destruction of Enron. My criticisms of it don't outweigh those characteristics, but I'll give them anyway.
First, the links drawn between Enron's collapse and today's financial crisis are strained (and indeed interpolated: I went to the printed text so that I could quote them, and found that the lines I'd heard in the theatre weren't there). Enron was different. It was a deliberate scam, in which profits were faked in off-balance-sheet vehicles to hide debts and smooth earnings from quarter to quarter, and thereby support the share price. It involved ruining employees, whose stock options became worthless, and stealing from shareholders. It's a more subtle question how banks made the catastrophic errors they did in the credit expansion of this decade. (For what it's worth, I've written a lot about it. On Enron, there is an excellent account in chapter 7 of Going Off the Rails: Global Capital and the Crisis of Legitimacy, 2003, by the FT columnist John Plender.)
Secondly, while there were no shades of grey in Enron - it was fraud - there were more nuanced characteristics among those whom the company touched. The play depicts the Republican Party as being in the pocket of Enron, and this is quite fair. Yet the Bush Administration deliberately didn't bail out Enron when the company was on the point of collapse, despite being lobbied to do so by Robert Rubin, Treasury Secretary under President Clinton. The Administration took the view that no large financial institution was at stake, and it let the company collapse. This was a catastrophe for Enron's employees, but the economic decision was right. The play might have reflected the conflicting pressures on the Administration, but it didn't.
Thirdly, the company wasn't the monolith that the play depicts. It was astonishingly badly run. The company's failure was precipitated not, in fact, by the fraudulent operations - these were discovered afterwards - but by the incompetence of its Treasury managers. The company's bonds were repayable as soon as its credit rating fell below a certain level.
Fourthly, Enron was a specific failure, whereas today's crisis is about the entire banking sector. The oddity is that one of the reasons that Enron's collapse had so little effect on the wider economy - despite being, till Lehman's, the biggest corporate bankruptcy in US history - was the market in credit derivatives. It enabled banks to insure against their losses. The very market that destabilised the financial system last year had worked well in 2001. Financial engineering has its uses. It's not a straightforward story, which is why it's difficult to capture in a Brechtian narrative.
There he goes again. Rowan Williams, Archbishop of Canterbury, calls bankers to repentance:
'Dr Williams told BBC2's Newsnight programme: "There hasn't been a feeling of closure about what happened last year.
'"There hasn't been what I would, as a Christian, call repentance. We haven't heard people saying 'well actually, no, we got it wrong and the whole fundamental principle on which we worked was unreal, empty'."'
Well, there has been. Alan Greenspan commented specifically on the “flaw in the model ... that defines how the world works”, the flaw being the assumption that banks would act to protect their shareholders and preserve financial stability.
What the Archbishop presumably means is not that sort of conceptual failure but an acknowledgement of ethical shortcomings. But that is question-begging, because it assumes that moral lapses explain the financial crisis. They don't. You could have saints and archangels trading derivatives, but if their risk models are wrong then you'll get the same result.
The financial crisis is a huge failure of a discipline that confused the notions of risk (the management of which is the business of financial markets) with uncertainty. Greenspan was right to say that in past decades (including this one) the system worked. Financial innovation led to the credit derivatives market, in which banks could insure against the risk that their loans to corporate clients would turn sour. Because those exposures were parcelled out across the financial system, the global economy easily absorbed the collapse of Enron (which genuinely was an ethical scandal, being a crooked operation). The system did collapse last year, owing to massive, pig-headed, culpable incompetence by bankers, who exploited a disastrous credit bubble and an ensuing asset-price bubble - but the fact that they were greedy as well is beside the point.
UPDATE: Incidentally, according to our report
"Dr Rowan Williams, the head of the Church of England [sic - that's obviously a mistake] said the Government should have acted to cap bonuses and he warned that the gap between rich and poor would lead to an increasingly "dysfunctional" society."
Those points don't follow. I'm in favour of narrowing inequalities by redistributing income through the tax system, but it's an altogether different and bad thing to advocate government control of what businesses may pay their employees. The problem with executive compensation is that it often hasn't been set in a competitive market - witness the allocation of stock options, which are simply repriced if the share price falls - not that it's too big.
Lehman Brothers, a bank founded in 1850, collapsed on 15 September 2008. Our leader marking the anniversary considers the decision to let it fail.
I felt at the time, and still feel, that this was a calculated risk worth taking. The notion that every bank was so inextricably linked with every other bank that it needed to be rescued committed the taxpayer to open-ended support. Lehman's collapse was entirely attributable to the hubris of one man: Dick Fuld, the bank's chief executive since 1994. He could have arranged a deal with Korea Development Bank; but he insisted on an impossible price, and his negotiating partner walked away.
In my former career, I helped establish a pan-European investment bank in the late 1990s. I wrote its founding business plan, and Lehman Brothers was a model that I cited. It was a sound medium-sized bank that punched well above its weight. It had been consistently successful in three different areas: investment banking, fixed income and asset management. The investment bank I envisaged would be like that, but with a speciality in equities rather than bonds.
That model was essentially abandoned by Lehman's in the great credit explosion of this decade. Fuld expanded into structured products and committed Lehman's (unusually for an investment bank) to a massive exposure to commercial property. He did the damage; it was reasonable to let the bank take the consequences.
In practice Lehman's collapse precipitated financial panic. I suspect that if it hadn't been Lehman's, it would have been something else that sparked a transition from credit crunch to chaos. Northern Rock was a terrible augury: what had previously been a mortgage lender with its roots in regional friendly societies essentially became a financial engineering shop, borrowing money short-term in the wholesale market and lending it long-term as mortgage finance. When the interbank lending market froze, the Rock couldn't meet its commitments. There were far bigger fish that were also dependent on short-term funding; and quite suddenly it wasn't available.
But whatever the counterfactual history, those weeks in the autumn of 2008 were the closest any of us has seen to the collapse of the Western financial system. I left the City in July 2008 to take up a full-time post at The Times. I thought the banks would need to make big further asset writedowns and that there would be a recession in the US. But I can't reasonably claim to have suspected, let alone predicted, anything close to what did happen next. I'll be writing this week about the causes and lessons of the fall of the house of Lehman Brothers.
Kenneth Rogoff, former chief economist at the IMF, makes an important observation about public debt:
"With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable. If the trajectory is unsustainable, how long can debt keep piling up? We don't know."
There is an impeccable case for governments to pile up debt in this recession. After the explosion of consumer credit in the past decade, there is a huge burden of household debt. It's the proper role of government to take on that burden to prevent "debt deflation": a downwards spiral in which a fall in prices increases the real value of private debt. The great flaw of Labour strategy since around 2002 is that it has failed to build up surpluses in a business expansion, so that deficits could be safely run in a downturn.
But we don't know how far a rapid accumulation of public debt will undermine financial confidence. Rogoff has previously argued that governments should tolerate higher inflation - 6 per cent for at least two years - to help consumers cope with debt. It's a trade-off. The debt burden will be worked off more easily. But if the US and the UK inflate their way out of trouble, they will need to pay higher interest rates on sovereign debt. It's particularly important for the UK, as an open economy with a floating currency, to maintain the confidence of international investors.
The US has been able to run a wide current account deficit because of a surplus of savings in Asia that has been recycled in the US government bond markets. There will be an adjustment, possibly a wrenching one, in US living standards as domestic savings are built up. As for the UK, there is in my view a non-trivial risk that the entire financial framework may be undermined as comprehensively as it was in the ERM crisis of 1992 (though for different reasons). I expect we'll muddle through regardless. But the Conservatives, as a traditionally pragmatic and pro-European party, may yet take us into the euro in the next Parliament, when we'll wish we'd done it sooner.
I had a column in the paper yesterday that took issue with non-economic environmentalism. Here's an extract:
'Green campaigners are rightly concerned with environmental degradation. There is copious evidence of global warming due to man-made emissions of carbon dioxide and other gases that trap heat. The pace of glacial retreat and a rise in sea levels confirm it. The journalists and politicians who take issue with the science are no more credible than the ones (sometimes the same people) who dispute Darwin. Climate change poses not only environmental hazards. The desperately poor state of Bangladesh faces twin threats of catastrophic flooding and Islamist militancy. Amid the devastation of low-lying areas and a mass flight to higher ground, malevolent extremism might thrive.
'For all that, environmentalism is a flawed idea. Its weakness is not that it lacks justice, but that it lacks a sense of priorities. How do you rank global warming relative to women’s rights in Afghanistan or the prevention of genocide in Darfur? “Save the planet” is an exhortation, not a policy, and it doesn’t get you far. In particular, it gives no guidance on how to weigh present needs, such as eradicating poverty in the developing world, against future constraints on natural resources. In short, it does not deal with trade-offs. That is a big omission.'
Stephen King, managing director of economics at HSBC (and formerly a close colleague of mine), writes in The Independent about the role of central banks. He concludes:
"Unfortunately, even when the act of life support [easy monetary policy] finally ends, I don't think we'll return to the conditions of the 1990s. Growth will be lower for a very long time, held back by ageing populations, increased regulation, growing protectionism and excessive debts. Central banks can prevent the worst economic outcomes from occurring. They cannot create the best economic conditions. They are only responsible for monetary policy. They are not magicians."
This is all highly plausible, unfortunately, including the trend to protectionism. The policy of quantitative easing (expanding the money supply by buying up government and corporate debt) that's been adopted by central banks in the US, the UK and Switzerland is right for the times, to ensure that the developed economies don't repeat the experience of the Great Depression, or - less dramatically - the deflationary pressures of the Long Depression of 1873-96. But it can do only so much. If households prefer to save or pay off debt, then quantitative easing will show up in higher inflation rather than growth.
Watch commodity prices. I would expect these to respond to easy monetary policy, as there is no product discrimination by consumers (one barrel of oil is like another barrel of oil). If these pick up, then headline inflation - though not core inflation, which excludes food and energy prices - may turn sharply. Other things being equal, bond yields would then rise and equity markets would fall. And then we might be in a further collapse in financial confidence.
There is no alternative to stimulative monetary and fiscal policy, allied to a massive writedown of banks' assets, if the Western economies are to escape a bitter and prolonged recession. But recovery won't be easy or assured.
I went on Radio 3's Nightwaves programme earlier this week, when the subject was the age of austerity - whether it's something we should celebrate or reluctantly get used to. Here are one or two points that I thought of (most of them, as usually happens, just as the programme had ended).
I see no merit in austerity for its own sake, but nor are acquisitiveness and consumption ("getting and spending", in Wordsworth's matchless phrase) valuable ends. The virtue of an affluent society is the ability it gives us to choose the good for ourselves. If you want a contemplative and simple life, you can adopt it. I value the environment and acknowledge the importance of mitigating climate change, but that is an economic task rather than a spiritual challenge.
The relation between living standards and pollution is much debated. There is a plausible economic case that it's like an inverted U-curve on a chart: pollution rises with growth in a developing country’s average per capita income, but then turns and declines as that country reaches a certain level of wealth. (This is an application of the Kuznets curve, which poses the same relationship between a poor country’s average per capita income and inequality in the distribution of income.) If we're heading for a long period of austerity, then environmental policies are unlikely to win support.
There was a lot wrong with the old social democratic, Keynesian consensus that Mrs Thatcher overturned. It couldn't cope with the persistent problem of the inflationary consequences of demand management. But it did embody an important principle: where there is sustained economic growth, liberal reforms such as a narrowing of inequality and the eradication of racial discrimination are easier to achieve. If you want an example of an austere, stable agrarian society, Vichy France is a fairly accurate model.
UPDATE: Daniel Finkelstein takes issue with me on the value of consumption but is tolerant of my reading habits.
UPDATE II: Incidentally, the cause of Vichy France is, with complete consistency and no merit, championed by conservative commentators who decry the loosening of social ties. I have on my shelves a squib of a book by Peregrine Worsthorne, entitled In Defence of Aristocracy, 2004. In it Worsthorne argues (pp. 176-7) that the wartime regime in France was:
"… a blessing in disguise because during the Vichy years, for the first time since the Revolution, the pro-republican and anti-republican elites, at all levels, started to feel able to work together…. Unquestionably the Vichy years opened new wounds on France’s body politic, but these did not cut nearly so deep as the old revolutionary wounds which Vichy did so much to heal."
The "new wounds" that Worsthorne is gently alluding to included the deportation of 750,000 Jews and others to the Nazi death camps. I'm intolerant of writers who make excuses for repressive regimes, and I find it extraordinary that Worsthorne gets away with this stuff.
I defended Boris Johnson's views on hedge funds last week. Will Hutton in The Observer takes a very different view. He argues:
"But hedge funds do represent the unlovely priorities of Anglo-Saxon capitalism. They were an important factor behind today's financial crisis. Brutally, it would matter scarcely a jot if the hedge-fund industry shrank to the size it was a decade ago. It might even promote a less casino-oriented financial system. Instead, I want to hear politicians talk about great innovations and inventions. I want them to fight for what counts - the clusters of wealth-generating excellence in medicine, health, biotechnology, engineering, our great manufacturing companies, creative industries, and business service companies. Wouldn't it be fantastic if instead of pleading for hedge funds on Radio 4's Today programme as Johnson did last week, he went into bat for, say, more resources for our financially pressed but brilliant universities and research teams. But the country's Brian Greenwoods don't invest the time and effort in lobbying, funding political parties or turning up at agreeable lunches. They just get on with saving lives."
Now, I have a lot of respect for Hutton's writings. On some economic issues, notably the euro, I think he talks more sense than almost anyone else in the British press. (Modesty prevents me from identifying the members of the British press whose judgements are more consistently reliable.) But the paragraph I've just quoted is a fantastic non sequitur.
I'm in favour of universities and all the other things that Hutton mentions. I don't consider, either, that the size of the hedge fund sector is of crucial importance to the economy. But so what? Hedge funds are a useful part of a sector that is crucial to a modern economy, namely financial markets, whose function is to put together those who have capital with those who can use it productively. Hedge funds make that process more efficient by, among other things, being able to take short positions in companies whose managements they believe are underperforming. It is a high-risk strategy, because your potential losses in a short position are unlimited. (If you take a long position, i.e. you buy the stock of a company, your potential losses are bounded by the fact that the stock price can't fall below zero. I talked more about this in an article here.)
Hedge funds can pose a risk to financial stability by the amount of leverage they take on, which is why regulation is needed. (There's a widespread misconception on this, though. Hedge funds are not regulated, but hedge fund managers operating in the UK have to be registered with the Financial Services Authority.) There is a test case: a US hedge fund with the awesomely inappropriate name of Long-Term Capital Management (LTCM) failed in 1998 and was rescued by an injection of capital from eight banks, co-ordinated by the Federal Reserve.
(LTCM's trading strategy was to buy bonds that were not widely traded and wait for their price to converge on those of more liquid bond issues with otherwise similar characteristics. The Fund failed because liquidity in the market suddenly vanished when Russia defaulted on its sovereign debt. There was nothing essentially unsound with the fund's trading; it just couldn't sell the securities when it needed to, and because it had large amounts of leverage it posed a systemic risk. This in a much bigger way is the problem with the banking system now. The banks hold securities for which there is no market. Government needs to intervene to provide that liquidity, just as it's the proper role of government to stabilise the business cycle through monetary and fiscal policy.)
But that's about it so far as the indictment goes. It's nonsense to claim, as Hutton does, that hedge funds were an important factor behind today's crisis. Hedge funds have almost nothing to do with it. This is a big and somewhat esoteric subject, which I'll write about at greater length in due course. But Hutton cites the failures of two Bear Stearns hedge funds and three BNP Paribas hedge funds in 2007 as the triggers for the freezing up of the interbank lending market.
He's wrong. The failures of these funds would have been (as most market participants expected at the time) restricted, in the damage they caused, to the parent companies and the investors, but for one factor. The banks themselves - the most regulated part of the financial system - were pursuing yield-based trading strategies. A more likely trigger for the credit crunch was the failure of IKB, a German industrial bank that held around €14 billion of structured credits in off balance sheet vehicles. This was almost a replica of the problems at Bear Stearns, with low asset quality and tightening credit limits. But it was in the banking sector. Banks ought never to have got involved in this business.
There is, incidentally, a serious factual error in Hutton's piece. Hutton says tangentially: "Along the way, Bernie Madoff's hedge funds were shown to be a $50bn rip-off."
Madoff did not run hedge funds. He ran investment advisory services. This may seem a pedantic point, but it it isn't. It has a large bearing on how Madoff's crooked operations escaped detection for so long. If you run a hedge fund, then the securities in your portfolio are held by external custodians. If you do not in reality hold those securities, then auditors will find out by checking with the custodian. If you run an investment advisory business, then you are managing clients' accounts within the firm. Hutton has completely misunderstood the nature of Madoff's business, in order to try to link it with hedge funds. To put it no higher, that's an error of fact rather than interpretation, and The Observer ought to correct it.
I have two incidental points about the gathering storm in Latvia, where the economy is caught in a massive recession and the country risks default. First, this is a story in microcosm of the entire financial crisis. The boom was fuelled by a massive expansion of credit, which fed into a property bubble. But the overheating was particularly extreme for the Baltic states, as inflation surged and current account imbalances widened dramatically. Latvia now faces an economic contraction of some 18 per cent this year. It's excuciating, and the country must get aid - otherwise it will default, it will bring the other Baltic economies down with it, and the Western banking system (notably the Swedish banks, which extended massive loans) risk another bout of contagious bad debts.
But there's an additional factor in Latvia's crisis: the exchange rate. The currency, the lat, is pegged to the euro. The pressure it's coming under recalls the EMS crisis of 1992 - notably the cases of the Finnish markka and the Swedish krona. In Sweden, the Government at one point attempted fruitlessly to support the currency by increasing overnight rates to triple digits. The Latvian Government likewise resists devaluation, because many of the loans extended during the boom are denominated in foreign currencies. This is not a sustainable position. Whatever happens, the pain will be massive and the debt burden will intensify.
There is no easy way out, but the Government's policy is self-defeating. There is no real middle way between a floating currency and full-blown currency union. I see no particular issue of principle either way. (I don't understand the supposed free-market case that sees the exchange rate as a price like any other, and which must therefore be left for the foreign-exchange market to set. A currency is just a measuring rod; and we choose how many currencies we have.) But as a practical matter, I consider the advent of a single European currency to have been a good for the states that have joined the euro zone. And it's undeniable that those countries that have adopted a reserve currency, either the dollar or the euro, have survived the crisis, admittedly in a battered state, better than Iceland or Hungary among others.
There are a few pointers about the banks and the economic crisis. Since the crisis turned into financial panic with the failure of Lehman Brothers, the economic collapse has - on the raw data of industrial production and trade volumes - become comparable to the Great Depression. I've argued here and in the newspaper that the duration of the recession will nonetheless be a lot shorter, because the tools of economic management are better understood now than they were 70 years ago. There is no perverse policy commitment comparable to the Gold Standard.
The three things that needed to be done to contain the crisis are, to varying degrees, in place. These are: monetary stimulus; a huge fiscal boost by the US (though this works less quickly and directly than monetary policy, and may well result in unproductive spending): and a purging of bad debts from the banking system by a huge asset writedown. Now, not all banks have cleaned up their balance sheets. The share price of Lloyds HBOS fell 11 per cent today. The company announced that bad debts would rise by 50 per cent this year. The lending practices of HBOS, which extended loans right to the end of an obvious bubble in property, have contaminated the banking system and inflicted huge damage on what was previously a healthy institution (Lloyds TSB).
But that bank appears to be unusual. Barclays reported first-quarter results this morning that were ahead of market expectations. (The improvement came in investment rather than retail banking, however, and the bank booked a one-off gain - so-called negative goodwill - from buying parts of Lehman Brothers at a knockdown price.) US banks, such as Goldman Sachs and Wells Fargo, beat market expectations in their recent results. And it looks - from advance information about the Fed's stress-tests of the main US banks - as if the banks are broadly well capitalised.
This is all important and encouraging. It suggests that policymakers have got it right. The crisis demonstrates that financial capitalism does contain an inherent systemic risk: the banks are tied to each other, in the wholesale lending market, and if there is a problem of bad debts then it can contaminate the entire system. But the policy response is working. There is no crisis of capitalism. One segment of the economy created massive instability; and governments and central banks have acted, in the Keynesian mould, to stabilise the economy. The revolution is postponed (again). The textbooks still hold.
UPDATE: On a connected issue, our main leader today (Friday) discusses the recent rally in global stock markets. It concludes:
"There are many lessons that need to be learnt [from the crisis]. Central banks must be prepared to deflate asset-price bubbles. Banking regulation must be improved. But the signals given by stock markets will be valuable. A bull market is a rational testament to capitalism's resilience."
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