The burden of this book is that the current financial crisis is the consequence of our uncritical acceptance of a laissez faire doctrine promulgated by the “New OIympians”. This term indicates the God like status the book says they claim. The New Olympians have convinced us that what we might call economic Darwinism is natural and inevitable. But in truth their motive, the book claims, is simply personal greed.
Unfortunately the authors fail to name the New OIympians although they use the term on almost every page. In consequence they do not explain how the current free market has come to be the accepted orthodoxy.
Before I try to track down the New Olympians and work out how the system from which they benefit came into being I believe it to be necessary to recognize the different spheres of economic activity. We all know about manufacturing on the one hand and the “service sector” on the other. Walmart and Meryl Lynch are both within the service sector but they are fundamentally different. Walmart is much more like say B P than it is like Meryl Lynch. Walmart deals with tangible things that people need – milk and bread and eggs on so on. A bank deals with money. Even within the financial system there is the lending of money to those who want to buy something- mortgages is an obvious example- and the manipulation of money. The division is not between manufacturing and service industry but between those who do something that has an end product and those whose activities have not. B A provides a service and B P provides a product but if we are to believe all those who have Masters in Business Administration, which I do not, running the two outfits is essentially the same. The distinction between producing and finance can be unclear in practice since firms that produce need to engage in financial activity and can make money from financial ventures. If BA takes over Iberia, as seems likely, that is a financial transaction as well as a business deal.
What has got us into our present fix is the doctrinaire assumption that all regulation is bad or at least there should be only as much regulation as is required to let “market forces” function effectively. That may be true for the “producers” although if so only because like democracy, every other system is worse, but it does not follow that the same is true for finance. That there is a fundamental difference is clear. Banks are not allowed to fail; too many voters stand to lose their house or their shirt. And if one bank fails people will lose confidence in others leading to further failure and all round financial collapse. When Rover folded people did not stop buying cars. No one was bothered except the Rover workers. Defects in the financial system have led to the “credit crunch” that is claimed to be, and probably is, the main cause of a world wide economic slow-down. Are these defects correctable in a piece-meal fashion or does the whole system require fundamental restructuring?
But before I try to analyse those problems let me return to the New Olympians. The “Gods” split into four groups:- the academic economists, the politicians, the popularisers and the exploiters. The chief of the first are Hayek and Friedman and if I were an economist I am sure I could add others, many being disciples of those two. The politicians of the right I suspect have embraced the free market in finance as well as trade because it accorded with their basic philosophy not because they were convinced by the academic case. Reagan did not read economic tomes in bed; he watched his old B movies. Margaret Thatcher’s economics was that of the corner shop of her revered father- in fact it was not a corner shop but a chain. There were more cerebral politicians, in England Keith Joseph comes to mind. Politicians of the centre Left – New Labour is an example – have also embraced the free market in finance as well as elsewhere. Both of the first two groups were to some degree popularisers and the journalists who peddled the free market doctrine were often themselves economists. Their chief organ was, and is, The Economist. But none of the members of those groups has become excessively rich. The exploiters have been the great beneficiaries. Unsurprisingly you will not find in that group vociferous critics of a financial free market but no more will you find influential advocates. I have no reason to suppose George Soros believes the system he has manipulated so successfully to be ideal or even desirable. By the way the world’s excessively rich are not in fact merchant bankers or fund managers or currency and commodity traders, although all those have been doing very nicely indeed.
What unites these four groups is a commitment to free enterprise in every field. I am convinced that adherence to this “liberal” philosophy came, and comes, first. The economic and social theories are rationalisations. The philosophy has not arisen from the evidence; the evidence has been twisted and selected to fit the philosophy -or else has been ignored. That is easily done since most economic pronouncements are untestable. To admit that financial institutions require tight regulation is close to blasphemy. It is wryly amusing to see The Economist trying to explain that banks that get into difficulties ought to be allowed to fail, but that actually they must be rescued, although there is no need for rules to stop banks acting imprudently in the first place. Takes some doing. A recent Leader claims that, “financial capitalism has helped to produce healthy economic growth and low inflation for a generation”. Perhaps.
The authors of The Gods that Failed would have us believe that there has been a plot driven by greed to foist free enterprise on us. They discount any disenchantment in Britain with the post war Labour programme still less any failure of that programme. Both occurred. The reasons, as I thought then and think now, were two. Firstly politicians are not interested in running things; that they find boring. So the nationalised industries were badly run. Having nationalised the coal industry the politicians considered the job done. But the miners did not shoulder their picks singing “Hey Ho Hey Ho; It’s off to dig we go.” One boss had simply been replaced by another. Secondly, nationalization was not socialism, whatever socialism might be, but state capitalism. The State owned the nationalized industries but the State is not the people in any practical sense. People became fed up with poor service about which they could do nothing.
To return to the credit crunch there seem to me to be two major flaws in the present financial system, flaws that have led to the present dire situation. Crucially, there is manipulation of money, not money loaned to a person or organization to do something, but simply to make more money. This is essentially gambling, and at its most risky with borrowed money. Then there is manipulation, sometimes legal sometimes not, designed to make an enterprise look better than it in fact is. Enron is the obvious example. The parceling up of debt, and buying and selling of the parcel is a mixture of both. The seller makes his debt disappear and the buyer gambles that the debt will in the end be worth more than he paid for the parcel. A third lesser but significant problem is insider trading and conflict of interest. Anderson was making too much money out of Enron to risk acting as an honest auditor.
Even the stock market is little more than gambling. A company will get money when it issues stock but most stock market transactions do no more than shift a piece of paper – or now an electronic record - from one person or institution to another. We call it “investing” but that is a comforting euphemism.
I mistrust the whole matter of finance. Finance seems to exist in a parallel universe. Here are a few of the things that bemuse me.
During the Depression Franklin Roosevelt famously stated, “The only thing we have to fear is fear itself.” We now call it lack of confidence but the point is the same and it still makes sense. However, in the Perils of Pauline when the villain ties Pauline to the track in the path of an oncoming train, the hero arriving the nick of time does not murmur, “Don’t worry my dear, the only thing you have to fear is fear itself.”
In finance metaphors are treated literally; we talk of “toxic” products, of “contagion”, of “unclogging the system”, of “bubbles” and, though not recently, of economies “overheating”. How does “contagion” for example work?
We accept that interest rates can be used to control inflation although there is no agreement about how they work and not much empirical evidence that they do. If raising interest rates does reduce inflation it may well be because we expect it to.
Which brings me back to “confidence”. Sir Robin Leigh-Pemberton a former Governor of the Bank of England once said, ”It is difficult to stop a currency rising when sentiment is running in its favour”. To put it crudely currencies rise because they are rising and fall because they are falling- and the same with shares. A respectable way in economics to gauge what is likely to happen is to ask people what they expect to happen. Things often turn out that way because in finance expecting something to occur largely ensures that it does. Greenhouse gases may be responsible for global warming but the belief of millions that this is so does not affect the truth or falsity of the connection. Global warming occurs in the real world.
We are told that it is vitally necessary that banks start lending to each other again. I suppose this constitutes liquidity. No one seems to see a need to explain why banks should need to lend to each other; to me it looks like taking in each other’s washing.
In order to lend, deposits are not enough so banks borrow on the “money market”. No one seems to see a need to explain who or what the money market is. But I find it is in fact composed of “financial institutions”, that is of banks! This looks like financial levitation.
Then there is the National Debt. Again the Government borrows on the money market. Although the banks are strapped for cash the government seems to have no difficulty in raising as large a loan as in wants. The government is raising this money in part from banks to whom the government has lent money to keep them afloat!
On the £5 note issued by the Bank of England it states, “I promise to pay the bearer the sum of £5”. What does this mean? It once meant £5 in gold, but that would still have been merely changing one currency for another. But we still dig up gold with great labour only to bury most of it again in the vaults of Fort Knox and similar fortresses. If as now shares slide, there is a flight to gold. This is totally irrational or rather it is rational only because the irrational is universally believed. Gold is useless except for small amounts needed in electronics. You cannot eat gold or make cars out of gold or build with gold. It is valuable only because we believe it to be valuable. And we believe that for mythological reasons. This nonsense affects us all. One does not know whether to laugh or cry.
This may be all very true but it gets us nowhere. Why have the wheels have fallen off the financial vehicle and, illogical though the financial system may be, can it be got back on the road?
Bernard Braden, the Canadian comedian – there is such a creature though very rare- once said, “Money isn’t everything but what it isn’t it can buy.” He meant buy real things like potatoes or cars or champagne not other money. Buying things was what money was invented to do. The further we get from using money to buy and sell real tangible items and services, the riskier finance becomes, and now financial transactions to buy and sell are swamped by transactions that deal only in money itself. The upshot of all this clever stuff is that no one knows who owns what, and who owes what and to whom. All loans involve risk but with complex and devious financial operations no one has much idea what the risk is or where it lies. It seems to me bizarre and unfair that the whole world will suffer through this arrogance and stupidity although nothing in the real world has changed. The root of our ills has been to treat money as a commodity, something that can be bought and sold, to buy or sell other money. Swapping shark’s teeth for cowrie shells to exchange for rhino horn then trading rhino horn for shark’s teeth benefits nobody except the traders in sharks teeth, cowrie shells and rhino horn. Replacing rhino horn by gold, cowrie shells by dollars and shark’s teeth by pounds, changes nothing.
The free-market advocates still fail to get it. My current Economist (8 Nov 2008) says, “There is no reason why investors should not speculate in corporate debt (Credit Default Swaps) if they can speculate on equities, currencies, commodities and the rest.” But why should they speculate on the rest? Where is the benefit in gambling at all, except to the successful gambler? It is gambling that has got us into our present mess. In the same issue I read, “The economies of America and China are complementary: America borrows China’s savings to buy what China makes.” But America is getting ever deeper in debt. Even in the Alice in Wonderland world of economics that surely cannot go on indefinitely. Then again, “.. intrusive supervision that limits risk taking and thus profitability”. Does not this mean “..limits my freedom to gamble with other peoples’ money and make a profit for myself”?

The defenders of the lack of system claim that “the market” is the best guide to value. But that is clearly not true. To take one example, the value of a unit of a currency ought to be a function of what it can buy and what it is likely to be able to buy in the future. The latter ought to be determined by the interest rate and the health of the economy- the less sound the economy the higher the interest rate. But that is not so. The exchange rate is driven by “sentiment”. In general, if the “market” had got things even roughly right there would be no credit crunch.
The solution is in theory clear: stop trading in money, not just currency but in debt and promissory notes and other intangibles. Unfortunately, there is no practicable way to do that. One cannot stop the buying and selling of shares “Futures“ have a use but one cannot easily prevent gambling in derivates, which is not useful.
Might it be possible for this irrational system to stagger on if the worst excesses were curbed? That is the best we can hope for; I have a sneaking feeling that might actually be the best thing to do. Perhaps the U S buying Chinese goods with money the Chinese have lent them does keep the whole business rolling. I said that can’t go on indefinitely but perhaps it can – provided no one points out that the sun does not go round the earth. As we keep hearing the whole financial system is based on “confidence” whether reasonable or unreasonable does not matter. Perhaps faith would be a more accurate term.
There are it seems to me three immediate causes of the credit crunch; leverage, derivatives and the selling of packages of loans. Leverage is the use of small amounts of money to borrow much larger amounts. That is not necessarily bad if the borrowed money is used to buy something worth more than what has been borrowed. A house mortgage is not a problem for the lender provided the house is worth more than the outstanding mortgage. Derivatives, I believe covers the class of speculation that involves buying or promising to buy, in order to sell later, and usually with borrowed money. “Selling short” is an example. The operator rents shares that he sells hoping to buy them back later after the shares have fallen in value. With “selling short naked” I gather he does not even have to borrow the shares. Kellogs buying next season’s maize from a farmer is useful for both. A trader opting to buy next year’s crop so that he can unload for more at the time, just benefits the trader. Forward buying of currency for an importer or exporter is sensible enough but that is not where the profits lie. Soros made a lot of money essentially by selling short in Sterling. Currency traders do the same daily even hourly for small profits on huge sums. Derivatives are forms of gambling. To gamble my Shorter Oxford defines as “to stake money on some chance”. The gambler should have no influence on the outcome; he should take no part in the game. If he does, by bribing the jockey or nobbling the favourite, he is interfering and should not be. Thirdly there is the packaging of debt and selling the package. Debt is negative money. This is I think really just another derivative.
A few things I think could be done.
Selling short. Governments have made this illegal for a temporary period so the practice can be stopped. I am indeed surprised that it is ever legal to sell something you do not own, with the exception of acting as a designated agent. But in that case the money goes to the owner minus the agent’s fee.
Leverage. There is not much that can be done in a general way; we just have to hope institutions will stop lending large amounts to others who have too little collateral. As Keynes said – I am not sure of the amounts – “If you owe the bank £1000 you have a problem; if you owe £1 million the bank has a problem.” But the specific case of mortgages can be dealt with by regulation - on both sides. Governments can require a mortgage to be something less than the sum required to buy the property and limit repayments to a fixed percentage of the mortgagee’s salary. Of course some will still get into difficulties but not too many. Then the Building Society can be required to hold a high percentage of the money it loans as deposits by savers. That is how it once was and still is in France. There has been no sub-prime crisis in France.
Packaging of debt. I doubt that it is bad debt that has caused the present crisis. It may not even be the packaging of debt – the Credit Default Swaps - but the collapse caused in that precious stuff “confidence”. I cannot believe that even a large number of mortgage defaults in the U S could rationally cause a worldwide crisis. I am sure the U S government could buy up every risky mortgage for a fraction of what it is pumping into the economy. But those who bought packaged debt did not know and did not believe they needed to know, what the package contained, nor did those who then insured the debt. This is argues a stupidity and recklessness beyond belief- buying a pig in a poke it certainly was. It also argues a technical laxity that is scarcely more credible. Was there no computer record of what made up each package? The Economist calls for “transparency” so I assume it would be possible for the contents of package debt to be required.
Credit cards. People have been allowed - perhaps encouraged would be more accurate – to run up debt on credit cards. The interest rate is relatively high and the amount often beyond the person’s ability to manage. A simple solution would be to abolish credit cards; there are no credit cards in France only debit cards. That is unlikely. I suspect the main problem is multiple cards. I have a £18000 limit on my only credit card. I suspect I could get half a dozen other cards with £10000 or so on each. I might well be able to run up £100,000 debt if I tried. I would have thought it feasible to hold a central register of cardholders and limit each person to one card.
This is all I can come up with. It leaves currency trading, leverage and derivatives - and excessive bonuses for successful gamblers – unaffected. Those are not likely to be current problems. Indeed reform is not urgent. No bank is likely to behave recklessly for some years. The need is to get banks functioning in principle much as they were. Whether in the long run limited regulation can keep a fundamentally irrational system operating I do not know. I will try, in another piece, to work out how the current set up has come about and what a rational system might look like.
Oct 2008