Friday, 12 April 2013

"The Crisis" was caused by Preventing Recessions.

What's to blame for "the crisis"? 

By "the Crisis" most people mean, when they ask that question, the recession and financial market crash which started in the USA in 2008 and spread like wild-fire round the world's financial systems, and is still smouldering in places like Cyprus and Slovakia to this day.

Most people blame "deregulation" by which they mean shouty, shirty men shouting down phones into screens. Poor regulation did play a part, but the financial markets weren't deregulated, and often the unregulated bits performed best. Certainly much of the 'deregulation' happened post Thatcher, where the (Ed Balls-designed) FSA focused on nit-picking about how quickly banks picked up the phone, thinking this was more important than Bank capital adequacy which the Bank of England used to focus on. This blaming of Capital markets is often just fear of that which is not understood. 

Many blame "greed". It's comforting to have a deadly sin as one of the reasons for discomfort. But we're all "greedy". There's no blame in responding to incentives. Others blame "neo-liberal economics" because anything prefixed with "neo" becomes the devil's work. Of course it's Liberal economics which has brought the world's poor out of poverty in their billions over the last thirty years.

The real reason for the extent and depth of "the crisis" is the "Greenspan Put". A 'put' is a type of option which gives the right to sell at a given price, thus, for a premium, you can use them to insure an underlying asset. During the 1990's & 2000's, following the .com bust, interest rates were repeatedly cut. Every time the housing market wobbled, the markets fell, or GDP growth stalled, the interest rate was cut, aggressively.

The problem with this approach is that by 2007, when the wheel came off the economy, lowering interest rates was, to use a clich√©, pushing on string.

So why did the wheel come off the economy in 2007? The reason is that there had been 16 years of uninterrupted growth beforehand. The problem Brown, who'd apparently abolished boom and bust, faced is that recessions are when growth happens. In the run-up to the .com crash, there was an enormous explosion of investment in Internet stocks. Shares would fly out of brokerages because the company announced they were opening a website. Companies in the new .com business were being valued on multiples of 'EBITDAM' (Earnings before interest, tax, depreciation, amortisation and .... marketing...). So sales less wages then? This was pure bubble stuff. And there was a massive over-investment in nonsense websites. The .com crash which came with the millenium hangover and lasted for 3 years however did NOT result in a recession. Why? because interest rates kept being pushed down, from 7% just before the bubble burst to under 4 in 2003. 

As the mal-investment was shaken out of the lastminute.coms, and the share-bubble unwound, another was being stoked up in property and debt. One of the effects of lowering interest rates is an increase in the cost of debt securities. (you can argue about cause and effect...). Thus, it became more efficient as interest rates dropped with shares' Price to earnings ratios, to finance a company through debt rather then equity. This is called "gearing up". Meanwhile, governments responded to the booming property market by... relaxing controls on how much, and to whom banks could lend. "Getting people on the property ladder" became more important than bank capital adequacy. The laws and rules by which this was done on the two sides of the pond differed, but the effect was the same. Banks were actively encouraged to "innovatively" lend more to people backed by less, and less equity in the home, and less and less tier-one capital in the bank.

Risk compensation ruled the day: When banks were ruled by the Governor's eyebrow, and the Old Lady of Threadneedle street kept an eye on the balance sheet, banks were safer. In the days of Basel II captial regime, RBS thought it could get away with a Tier one capital ratio of 5%. Nowadays 10-15% is more normal. This was acceptable because "Value at Risk" was calculated with reference to volatility. As volatility falls, the acceptable level of capital needed fell, leaving the system ever more vulnerable to systemic shocks such as the absolutely unlikely event of .... property prices falling....

Banks, which had got used to their being bailed out by the state by means of an interst rate cut, effectively outsourced risk regulation to the regulatory authorities. Whatever the regulator said was OK was OK. The banks then got on with lending "innovatively" to people with products like 105%, self-certification mortgages. Politicians encouraged this. Homeowners are more likely to vote, and vote for the party they credit with their "investment" in housing.

So. One bubble replaced another in the property market. And property market eventually popped, taking the banks with it. This led to the bubble ending up in the last place it can: Sovereign debt which is now so expensive, it's paying a negative real yield.

Ultimately the reason for the crisis is that the USA and the UK did not have the recession which was needed in 2000. The mal-investment wasn't purged, just moved. For recessions aren't things to be avoided. They are inevitable and necessary. Like Eucalyptus needs the fire to germinate, recessions clear dying businesses and free the resources of capital and labour to new, more efficient, faster-growing businesses. The longer you prevent this process from happening, the more zombie companies you have lying around, able to service their debts, but holding onto Labour and capital which could be better used elsewhere. This has been Japan's curse for twenty years. It remains to be seen whether this round of monetary cocaine (abenomics) will work. Without a cleansing recession to clear the mal-investment out of the economy, mal-investment just builds up until it becomes an intolerable burden of companies doing things of limited use, propped up by the state and banks.

This is ultimately why planned economies fail. Mal-investment can be sustained by political will until the economy's making steel no-one needs in a gargantuan make-work scheme. This is the reason the USSR measured tractor production by ... weight.... Even in the worst free-market system, there's only so may places it can hide before the wheel comes off. The economic cycle is around 7-10 years. Even the Bible knew this. Mr Brown should have realised, as a son of Presbyterian preacher, he hadn't abolished the seven fat and seven fallow years (Genesis 41:30) but instead put off the day of reckoning. (Isiah 10:3). It certainly wasn't Margaret Thatcher's fault, however fervently lefties wish it. It wasn't only Gordon Brown's fault, however much I wish it. The crisis did start in America, but the main people to blame for the crisis, however are idiot regulators and central bankers, who followed Mr Greenspan's example.


Blue Eyes said...

Yep. But you forgot the collapse of Long Term Capital Managers (or whatever it was called), the Asian crisis, the Russian crisis and probably others which I have forgotten.

I vividly remember a headline in 1998 or 1999 when Brown announced that he would not allow Britain to go into recession for the sake of maintaining an arcane fiscal rule.

That is where the rot started. He was doing pretty well up until then.

Anonymous said...

In all honesty you really can’t write an article about the cause of the crisis without mentioning the tsunami of free money that poured in from China. They were falling over themselves to lend us money for over a decade, and by god we spent it.

Until Chinese interest rates are set by the market, we all still have a serious issue

Smoking Scot said...

"Mal-investment can be sustained by political will"

100% right. The EU being a perfect example.

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