Professional analysts scrutinised the contents of these regulatory announcements and advised their clients on their implications. They wined and dined farmers; but once the farmers were required to be careful about the information they disclosed, these lunches became less useful. Some smarter analysts realised that understanding the nutrition and health of the ox wasn’t that useful anyway. Since the ox was no longer being weighed - what mattered were the guesses of the bystanders - the key to success lay not in correctly assessing the weight of the ox but in correctly assessing what others would guess. Or what other people would guess others would guess. And so on.
Some people - such as old Farmer Buffett - claimed that the results of this process were more and more divorced from the realities of ox-rearing. But he was ignored. True, Farmer Buffett’s beasts did appear healthy and well fed, and his finances ever more prosperous; but he was a countryman who didn’t really understand how markets work.
International bodies were established to define the rules for assessing the weight of the ox. There were two competing standards - generally accepted ox-weighing principles, and international ox-weighing standards. But both agreed on one fundamental principle, which followed from the need to eliminate the role of subjective assessment by any individual. The weight of the ox was officially defined as the average of everyone’s guesses.
One difficulty was that sometimes there were few, or even no, guesses of the weight of the ox. But that problem was soon overcome. Mathematicians from the University of Chicago developed models from which it was possible to estimate what, if there had actually been many guesses as to the weight of the ox, the average of these guesses would have been. No knowledge of animal husbandry was required, only a powerful computer.
By this time, there was a large industry of professional weight-guessers, organizers of weight-guessing competitions and advisers helping people to refine their guesses. Some people suggested that it might be cheaper to repair the scales, but they were derided: why go back to relying on the judgement of a single auctioneer when you could benefit from the aggregated wisdom of so many clever people?
And then the ox died. Amid all this activity, no one had remembered to feed it.
The assets of British banks are five times the liabilities of the British government. But the assets of these banks mostly consist of claims on other banks. Their liabilities are mainly obligations to other financial institutions. Lending to firms and individuals engaged in the production of goods and services - which most people would imagine was the principal business of a bank - amounts to about 3 per cent of that total.
Modern banks - and most other financial institutions - trade in securities, and the growth of such trade is the main explanation of the growth of the finance sector. The finance sector establishes claims against assets - the operating assets and future profits of a company, or the physical property and prospective earnings of an individual - and almost any such claim can be turned into a tradable security. ‘High-frequency trading’ is undertaken by computers which are constantly offering to buy and sell securities. The interval for which these securities are held by their owner may - literally - be shorter than the blink of an eye.
If securities are claims on assets, derivative securities are claims on other securities, and their value depends on the price, and ultimately on the value, of these underlying securities. Once you have created derivative securities, you can create further layers of derivative securities whose values are dependent on the values of other derivative securities - and so on. The value of the assets underlying such derivative contracts is three times the value of all the physical assets in the world.
What is it all for? What is the purpose of this activity? And why is it so profitable? Common sense suggests that if a closed circle of people continuously exchange bits of paper with each other, the total value of these bits of paper will not change much, if at all. If some members of that closed circle make extraordinary profits, these profits can only be made at the expense of other members of the same circle. Common sense suggests that this activity leaves the value of the traded assets little changed, and cannot, taken as a whole, make money. What, exactly, is wrong with this commonsense perspective?
Not much, I will conclude.
And we have experienced a controlled experiment of sorts, in which Communist states suppressed finance. The development of financial institutions in Russia and China was arrested by their revolutions of 1917 and 1949. Czechoslovakia and East Germany had developed more sophisticated financial systems before the Second World War, but Communist governments closed markets in credit and securities in favour of the centrally planned allocation of funds to enterprises. The ineffectiveness and inefficiency of this process contributed directly to the dismal economic performance of these states.
A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.
And so it is with finance. The finance sector today plays a major role in politics: it is the most powerful industrial lobby and a major provider of campaign finance. News bulletins report daily on what is happening in ‘the markets’ - by which they mean securities markets. Business policy is dominated by finance: the promotion of ‘shareholder value’ has been a mantra for two decades. Economic policy is conducted with a view to what ‘the markets’ think, and households are increasingly forced to rely on ‘the markets’ for their retirement security. Finance is the career of choice for a high proportion of the top graduates of the top schools and universities.
Finance can contribute to society and the economy in four principal ways. First, the payments system is the means by which we receive wages and salaries, and buy the goods and services we need; the same payments system enables business to contribute to these purposes. Second, finance matches lenders with borrowers, helping to direct savings to their most effective uses. Third, finance enables us to manage our personal finances across our lifetimes and between generations. Fourth, finance helps both individuals and businesses to manage the risks inevitably associated with everyday life and economic activity.
Or perhaps the relevant question is ‘Why does it appear so profitable?” The common sense that suggests that the activity of exchanging bits of paper cannot make profits for everyone may be a clue that much of this profit is illusory: much of the growth of the finance sector represents not the creation of new wealth but the sector’s appropriation of wealth created elsewhere in the economy, mostly for the benefit of some of the people who work in the financial sector.
The objective of reforming the finance industry should be to restore priority and respect for financial services that meet the needs of the real economy. There is something pejorative about the phrase ‘the real’ - meaning the non-financial - economy, and yet it captures a genuine insight: there is something unreal about the way in which finance has evolved, dematerialised and detached itself from ordinary business and everyday life.
When my friends were joining the Bank or the Royal Bank, and I was beginning the study of economics, it was possible to believe that the historic problems of financial instability had largely been solved. There had been no major financial crisis since the Great Depression, and the failure of a major financial institution seemed inconceivable.
The oil shock of 1973-4 gave oil-producing countries, particularly Saudi Arabia and other states in the Persian Gulf, windfalls beyond their capacity to spend. ‘Petrodollars’ were recycled as loans to Europe and the USA. Meanwhile Japan, followed by other Asian countries such as South Korea, Taiwan and Hong Kong, first imitated and then improved modern production methods, and began to export manufactured goods to Europe and North America. After 1980 mainland China followed these countries into the world trading system. Asian export success created trade surpluses, with corresponding trade deficits in the West. As the oil producers had done a decade earlier, the surplus countries lent the funds back to those economies with trade deficits.
Yet these cleverer people managed things less well - much less well - than their less intellectually distinguished predecessors. Although clever, they were rarely as clever as they thought, or sufficiently clever to handle the complexity of the environment they had created. Perhaps the ability to meet clients at the nineteenth hole is more relevant to making good investments than the ability to solve very difficult mathematical problems.
We aren’t dinosaurs. We are smarter and more vicious than that, and we are going to survive.
Fifty years ago there was one large speculative financial market: the stock exchange. The volume of trading in it was, by modern standards, modest: the average holding period for a share was seven years. The stock exchange was also the place where government bonds were traded, but the bond market was sleepy in the extreme.
The list of factors contributing to the change is long, and has one striking feature: the change in the nature of finance had little to do with any change in the needs of the real economy. Those needs remain much the same: we need financial institutions to process our payments, to extend credit, to provide capital for business. We want financial institutions to manage our savings and help with the risks we face in our economic lives. Some aspects of these services are better; many are not.
As derivative markets grew, people used them to back their judgement on more or less anything - not just foreign exchange, or interest rates, but the possibility that a business might fail, a mortgage would default or a hurricane would strike the East Coast of the USA.
Rating agencies - businesses such as Moody’s and Standard & Poor’s (S & P) - had diversified from their original business of commercial credit assessment into assessment of the credit quality of bonds. In the 1970s two changes occurred that gave rating agencies a central place in the financialisation process. The agencies began to charge issuers of securities for their services as well as - or, increasingly, instead of - investors; and they achieved regulatory recognition as ‘Nationally Recognised Statistical Rating Organisations’. Many financial institutions and regulatory bodies restricted investments to securities that met standards laid down by a rating agency. Ratings determined the regulatory risk-weighting of securities. The banks that created asset-backed securities paid the rating agencies - which appreciated that there was a competitive business in supplying such accreditation - and banks ‘reverse-engineered’ their products to fit the agencies’ models. Many investors and traders did not care much what was in the package so long as it achieved the required credit rating.
The Thatcherite emphasis on hard work and self-reliance sat alongside a belief that compassion should be a private virtue rather than a social practice. These were attitudes very different from the greedy individualism and sense of personal entitlement characteristic of much of the finance sector today.
In both Britain and the USA different functions within the financial system were provided by different institutions. Commercial banks operated the payments system and met the short-term lending needs of their customers. Investment banks (then called ‘merchant banks’ in the UK) handled larger transactions involving the issue of securities. If the buyer wanted to sell these securities, he or she would contact a stockbroker, who would negotiate the trade with a specialist (also called a jobber or market-maker). While banks undertook some mortgage lending, most such loans were made by specialist non-profit businesses - thrifts in the USA, building societies in the UK.
Some thoughtful commentators believed that the financial institutions of the future would be narrow specialists.!3 And indeed most functions of banks are now also performed by specialist institutions, such as credit card companies and mortgage banks. Supermarkets diversified into simple financial services, such as deposit accounts. Private equity houses (venture capital firms) specialise in the provision of finance for business. Specialist hedge funds - tightly run speculative trading ventures such as those of George Soros and Jim Simons - attracted funds in the years after 2000.
But, apparently paradoxically, the trend to specialisation was accompanied by a trend to diversification.
Partnerships and owner-managed businesses differed from public companies with dispersed shareholding in significant ways. Ownership and control of the business were combined in the hands of senior employees. The risks of the business - upside and downside - were absorbed by a few individuals, whose personal finances were ultimately on the line. Partners would monitor each other closely, and limit the risks the business incurred. They preferred activities that they understood well, and would review carefully the extent to which the business held speculative positions on its own account. The capital of the business was more or less limited to its accumulated profits and the resources of its partners.
Sceptics had always feared that limited liability companies would be vulnerable to negligent management, speculation and excessive risk-taking. That concern was the essence of Adam Smith’s warning of the problems associated with the management of other people’s money, and was why limitation of liability was tightly restricted until the second half of the nineteenth century.
But their acquisitions were almost all failures. The more senior figures in the firms that had been purchased, enriched by the transactions, retired: the more junior, deprived of the chance of the rich pickings of partnership and ill at ease in the new environment, left.
While the USA was the dominant economic power, Germany’s recovery would earn the description of ‘economic miracle’, and in Japan a pace of economic growth never previously experienced anywhere would turn the country into a major industrial power. France enjoyed the ‘trente glorieuses’; Britain had ‘never had it so good’.
Since many oil-producing countries could not easily spend their new revenues, and many oil-consuming countries did not wish to reduce what they spent, banks established a seemingly profitable business lending the petrodollars earned by oil exporters back to the governments of oil importers. Countries can’t go broke, Citicorp chief executive, Walter Wriston famously proclaimed. Technically he was correct: but the consequence - the absence of any orderly judicial or administrative process for handling debt default by nation-states - has proved to be an enduring problem rather than a source of stability for the banking system or for global finance.
Several Latin American states defaulted in the early 1980s, when interest rates on US dollars - in which they had borrowed - rose sharply. The resolution of the crisis set a clear precedent for the future: the US government and the IMF would intervene as needed to protect the balance sheets of large American banks. The scale of the losses banks had incurred was disguised by a combination of central bank support and accounting devices. Bankers, regulators and governments held the hope - often justified - that the banks concerned would be able to trade their way back to solvent and even well-capitalised positions. Lloyds and Citicorp did just that. These zombie banks, neither dead nor alive, came back to life. But the zombie bank, insolvent but still trading, would be a recurrent motif in the aftermath of the recurrent financial crises.
The frightening truth is that with short term trading conducted by computers using algorithms, no person fully understands what is happening. Although no particularly serious consequences followed on that occasion, the vision of technology out of control was a disturbing portent of the future.
At the peak of the boom it was claimed that the grounds of the emperor’s palace were worth more than the state of California. Whether this had been true or not, it would not remain so: the bubble burst. Japanese and foreign investors incurred large losses: the principal Japanese stock market indexes are even today less than half the level they reached at the peak. Japanese banks, which had expanded massively on the security of inflated asset values, were effectively but not formally bankrupted. These zombie banks would haunt the Japanese economy for two decades.
So emerging markets became an investment theme. But financial markets can always have too much of a good thing. Enthusiasm to place funds in emerging markets - especially in Asia - left the countries concerned with unsupportable foreign debt levels and overvalued domestic assets. In 1997 the Thai exchange rate collapsed as foreign investors rushed to salvage their positions while some value remained. Contagion spread through Asia. The following year Russia defaulted on its debts.
The Eurozone - an ambitious scheme to link the currencies of France with Germany and the countries closely bound into the German economy - had grown into a political project that included Spain, Italy, Portugal and even Greece.
The booms are generally triggered by events external to the financial system. The busts may also appear to have extraneous causes: Russian default, a setback to US house prices, the collapse of Lehman. But these are triggers rather than explanations. The mechanisms of crisis are an intrinsic part of the modern financial system. It is not just that the modern financial system is prone to instability. Without the mechanics that produce recurrent crises the financial system would not exist in the form it does today.
The urge to consolidate - a polite term for the attempt to create monopolies - is always strong in the business community, and had not died with the introduction of anti-trust policies in the USA. A new wave of mergers in the 1920s established companies such as General Motors and ICI. In the 1960s domestic consolidation was widely seen, for no obvious reason, as an appropriate response to growing international competition. The conceit that great managers and their teams had skills relevant to almost any business led to a fad for conglomerates: companies such as ITT and Litton Industries in the USA and Hanson and BTR in the UK were market favourites, able to use their overvalued shares to make cheap acquisitions.
The experience of the newer ICI was not such a happy one. The stock market reacted favourably to the announcement of its changed objectives, but less favourably to the subsequent reality. ICI’s share price peaked in early 1997, and the decline thereafter was relentless. In 2007 what remained of the once great business was acquired by a Dutch company. The company whose objective was solely ‘to maximise value for shareholders’ was not successful even in achieving that. Bear Stearns, which famously proclaimed ‘we make nothing but money’, was an early casualty of the global financial crisis. The paradox that the most profit-oriented companies are not necessarily the most profitable is the subject of my book Obliquity.
In an illuminating comment on the financialisation of business, Jack Welch - now long retired from General Electric - would in 2009 proclaim shareholder value ‘the dumbest idea in the world’.
But the linkage between executive pay and performance provided by share options was weak. Based on market expectations rather than business realities, rewards linked to share prices were on the product of fickle opinion and, like the bonuses of traders, asymmetric. The option allowed beneficiaries to participate in the upside but did not require them to share in the downside, a structure that encouraged the risky transformational change that proved so destructive of ICI, GEC and Citibank: the link to share prices - Weill’s ‘nearby computer monitor displaying Citigroup’s changing share price’ - created an intensely short-term focus. What useful business information could a chief executive glean from minute-by-minute fluctuations in the value of the company he ran?
Managers were spending other people’s money, with the profusion and negligence that Adam Smith had anticipated.
Globalisation has had dramatic effects on world income inequality: economic growth in China and India has lifted more people out of poverty in the last two decades than in any previous era of world history. But globalisation has tended to increase income inequality within already rich countries. While it enabled people with unique or distinctive skills - whether musical or sporting celebrities or consulting engineers - to deploy these skills in a wider market, it also intensified competition for unskilled labour as low-tech manufacturing was able to relocate to low-wage countries.
Fuelled by securitisation, credit card debt and other consumer lending increased rapidly. Home-owners were able to obtain ‘equity release’ (i.e., to borrow against the increased value of their property), while mortgages were extended to people who had never previously been eligible for housing finance. This credit expansion allowed consumption to continue growing even if incomes did not.
Credit expansion could not continue indefinitely: it would inevitably go into reverse when the low quality of much of the induced lending was revealed. And that was what happened in the global financial crisis. The social tensions that had been suppressed when consumption was growing faster than incomes were no longer contained. Public opinion turned against banking and finance, reflected in the Occupy movement and the surge in popularity of fringe political movements.
Risk had been anathema to that older generation of bankers; if a loan was perceived to be risky, it was not made. Of course, these traditional bankers sometimes made mistakes, and their borrowers failed to repay; but there was no such thing as a calculated risk, and no accounting provision for expected losses, because none were expected. In the era of financialization, bankers embraced risk. Risk was a source of return, and could be calculated and managed. Perhaps.
The key insight of Adam Smith’s Wealth of Nations is misleadingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it.
In the 1970s David Henderson, an economist with extensive experience in government, had delivered a series of lectures for the BBC on ‘the unimportance of being right’. In it he said: ‘one thing that you might think would count, but which in fact is given no attention whatever (in securing promotion to positions of influence), is whether your advice has been any good’. Henderson went on to observe that ‘if this is possibly true of the British public service, it is, I think, more obviously true of the economics profession, both in this country and elsewhere’ and quoted another commentator, Samuel Brittan: ‘it is much more important for a paper to be competent than for it to be right or enlightening’’ If there has been any change since Henderson wrote, in either government or the academy, it has been for the worse.
The commitment of leaders of the financial community to the values of the free market was a pragmatic alliance of convenience, not the product of deep intellectual conviction. If that had been in doubt, the global financial crisis dispelled it. The titans of finance were able to persuade themselves and others that arguments for letting the market take its course might be compelling as matters of general principle; but these arguments did not apply in the case of systemically important financial institutions, such as Citigroup and Goldman Sachs, and, in particular, did not apply to the businesses of which they had the good fortune to be senior executives. Finance is special. Once these exceptions to the general rule were recognised, however, the flow of free-market rhetoric from the financial community could continue unabated, and it did.
The notion that the market-place was a venue in which unscrupulous merchants robbed unwitting customers, and foreign trade a means of extracting wealth from foreigners, dominated economic thought from the days of Aristotle until the mid-eighteenth century. We might honour the seventeenth-century French economist and politician Jean-Baptiste Colbert as the champion of this doctrine, since many of his compatriots - along with Ruskin, whose grasp of economics was never strong, and more recent critics of commercial activity - adhere to it still.
Yet a central insight of modern economics - one that Friedman attributed, not unfairly, to Adam Smith - is that exchange can benefit both parties, if they have different preferences or different specialisms. Perhaps I have a dairy herd and you have a coffee plantation, and we both like milky coffee. Or perhaps we both practise mixed agriculture, but you drink only coffee and I drink only milk. In either case, trade will make us both better off.
Modern financial economics treats risk as a commodity like milk or coffee. People have different preferences and capabilities in their approach to risk and their ability to manage it, just as they have different tastes in food, or farm different kinds of land, or hold different agricultural skills. Trade between them benefits both parties. In this way markets in risk enable the inescapable risks of modern life to be handled more efficiently.
If this analogy between risk and other commodities were valid, the standard tools of economics could be applied to the trading of risk. This approach has been the basis of financial economics for half a century. The metaphor has many attractions for those who work in financial markets, implying that the claims of market efficiency that are made for trade in milk and coffee are equally applicable to trade in foreign currency and credit default swaps. The larger the volume of trade, the wider the scope of markets, the greater the benefits from free exchange in securities markets.
The trade in risk that had occurred was between people who had some understanding of what they were doing - and of the nature of the risk - and people who did not. It was the world of Colbert and Ruskin, not that of Friedman and Greenspan. Far from spreading risk and placing it in the hands of people well placed to manage it, the LMX spiral concentrated it in the hands of people who had no capacity to manage it at all.
He described the securities - called Abacus - to a girlfriend:
I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself ‘Well, what if we created a “thing”, which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?’).
There is a paradox here. ‘Ketchup economists’, like others in the financial sector, emphasise the essentially unique characteristics of the field they study. But their analysis of risk aligns markets for risk with markets for other commodities. By doing this, they fail to acknowledge the fundamental difference that does exist between financial markets and markets for other commodities. Markets for securities are, in large part, based on differences in information, or perceptions of information, between the two parties to the transaction, rather than on differences in preferences and capabilities. This observation helps to explain both why finance can be, or can appear to be, inordinately profitable, and why that profitability need bear no relation to the value added from financial activities.
Even games of pure chance are more popular if you create an impression that the player can influence the outcome by choosing the numbers, placing the card or pulling the lever of the one-armed bandit. Flying in a commercial aircraft is much safer than driving one’s own car: but we do not see it this way. We feel less vulnerable to risk if we have some element of control.
As with games involving mixtures of skill and chance, such as poker, there are a few people with genuinely outstanding abilities who profit at the expense of the general run of players, and many more who persuade themselves, and perhaps others, that recent runs of good fortune are the result of their exceptional skill.
Much of this literature, in a patronising tone, describes such behaviour as irrational.? But there is nothing irrational, in any ordinary sense of the word, about dreams, optimism or liking for control: few of us would make it through life if we did not imagine the future, take an optimistic view and try to take control of our fate. The lottery takes advantage of these behavioural characteristics for both public benefit and private profit. People who buy lottery tickets enjoy the thought that they might win. They mostly do not, except in a trivial sense, regret their purchase even when they lose. They are not making a mistake in chasing the dream.
In a considerable feat of persuasive marketing, economists have claimed ownership of the term ‘rationality’. Rationality is defined as conforming to the axioms of economic models - and in the context of uncertainty such ‘rationality’ has a particularly strict - and complex - interpretation. ‘Rational’ people judge uncertain situations by attaching probabilities to the various outcomes, and they revise these probabilities in the light of the new information they constantly receive. They don’t ‘chase the dream’, because they weigh outcomes by the likelihood they will actually occur. Rational people are able to assess all possible outcomes and attach probabilities to them. Rational people are free of bias towards optimism or control illusion. If they hold ‘rational expectations’, the outcomes of their risky choices will be validated by the relative frequency of events.
Five years later, he was ready to recognise that the issue was more fundamental. In an interview with the Financial Times, he acknowledged that he had lost faith in ‘the presumption of neoclassical economics that people act in rational self-interest … the whole structure of risk evaluation - what they call the “Harry Markowitz approach” - failed’.
Greenspan may have moved on, but most financial economists have not.