OUR GLOBAL FINANCIAL CRISIS OCCURRED BECAUSE “NO-ONE TOOK AWAY THE PUNCHBOWL“.

Fifty years ago, William McChesney Martin Jr. told us that the function of a central bank was “to take away the punchbowl just when the party is getting good”. Martin was the ninth (and, to this day, longest-serving) chairman of America’s central bank, the Federal Reserve System, being in office from 1951 to 1970 under no fewer than five presidents, starting with Harry S. Truman and Dwight D. Eisenhower.

In making this declaration of purpose, Martin was drawing attention to the existence of economic cycles. A cycle begins when the economy emerges from recession and culminates in a puff of inflationary smoke, just as the party is “getting good”. Martin wanted the central bank to leap into action towards the end of this period by raising interest rates, with the object of inducing a short, sharp recession to kill off the incipient inflation. Since electorates in general tend to punish any party-in-power which creates a recession, this approach brought him into conflict with his presidents. A future president, Richard Nixon, would blame Martin for causing him to lose to J.F Kennedy in the elections of 1960.

Martin had one great successor as Chairman of the Fed: Paul Volcker, who served from 1979 to 1987 — almost as long as Martin — and is credited with ending the great stagflation of the 1970s. (Stagflation, the most intractable form of inflation, occurs when prices rise at a time of economic decline or stagnation.) In the great Martin tradition, Volcker achieved his object by hiking the Federal Funds rate (the rate at which the System lends money to commercial banks, which determines the price of the funds they lend to their customers) from an average of 11.2% in 1979 to a peak of 20% in 1981. As a consequence, inflation fell from 13.5% in 1981 to 3.2% in 1983 and healthy economic growth could resume.

What is the relevance of all this for our current Global Financial Crisis (2007- )? The answer is that we are where we are today because, in the 1990s, Volcker’s successor, Alan Greenspan, reversed the course set by his two great predecessors. By that time, Greenspan was well aware that ‘the party was getting good’. He even talked about it, although he did not use the same expression, so far as I am aware; instead, he referred to the eruption of “irrational exuberance” in the marketplace. However, he did not attempt to take away the punch bowl; instead, he threw even more stimulants into it by lowering interest rates. The “party” swung wildly out of control, creating the biggest financial bubble in the history of the world.

Why did Greenspan not behave in the manner prescribed by Martin and Volcker, when they had encountered the same kinds of problem? Presumably because he recalled how the public had reacted to the Volcker measures. These had elicited the most widespread protests in the history of the Fed, owing to the effects of high interest rates on the construction and farming sectors, culminating in the blockading of the Fed’s headquarters in Washington by heavily indebted tractor-drivers. Greenspan has offered us a somewhat lame justification for his approach, arguing that it is easier to clear up the mess resulting from the bursting of a financial bubble, than it is to pursue policies which cause it to burst. As a proposition, this is demonstrably untrue and, in any case, it misses the point; Martin’s aim had been to prick bubbles before they became dangerous; Greenspan had been chairman of the Fed during the entire period when his was forming.

In 2005, when Volcker was asked about the state of the US economy under his successor’s rule, he replied that “circumstances seem to be as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there should be so little willingness or capacity to do much about it”. When Greenspan’s bubble finally burst in 2008, as we all know, millions were thrown out of work throughout the world. Since 2009, the economic policy of the Obama administration has consisted of throwing yet more stimulants of an ever more problematic nature into the metaphorical punchbowl of national economic policy, hoping that, somehow, the recession will go away — or, if this is not possible, that it will not turn into an outright Depression in the manner of the 1930s. This approach is known in the lingo of Washington as “kicking the can down the road”, something that all of us tend to do when we are not sure what to do; we postpone the day of wrath.

America needs a second William McChesney Martin Jr. to reform the Fed and transform the American banking system. Should he be an economist by profession? Not necessarily; Martin majored in Latin and English at college. Economists focus too much on theory, although there are exceptions like Volcker. We need common sense plus a lot of practical experience. (This post also appears in today’s Weekly Zaman, a Turkish newspaper.)

William Hopper

WHAT SHOULD THE BRITISH AND THE AMERICANS DO ABOUT THEIR “UNIVERSAL BANKS”?

Last week I discussed the problems arising in the Anglosphere from the existence of what are sometimes called “universal banks” — that is to say, financial institutions which conduct both commercial and investment banking under one metaphorical roof. Commercial banking can be compared with the services offered by gas or electric utilities; it performs simple, boring but essential activities like taking deposits of cash, effecting payments and making short-term loans. By way of contrast, investment banking is a much more complex affair which can encompass a multitude of activities, ranging from raising long-term capital for manufacturing companies and managing investments on behalf of private citizens to making markets in shares and speculating in commodities. I am, by the way, an investment banker by trade, being a former director of a leading London merchant bank called Morgan Grenfell and still active in that area to a modest extent.

For half a century after World War II, these two kinds of activity were kept firmly apart in both London and New York – by a law called the Glass-Steagall Act in the US and by the custom of the market in the UK. Glass-Steagall had been enacted in 1933 for a very simple reason: universal banking had been tried and had failed after World War I, being one of the underlying causes of the Great Depression of the 1930s, whence its abolition. Regrettably, Glass-Steagall would be, effectively, repealed in the 1990s; a similar event, popularly known as ‘Big Bang’, took place in the UK in 1986. As a result, universal banking returned to New York and arrived in London at more or less the same time. It constitutes one of the underlying causes of our current Global Financial Crisis (2007 – ).

Needless to say, the universal banks would like to continue behaving exactly as they do at present. This is because they make a vast deal of money by sitting on every side of a transaction. They could lend money to Company A; manage its pension fund; speculate in its shares – and, simultaneously, organise a bid for it from Company B using “inside knowledge”. They also benefit from what is known as asymmetry of information. In the kind of market of which the philosopher, Adam Smith, approved two hundred and fifty years ago, information was shared more or less in equal measure between buyer and seller, lender and borrower – very far from the situation today. If you want to know more about this one-sided activity, you should see an excellent feature film called Inside Job, brilliantly narrated by the actor, Matt Damon.

Everyone, other than the bankers involved, agrees that “something has to be done about it!” The unresolved question is: what? In my opinion, the simplest and the best solution will undoubtedly be to restore the status quo by: (a) resurrecting Glass-Steagall in the US; and (b) passing a similar law in the UK. If this was done, the conflicts of interest entrenched in our current system would vanish overnight; in addition, investment bankers would no longer be able borrow on the credit of taxpayers and misuse the money, as described in last week’s article.

Opponents of this view argue that full legal separation would drive bankers away from London and New York. First, we lost manufacturing, they say — and now we would lose financial services as well. This argument is superficial and, indeed, spurious. On the one hand, if you moved an automobile factory from the UK to Taiwan, there would undoubtedly be a serious loss of value to the British people on several different levels. On the other, if you moved the legal residence or even the head office of Barclays Bank to Hong Kong (by way of example), Barclays would continue to function as a leading British bank, regulated under British law and paying British taxes. (I am much more concerned about the small amount of tax that Barclays pays today to the British government, in spite of the fact that its legal residence and head office are in the UK.)

The defenders of universal banking have proposed a different kind of solution which they call “ring-fencing the retail bank” – retail bank being a synonym for commercial banking. The rationale for this approach was provided in a recent talk by Sir John Vickers, chair of Britain’s government-sponsored Independent Banking Commission, which will make proposals for the future of the entire system in September of this year. Ring-fencing means that commercial and investment banking would continue to be conducted in one and the same company, but the former activity would be subject to higher capital requirements than the latter.

There are two serious objections to this approach. First of all, why should commercial banking, which is inherently safe and which will inevitably benefit from a government guarantee (formal or informal), be subjected to higher capital requirements than investment banking, which involves much greater risks? This approach could only add to the cost of lending and would, therefore, unnecessarily, depress economic activity. Second and even more important, the proposed solution misses the point. The primary objection to universal banking has nothing to do with capital ratios; it concerns the misuse of information and a consequent abuse of power. For true “ring-fencing” to work, you would have to create barriers to the flow of information between the commercial and investment bankers, and that cannot be achieved within our existing universal banks, since by law their senior executives and directors must possess total knowledge about everything that happens in all departments.

Long live Glass-Steagall!

Will Hopper

(This article appeared in Weekly Zaman dated March 19, 2011. Zaman is Turkey’s largest selling daily newspaper.)

HOW TO BECOME “THE MAN WHO BROKE THE BANK AT MONTE CARLO” IN FIVE MINUTES FLAT

The last weekly edition of Zaman featured a lengthy article headed, “‘King’s Speech’ Crowned Big Winner at Oscars”, celebrating the fact that a feature film of that name had won no fewer than four Academy Awards. Having read this piece, I rushed out to see the film at the Everyman Theatre in Hampstead in London, where I live. I am happy to tell you that I thoroughly enjoyed the experience and even wept quietly at appropriate moments – something which is now OK for real men.

Since then another, even more significant, “King’s Speech”, has sprung onto our computer screens. I refer to a talk given by Mervyn King, Governor of the Bank of England, in which he discusses imbalances in the world economy. The essence of his case is that our banks, as at present constituted, cannot be allowed to go bankrupt, since they play such a key role in the national economy. If an engineering company fails, its employees, suppliers and customers suffer; if a bank fails, the entire community suffers. As a consequence, the liabilities of our banking institutions have to be, effectively, underwritten by the state. This guarantee can be formal or informal, depending on circumstances; an informal guarantee may be even more comprehensive than a formal one, in part because it is less well-defined.

The good side of this bargain is, of course, that ordinary citizens can bank their money with an absolute assurance that they will get it back, as and when deposits mature. Big Government, representing millions of taxpayers, guarantees it. The bad side is that this privilege stimulates gambling on the part of these same institutions, using the cheap, abundant money made available to them in the marketplace. Since governments in the developed world can today borrow at negative real rates of interest, so can the banks they guarantee.

King argues that we must now reform the structure of banking, so that no bank is ever again “too important to fail” and none will, therefore, be in need of a guarantee. In support of his view, he has described the current setup as “casino banking”, an expression which is accurate as far as it goes but requires some qualification. There is nothing inherently wrong with gambling as such, providing it is honestly conducted. However, the metaphorical casino which constitutes today’s banking market is far from being honestly conducted. Instead, the odds are firmly fixed in advance in favour of the gambler, since profits are privatized and losses nationalized. In other words, if banks generate a profit using their ample supply of cheap money, they can keep it; if, on the other hand, they generate a serious net loss, they can pass it on to the taxpayer. If I was allowed to sit down at a roulette table in a real casino and play on those terms, I would become “the man who broke the bank at Monte Carlo” within five short minutes.

Our casino bankers enjoy two other extraordinary privileges. First, because so many kinds of activities – commercial and investment banking, investment management, dealing in money, forex, futures and commodities, and so one — are now undertaken under one roof, each bank on its own is shot through with scores of conflicts of interest, worsened by an extreme “asymmetry of information” between them and the rest of the world. Secondly, all of the underwriting banks taken together constitute a semi-cartel of a kind that would not be tolerated in any other sector of the economy.

There is nothing new about this semi-cartel. For decades the members of the so-called “Bulge Bracket” in New York and London have competed fairly vigorously with each other for the role of leader in underwriting syndicates – and then co-operated happily and profitably in executing those same deals. I know: as a senior director of the leading merchant bank, Morgan Grenfell, in the 1970s, I did exactly that. Fees were fixed by custom rather than by secret agreements, but they changed little from deal to deal and from year to ear. The situation deteriorated in 2007 and 2008 when the Bulge Bracket shrank owing to mergers arising out of the Global Financial Crisis.

To sum up, the current banking market constitutes a capitalist’s dream. He can borrow almost any amount of money at a negative real interest rate; having done so, he can invest it in the expectation of earning a high positive return, owing to the operation of the bankers’ semi-cartel and to the exploitation of many different kinds of conflicts of interest; and if, through foolishness or incompetence, he makes a net loss, he can charge it all to somebody else. Wow!

What is to be done about it? Three solutions should be pursued in parallel. First, commercial banking should be legally segregated from: (a) investment banking; and (b) some at least of the other activities listed above. Second, underwriting banks should be instructed to dissolve their semi-cartel; if they fail to do so, the matter should be referred to the competition authorities in the US, the UK, Singapore, Hong Kong and certain other jurisdictions. Thirdly, shareholders (who include governments and possess the ultimate power) should make a serious attempt to introduce a healthier managerial culture to all of our banks, in some cases by replacing senior executives with competent young men and women drawn from the middle ranks of management. The distinguishing mark of many of our leading banks in recent years has been incompetence.

I will discuss these solutions at greater length in future columns.

(this article was published in Weekly Zaman of 12-03-11)

Will Hopper
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WESTERN CAPITALISM CAN LEARN FROM ISLAM HOW TO BORROW JUDICIOUSLY

Dear Fellow Puritans:

When I picked up my Financial Times at 7.00 o’clock one morning last week in McDonalds in Hampstead, London (the place where I habitually eat breakfast), I was amazed and shocked to read: “Northern Rock to offer 90% mortgages”. Far too much, I thought.

Northern Rock is a bank which started life in the Victorian era as a “building society” with the specific object of making secured loans to ordinary families living in the North East of England, enabling them to own the houses in which they lived. For a century and a half, the Rock (as it was known) performed this boring but useful task in an exemplary fashion.

In the 1990s, however, it passed under the control of a new breed of managers, sometimes referred to ironically as “financial engineers”. They believed that the sole purpose of any business activity was to earn a profit for shareholders; and that, for this to happen, large salaries and bonuses had to be paid to executives like them. Under its new regime, the Rock did not abandon mortgage lending as such, but it did change course in two highly significant ways.

First, it began to lend a much larger proportion of the purchase price of a house than had been permissible before — in some cases, well over 100%! For example, it might lend £115,000 against the purchase of a house with a market value of only £100,000. House prices had been rising year-on-year for a generation or more at that time and the general expectation was that they would continue to do so indefinitely. If this view was correct, it followed that the Rock was likely to be “bailed out” by market forces. In behaving in this way, its managers were speculating wildly on the assets side of their balance sheet. Previously it had been considered imprudent to lend more than 70% of the market value of a house to its owners and many people received less. (In my opinion, 70% should still be the rule today.)

Secondly, having decided to lend speculatively, the Rock’s new owners also decided to fund themselves in like manner. They did this by tapping into the so-called “interbank” market – the medium through which banks lend to one another – overlooking the fact that money of this kind was highly volatile and could, therefore, disappear at any time. Traditionally — and like other building societies – the Rock had attracted its deposits from those very same people who later would become its customers for loans. Thus when a young man and woman got married, or planned to get married, they would save for several years towards the cost of a future home by depositing their surplus earnings with the society. When that deposit reached a certain critical level (normally 30% of the value of a new house), the Rock would grant them a loan for the balance of the purchase price.
Building societies were a reflection of that great Victorian virtue known as “Self-help”, a phrase that would be adopted by the Scottish author, Samuel Smiles, as the name of his most famous book. There was nothing selfish about “Self-help”. In his third edition (1867), Smiles told us that “the duty of helping one’s self in the highest sense involves the helping of one’s neighbours”.

This double conjuring trick by the Rock worked brilliantly for some years. House prices soared, interest costs fell, profits rose — and huge bonuses could be paid to executives. That is to say, until one day in September 2007, when the bubble burst. Property collapsed in value (it has not since recovered outside London) and the interbank money market closed down. The Rock would have gone bankrupt if it had not been nationalised by the British government. This event marked the formal beginning of the Global Financial Crisis (2007 — ).

What has all this to do with Islam? A great deal from a philosophical point of view. If one goes back to the origins of the three great Abrahamic faiths, Judaism, Christianity and Islam, one finds a common thread in a distrust of debt as a method of self-financing. In the Psalms of David, number 37, we learn that “The wicked borroweth and payeth not again”. In Ecclesiasticus 18.33, we are told that we should not impoverish ourselves by “banqueting on borrowing”. The puritan movement continued this tradition in both Britain and America; in 1739, Benjamin Franklin, one of the Founding Fathers of the United States, would tell us in a graphic phrase, reminiscent of Ecclesiasticus, that he would “rather go to bed supperless than run in[to] debt for a breakfast.” He also compared a debtor with “an empty bag [that] cannot stand upright”, a phrase that would be borrowed by Smiles in “Self-help” – and later, interestingly, by the founder of the Japanese company, Toyota. Sadly, Britain, America and much of the western world abandoned this prudent approach in the last third twentieth century, as witness Northern Rock and many other financial institutions.

Happily, Islam stood aloof. I am by no means an authority on the Koran but I understand that, from an Islamic point of view, borrowing is not actually forbidden but is regarded as an activity to be undertaken only for a serious purpose and with a sense of responsibility towards all parties to a transaction. In other words, just as there is good capitalism and bad capitalism, so there is good borrowing and bad borrowing. Judaism and Christianity have both walked away from this founding principle. Islam has kept the faith; it follows that Western capitalism has much to learn from it. (Note: this article was published in the weekly English-language edition of the Turkish newspaper Zaman dated Saturday, March 5, 2011.)