The early days of the financial crisis saw a raft of soul-searching, with blame almost unanimously apportioned to neoliberalism and the failure of regulatory oversight.
I have an alternative hypothesis. What if re-regulation isn’t the answer, and government spending, the socialisation of risk and information asymmetries fostered by protectionism were, in fact, the cause?
What if the GFC was borne of too little capitalism – not too much?
Let’s embark on a quick refresher:
- US drops interest rates to 1% in 2003 following the dotcom bust and September 11 attacks
- The subprime market (for people with poor credit) booms, accounting for nearly 20% of all US mortgages
- Rates steadily increase to 5.25%, triggering a rise in subprime foreclosures and the bursting of the US housing bubble in 2006
- Collateralised debt obligations – financial instruments designed to allow investment in the subprime market – collapse in value
- Lehman Brothers folds under the weight of CDO exposure in 2008; banking confidence evaporates and lending decreases
- Businesses’ ability to hire and embark on capital projects is constrained through diminished access to credit; unemployment rises
- Wealth is savaged across the board as shares tumble worldwide on pessimistic business outlook
- Governments inject unprecedented levels of stimulus to prop up demand, jobs and insolvent banks
- Panic re-emerges in 2011-2012 as some European countries lose the ability to service their debt
Collateralised debt obligations, part of the derivative family lovingly referred to by Warren Buffett as “financial weapons of mass destruction,” are opaque and highly complex financial instruments that sat on investors’ balance sheets (or more likely, off them) like time bombs, waiting for an asset collapse and their real value to be snuffed out.
There’s nothing wrong with opacity or complexity. But parties to transactions require honest appraisals of investment quality to make informed purchasing decisions. It’s not rocket science; capitalism creaks in the face of information asymmetries.
Enter Standard & Poor’s, Moody’s and Fitch, who gave triple-A ratings to products that were anything but. The Securities and Exchange Commission in the US anointed this clique the moniker of Nationally Recognized Statistical Rating Organizations, and over time American laws required NRSRO-rated securities to be held by money market funds and insurers.
In theory a new entrant could apply for NRSRO status but the criteria made it all but impossible. The big three were a protected species, operating in an environment of compromised motives — on one hand trusted by investors to provide objective and accurate appraisals, and on the other, paid to rate securities by the very organisations that issued them.
So we come to a fork in the road. We may agree with the problem, but how do we solve it? More regulation or less?
The political instinct is to regulate. See an errant company, rein it in with new laws. But what if, instead, we went the other way? Lowering government barriers to entry in the credit rating industry, as an example, would allow new entrants to inject fresh information into the market and compete on a platform of honesty. What we know about protected industries is that innovation tends to stagnate, oligopolistic behaviour emerges and the incentive to be transparent decreases.
Knowingly or unknowingly, investment houses ploughed into these hollow securities with gusto. Values collapsed with the housing bubble, but instead of letting shareholders pick up the pieces — as they should have — the liability was transferred to the taxpayer through a round of nationalisations and toxic debt buybacks.
The big financial institutions in the US and Europe had become so protected, so entrenched over decades of regulation that the crisis of confidence arising from a collapse would have been intolerable. This is the socialisation of risk: financial institutions make bold investment decisions (fine), reap all of the upside (also fine), but aren’t responsible for any of the downside due to their indispensability (not so fine).
Alan Greenspan once said “If they’re too big to fail, they’re too big.” Again we reach that fork in the road: do we take the cumbersome approach of blocking mergers, breaking up deposit-taking and investment functions, imposing new levies and raising capital thresholds, or instead pare things back and accommodate new entrants?
The Australian government implemented a guarantee for large deposits in local banks at the start of the crisis. The motive was fine — other governments were doing the same thing and we didn’t want to be at a disadvantage. Our banks came out of the crisis largely unscathed, with praise deserved for their conservative investment profiles. But a telling legacy of the guarantee is that while in force, the big four increased their share of the deposit and loan markets. Competition was stifled. We emerge with a more concentrated banking system, more sensitive to future shocks.
Regulation breeds dependency. It’s at the core of how this situation came to be.
Governments are posed by an inherent conflict of interest between doing what’s right by public finances, and being seen to do what’s right by the public. So when banks teeter and demand collapses they embark on waves of stimulus spending because, well, you have to do something.
Yet there’s nothing empirical to support its efficacy. It becomes a degenerate arms race of who can piss the most up against the wall.
In The General Theory of Employment, Interest and Money, John Maynard Keynes wrote:
“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.”
Invisible hand on heart, this is the kind of logic employed in deficit politics.
The problem with the economically conservative position here is the government can come out — as it has — and point to low unemployment, healthy retail spending and business confidence as a result of its financial intervention, and the onus is on me to show they’re not correlated, and to prove we would’ve been in the same boat had we not done anything.
I can’t. Just as I can’t prove that god doesn’t exist, and that Queen Elizabeth isn’t a reptilian humanoid, and that blue cheese isn’t, in fact, mined out of Alan Jones’s bile duct.
Deficit spending is theft from the future. It creates artificial demand, props up jobs that aren’t self-sustaining, bogs us down with interest repayments and creates an obligation to repay that money, foregoing the opportunity to use it down the track on something with the prospect of better dividends. It is an exercise in evaporation on the grandest scale.
This is the reality in which the US and Europe find themselves. Billions of dollars spent and no growth later, they’re struggling to service that debt and being savaged for it. Investors are less willing to buy bonds so governments promise higher interest rates to hock them off, and thus begins the vicious cycle that’s resulted in casualties like Greece and Ireland but most certainly won’t end there.
Don’t think we’re safe and sound in Australia. The government is quietly losing its nerve which is why we’re seeing the theatre of a 2012-13 Surplus At Any Cost.
With $212 billion of debt transformed into gazebos, insulation, pokies money and other productive assets of note, we’ve lost the flexibility to cope with any future collapse in revenue, which is starting to look as inevitable as a Greek evading tax or a Frenchman going on strike.
Being saddled with debt is like being in jail. The US and Europe might there for murder, and us for robbery, but we’re still there at the end of the day. Such is the folly of relativism – Australia is better off relative to basket cases in the northern hemisphere, but any objective appraisal of our public finances should give cause for concern. We’re running low on ammo.
To solve this problem it’s generally accepted that financial organisations need to be made accountable, but how to achieve it? Regulation is a lumbering beast; it’s difficult to target, hard to enforce and often treats the symptoms rather than cause.
Prevent banks from loading up with toxic debt by allowing them to get better appraisals on the make-up of that debt. If they’re still foolish enough to do it, disincentivise the culture of excessive risk-taking by signalling that the taxpayer won’t come to their rescue. Reserve deficit spending for the promise of demonstrable returns like bottleneck breakers and productivity boosters.
Instead of distorting incentives and then trying to cumbersomely redress those distortions after the fact, eradicate them from the outset. It’s more elegant, less costly, and offers the only real prospect of lifting the world out of indefinite economic malaise.