28 October, 2008

Crisis: The Blame Game

We’re in for a bad time next year, although in my view we shall be seeing the bottom at the end of 2009. Unsurprisingly the world echoes with demands for the head of whoever caused it all. Here is your cut out and keep guide to the blame game.

First some private individuals.

Hyman Minsky. For not making himself understood. Minsky, who died in 1996, researched the behaviour of markets in a boom; he identified a ‘speculative euphoria’ in the late part of the cycle, where people borrow to invest, not believing it can go wrong. The weight of debt and low asset quality eventually cause a downturn. This is called a Minsky Moment.

Alan Greenspan. One of the media’s favourites for the stocks. He was head of the Federal Reserve for nearly 20 years and was responsible for the low interest rates America enjoyed in the Bush-Clinton-Bush years. He thought that globalisation and the internet had pushed up America’s growth and there was no need to raise interest rates to hold the economy back (although he did warn of ‘irrational exuberance’). There was little inflation in the sense of stuff you have to buy going up in price, the question remaining being ‘is a house stuff you have to buy?’

Bill Clinton. The Community Reinvestment Act., passed in 1977 to encourage lenders to lend to poorer people, was revamped by Clinton’s liberals allotting targets for different institutions, compelling them to lend to people who couldn’t afford to pay back. The targets set were over 40% of new loans to be to sub-prime borrowers. That is to say something like a half of new loans had to be to people who probably shouldn't have had them. If this is what regulators can do, perhaps it’s a crisis of over-regulation?

Gordon Brown. One of the first things Brown did on becoming Chancellor (apart from making the Bank of England ‘independent’ of which more later) was to reorganise the banking regulation system. This had been carried out by the Bank of England (the famous raising of the Governor’s eyebrow being enough to put banks back on the straight and narrow). Brown set up a tripartite system with the Bank of England, the Treasury and the Financial Services Authority, which meant that when the Northern Rock debacle happened nobody knew who was in charge.

In his frantic efforts to transform the UK into a welfare society Brown borrowed heavily in the good times and now, when room to borrow is desperately needed, he risks a run on the currency, with interest rates higher than they need be, deepening the recession.

The Monetary Policy Committee of course only have control over monetary policy - interest rates. Brown has control over fiscal policy (government spending) and the more it goes up the higher interest rates need to be. An ‘independent’ Bank of England would have told him to stop spending so much.

Milton Friedman. The arch-monetarist is being blamed and people are freely mentioning the term Keynesianism as our future. Had he lived he would have given as good as he got. He exposed Keynes for the fraud the old boy was and would have criticised Greenspan and the over regulation of the markets.

Other blame candidates:

Bankers’ pay. The first thing to remember is that it is entirely the business of the shareholders (ie owners) of the banks how their employees are remunerated. Some have said that the banks were paying more and more to employees to shovel more rubbish into their portfolio, but these guys (very well paid indeed, some of them) were doing what the management ordered. They were told to shovel more rubbish into the portfolio. Certainly some more long-term approach to remunerating senior management might have been wiser, but in the banks’ defence it is a bonus- based system and when times are bad, as they are now, employees can lose two thirds of their expected earnings. It looks bad in retrospect but these people are not the cause of the recession.

Regulators. People are saying that the regulators were unable to understand some of the instruments they were dealing with. Some say they had too light a touch. But I find myself unsatisfied with this approach. For many years – certainly back to the 70s, banks had leveraged themselves twenty times. That is to say they had bought assets worth 20 times their capital, or to put it more realistically, 95% of their assets were funded by debt so only 5% could go wrong without the bank becoming insolvent. Some banks in the last few years leveraged up to 30 times but that is not completely unreal. And if the regulators had asked they would have pointed to the quality of the assets, which was thought to be high.

Ratings Agencies. The main ones are Standard & Poors, Moody’s and Fitch. Until the latter part of the last century most analysis by banks was done in-house. The ratings agencies were mainly for the private investor: typically AAA was the best rating, to solvent governments and first class banks, whilst BB+ was the lowest that could be regarded a investment grade. Naturally the lower the rating the more interest was charged. As turnover in financial instruments increased and more borrowers gained access to the capital markets increasingly the banks outsourced their own analysis to the ratings agencies. It is important to remember that until the liquidity crisis became front-page news, most of these special investment vehicles, companies set up with a mix of assets in order to achieve a specific rating, were AAA.

The ratings agencies now admit to mistakes in their modelling, and most crucially it must be remembered that they were paid not by the investor but by the banks who had created the investment vehicle. Lest all the business went to the other two, a ratings agency was more or less obliged to lower its standards.

So, take your pick. For me I blame Greenspan for overly lax monetary policy, Brown for screwing up the regulatory system and for making things worse for Britain than they might have been through rash overborrowing. I rather absolve the regulators, except for the ridiculous Community Reinvestment Act. I don’t believe we could have expected the regulators to make an accurate critique of the ratings agencies’ analysis models.

But I do blame the ratings agencies, who have made a huge mess. The question is: will anyone trust them again? And the answer is: yes. We will get out of this crisis and some day we will find ourselves in another, just as bad. I am with Minsky: these crises are simply part of the system.

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