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The UK economy
The financial crisis – an explanation from a UK perspective - Sept 2008
There is little doubt that the US, UK and the global economy will go into decline over the next 6 months, resultant from the developing financial crisis. The prospects in the US look particularly bleak.
Those on low pay will suffer the most. The US and UK governments, like everyone else, will have to ‘cut its cloth’ and reduce unnecessary or low priority spending in order to maintain social support and help those on low pay. For governments this will be nightmarish.
However, in addition, it is necessary for political leaders to step up and offer convincing remedies for problems in the economic and financial system – in the shorter and longer term. To do so, however, requires the economic and financial ‘problem’ to be defined. Exactly what problems in the economic & financial system are we addressing ?
Therein lies the problem. So many economists, bankers and politicians have offered their different versions of ‘who is to blame’. Symptoms are sometimes glibly mixed with causes. Clearly, addressing symptoms will leave the causes intact, so we have to get the root causes and symptoms properly lined up, if policies are to be robust.
Defining the causes of the crisis is not easy in the circumstances. Different definitions lead to different sets of solutions however, and so better attempts are needed at describing what happened, and at distinguishing between causes and symptoms.
I will bravely stick my neck out and attempt a crude summary of the problem, and where that leads in terms of remedies.
The global economy
The bottom line is that, what economists call ‘global imbalances’ (ie the reliance of the US and UK economies on cheap manufactured imports from China and elsewhere) have led to the financial tail wagging the dog. In other words, the way in which the US and UK have responded to these imbalances has turned finance into the master of the ‘real economy’ instead of the servant of it.
The US economy in particular tried to deal with the huge rise in imports from China & elsewhere, by adopting a ‘low exchange rate’ policy, and propping up the economy with large spending increases. This proved disastrous. As a result, US industry failed to respond to the new situation and reform fast enough. Instead the US turned itself into a ‘retail-based’ economy founded on borrowing, with huge consumer and business debt….and very little net savings among households and businesses. (The term ‘Wal-Mart-ization’ was coined). This ‘response’ underlies all else. The UK response has had many similarities, especially slow reform of the industrial sector, massive consumer debt, and an asset bubble.
The US avoided inflation and high interest rates arising from its big hike in spending & borrowing, first because the imported goods coming in were cheap, and many prices fell, and second because China, awash with dollars from their exports, lent their cash back to the US government enabling Washington to pay for its vast increases in spending (including spending for two costly wars). China was happy to keep lending to the US, and this prevented upward pressure on US interest rates - China’s lending, it should be remembered is not just economic; it is political too. China’s leaders are well aware of the role of Soviet indebtedness to the USA in the collapse of the USSR.
With the unusually low savings rates in the US and UK compared to much of the rest of the planet, consumer, mortgage and business debt relied increasingly on international borrowing rather than money held in people’s bank accounts, in parallel to governments.
However, the potentially disastrous consequences of these policies were glossed over – indeed, as a matter of economic policy the amount of borrowed money sloshing around in the economy tended to be dismissed as a key economic indicator. But the resultant low interest rates in the US meant that borrowing was getting out of control. In fact, as bank interest fell below inflation, it meant that in reality, the banks were paying its customers to borrow ! (negative interest rates). There was huge borrowing to buy shares, to buy bonds and to lend on to housebuyers – a classic ‘asset bubble’ with house prices artificially inflated. The financial sector in the US and UK began to run the economy, and suddenly the ‘real economy’ mattered much less, (much to the delight of Beijing !).
Regulation and de-regulation
So what about the now infamous CDOs (Collateralised Debt Obligations) ?
The first thing to remember is that not all regulation or de-regulation is the same. US and UK financial markets were de-regulated in the sense that the traditional division of labour between banks, investment banks, and other financial organizations were broken down. Investment banks and insurance firms could do things that banks do, and vice versa, to put it crudely. Hundreds of new ‘super smart’ financial boutiques also sprung up, and the concept of ‘conflicts of interest’ was fudged. Although no bad thing in itself, the problem was that the regulators were not reformed to match the new liberalized markets. Government bureaucracy was slow as ever, and there was inadequate preparation for liberalization (in the UK, it started with the so-called ‘Big Bang’ and continued with subsequent liberalizations).
With rules based on the ‘letter of the law’ rather than catch-all principles, the small print of regulation and its enforcement always lagged behind the ever-increasing complexity of tradable financial products and risks being dreamt up by the new liberalized sector. Regulators were ever chasing the traders with rules to match the new products and risks, and falling levels of transparency, following the liberalization in ‘demarcation’ between institutions.
In the US the regulators stayed unreformed, stuck in their old division of labour before the liberalizations – insurance was not even regulated nationally. In the UK the current PM, Gordon Brown, took credit for stripping the Bank of England of much of its regulatory powers, and handed them to the relatively new Financial Services Authority (FSA), who had a massive job of catch up. This was an impossible task. What’s more, the Bank of England retained the role of ‘lender of last resort’, ready to bail out banks.
However, the then Chancellor Brown was already known for wildly optimistic expectations of how the UK government would implement major changes. But worse, Chancellor Brown glossed over important detail – the new relative roles in financial regulation between the FSA and the Bank of England were left undefined. As those with more experience know, this can be fatal in a crisis, when governmental organizations will blame each other. As easily predicted, when the crisis came, first with Northern Rock, each expected the other to be monitoring for banking-crash symptoms !
A pack of cards
So when all these factors are taken together – essentially a failure of government to work through the consequences of its own changes – the financial system began to spiral out of control. Easy credit for US and UK homeowners based on international finance created new opportunities that were very dangerous for the system in the longer run. In the US easy loans were offered to high risk borrowers, often by exaggerating their incomes. Before the end of the millennium a new way of making money arose – lumping together lots of mortgages and then selling slices of the new ‘pool’ of debt, in effect, cutting the cake a different way. Structured finance and CDOs were born.
Of itself this was not a problem except that it created perverse incentives. Were these structured finance and CDO practices a cause or a symptom of the expansion of high risk (sub-prime) lending ? The jury is still out on this, but my money is on cause. But the effect of these new products was that the quantity of high risk loans in the new re-grouped pools of debt was opaque. Banks buying and selling the re-sliced debt, mesmerized by easy money and the ‘asset bubble’ stopped bothering to do their homework (‘due diligence’ in the jargon). Amazingly, they just didn’t know the value of what they were buying or selling. In this aspect at least, accusations of a casino economy were correct. The stage was set for the bubble to burst.
This is what caused the burst bubble – if banks didn’t know how much bad debt was hidden within the restructured loan packages being bought and sold, the incentive was created by CDO traders to make money by slipping in even more bad loans into the repackaged debt, thus accelerating the growth of high risks loans(sub prime) to people who couldn’t pay them back. Ultimately of course this was inevitably going to ‘end in tears’, and once the cat was fully out of the bag, banks stopped lending to each other for fear of never being repaid, and the system froze – the credit crunch had arrived.
However, it got worse. The rise of finance boutiques proliferated ever more complex products and risks. Hedge funds and other vehicles multiplied. Finance deals, with lots of intermediaries, became so unravelable that neither the shareholders of investment banks nor the struggling regulators understood the products and the risks. Shareholders of banks, investment banks and insurance companies lost control of the risks in their own businesses. Once this happened the free-for-all accelerated.
Many complex financial trades involved smaller investment boutiques with specialized knowledge – investment banks and banks no longer knew if the trading benefitted their own businesses or the specialized firms. More and more deals were ‘off balance sheet’ (ie not in the accounts of the banks and investment banks). These types of deals had already sunk Enron. If the banks’ owners lost control, the regulators with their old structures in the USA, and with the confused responsibilities in the UK, didn’t stand a chance - and in any case in the USA much of the lending/borrowing activity of investment banks was outside international (Basle 2) and domestic banking regulations altogether !
The pack of cards was ready for a-tumbling. How much tumbling however is still not clear, since it will take years to unravel the overcomplex investments and risks, and the still-opaque CDOs.
What to do ?
First, forget the shallow debate about ‘unfettered free markets’ and ‘over-regulation stifling efficient markets’. This is all futile nonsense. The market is a system with rules – rules to prevent monopoly, fraud, theft, conflicts of interest and lack of transparency. The quantity of rules can never be comparatively calculated; it is the quality of rules that matter, a concept which includes ease and success in enforcement.
The alternative is a restrictive state-directed financial system. The Russian system for example is no better if not worse, and the new US plan for the state to take over bad debts is an approach which the Chinese government has been trying to implement for nearly a decade, without success (the Chinese banking system is fragile and weighed down with huge bad debts from state firms and state-backed financial traders). State dominance of finances is clearly not the answer.
There are however four ways to increase the quality of the rules.
- Global financial rules need strengthening, and greater incentives are needed for countries to ensure their own regulations conform. The Basle 2 regulations require revision in scope and in conformance monitoring. The German Government has proposed some sensible reforms. The US must be forced to come in line.
- The US and UK are the main sources of the problem – both high government and consumer debt, and zero savings. US regulation needs to be ‘de-compartmentalised’ and put on a national, accountable footing. In the UK the relative responsibilities of the FSA and Bank of England need clarifying. In the end almost certainly the UK will need one regulator, with clearer rules on the role of ‘lender of last resort’ (the bank bailout role). Gordon Brown was wrong to agree to more ‘behind the scenes bailout’ powers for the Bank of England. In both countries better rules are needed on transparency and conflicts of interest.
- Off balance sheet trading (hidden financial deals) should be dramatically curtailed. Many regulations, including accounting rules, need revision, but in addition greater use of catch-all principles-based regulation is needed – where firms and banks (etc) conform to key principles, not just the small print ‘letter of the law’. The rights of bank (etc) shareholders needs strengthening against their executives and their technical financial advisers – especially in areas like due diligence and subsequent financial reporting, to, inter alia, prevent the CDO problem ever happening again.
- In the shorter term emergency measures are needed to slow house repossessions, in the US and the UK. Such measures are already applied to poor countries’ debt under the Heavily Indebted Poor Countries Initiative – debts are reduced to the level at which borrowers can afford and the rest of the debt written off under certain conditions. But in mortgages, it is easier, since debts don’t have to be written off – they can be set aside for a period of time or linked to a portion of future sale proceeds if & when house prices recover. Banks must take a ‘hit’ too. The current rules in both countries favour ‘summary repossession’ rather than mutually beneficial measures for the longer term.
However, ultimately, the underlying cause of the crisis – global imbalances – need to be addressed. This is politically and economically much more difficult - and potentially confusing for ideological dogmatists on all sides of the political spectrum.
Both the US and the UK should retreat from running their economies on the back of consumer and government debt, financed internationally. In both countries problems exist in industrial structure, competition and market entry, the methods of R&D spending, poor education and training and weak ‘relevance’ to economic need, the manner of banking competition, and many other areas where reform is urgent, but difficult. The US and the UK need to learn to compete again, and play to their strengths.
Both countries need to get exports and imports much closer together in value, so that ‘global imbalances’ are reduced. Their governments need to be leaner, more effective and fleet-of-foot. They need to learn that they can no longer afford to live with large sections of the population, seemingly more pliant politically, but poorly educated, poorly skilled and dependent on a huge state support structure. The problem is not so much that China’s economy will overtake the UK and US, it is the fact that education and skills levels are already overtaking them.
Japanese economists have for decades been prone to say ‘Western markets are predicated on short supply, minimum quality, and high profits’. Maybe they have been right all along.
If these lessons are learnt, there will have been long term benefit from the crisis. The outcome, we can hope, is that the financial tail will no longer wag the dog, and that finance will be the servant of the real economy again, not the master of it.
Prof Paul Reynolds
Afghanistan
First, seven years on, not only are we a long, long way from achieving the original reasons for the invasion, we are getting further away from it. Insurgents and militias now control a majority of territory, and key ministries are under insurgent influence. The Talebs have not been driven from power, and Afghanistan is just as a much a lawless haven for ‘terrorists’ as it was before 2001. Other than bombing Pakistan and risking a wider war, no credible strategy has been put forward for reversing the decline.
Second, and more importantly, key necessary steps towards peace are not being taken. No cross-border insurgency can be won without the border being clear and defined. For historical reasons, and for constitutional reasons in Pakistan, the Afghan-Pakistan border remains undefined. A condition of billions of dollars of support for Afghanistan and Pakistan should be the signing of a Treaty defining the border. This however is even more important than at first seems. It is a stark fact that the Pakistani Constitution does not fully extent to the border. The Tribal Areas where insurgents, we are told, have their bases, are not fully under the Pakistani Constitution – there are no Constitutional human rights, elections, courts or other symptoms of the rule of law. A better situation for insurgents one cannot imagine, All international state aid to Pakistan should be conditional on applying the Constitution and rule of law to these Tribal areas.
Third, the policies being imposed on the Afghan government, and the modus operandi of the Coalition, are both very obviously wrong-headed. We’ve all heard about the appalling waste and inefficiency of aid monies, and the missing billions. But worse are Coalition attempts to break with Afghan traditions, and force through a heavy centralisation of power. The result is ‘honeypot corruption’ with small cliques unable to pocket the money fast enough. Provincial and District governments stand idle while central government stalls and steals, and aid money gets channelled to unaccountable non-constitutional bodies around the country, many controlled by insurgents and drug barons. And what about the military side ? This is a terrible mess, with FOUR separate lines of command – ISAF/NATO, the US Operation Enduring Freedom, and two direct US lines of command from Washington. Many operations are undertaken via one line of command without the knowledge of the other, as British senior military officers will angrily testify to. The result is a conflicting set of strategies where even how allies and enemies are defined changes daily, depending on who you talk to. Are we fighting Pashtun nationalists in Pakistan & Afghanistan; drug warlords and tribes; Mosque-based militias (Deobandis as they are known), global political Islam after 9/11; or factions in the Pakistani army seeking (as they claim) ‘strategic depth’ to prevent Indian influence ?
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