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The year of the riskmongers
Whatever our troubles, let us all be thankful. At least, or at least for now, the interventions of the central banks and the finance ministries have prevented the collapse of the financial systems of the developed Western countries. Even so, the question remains as to what will be the wider impact of the credit crunch of 2007.
Like many other analysts, Chris Giles and Gillian Tett of the Financial Times are posing what they describe as "the million – or trillion – dollar question":
Are these market troubles... unfolding in a parallel universe inhabited by over-excited bankers and hedge fund managers; or are we witnessing a 'time-lag' problem, meaning that the damage from the financial crisis is very real but has yet to feed through to the 'real' economy?
We all have at least some idea of what the 'real' economy, as these FT writers call it, does. It produces material goods and non-financial services, provides employment for workers, and creates profits in a way that is not too difficult to understand. But what is the purpose of, to use the converse expression, the 'non-real' economy? According to conventional economic theory, its role is to manage risk; and it does so by turning risk, in other words the possibility that something will or won't happen, or by how much and when, into something which is bought and sold. As another FT analyst, Professor John Kay, recalls:
The financial economics I once taught treated risk as just another commodity. People bought and sold it in line with their varying preferences. The result, in the Panglossian world of efficient markets, was that risk was widely spread and held by those best able to bear it.
Also in this 'Panglossian world', the markets determine the correct prices for all commodities. However, there is a problem; which is that the real world bears little resemblance to the models constructed in economic theory. In his statement to the Treasury Committee on 12th September, the Governor of the Bank of England, Mervyn King, gave his diagnosis of the emergence of a deep financial crisis despite the underlying strength of the 'real' economy:
The world economy has been strong for the past five years. Our own economy has been growing at a steady rate for a considerable period. There are major problems in the US housing market to which the authorities there are responding with both macro and micro measures. But the losses from defaults so far remain small relative to the capital of the banking system.
None of this is meant to say we should be complacent. But the source of the problems lies not in the state of the world economy, but in a mis-pricing of risk in the financial system. And it is on that set of issues that we need to focus to determine the remedies, both short-term to address the current problems and long-term to prevent a recurrence.
So the markets have been trading risk at the wrong price, thus creating a deadlier kind of risk- the possibility of a meltdown of the system itself, necessitating a rescue by the state. When questioned by Treasury Select Committee on the matter of the near-collapse of the UK's Northern Rock Bank, Mervyn King expressed a further regret:
The governor said that he would have preferred to give covert aid to Northern Rock, without the public being aware of the Bank's intervention, but that would have been illegal. He blamed the EU 'market abuses' directive, which would have required the directors of Northern Rock to disclose any support they received from the Bank [of England], as being part of the problem.
According to pro-market theory, capitalist markets ought to work. They should not need to be propped-up by governments and other central institutions. Thus when crises occur as they inevitably do, the cause cannot be the market system itself, which supposedly puts human nature- specifically our intrinsic desire for individual selfish gain- at the service of the community as a whole.
In a lecture delivered in Scotland in 2005, the then Chairman of the US Federal Reserve, Alan Greenspan, made some introductory remarks about the "renowned economic and financial skills" of Britain's then Chancellor of the Exchequer, Gordon Brown; following which he eulogised on the legacy of the 18th Century political economist Adam Smith:
He [Smith] concluded that, to enhance the wealth of a nation, every man, consistent with the law, should be "free to pursue his own interest his own way, and to bring both his industry and capital into competition with those of ... other ... men". "It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest". The individual is driven by private gain but is "led by an invisible hand" to promote the public good, "which was no part of his intention". This last insight is all the more extraordinary in that, for much of human history, acting in one's self-interest--indeed, seeking to accumulate wealth--had been perceived as unseemly and was, in some instances, illegal.
Saving Private Banks
The usual targets for blame when the market goes wrong include excessive state interference and regulation. But currently such claims can have no credibility. The present crisis follows many years of de-regulation, encompassing the relaxation of controls in both the USA and the UK on the home-loan sector and the trading of financial instruments, and in Britain the de-coupling of the Bank of England from the direct control of the government. So, as the liquidity of the Northern Rock Bank began to run dry in mid-September, a different kind of analysis emerged. Associate editor of the right wing Spectator magazine Martin Vander Weyer noted:
...depositors are queuing round the block to get their money out. Are they right to do so before the Rock crumbles, or is this that well-known phenomenon of markets - the madness of crowds?
I'd say depositors can sleep more soundly tonight than directors of Northern Rock. Barring total meltdown - which no one is predicting - your money's safe because the authorities cannot allow a major high street lender to fail, with the ramifications that would have for the banking system and economic confidence.
And the Murdoch-owned tabloid The Sun editorialised with an almost identical comment:
IT’S no surprise savers are deserting Northern Rock. It’s human nature to panic if you get the slightest inkling your nest egg is at risk. But the truth is it’s not. The Bank of England will not let the lender behind one in five British mortgages fail.
What a perfect arrangement the market would be if it were not for human nature, with its tendencies towards panic and madness. But don't worry! The central authorities will intervene to prevent the system from going under.
But was the behaviour of the Northern Rock savers really so irrational? As some of them were no doubt aware, a company called Farepak, which collected the savings of people who are among the poorer members of British society towards food for their Christmas celebrations and presents for their children, collapsed in the autumn of 2006. The Farepak subscribers, who lost a total of at least £38 million, still await their compensation- which will in any case be only a miserable 5% of their savings.
Short circuits
The Northern Rock savers did not begin clamouring to withdraw their money until well after the onset of a steep decline in the value of the company as measured by the stockmarket. But apparently it was not so much panic and madness that plunged the shares downwards, but rational and highly lucrative activity. Martin Vander Weyer complained on 3rd October:
The halving of Northern Rock’s share price between February and August was driven not by selling by small investors but by short-selling by hedge funds such as Lansdowne Partners — borrowing stock in order to sell at a higher price and buy back later at a lower price. In the final collapse of the shares, short-selling has again been the driver — and hedge funds are thought to have made a £1 billion profit.
Among the multiplicity of arcane ways to make money in the lightly regulated 'non-real' economy, short-selling is one of the easiest to explain. Let's say you think the price of an item traded on the market- for instance shares in a particular company - is going to fall, or at least that it's vulnerable to a fall in price. You, and others who have pooled their resources in a hedge fund, can pay a relatively small fee to borrow large amounts of these shares, which you then sell immediately. Even if they weren't going to drop in price anyway, the fact that you have unloaded big quantities of them onto the market will hopefully (from your point of view) send their price plummeting downwards. You then re-purchase (at the new lower price), the same amount of these shares and return them to the source from which they were borrowed; pocketing a sum of money which is equal to the quantity of the shares you borrowed multipled by the difference between the price at which you sold them and the price at which you bought them back. Hey presto!
Of course, share prices have been capable of going down as well as up long before hedge funds were invented. The 1929 Wall Street crash took place without the assistance of modern financial instruments. The primary business of stock markets is not the raising of investment funds by companies by means of issuing new shares, but the buying and selling of existing shares; not just on the expectation that an income can be earned from the dividends which the company passes on to its shareholders from the profits of its business, but also on the expectation of future increases- or decreases- in the price of the shares. This is speculative activity, a form of gambling; but it does influence firms in their 'real' economy operations. The worth of a company is considered not just on the basis of the book value of its assets, but also on the total value of its shares. As is now occurring with Northern Rock, a firm whose shares slide too low is likely to become a target for a predatory takeover.
Nevertheless, by making it possible to aquire money as a result of falls as well as rises in share values, hedge funds have increased the volatity of share price movements.
The practice of short selling explains a notable phenomenon of this year's financial crisis: while some institutions are in deep trouble, others are making fabulous profits. On 9th October, Bloomberg News reported that:
Goldman Sachs Group, increasingly perceived as the world's biggest hedge fund, will report record earnings for 2007...
Like New York-based Goldman, Morgan Stanley and Lehman Brothers Holdings Inc also will report record earnings this year, according to analyst estimates compiled by Bloomberg.
Where Paulson, Harbinger and Goldman used hedging strategies to prosper in the third quarter, Merrill Lynch & Co, Bear Stearns and UBS AG weren't so nimble when the subprime tide ran out. The divergence, following three years when earnings at the top investment banks rose almost in lockstep, also illustrates why hedge funds exist — to take advantage of others' distress...
Whether due to their innate human nature, or more calculatingly to increase the level of panic and thus bolster their short-selling position, those who are able to take such advantage are waxing exuberantly on the prospect of more distress in the USA:
"You have only seen the first round in the deterioration of the mortgage area," said James Melcher, president of Balestra Capital, a New York-based hedge fund with about $US270 million of assets. "The second round is just starting, and it's going to be worse."
Play your cards right
In terms of the impact of the crisis on Britain, Associate Editor of The Times Anatole Kaletsky is hopeful in the long run:
The main problem for Britain is that so much of the country’s prosperity depends ultimately on the wealth generated by financial globalisation. It is, therefore, almost inevitable that house prices and Treasury tax revenues will suffer in the next year or so, just as they did after the financial upheavals of 1987, 1992, 1998 and 2001.
From a longer-term perspective, however, this crisis will probably turn out to be another storm in a teacup. Lenders will doubtless become more cautious for a while after the traumas they have just suffered, but the economic effects of these tougher lending standards – on employment, wages, profits and even house prices – will be largely compensated by the Bank of England and the Fed setting interest rates at a lower level than seemed likely a few months ago.
More fundamentally, last month’s crisis is no more likely than its predecessors of the past decade to interrupt the relentless progress of globalised finance. The economic logic of financial globalisation will remain as compelling as ever: investors and savers from around the world will continue to seek out financial opportunities wherever they may arise. Bankers and fund managers will continue to identify these opportunities, structure new types of financial instruments and then distribute them across national boundaries – always learning something from their previous mistakes, though never quite enough to satisfy bearish sceptics.
And provided the Government and the Bank of England continue to play their cards well, as they broadly have since the mid 1980s, London will remain the natural place for these financial businesses to grow.
There is more to this thesis than mere bullish optimism. Kaletsky produces no claim that the financial markets create any wealth, merely that they help bring much of it to Britain's door. The UK is indeed most unlikely to be displaced any time soon from its eminent position in world finance, and the processes of globalisation and financial innovation will no doubt continue. Governments and central banks will be willing to bail out the markets when called on to do so.
However, as we have seen this year, globalisation ensures that a crisis in one major country spreads its effect to others. And financial innovations- in the present case the securitisation of debt-based assets, the high levels of leverage and the operations of the hedge funds- have acted to turn a small earthquake in a minority sector of the US mortgage market into a tsunami which threatened the Western financial system. Could a further deepening of globalisation and the creation of newer and more improved financial instruments allow the conditions for a crisis that could overwhelm the capacity of the central institutions to stave off a real, serious recession?
Time will tell. Meanwhile, an important lesson can be learned. Pro-market legend has it that the brewer and the baker of Adam Smith's time, acting purely in their own self-interest, came to the aid of society and increased its wealth. In 2007, the broker and the banker were rescued by the state from the consequences of their own self interest; and thus society was protected.
The major gainers from this current crisis have been Goldman Sachs, Morgan Stanley, the Lehman Brothers and the Lansdowne Partners. When the next big financial crisis comes along- as it will- the socialist movement may be in a position to make some serious gains.