The Treasury has had Professor John Kay in town this week. Kay has had a long and distinguished (microeconomics-focused) career in the United Kingdom as an academic, adviser, FT columnist, author etc and last year published a new book Other People’s Money: Masters of the Universe or Servants of the People, the introductory chapter of which is here. Key’s Treasury guest lecture was built around the ideas in this book. To be clear, I have not read the book – although despite the skeptical comments that follow I may now do so.
It wasn’t a lecture, and apparently isn’t a book, about the 2008/09 financial crisis per se. That said, the book probably wouldn’t have been written without the crisis, and he clearly sees the crisis as a manifestation of what, in his view, has gone wrong with the financial sector. In a line from his website :
The financial crisis of 2007-8 has dominated subsequent discussion of economic policy. In my view the responses are characterised by two widespread misunderstandings. The first mistake is to believe the crisis is an inexplicable, once in a lifetime, event, rather than another demonstration of an increasingly dysfunctional financial system.
Kay began with a line many have used – the changing nature of the people who go into banking. In the 1960s, when he grew up in Edinburgh, banking was for the people not quite smart enough to get into university (as in New Zealand, only a small proportion of school leavers then went to university). By contrast, these days finance attracts many of the smartest graduates from top universities. The range of products is, of course, much more complex. But not, Kay would argue, so correspondingly socially useful, despite the staggering remuneration on offer to a fairly small number of people in these institutions (if I recall rightly, he notes that most people in the big UK bank Barclays actually earn less than the UK median wage). And, of course, the incidence of financial crises is much greater today than it was in the post-war decades.
For a time, politicians across much of the advanced world fell at the feet of bankers. Kay showed an amusing clip of Gordon Brown, then Chancellor of the Exchequer, opening a new headquarters in Europe for Lehmans only 10 years or so ago. And in the United States in particular, there is the ongoing unease over the revolving door that seems to operate between senior government positions and highly-remunerated positions in the financial sector (it isn’t just Goldmans’ alumni going into government and back into the financial sector (eg Robert Rubin), but the flow from government positions into the financial sector – be it Bernanke, Summers, Geithner or whoever). Bernie Sanders is currently tapping that anxiety.
Kay isn’t “anti-finance”. As he notes
A country can be prosperous only if it has a well-functioning financial system, but that does not imply that the larger the financial system a country has, the more prosperous it is likely to be. It is possible to have too much of a good thing. Financial innovation was critical to the creation of an industrial society; it does not follow that every modern financial innovation contributes to economic growth. Many good ideas become bad ideas when pursued to excess.
And so it is with finance. The finance sector today plays a major role in politics: it is the most powerful industrial lobby and a major provider of campaign finance.
He seems to be arguing some combination of the following:
- Banks are too large, and encompass too many different types of activities within them,
- Banks should be broken up.
- There is “too much finance”
- Banks have huge political clout (especially in the US and the UK), and exercise that in their own interest, in particular in the (successful) pressure for bailouts.
- Someone should pay for what went wrong in 2008/09.
- Banking regulation has become too prescriptive and detailed.
I didn’t find the overall story that persuasive, partly because it doesn’t seem to generalize across countries, and partly because it doesn’t even seem to get to the heart of the 2008/09 issues. There are bits of the story I agree with – concerns about the volume of increasingly detailed, lawyer-driven, focus of regulation, often in effect more concerned with process and form than with economic substance. And I sympathise with his unease about the hubris implicit in the belief among central bankers that they can somehow determine what risk weights to use for each and every type of credit.
So what bothers me?
First, is there any evidence that banks were “bailed out” because of the political clout of the sector? I’ve read huge number of the books written since the crisis, and tracked events through the crisis very closely, and that interpretation simply just doesn’t ring true – in the US, the UK, Ireland, or anywhere else for that matter. After all, by and large it was not bank shareholders (or senior management) who were bailed out – and many of the senior management of banks had large proportions of their own wealth tied up in shares in their own banks. The bailouts typically primarily benefited creditors (not exclusively – after all, even Bear Stearns shareholders walked away with a small amount of their money) and – so the argument went – the economy as a whole. Creditors weren’t always voters, but most voters were creditors of banks in one form or another, and most were employees – alarmed at the prospect of extreme economic disruption.
This isn’t the place to debate whether any or all of the bail-outs were good things or not, simply to note that – as things were by 2008 – they would have happened, largely as they did, if financial sector interests had had no clout and no superior access to politicians at all.
And what of the line that banks are simply too big and complex to be run effectively? Well, for decades we saw that argument run about corporate conglomerates across the western world (including our own Fletcher Challenge). But actually the market had ways of taking care of that problem – companies were bought up, restructured, dismantled etc, by purchasers who could make more of the assets that the unwieldy conglomerates could. The “asset strippers” weren’t always attractive personalities, and some probably went close to (or even beyond) the edge of the law, but the point simply was that the market has a way of ensuring that assets are owned by those who can place the highest value on them. Bank takeovers aren’t always easy, but they happen. It isn’t obvious what the (financial stability) policy problem is, unless a strong case can be mounted that some combination of size and complexity effectively buys a bailout insurance policy. I don’t think the evidence for that point is particularly persuasive either.
At one point is his lecture drew the distinction between whether we thought as banks as a “den of thieves” or as a “monastery”. I’m not sure either description is remotely warranted. Avaricious, arrogant and unpleasant as many of these leading bankers seem to have been, I don’t see any sign that the crises of 2008/09 – in any country – occurred because anyone systematically set out to dupe anyone else. Don’t get me wrong: I’m not suggesting there was none of that sort of activity, simply that much more of what went on is down to some combination of:
- choices of politicians (choosing to adopt the euro, which involved holding interest rates well away from natural interest rates for year after year – most obviously in Spain and Ireland – and the high degree of political pressure brought to bear in the United States on the financial system to take on low quality housing loans)
- collective over-optimism, among borrowers, lenders, citizens and politicians.
Were people let down? Yes, no doubt. Banks failed, but so did most of the world’s leading regulators and central bankers (as Kay put it, the effortless subsequent continued rise of several, who had been quite dismissive of risk before the crisis, illustrates the “unimportance of being right”), and most of the world’s leading finance ministers (and most of those who might have wanted to replace those central bankers and finance ministers). So who should pay, and in what form?
And of course there is the “so what” question. If one believes that the financial crises (or even the build up of debt prior to the crisis) was responsible for the world’s current economic travails (eg GDP per capita 15 per cent or more below pre-crisis trends) one might perhaps regard the financial sector as a dangerous bacillus, attacking the common wealth. But as I’ve noted here several times, I don’t think the case is that strong. Through its history, for example, the US was plagued by financial crises, and yet each time the economy bounced back – usually quite quickly – to much the same growth path it was previously on
What of New Zealand? Is there too much finance here? We don’t have complex banks (they lend, mostly in quite vanilla forms, and the borrow – domestic households and institutions, and from abroad.) We don’t have many complex instruments either – actively traded or not. It isn’t obvious banks have huge political clout either – for better or worse, in the midst of the crisis we forced them to join the deposit guarantee scheme, we forced through the local incorporation policy, we compelled them to pre-position for OBR, and we’ve imposed higher effective minimum capital requirements than most of the countries. We didn’t have a domestic loan losses financial crisis during 2008/09 (actually neither did the UK), and yet, as I’ve repeatedly highlighted, our economic performance over the last decade has been distinctly mediocre. There is a lot going on globally, insufficiently understood, but it isn’t yet remotely clear that finance is the problem, rather than just another symptom.
The New Zealand financial sector is larger than it once was. But much of that isn’t about over-mighty financial institutions and their “master of the universe” bosses – although we had our period of craziness in the mid-late 80s. But if high house prices here – as in much of the West – are about the interaction of supply restrictions and population pressures, the increase in the stock of credit is substantially an endogenous response to those structural distortions. If governments make urban land really scarce and expensive, younger generations will need to borrow more real resources from older generations to be able to afford a house at all. The stock of credit (on the one side) and deposits (on the other side) rises, and financial institutions facilitate that- and value-added associates with that activity and accordingly appears in the national accounts. Don’t blame banks for that, but governments that so badly mess up the markets in housing supply.
I’m left uneasy about what social value much of the activity in the financial sector generates. As an analyst, even as a citizen, I’m curious about that. But I’m not sure that Kay – or others – have made a convincing case that is deeply harmful either. In principle it could be – as others might argue that sugar, alcohol, fast food, or fast cars could be harmful. Kay avers that he wants less intrusive regulation, but in fact the thrust of his arguments tends to give aid and comfort to those who want more of it. That appeals to regulators, responds to a public itch “something is wrong, and banks aren’t overly sympathetic causes”, but doesn’t rest sufficiently on a hard-headed analysis of the role of governments and regulators in past crises, and the importance of markets – messy as they often are – as “a chaotic process of experimentation…the means through which a market economy adapts to change”.
That last quote comes from an excellent lecture, The Future of Markets, which I return to often, given by one John Kay in 2009.
In conclusion, I would just note that at one of his sessions this week, Kay was apparently asked about deposit insurance. He asserts that it is simply imperative: without it the pressure for bailouts of all creditors inevitably becomes almost impossible to resist. It was a point I made here last week, and remains good advice for our political parties, our government, and for those among the official agencies who continue to believe that the OBR tool deals with these pressures.