The past 20 years has seen an unparalleled boom in the money markets. As the free market blossomed, so too did cheap debt, huge bonuses and ostentatious wealth. Now, as our financial system lies on the brink of collapse, it is time to build a new one, based on fairness instead of naked greed, and with long-term commitment to building businesses and supporting investment
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This Terrifying Moment is Our One Chance for a New World
The past 20 years has seen an unparalleled boom in the money markets. As the free market blossomed, so too did cheap debt, huge bonuses and ostentatious wealth. Now, as our financial system lies on the brink of collapse, it is time to build a new one, based on fairness instead of naked greed, and with long-term commitment to building businesses and supporting investment
By Will Hutton – Observer
5 October 2008
I never imagined I would live through events like those of the past three weeks. The Western banking system faces disintegration. Economists and policy-makers are at loggerheads over how to intervene to stop the panic that is sweeping the world and inspire sufficient trust for the key money and credit markets to reopen.
This is a crisis that has been 30 years in the making – a Gordian knot of libertarian free-market fundamentalism, unregulated globalisation, the collapse of social and political forces committed to fairness, the explosive impact of financial innovations such as ‘securitisation’, and sheer greed. Each has contributed to the fiasco - and all now need to be unravelled if the economy is to have a sustained recovery.
In the Seventies, there was a revolution born of a free-market belief that inflation and low growth were the consequence of too much state action – too much public spending, too much taxation, too much union power and too much money being printed. Instead we would rely on what Ronald Reagan once called the ‘magic of the market’. Governments should balance their books and let companies, banks and workers make their own decisions liberated by free markets. Thus stagflation would be bested.
Some of this made sense. Nationalised industries were not especially well run, some highly unionised industries such as printing and cars suffered low productivity, and governments had become too addicted to running budget deficits. Challenging the shibboleths of the Seventies was long overdue, and over the Eighties it began to produce some results – lower inflation and more growth.
And then the Berlin Wall fell, the Soviet Union collapsed, and the revolution hardened into something more dangerous – an ideological commitment to the view that government regulation had no place whatever in the economy. The left critique of capitalism – that markets delivered instability, booms and busts, monopoly and gross inequity that paradoxically undermined the values of integrity and trust that bind markets together – was proven wrong. There should not even be a mixed economy between private and public sectors. The job was to enlarge the role of markets.
In the United States this would manifest itself in Newt Gingrich’s ‘Contract with America’ that gave free licence to the anti-tax, anti-government, pro-deregulation instincts of an increasingly fervent Republican party. That wasn’t all. The financial markets were exploiting the new freedoms to insist that governments did Republican things. The Bush presidency sealed the market fundamentalists’ victory.
This was manna from heaven for the City of London, desperate to recover its place as the fulcrum on which the British economy pivoted. Ditching the gold standard in 1931 had dealt it a harsh blow. Controls directed cheap finance into industry throughout the Depression and into the war. The City hated it, but, by 1951, 20 years of ‘proud finance being humbled’, as Winston Churchill had put it, had prompted Britain’s partial reindustrialisation.
Despite its troubles, the City of London remained the apex of Britain’s social structure throughout this period. This is to where the privately educated, Oxbridge professionals in law, accounting and banking commuted from their large Home Counties houses to practise ‘gentlemanly capitalism’ - a capitalism that does not focus on manufacture, science and technology, but on property, international lending, deals and the trading of financial securities. It provided a good living in the Fifties, Sixties and Seventies, but London had ambitions. North Sea oil created the balance of payments surpluses that would allow the incoming Tory government to lift controls. The way was open for London to combine with New York to become the centre of world finance.
The regulations that inhibited London’s development were progressively eliminated. ‘Big Bang’ in 1986 allowed the brokers and jobbers on London’s stock market to be bought up by American, European and Japanese investment banks so they could do in London what was outlawed in New York by Roosevelt’s Glass-Steagall Act, introduced in the aftermath of the credit crunch that caused the Great Depression. They could manage huge investment funds, trade in any kind of financial security both on their own account and for clients, advise on deals and act as large banks - all under the same roof despite the conflicts of interest that were prohibited in New York. London began to rise in the league tables of international finance. The foundations of Anglo-American financial capitalism were being laid – and with them the seeds of its own demise.
In the early Nineties came a breakthrough that would transform the financial landscape. Goldman Sachs took the concept hitherto used by mortgage companies of packaging up mortgage payments and selling them as a financial security and applied it to an Arizona trailer park. The site pledged its income to a new company, specially set up, which then issued securities – backed by Goldman. The market bought them. ‘Securitisation’ took off: there are more than $8 trillion of securities backed by a weird and wonderful range of income streams. America, followed rapidly by Britain, did not have to worry that it did not save enough to support its borrowing ambitions; it could sell these securities to all comers from all over the world – especially in Asia and to China’s central bank – to finance ambitions to borrow.
And we did. Banks issued bonds allowing huge takeovers. Hedge funds and private equity companies blossomed. Money flowed into residential housing. In 1999, Bill Clinton abolished Glass-Steagall; it was pointless given what was happening in London. New York and London were in an unseemly race to regulate less. And if regulators raised an eyebrow they were told not to worry. The securitised bonds – this packaged income – could always be sold to raise cash; and on top banks took out insurance against the risk of default.
Nor should regulators worry if banks directed the investment funds under their management to buy any unsold bonds which might look like a fraudulent conflict of interest; one day they would rise in value.
So confident did bank directors become that they authorised their managers to run hidden portfolios of securitised assets offshore in secret tax havens; thus would profits be boosted at no risk.
Bonuses grew larger and larger, residential and property prices kept rising, fees from ever-bigger deals became juicier and juicier. And when there were setbacks, such as the dot.com bubble bursting, chairman of the Federal Reserve Alan Greenspan was on hand to flood the markets with cheap money. The free-market fundamentalists seemed to be right. Markets never did make mistakes, financial business kept booming, leverage became astronomical. The ever more extravagant school fees were easily paid and Britain’s Home Counties – like New York and the Hamptons – became home to parties of astounding luxury and lifestyles of grotesque opulence. Gentlemanly capitalism became super-gentlemanly capitalism. The Financial Times’ How to Spend it magazine is studded with dresses that cost up to £30,000. Private submarines, jets and yachts became the rage. One hedge fund manager I knew considered himself underpaid at $200m for one year’s work.
There was no effective opposition. The left and organised labour collapsed as intellectual, social and political forces; there was no conviction that any alternative to this shareholder value-driven, financial, ‘securitised’ capitalism existed, or any political muscle to support it even if there were. Mainstream culture moved away from public purpose and fairness; the new priorities were individual self-fulfilment, personal experience and loyalty to self. For example, in the 1990s I fervently opposed the demutualisation of our building societies, built on the values of fairness and collective self-help, arguing that in the interests of pluralism alone we needed a variety of financial institutions to serve the public. They would inevitably try to expand too fast; and inevitably end up being taken over.
So it has proved. Every demutualised building society has been taken over. But nobody wanted to listen. The directors wanted the vast personal gains and the members were only scarcely less greedy. In any case, building societies were collective institutions from another age rather like trade unions and no more worth defending.
Investment bankers seemed cut from the same cloth as Russian oligarchs and football stars; their fantastic wealth was part of the new order – one that produced growth every year since 1992 and a never-ending rise in house prices. If the rich were getting very rich, ordinary people were not doing badly either. Britain had stumbled on a new social compact.
Leader writers of right-wing newspapers could dub the high priests of finance ‘wealth generators’ without demur – and if any regulator tried to limit their operations, the world would fall on their head. When Tony Blair flirted with the stakeholder capitalism that I proposed in The State We’re In for a few weeks early in 1996, his colleagues, especially Gordon Brown, were appalled. The idea would upset the new gods in the City of London, and in any case was wrong because it challenged the free-market orthodoxies. The only way New Labour could win and govern was to accept the Thatcherite settlement, and try to promote social justice within those constraints. And so the madnesses became rocket-propelled.
And now the roof has fallen in, setting up potentially the most dangerous vicious circle since the Great Depression – and it could be most vicious of all here in Britain. The belief that securitised loans could always be sold or insured has proved illusory. Worse, too many have junk assets as security – commercial property, buy-to-let property, junk American loans and overstretched buyers in the residential property market. The debt will stay toxic until the economy recovers again. But worse, the margins on any new loans the banks could offer are tiny or non-existent. They have dried up, and as a result the price of property is collapsing, so that the debt is becoming even more toxic. Because everybody knows this, and nobody trusts anybody else, the banks are in a trap.
Should the taxpayer shore up the banks’ core capital to give them capacity to lend? Or should the taxpayer buy toxic debt, as the American Paulson plan proposes, and release the banks from their crippling, if self-inflicted, burden? And if so, would toxic debt from every international bank registered in London be included? In addition, should there be some form of government-sponsored insurance to support new lending? So far the British government is committed to a case-by-case, go-it-alone approach in which risking taxpayers’ money is seen as an instrument of the last resort. In Japan that approach left the country saddled with zombie banks that devastated its economy for a decade. Britain’s refusal to drop the laissez-faire ideology risks both that fate and a complete financial seizure in the interim.
Yet despite the government’s instincts, we have nationalised £150bn of bank assets in Northern Rock and Bradford & Bingley – and last week effectively nationalised the money markets. The Bank of England has been forced to step in as a sort of ringmaster, now lending more than £100bn to banks under its special liquidity scheme, and another £100bn-plus because banks will not lend to one another. But despite this £350bn of public support, the money markets remain frozen while ordinary savers move their cash to safe havens such as National Savings, Premium Bonds, Northern Rock and Irish banks. Credit flows are dwindling to nothing. Unless there is a reversal, there will be a major economic recession – even a slump.
The problem is that panics occur because of the primeval desire to protect oneself and one’s own. The fear feeds on itself, and unless some major event brings everyone to their senses it will grow. This panic is international. What transfixed London on Tuesday was less what had happened in Britain – the necessary and inevitable action on Bradford & Bingley – but the failure of the US House of the Representatives to pass the Paulson plan. Meanwhile, bank collapses required public bail-outs in France, Holland, Iceland, Belgium and Germany. Then came the Irish guarantee of every deposit in its banks.
The Irish ‘beggar thy neighbour’ policy shocked Europe; such an extreme response could only have been prompted by the potential collapse of a bank. Ireland had jumped straight to the last resort policy of a blanket deposit guarantee, potentially forcing the whole of Europe to follow in fear of losing deposits to Dublin’s secure accounts. The need for better European collaboration could not be better dramatised, and yesterday’s Paris summit called by President Sarkozy, expected to limit such a Dutch auction in deposit guarantees, is a start. Eurosceptics in Number 10 and the Tory party may wish otherwise – but Britain alone does not have the muscle to support the vast international financial centre that is the City of London. British bank assets are five times British GDP – let alone the assets of international banks domiciled here.
We are as vulnerable as Iceland, Switzerland and Ireland, as one top financial regulator told me. We need Europe. If the scale of the threat is obvious, so is the opportunity. A political fortune awaits the government that seizes the opportunity to rebuild the delinquent casino that is the British financial system, and around different principles – a long-term commitment to building businesses, support for investment and innovation, and fairness. Anglo-Saxon capitalism may have delivered a 10-year boom, but the price has been savagely high. Now there is a once-in- 50-years opportunity to create new institutions, new practices and new incentives. If Gordon Brown and his government eschew it they will deserve to be trounced at the general election, and then have to live with having passed up the golden opportunity of their lives.
Talking of making bankers pay for the mess they have created, as they do in America over the Paulson plan, is pointless. The task now is to survive without a slump – and create a new financial system that moves decisively away from the mores of super gentlemanly capitalism.
We have to mimic the Paulson plan and set up a so-called ‘bad’ bank, with up to £100bn of purchasing power. We must buy toxic loans from all British-based banks, with the object of selling them in better market conditions. Most such operations, as in Sweden in the Nineties or Britain in the Seventies, end up losing no money whatever. This will stop the banks becoming zombie institutions.
Second, we have to reopen the markets in securitised assets. This requires two initiatives. The taxpayer will have to find £50bn-plus to invest in the shares of our leading banks so there is no doubt they are solvent and can support both the existing level of debt and the new issue of more. The taxpayer should also give an additional stimulus by running a temporary insurance scheme so that overseas and domestic buyers of securitised loans know there is no risk of losing any money – in other words, a form of targeted and temporary deposit insurance.
The government will become the biggest single shareholder in the financial system. It can require the banks to behave differently – to move from financing casino capitalism to productive enterprise. There can be a new emphasis on relationship building and offering cheap long-term loans to business. We should create a long-term investment bank. Investment banking and commercial banking should be split, reinforced by a British Glass Steagall Act. The British vogue for takeover can be constrained.
The regulatory regime must be overhauled; never again should regulators turn a blind eye to off shore banking and wild ratios in which lending can reach 30 or 40 times a bank’s capital. EU and American regulators need to work much more closely – and Britain needs to be part of the process. The UK taxpayer does not have the firepower to support a bust international system – one of the reasons that Brown’s reluctance to consider a joint European initiative is short sighted. We may even have to consider joining the euro to get the necessary financial power behind London.
A 30-year experiment has come to an end. The world of go-getting investment banks has gone forever. The danger is that we go from feast to famine; debt remains a vital element in any economy, and if we too suddenly try to live without it we will crush ourselves economically. What we are witnessing is a system failure that requires a systemic response – the creation of a new system that sponsors a fairer, more productive capitalism in its place, while maintaining high flows of credit and debt.
This is a terrifying moment; but it is also our generation’s once-in-a-lifetime chance to change British capitalism. Brown has an awesome responsibility to his party and his country. I hope he rises to the challenge.
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