The worst thing is that another economic shock could take us back to the brinkby George Magnus / September 10, 2018 / Leave a comment
Photo: Johnny Green/PA Wire/PA Images This coming Saturday, 15th September, marks the 10th anniversary of the day Lehman Brothers filed for bankruptcy. It was a seminal moment that I remember well. The build-up to and speculation about the Lehman crisis had been going on for some time. I recall walking around the main fixed income (or bond) trading floor the previous Friday—normally a boisterous and noisy place—but this time, you could hear a pin drop, such was the tension and the angst on the floor. I have other personal reflections, as an economist, partially successful soothsayer, and now also one of many trying to figure how we got into the mess we are in today. At the time of the crisis, I was a senior economic adviser at the investment bank UBS, having been Chief Economist until 2006. Though I have made many errors of economic judgment in my career, the extra research freedom allowed me to spot the oncoming financial crisis in late 2006. US home prices had peaked in July that year, and the consequent unravelling effects on the real estate market, financial institutions, and the banking industry’s loan, funding and collateral structure were rapid and remarkable. By the beginning of 2007, some discussion was growing around a so-called Minsky Moment. This was named after the US economist Hyman Minsky, who figured rarely if ever in university economics syllabuses, but whose principal teaching was about the recurrent causes of financial instability. Minsky taught that leverage accumulates in “good times,” culminating in a third and final phase when borrowers are dependent on new loans to amortise and service debt. Once the main asset(s) on which the leverage depends rolls over, chaos ensues. For Minksy, systemic financial crises were endogenous to (but not only to) capitalism. To mitigate or avoid them requires rethinking the role of banks in society and what we prioritise in the economy, for example jobs, investment, and income inequality. I emphasise Minsky to underline that it isn’t true that no one saw the crisis coming. I know people who were working at the time in the IMF and Bank for International Settlements who were on the case. Some economists who you may know such as Paul McCulley, Raghuram Rajan, Nouriel Roubini and Steve Keen were also prescient in their warnings, as well as several major investors “featured” in the film The Big Short. The problem was that no one wanted to listen. I only ever had one invitation to present on it to the bank’s most senior executives, but that was in the summer of 2008. By then of course, the die was cast. Before the crash, some very senior bankers had no idea about derivatives, complex financial products, or leverage in financial systems. Some very smart traders running big positions in securitised products, such as collateralised debt obligations, used models of house prices with 10 years of data. Really you need evidence going back to the 19th century to illustrate the recurrent cyclical nature of property busts. As JK Galbraith wrote in his brilliant A Short History of Financial Euphoria, two particular phenomena contribute to phases of financial euphoria: the first is the extreme brevity of financial memory, and the specious association of money with intelligence. To quote: “There can be few fields of human endeavour in which history counts for so little as the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.” And that’s what I call a bull’s eye. Have we learned the lessons of 10 years ago? I would say, some. Banks are better capitalised, and have more loss-absorbing equity and less debt. The earlier you do this in a crisis the better. Banks trade for themselves less and have increased their funding from more stable deposits. They are subject to regular stress tests to see if they can withstand shocks. There is a much more intrusive regulatory culture. We can probably do better now spotting problems in a rogue financial institution or insurance company. Can we stop systemic crises? The answer is probably not. I don’t think there’s one brewing yet, mostly because people are still too frightened about over-leverage. Yet, we haven’t changed the structure of the banking system that much since 2008, and whether China can contain its own leverage problems, for example, is an open question. But the banking system is only as robust as the economy is well managed and strong, and we haven’t come to terms properly with challenges arising from unequal distribution, wage stagnation, the need for better investment and infrastructure, better taxation systems, and long-term policies to boost educational attainment and productivity. We are also still struggling with imbalances between savings and investment—too much of the former, too little of the latter. Until these big macro issues and imbalances are better managed, our financial system will doubtless remain edgy. A big shock, say in China, a US recession in the next two years, a badly managed Brexit, property market decay, global liquidity shortages, or disruptive new financial technologies are all capable of taking us back to the brink.