THINKING SHORT

John Bradley

Boomerang: The Meltdown Tour, by Michael Lewis, Allen Lane, 240 pp, £20, ISBN: 978-1846144844
The Big Short: Inside the Doomsday Machine, by Michael Lewis, Penguin, 288 pp, £9.99, ISBN 978-0141043531
Panic! The Story of Modern Financial Insanity, Penguin, 400 pp, £10.99, ISBN 978-0141042312

All important events in history generate long-tailed literatures of dissection and explanation. This is particularly true in the world of finance, business and economics. For example, the success of the Irish economy during the 1990s produced a mountain of books that tried to explain the unexpected rise of the so-called Celtic Tiger. The subsequent spectacular collapse in 2008 is producing even more books that pick over the whole sorry saga with the benefit of hindsight. Somehow it seldom or ever seems possible to predict success or failure. But after the fact everything becomes clearer. The fervent hope is that lessons are learned and the egregious mistakes of the past are less likely to be repeated in the future. The inescapable reality is that the human race has an irrational self-destructive tendency that will never be cured.

In the case of explaining economic failure it is useful to identify two main approaches. The first is based on conventional or orthodox economic analysis and asserts that failure was caused by ignoring the advance signs of trouble and failing to follow sound policies. The Reinhart and Rogoff book This Time is Different: Eight Centuries of Financial Folly (2009), is an example of this approach. The second approach asserts the opposite. Namely, that the blind implementation of conventional or orthodox policies actually caused the failure and preventing it would have required the casting off of orthodoxy and the adoption of new and radical policies. The revival of interest in Marxian analysis falls within this genre.

These two approaches tend to be adopted by and directed at people who play an active role in policy-making and analysis, either as academics or as practitioners. In other words, the sources of failure are not sought in the misguided, self-serving, often immoral and unpredictable actions of individuals or groups of people but in the flaws that are inherent in the frameworks that guide policy-makers and market participants. It’s all very impersonal, and John Maynard Keynes memorably characterised these two approaches when in 1937 he wrote in his seminal General Theory that:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

You will find little in the work of Michael Lewis that derives from either of the above two approaches. Originally a trainee stockbroker and trader, and later transferring to financial journalism, his technique is to adopt the role of idiot savant. In excoriating detail, with bitter humour and piercing insight, he illuminates many of the reasons why the past two decades have seen a series of ever more serious economic failures. Based on his long experience of explaining economic catastrophes, going back to his 1989 book Liar’s Poker, which deals with the stock market crash of 1987, Lewis gets behind the wall of often impenetrable jargon used by economic and financial power-brokers and challenges their claim to understand what is going on and to make wise decisions. As a devastating and subversive demolition of the notion of homo economicus that underpins orthodox economic theory, you will not find better than Lewis.

With what was excruciatingly bad timing, Alan Greenspan published his self-congratulatory autobiography The Age of Turbulence: Adventures in a New World, on September 17th, 2007. In it he asserted that the financial innovations of the previous decade had made the global financial economy more stable and resistant to shocks. Government should butt out since the “market” knew best. Lewis, in Panic and The Big Short explodes all such claims and exposes the self-serving, irrational and ultimately destructive behaviour of the main players in unregulated financial markets. After dipping into the papers in Panic!, an edited volume of readings going back to the 1987 stock market crash but also embracing the Asian collapse of 1997, the fall of Long-Term Capital Management in 1998, the dot.com bubble of 2000, and the sub-prime crisis and financial collapse of 2007/8, it beggars the imagination that the inevitable bursting of the 2008 sub-prime bubble could not have been anticipated, mitigated, or even prevented.

Of course the Irish banks were not at the centre of the kinds of crazy financial deregulation and innovation that led to the global financial meltdown in 2008, even if they suffered serious collateral damage emanating from that meltdown. Their mistakes were more crude and homespun and consisted of reckless lending to Irish property developers, funded by foreign short-term loans rather than domestic deposits, in a bubble market and on the shaky security of wildly overpriced properties and land. Many of the imbalances in the Irish economy that suddenly emerged as the recession hit were not at all obvious prior to the recession, even to the usually stern and omniscient international agencies like the IMF and the OECD. Warning signals had been sounded by local economists. The Central Bank had studied property market developments as the domestic bubble economy grew during the 2000s, and sent out messages that all was not well and that there was a problem with excessive lending. But such messages had little or no effect since they were timid and muted and consequently all too easy to downplay, ignore or suppress. Nobody, and least of all the Central Bank of Ireland, wanted to be blamed for precipitating the very economic collapse that it feared would occur merely by talking about it.

Ireland was not alone in crashing in 2008. All EU states with the exception of Poland suffered recessions of varying depth. In Boomerang, Lewis goes on a kind of Rabelaisian tour of the three small economies that suffered most damage from the global financial crash: Iceland, Greece and Ireland. He also tours Germany, the source of much of the foolish, low interest money that flooded into the Irish banks, and the USA, where the collapse started. He flew into Ireland in early November 2010, two years after the Irish government had taken the decision to guarantee all the debts of its bankrupt banking system. His wry characterisation of the Irish financial disaster cannot be bettered:

Left alone in a room with a pile of money, the Irish decided what they really wanted to do with it was buy Ireland. From each other.

Fuelled by easy money from countries like Germany, and accompanied by a level of incompetence on the parts of the Central Bank and the Financial Regulator that makes one weep, the Irish property development market became a giant Ponzi scheme. One forgives Lewis for dramatising the inevitable collapse of the scheme on October 2nd, 2008, when Patrick Neary, the Bank Regulator, appeared on television to reassure the population that the banking system was in perfect good health. Lewis quotes economist Colm McCarthy as saying:

 “What happened was that everyone (…) had the idea that somewhere in Ireland there was a little wise old man who was in charge of the money, and this was the first time they’d seen this little man. And then they saw him and said, Who the f**k was that? Is that the f**king guy who is in charge of the money??? That’s when everyone panicked.”

Lewis convincingly shows that unregulated or weakly regulated financial markets almost always destabilise the operation of the “real” economy, that is, that part of the economy that employs people to produce tangible goods and services for home consumption and export. In the case of Iceland, its banking system grew so large and engaged in such reckless and ill-considered investments that its inevitable and entirely predictable failure literally destroyed the real economy. The case of Greece was different. The main culprit here was the corrupt and incompetent government, who were aided and abetted by Goldman Sachs to falsify official data and managed to gain entry to the euro zone under false pretences. In a pleasing symmetry, Lewis says that: “In Greece the banks didn’t sink the country. The country sank the banks.”

In the case of Ireland, the weakness of regulation and oversight permitted the banks to fuel a spiral of inflation in the property market through their easy access to foreign short-term funding at very low interest rates. The bursting of the bubble in 2008 destroyed the Irish banking system and left the rest of the economy encumbered with massive debts that will take a generation to repay. Could the slide to disaster have been stopped? Almost certainly not! In The Irish Banking Crisis: Regulatory and Financial Stability Policy 2003-2008, the Central Bank’s own internal inquiry into the collapse of the banking system, it was stated that there was

an unwillingness by the CBFSAI to take on board sufficiently the real risk of a looming problem and act with sufficient decision and force to head it off in time. ‘Rocking the boat’ and swimming against the tide of public opinion would have required a particularly strong sense of the independent role of a central bank in being prepared to ‘spoil the party’ and withstand possible strong adverse public reaction.

Perhaps the most unexpected and shocking outcome of the global financial crisis, and one that Lewis tends to downplay, was that the euro, designed to create a zone of monetary stability in the heart of Europe, has almost been torn apart as the contagion from events that started in the USA and the UK, spread to the rest of Europe and cruelly exposed institutional flaws and weaknesses in the way in which the currency union was set up and operated. We now face a situation where if the euro is to survive it will be because Germany wills it to survive. As Lewis summarises:

As the Germans were not only the biggest creditor of various deadbeat European nations, but their only serious hope for future funding, it was left to Germany to act as moral arbiter, to decide which financial behaviour would be tolerated and which would not. … Conceived as a tool for integrating Germany with Europe, and preventing Germany from dominating others, the euro has become the opposite.

During his visit to Germany, Lewis interviewed Jörg Asmussen, deputy minister of finance and a career civil servant. He asked Asmussen why he “hadn’t taken time out of public service to make his fortune working for some bank, the way every American civil servant who is anywhere near finance seems to want to do”. Asmussen’s response was rather charming and illustrates the difference between Anglo-Saxon financial morals and those of the social market economies of central Europe: “But I could never do this’, he said. ‘It would be illoyal (sic)!”

The longer-term fallout of the financial crisis has produced some very puzzling and strange consequences. For example, Lewis documents in The Big Short that the two main credit rating agencies, Moody’s and Standard & Poor’s, assigned triple-A ratings to a massive quantity of mixed securitised sub-prime mortgages that we now know should have been rated as junk. Their reasons for doing so were only too obvious: huge fees were paid for these ratings that would have gone elsewhere if they had turned out to be other than triple-A. Yet today we have a situation where these same rating agencies destabilise the weaker euro zone countries by downgrading their sovereign debt.

Even after presiding over the biggest financial collapse since the Great Depression of 1929-1931, the replacement senior management of the failed banks, now effectively owned and funded by the taxpayer, still demand and receive salaries and bonuses that are out of proportion to those of senior management in the real economy. One is driven to the conclusion that in an increasingly secular society, the banking system has now supplanted religion with its narrow, oligarchic management hierarchy, its impenetrable private language and its quasi-mystical powers.

Perhaps Lewis’s most disturbing insight is one that strikes at the heart of the neo-conservative assertion that markets, if left to themselves, will order society and reach stable equilibriums. Nothing could be further from the truth.

One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicise the problem.

What this means is that investment banks were peddling securitised sub-prime mortgages, claiming that they were triple-A rated (by the obliging folk in Moody’s and Standard & Poor’s), but fully realising that they were actually junk. They then took out massive bets that these securities would collapse in value and made awesome sums of money when they did.

Although Lewis is very effective in debunking the myth that we should put our faith in bankers, he seldom talks about the rest of the economy: the “real” economy. It is important that public discourse in Ireland turn from an obsession with the “financial” economy to consider what has to be done to restore the health of the real one. Popular media will always chase after drama and suspense: midnight meetings of EU finance ministers as Greece totters on the brink of collapse; rows in the council of ministers as the rich EU states gang up on the spendthrift “deadbeats”, to use Lewis’s term; revelations about who did what on the night the Irish bank guarantee was agreed, etc.

Unusually in Europe, Ireland lacks media that deal systematically with business, economic and financial affairs. We seldom think aloud or in depth about the manner in which our economy functions. Such issues tend to be highlighted only when there is crisis or scandal. Even research organisations like the ESRI have tended to fall silent in recent years on the controversies that have engulfed the economy and prefer to deal internally within government circles rather than externally by informing the wider public who are ultimately paying for the whole fiasco. The Fiscal Advisory Council, whose secretariat is based at the ESRI, is permitted to call for deeper cuts and higher taxes without feeling the need to examine in any depth the likely consequences for employment and the operation of the real economy.

A better understanding of the manner in which the recent recession impacted on the economy requires a reexamination of the first Celtic Tiger period (1986-2000) and its continuation into the decade of the 2000s, culminating in the bust of 2008. Research shows that it was the differing performances of the internationally traded and the non-traded sectors that largely dictated the sustainability of the former (“real” Celtic Tiger) period of sustainable, strong growth and convergence to EU average standards of living, but the unsustainability of the latter (“faux” Celtic Tiger) period that was characterised by a bubble economy based on property speculation fuelled by excessive credit creation. During the “real” Celtic Tiger period (1986-2000), it was the manufacturing sector that initially primed the resumption of growth after the recession of the early 1980s and which was the core factor in generating the wealth that was so recklessly dissipated in the years 2000-2008.

During 2000-2007 Ireland slid into a serious and unsustainable property boom, where the short-term returns to investing became so high as to deflect attention and resources away from the tradable sectors that were needed to sustain exports. With the benefit of hindsight, the bad omens were only too obvious: years of reckless lending by banks who threw financial petrol on a fire that was already almost out of control; an unwillingness on the part of the Central Bank to call the banks to order; excessive dependence on tax revenue derived from property churning; paranoia on the part of policy-makers when anyone had the temerity to suggest that all was not well. The crash, when it inevitably came, was both unexpected and catastrophic.

The banks were an easy and obvious scapegoat for the economic collapse of 2008 and the depth of the subsequent recession. Lewis tells us all we need to know about the poisonous role of out-of-control, unregulated financial institutions. But such a narrow financial focus serves to downplay other causes of the slide into catastrophe. Next in line was the rapidly emerging disarray in the public finances that had been triggered in large part by the end of the property bubble of the 2000s. In those unsustainable good times the exchequer had come to depend excessively on tax revenue associated with the churning at ever higher prices of property and development sites and had reduced many other tax rates. The post-bubble collapse of sources of revenue exposed a massive gap in the public finances at the very time when an already high level of public expenditure was under pressure to rise further in order to pay for the by now large and expensive public sector and for income support to assist the rapidly rising numbers out of work.

These and other causal factors of the financial and economic crisis are all closely interrelated. Excessive credit creation at home served to fuel the domestic property bubble, and escalating property prices fuelled more widespread inflation and loss of international competitiveness. The artificial and unsustainable property boom served for a time to generate extra revenue, relaxed normal prudential constraints on public expenditure, and when the boom-time economic music stopped, a fiscal situation that had appeared to be in equilibrium was found to be profoundly out of equilibrium. The implosion of the bloated building and construction sector, which employed over 13 per cent of the labour force at its peak in 2007 ‑ the same share as manufacturing! ‑ dragged down the employment-rich market services sector, which supported some 44 per cent, and forced contraction in the wider public service sector (government, health and education), which supported some 26 per cent, that is, the 70 per cent of total employment that depended on the internal health of the domestic Irish economy rather than on the state of international export markets. To make matters worse, the Irish banks were discovered to have squandered resources of such huge magnitude as to be almost impossible to comprehend. To give a sense of scale, sadly lacking in much public commentary, the losses made in one institution, the former Anglo Irish Bank, were larger than the totality of all EU structural funds received by Ireland over the twenty-four-year period 1989-2012.

There are signs that some recovery in growth is being experienced in the Irish economy, but this is precariously dependent on continued recovery in the global economy as well as the termination of large scale fiscal contractions that were mandated by the international institutions who are providing bail-out support to the government. However, the strict criteria set out by the international organisations who are overseeing Ireland’s adjustment programme will be difficult to achieve if the global economic recovery is weak, even though good progress towards these targets is made. Forcing the Irish government into bigger cuts and even higher taxes would almost certainly be self-defeating.

Ireland needed a wake-up call, and it came when a justifiably exasperated José Manuel Barroso, president of the European Commission, rounded on the Irish MEP Joe Higgins and told the brutal truth:

To the distinguished member of this Parliament who comes from Ireland, who asked a question suggesting that the problems of Ireland were created by Europe, let me tell you: the problems of Ireland were created by the irresponsible financial behaviour of some Irish institutions, and by the lack of supervision in the Irish market.

What does the future hold? Between 1985 and 2000, Irish GDP per head grew from 67 per cent of the EU average to 115 per cent. No economist, including myself, predicted such a dramatic turnaround. But with hindsight we now recognise that success came not overnight, but as a result of decades of strategic policy decisions in the areas of education, training, improved infrastructure, policy stability and transparency in corporate taxation and a willingness of households to carry a correspondingly higher tax burden. Many of the gains of these years have now been dissipated both in terms of lower current income and higher national debt. However, the underlying Irish development strategy is as sound today as it was at the height of the 1990s “real” Tiger period, even if it needs modification and updating. But to grow out of our present crisis we first need to face into the consequences of our past policy mistakes and implement institutional and other safeguards that will minimise the prospect of future policy-induced economic catastrophes. Blaming the rest of the world for our own greed and policy errors is ridiculous and a luxury that we can ill afford.

John Bradley was for many years a research professor at the ESRI and now works as an international consultant in the area of economic and industrial strategy. He regularly advises the European Commission, the World Bank and other international organisations and governments on policy issues related to promoting long-term economic growth and development.

02/11/12

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