Sunday, July 8, 2018

Lanchester—"After the Fall: Ten Years After the Crash"

John Lanchester at the London Review of Books, 5July2018:
Some of the more pessimistic commentators at the time of the credit crunch, myself included, said that the aftermath of the crash would dominate our economic and political lives for at least ten years. What I wasn’t expecting – what I don’t think anyone was expecting – was that ten years would go by quite so fast. At the start of 2008, Gordon Brown was prime minister of the United Kingdom, George W. Bush was president of the United States, and only politics wonks had ever heard of the junior senator from Illinois; Nicolas Sarkozy was president of France, Hu Jintao was general secretary of the Chinese Communist Party, Ken Livingstone was mayor of London, MySpace was the biggest social network, and the central bank interest rate in the UK was 5.5 per cent.
It is sometimes said that the odds you could get on Leicester winning the Premiership in 2016 was the single most mispriced bet in the history of bookmaking: 5000 to 1. To put that in perspective, the odds on the Loch Ness monster being found are a bizarrely low 500 to 1. (Another 5000 to 1 bet offered by William Hill is that Barack Obama will play cricket for England. I’d advise against that punt.) Nonetheless, 5000 to 1 pales in comparison with the odds you would have got in 2008 on a future world in which Donald Trump was president, Theresa May was prime minister, Britain had voted to leave the European Union, and Jeremy Corbyn was leader of the Labour Party – which to many close observers of Labour politics is actually the least likely thing on that list. The common factor explaining all these phenomena is, I would argue, the credit crunch and, especially, the Great Recession that followed.

Perhaps the best place to begin is with the question, what happened? Answering it requires a certain amount of imaginative work, because although ten years ago seems close, some fundamentals in the way we perceive the world have shifted. The most important component of the intellectual landscape of 2008 was a widespread feeling among elites that things were working fine. Not for everyone and not everywhere, but in aggregate: more people were doing better than were doing worse. Both the rich world and the poor world were measurably, statistically, getting richer. Most indices of quality of life, perhaps the most important being longevity, were improving. We were living through the Great Moderation, in which policymakers had finally worked out a way of growing economies at a rate that didn’t lead to overheating, and didn’t therefore result in the cycles of boom and bust which had been the defining feature of capitalism since the Industrial Revolution. Critics of capitalism had long argued that it had an inherent tendency towards such cycles – this was a central aspect of Marx’s critique – but policymakers now claimed to have fixed it. In the words of Gordon Brown: ‘We set about establishing a new economic framework to secure long-term economic stability and put an end to the damaging cycle of boom and bust.’ That claim was made when Labour first got into office in 1997, and Brown was still repeating it in his last budget as chancellor ten years later, when he said: ‘We will never return to the old boom and bust.’

I cite this not to pick on Gordon Brown, but because this view was widespread among Western policymakers. The intellectual framework for this overconfidence was derived from contemporary trends in macroeconomics. Not to put too fine a point on it, macroeconomists thought they knew everything. Or maybe not everything, just the most important thing. In a presidential address to the American Economic Association in 2003, Robert Lucas, Nobel prizewinner and one of the most prominent macroeconomists in the world, put it plainly:
Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of that economic disaster. My thesis in this lecture is that macroeconomics in this original sense has succeeded: its central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.
Solved. For many decades. That was the climate of intellectual overconfidence in which the crisis began. It’s been said that the four most expensive words in the world are: ‘This time it’s different.’ We can ignore the lessons of history and indeed of common sense because there’s a new paradigm, a new set of tools and techniques, a new Great Moderation. But one of the things that happens in economic good times – a very clear lesson from history which is repeatedly ignored – is that money gets too cheap. Too much credit enters the system and there is too much money looking for investment opportunities. In the modern world that money is hotter – more rapidly mobile and more globalised – than ever before. Ten and a bit years ago, a lot of that money was invested in a sexy new opportunity created by clever financial engineering, which magically created high-yielding but completely safe investments from pools of risky mortgages. Poor people with patchy credit histories who had never owned property were given expensive mortgages to allow them to buy their first homes, and those mortgages were then bundled into securities which were sold to eager investors around the world, with the guarantee that ingenious financial engineering had achieved the magic trick of high yields and complete safety. That, in an investment context, is like claiming to have invented an antigravity device or a perpetual motion machine, since it is an iron law of investment that risks are correlated with returns. The only way you can earn more is by risking more. But ‘this time it’s different.’

The thing about debt and credit is that most of the time, in conventional economic thinking, they don’t present a problem. Every credit is a debt, every debt is a credit, assets and liabilities always match, and the system always balances to zero, so it doesn’t really matter how big those numbers are, how much credit or debt there is in the system, the net is always the same. But knowing that is a bit like climbing up a very, very long ladder and knowing that it’s a good idea not to look down. Sooner or later you inevitably do, and realise how exposed you are, and start feeling different. That’s what happened in the run-up to the credit crunch: people suddenly started to wonder whether these assets, these pools of mortgages (which by this point had been sold and resold all around the financial system so that nobody was clear who actually owned them, like a toxic version of pass the parcel in which nobody knows who is holding the parcel or what’s in it), were worth what they were supposed to be worth. They noticed just how high up the ladder they had climbed. So they started descending the ladder. They started withdrawing credit. What happened next was the first bank run in the UK since the 19th century, the collapse of Northern Rock in September 2007 and its subsequent nationalisation. Northern Rock had an unusual business model in that instead of relying on customer deposits to meet its operational needs it borrowed money short-term on the financial markets. When credit became harder to come by, that source of funding suddenly wasn’t there any more. Then, just as suddenly, Northern Rock wasn’t there any more either.

That was the first symptom of the global crisis, which reached the next level with the very similar collapse of Bear Stearns in March 2008, followed by the crash that really did take the entire global financial system to the brink, the implosion of Lehman Brothers on 15 September. Because Lehmans was a clearing house and repository for many thousands of financial instruments from around the system, suddenly nobody knew who owed what to whom, who was exposed to what risk, and therefore which institutions were likely to go next. And that is when the global supply of credit dried up. I spoke to bankers at the time who said that what happened was supposed to be impossible, it was like the tide going out everywhere on Earth simultaneously. People had lived through crises before – the sudden crash of October 1987, the emerging markets crises and the Russian crisis of the 1990s, the dotcom bubble – but what happened in those cases was that capital fled from one place to another. No one had ever lived through, and no one thought possible, a situation where all the credit simultaneously disappeared from everywhere and the entire system teetered on the brink. The first weekend of October 2008 was a point when people at the top of the global financial system genuinely thought, in the words of George W. Bush, ‘This sucker could go down.’ RBS, at one point the biggest bank in the world according to the size of its balance sheet, was within hours of collapsing. And by collapsing I mean cashpoint machines would have stopped working, and insolvencies would have spread from RBS to other banks – and no one alive knows what that would have looked like or how it would have ended.

The immediate economic consequence was the bailout of the banks. I’m not sure if it’s philosophically possible for an action to be both necessary and a disaster, but that in essence is what the bailouts were. They were necessary, I thought at the time and still think, because this really was a moment of existential crisis for the financial system, and we don’t know what the consequences would have been for our societies if everything had imploded. But they turned into a disaster we are still living through. The first and probably most consequential result of the bailouts was that governments across the developed world decided for political reasons that the only way to restore order to their finances was to resort to austerity measures. The financial crisis led to a contraction of credit, which in turn led to economic shrinkage, which in turn led to declining tax receipts for governments, which were suddenly looking at sharply increasing annual deficits and dramatically increasing levels of overall government debt. So now we had austerity, which meant that life got harder for a lot of people, but – this is where the negative consequences of the bailout start to be really apparent – life did not get harder for banks and for the financial system. In the popular imagination, the people who caused the crisis got away with it scot-free, and, as what scientists call a first-order approximation, that’s about right.

In addition, there were no successful prosecutions of anyone at the higher levels of the financial system. Contrast that with the savings and loan scandal of the 1980s, basically a gigantic bust of the US equivalent of mortgage companies, in which 1100 executives were prosecuted. What had changed since then was the increasing hegemony of finance in the political system, which brought the ability quite simply to rewrite the rules of what is and isn’t legal. One example I saw when I was researching Whoops!, my book on the crisis, was in Baltimore. There people going to buy houses for the first time would turn up at the mortgage company’s office and be told: ‘Look, I’m really sorry, I know we said we’d be able to get you a loan at 6 per cent, but something went wrong at the bank, so the number on here is 12 per cent. But listen, I know you want to come out of here owning a house today – that’s right isn’t it, you do want to leave this room owning your own house for the first time? – so what I suggest is, since there’s a lot of paperwork to get through, you sign it, and we sort out this issue with the loan later, it won’t be a problem.’ That is a flat lie: the loan was fixed and unchangeable and the contract legally binding, but under Maryland law, the principle is caveat emptor, so the mortgage broker can lie as much as they want, since the onus is on the other party to protect their own interests. The result, just in Baltimore, was tens of thousands of people losing their homes. The charity I talked to had no idea where many of those people were: some of them were sleeping in their cars, some of them had gone back to wherever they came from outside the city, others had just vanished. And all that predatory lending was entirely legal.

That impunity, the sense that these things had consequences for us but not for the people who caused the crisis, has been central to the story of the last ten years. It has also been central to the public anger generated by the crash and the Great Recession. In the summer of 2009, when I was writing Whoops!, I remember thinking that a huge storm of rage was coming towards governments once the public realised what a giant hole had been dug for them by the financial system in collusion with their leaders. Then the book came out, and I was giving talks about it all over the place from its publication in January 2010 through the spring and summer, and there was this mysterious lack of rage. People seemed numb and incredulous but not yet angry.

In July 2010 I was in Galway for the arts festival, giving a talk in a room where, I later learned, a former taoiseach was famous for accepting envelopes full of cash during Galway’s racing week. By that point in the publication process you normally have your talk down to a fine art, or as fine as it’s going to get, and my spiel consisted of basically comic points about how reckless and foolish the financial system had been. Normally when I gave the talk people would laugh at the various punchlines, but now there was complete silence in the room – the jokes weren’t landing at all. And yet I could tell people were actually listening. It felt strange. Then the questions began, and all of them were about blame, and I realised everyone in the room was furious. All the questions were about whose fault the crash was, who should be punished, how it was possible that this could have happened and how outrageous it was that the people responsible had got away with it and the rest of society was paying the consequences. I remember thinking that the difference between Ireland and the UK is just that they’re a few months ahead. This is what’s coming....