Nobody knew with the least precision what Mr. Merdle’s business was, except that it was to coin money.
Charles Dickens, Little Dorrit (1857)
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
John Maynard Keynes, The General Theory of
Employment, Interest and Money (1936)
Thus the whirligig of time brings in his revenges.
William Shakespeare, Twelfth Night (1601)
In late January 2009 the World Economic Forum met as usual in Davos. The theme, “Shaping the Post-Crisis World,” was either optimistic or long-range, since at that stage it was by no means clear when the world would emerge from crisis. The summing-up message from the forum was that global leaders must develop a swift and coordinated response to the most serious global recession since the 1930s. This was predictable rhetoric: the world’s leaders riding to the rescue of the world’s people.
Behind the elegant words, during the forum there had been pointed criticism of the Western-inspired capitalist model that had so conspicuously broken down. After years of criticism by Western economists for the sins of state interference and “crony capitalism,” Asian policymakers felt justified in hitting back. Now it was the turn of the West to take correction, for its credit-fuelled asset bubble and its painfully imploding growth model.
China’s premier, Wen Jiabao, pilloried Western banks for their “blind pursuit of profit and lack of discipline” and, quoting Adam Smith, scolded the former high priests of untrammelled capitalism for their “unsustainable model of development characterized by prolonged low savings and high consumption.”
Other voices chimed in alongside him. One, Prakash Javadekar, from India’s Bharatiya Janata Party, described Western capitalism as “nothing but overindulgence.” Eisuke Sakakibara, a former senior Japanese finance official, predicted, “The American age is over.” Kishore Mahbubani, dean of Singapore’s Lee Kuan Yew School of Public Policy, said Asians had learned some valuable lessons from watching mistaken Western excess: “Do not liberalize the financial sector too quickly, borrow in moderation, save in earnest, take care of the real economy, invest in productivity, focus on education.” The critics had a phrase for the Western overindulgence that they were attacking: “casino capitalism.”
“Casino capitalism” was a phrase popularized in 1986 by Susan Strange, Professor of International Relations at the London School of Economics from 1978 to 1988. It was the title of what became her best-known book. In it, she warned about how the speed at which markets work, combined with their near-universal reach, would result in levels of global volatility that had never been experienced before. In a world where the vast bulk of market trading has no direct relation to any real business requirement, what concerned her was how the instability of active markets could devalue the economic base of real lives or, in macroeconomic terms, could lead to the collapse of national and regional economies. She focused particularly on innovations in the way in which financial markets work; the sheer size of markets, the trend for commercial banks to expand into investment banking, and the deregulation of the markets.
“Casino capitalism” brought other, less purely economic, troubles in its wake. The fraudster has always been drawn to the casino, and the liberalized financial markets with their ability to create sudden geysers of cash inevitably attracted the attention of manipulators and crooks. Even those who have not seen Michael Douglas’s Oscar-winning performance in Oliver Stone’s 1987 film Wall Street will know the approximate meaning of “pump and dump” and “short and distort,” and will be familiar with the caricature of the ruthless, amoral city banker making millions from dubious transactions. And those who remember the arbitrageurs, the corporate raiders and the junk-bond kings of the 1980s will know that, like any good caricature, Douglas’s role was based on close observation of reality. Even then, the barbarians were at the gates; in the twenty years or so since then, the gates seem to have been opened wide.
So it is not surprising that the financial markets and their waywardness—their upheavals, distortions, manipulations—have caused intense and widespread anger; or that we ask ourselves if globalization is allowing them to get completely out of hand. It is not surprising that we ask whether they will eventually blow up in a way that permanently damages economic and social well-being. Or that we ask, Why should ordinary people suffer from all this destructive excess?
The global economic crisis that began in 2007 has been the deepest, broadest and most dangerous financial crisis since 1929. It may even come to rank as one of the great turning points in the history of the modern world—as a time with epoch-moulding consequences. We are too close to it to be certain of this, of course, let alone to have a clear view of what its consequences will be. But at the very least, as the head of America’s National Economic Council, Lawrence Summers—a strong defender of free markets—concluded in the spring of 2009, the belief that the market is inherently always self-stabilizing, has been “dealt a fatal blow ... it is wrong a few times a century and this is one of those times.”
For a while, the scale of what was happening was not fully apparent. When the storm broke, in the summer of 2007, many hoped that the worst would be over by Christmas (rather as the European powers in August 1914 had thought the war would be over by Christmas), or at least by the spring or the summer of 2008. In fact it was to grow into something far worse—a hurricane unprecedented in its savagery.
The scope of the financial crisis was shocking, affecting the global economy deeply in every area, causing the tightening of credit, stock-exchange declines, liquidity problems in equity and hedge funds, devaluation of assets underpinning pension funds and insurance contracts, massively increasing public debt and spreading currency volatility. To many it felt as though the crisis had come out of a clear blue sky—leaving, for instance, Alan Greenspan, chairman of the US Federal Reserve from 1987 to 2006, “in a state of shocked disbelief.”
But there were warning signs, and the first breezes of the on-coming hurricane were perhaps detectable as early as 2005. It is all too easy from today’s vantage point to pick out the forecasts that were uncannily correct and to ignore the consensus that was too optimistic. But there was in fact a growing concern among economists and financiers that the world’s markets were looking increasingly stretched—and a growing sense that at some point the music would stop.
By the end of 2005, more and more economists were pointing out that America was living beyond its means. It was by then the world’s biggest debtor country, and US consumers saved virtually nothing. Meanwhile, the fiscal position had deteriorated dramatically. The Bush administration had cut taxes while spending vast sums in Iraq. The US economy was dependent on the reserves of Japan, China and others being invested in US Treasury bonds to fund the fiscal and current-account deficits. Low interest rates kept American consumers active, and the economy grew robustly. But it was unbalanced, and economists were not slow to point this out. Nonetheless, very few indeed imagined how savage the correction would be when it finally came.
Below the surface lay a more fundamental shift in the world’s economic centre of gravity—a trend that was established well before 2007, and that will continue over the next generation and beyond. This shift has not been halted by the current crisis: in fact the crisis will accelerate it. There is a much wider dynamic at work that will change the world economy as much in the next half century as it has changed in the last.
For the last two hundred years the world’s economic centre of gravity has been focused on Western economies, the US in particular. The G7 today still generates over half of the world’s output, although it has only a seventh of its population. But from 1990 the economic hegemony of the older industrialized world has been increasingly challenged by the rise of developing economies, especially in Asia—and, within Asia, particularly by the world’s two largest countries, China and India. The mushrooming of these economies has created what can perhaps be described as a macroeconomic rectangle. The rectangle is made up of, on one side, consuming nations—in particular the US (which has become what might be termed the world’s consumer of last resort), but also countries such as the UK and a number of other European economies. On another side of the rectangle there are what might be called the “workshop nations”—mainly the fast-growth emerging economies, which have been manufacturing a vast range of goods for consumption in the West. On a third side are the resource providers—those economies whose wealth of hydrocarbons and other commodities has fuelled the production of the workshops and has therefore commanded such high prices in recent years. And finally, on a fourth side, there are two major capital-goods exporters that have equipped the workshops (Japan and Germany).
This rectangle delivered very strong global growth in the last decade, but it was inherently unstable, and it has given rise to the financial imbalances that lie at the heart of the present crisis. The workshop nations, the resource providers and the capital-goods exporters have accumulated massive savings, the vast bulk of which have been invested in the world’s reserve currency, the US dollar. This investment had profound consequences. Yields in the government bond markets were significantly reduced as they drew in the surplus liquidity from emerging markets (over 50 percent of US Treasury debt is now owned by foreign investors, with China overtaking Japan in 2008 as the single largest holder). This decline in yield prompted investors to look for alternatives that seemed to fit the requirement of higher yields with—apparently—limited risk. Mortgage-backed securities were the obvious choice: those securities were liquid, and were backed by mortgages on people’s homes. This stimulated huge growth in the issuance of these securities: in 1990, just 10 percent of mortgages in the United States were securitized—repackaged into bonds—but by 2007 this had risen to over 70 percent. This in turn permitted a massive growth in total mortgage lending—far more than the lenders could ever have financed from their own balance sheets.
The combination of a tidal wave of liquidity and the search for yield meant that the ratio of risk to return began to rise. The overall result was a boom in house prices and a binge of consumer borrowing. By any measure, Western consumer economies were becoming very highly geared, relying heavily on borrowing. In the US, the ratio of household debt to GDP rose sharply—to 100 percent in 2007, from 66 percent ten years earlier. By the summer of 2008, the UK’s overall household debt had reached 109 percent of GDP—the highest in the G7.
Loose monetary conditions in the US and in much of the emerging world gave added potency to this already lethal cocktail. Following the bursting of the dot-com bubble in 2000, the terrorist attacks of 11 September 2001 and the consequent stock market falls, the US Federal Reserve reacted by sharply lowering short-term interest rates in order to head off a downturn in economic activity, and it held them low for an unusually long period. This loosened the money supply not only in the US but in other economies around the world that habitually manage their currency against the dollar—including many of the world’s fastest growing emerging markets. So when the US held interest rates low, the result was lower monetary conditions not just in the US but also in many parts of the emerging world.
As the consumer was gearing up, so were the banks. In the US, the aggregate debt of the financial sector rose from 22 percent of GDP in 1981 to 117 percent by the third quarter of 2008. In the UK, the gross debt of the financial sector reached almost 250 percent of GDP. In the Western financial system as a whole, leverage/gearing increased rapidly, both directly and indirectly—directly, in that bank balance sheets became more and more highly geared; and indirectly, in that the banks packaged and sold securitized assets (often with mortgages as the underlying source of value) to investors around the world. Securitized assets—mortgages and other loans repackaged into bonds—had been in existence since the 1980s. What changed was the huge growth in volume and a spectacular increase in the complexity of the financial engineering used to create new investment vehicles for those looking for a good yield on what appeared to be safe assets. The result was that the first decade of the new century saw the mushrooming of a complex web of so-called structured finance around the world.
Another sign of the growing complexity of these financial interrelationships was that in one decade the gross value of financial derivatives leaped by a factor of four. The structuring and securitization that all this financial engineering made possible resulted in the diffusion of risk to investors around the world—which meant that lenders could create more mortgages and other loans for each dollar of capital than they could before. And that, in turn, meant three things: first, that lenders could easily be tempted into overlending and therefore inflating asset bubbles to bursting point; second, that the transfer of risk could make it very difficult to see who was ultimately the bearer of the loss in the case of a credit collapse; and, third, the complexity of the structures could make it extremely unclear what their real value was in the event of credit difficulties in the underlying asset. (It is all this that gives rise to the problem of what have become popularly known as “toxic assets.”) Gillian Tett of the Financial Times memorably described all this as “candy floss” money—akin to the way a small amount of sugar can be spun into a huge cone of candy floss.
Behind it all, and compounding the dangers, lay a market predisposition to overconfidence. For years the West had been enjoying what was dubbed “the Goldilocks economy.” It was called this because it was deemed to be, so to speak, neither too hot nor too cold but just right—though the connotations of its being a fairy tale later turned out to be relevant, too. Countries like the US and Britain, so it was said, could go on eating all the porridge produced by China forever. The markets had made it possible to achieve strong growth without the risk of inflation and overheating. Business cycles were a thing of the past, it seemed.
To make matters yet more perilous, even the risk managers were too often coming to believe in their own invulnerability. “The golden age of risk management” was a phrase used by some to describe a financial system in which risk-measurement models were so sophisticated that they would remove more uncertainty than ever before from the tricky business of making profits from finance. At the heart of this belief was the widespread assumption that the markets would always be liquid enough to allow any financial instrument to be bought or sold readily. What was measurable seemed manageable; and what was manageable must be comfortable. In this so-called golden age, banks and investors systematized the risk by the use of sophisticated models whose ultimate purpose was to price debt—the trouble being that no one predicted how rapidly the models would fall apart if confidence broke down and the financial markets became very illiquid. Thus the golden age was in fact an undermanaged age, because not enough people understood the models and their limitations, and because the immediate rewards were simply too large to be forgone: all boats floated as the tide came in.
“The perfect storm” is a phrase so often used that its origins are sometimes forgotten—it was the title of an investigative book by Sebastian Junger published in 1997 about the 1991 Halloween nor’easter that sunk the fishing boat Andrea Gail and devastated the lives of many American fishing and sailing families. The title arose from Junger’s interviews with meteorologists about the weather patterns building up to the storm. They said this was a storm in which all the ingredients were as bad as they could be—if a computer had designed the worst storm imaginable, it could not have done better. It would be wrong to call the financial crisis that began in 2007 “the perfect crisis,” since it could certainly have been immeasurably worse. And yet what is clear as one reviews the crisis even from a little distance in time is just how many forces simultaneously fed into the same destructive vortex.
We have touched upon some: the massive financial imbalances caused by macroeconomic relationships; a sustained global period of loose money; a fundamental complacency both macroeconomic, institutional and individual; a financial system that was overconfident in its own risk-management techniques; the globalizing of the bubble through securitization and the widespread dispersion of risk. Economic historians will surely study this period for many years to come.
And, as often with storms, there was something of a heavy calm before it. False calm, certainly; and followed by a series of events of breathtaking savagery.
Why was the storm, when it finally burst, so unexpectedly severe? By early 2007 the signs were pretty clear: everything looked stretched—not just mortgages, but other financial markets such as those in leveraged loans. Property markets were slowing down in the US, Britain and elsewhere, and fears of an end to the Goldilocks economy were rising (though inflation seemed as great a risk as recession).
The world’s finances certainly seemed stretched—and yet they were underpinned by large pools of liquidity. Asian and Middle Eastern sovereign wealth funds were flush with investable money. The foreign-exchange reserves of the major developing-economy exporters were rising month by month. The global private equity market was booming; 2007 was a record year for fund-raising. There was nervousness, certainly, but liquidity seemed limitless.
The International Monetary Fund’s official forecast published in April 2007 captured the prevailing thinking of the time. “It may surprise readers to learn that this World Economic Outlook sees global economic risks as having declined since our last issue in September 2006,” began the second paragraph of the fore-word. The report went on to predict the “continuation of strong global growth” despite worrying news from the US housing market and a slowing of growth in the US. Among positive signs, the IMF noted a strong US labour market. Elsewhere, it pointed to the fastest growth in six years in the euro area, increased momentum in Japan, and remarkable growth in China and India. During the five-year period 2003–7, it reminded readers, the global economy was achieving its fastest pace of sustained growth since the early 1970s. Yet five months later there would be no doubt in anyone’s mind: the unthinkable was happening.
In fact the poison was already spreading through the system when the IMF forecast appeared. In the spring of 2007 the mortgage-securitization markets started to dry up. By the autumn of 2008 they were nearly shut down altogether—meaning that about a third of the private-credit markets thus became unavailable as a source of funds. And the market had turned. By September 2008 average US house prices had fallen by over 20 percent from their mid-2006 peak. The signs of pain were becoming all too obvious from 2007 onward as the number of foreclosures rose, and as banks had to take large write-downs on the value of mortgage-backed securities still on their books.
Fear began to spread through the financial markets. In the autumn of 2007 it looked as if the interbank funding markets were seizing up. Banks had drastically curtailed lending to each other, as they mistrusted each other’s balance sheets. The financial system, as some-one said at the time, increasingly resembled a football team each of whose players refused to pass the ball to his teammates for fear of not receiving it back.
For the banking system, funding problems are deadly; they can kill banks more quickly than capital shortages. Central banks worked to stave off a complete collapse of the global banking system with massive injections of cash into money markets in coordinated efforts to ease conditions.
Banks and other lenders began to fail, both in the US and in Europe. In September 2007, pictures of people in orderly queues outside branches of the Northern Rock Bank in the UK evoked folk memories around the world of bank runs of earlier times. And by the second half of 2008 the world’s news seemed to be dominated by bailouts, recapitalizations and bankruptcies.
The pivotal event occurred on Sunday 14 September 2008, when Lehman Brothers announced it would file for bankruptcy—the largest bankruptcy in US history. This dealt a body blow to a financial system already gravely weakened by over twelve months of increasing stress. Until then, creditors’ confidence in the stability of the system had perhaps been strong enough to ascribe individual failures to specific issues arising from, for example, the drying-up of the securitization market. But from that moment on the fear grew that the entire financial system might collapse.
What would a collapse of the system mean? Bank closures, countless businesses and individuals denied access to their savings or to credit—leading to business failures, unemployment, widespread social distress, panic. Shades, in fact, of the 1930s. And the fear was no respecter of borders, as it spread around the world like the medieval plague.
By now the financial crisis was also gravely weakening the economy, and almost no country was spared. This was not only the first major financial crisis of the globalized securitization era: it was also the first crisis of the global “just-in-time” economy. The philosophy of just-in-time is about having “the right material, at the right time, at the right place, and in the exact amount,” without the safety buffer of warehouses full of reserve supplies. Just-in-time management was mooted by Henry Ford in the early 1920s, and was refined and rigorously applied by Toyota from the 1950s onward. Today it is increasingly a global practice and a sine qua non of successful manufacturing. But it had two major effects on the consequences of the crisis that began in 2007.
First, it meant that there was no elasticity in the system. The shock waves from the financial earthquake’s epicentre jarred manufacturing with unprecedented immediacy in a way that few really foresaw. In sector after sector, business people were quite suddenly recounting stories of empty order books. This was not just the case in retailing, where it might perhaps have been expected, but also in chemicals, construction, engineering, steel, plastics, aerospace and more. Hardly any sector was unscathed.
Second, it spread the shock waves globally in parallel to the financial shock, through supply chains that had become globalized as in Thomas Friedman’s famous example of his Dell laptop. So, while banks all over the world were staggering because of the collapse of financial asset values, manufacturing supply chains transmitted the ferocity of the downturn in the economy all around the world with unprecedented speed.
And the sudden weakening of the economy fed through in turn to the commodity markets and into capital goods exports. All four sides of the rectangle were thus impacted. Oil prices, for example, fell in four months to less than a quarter of their peak price: from a record of $147 a barrel on 11 July 2008 to a low of $34 on 21 December 2008. As a result, in countries like Saudi Arabia and Kuwait, where oil provides 90 percent of the national income, there were concerns—the first for many years—about balancing national budgets.
In the spring of 2009 the International Monetary Fund, striking a very different tone from two years before, warned of deep recessions in all advanced economies and blamed the “mutually reinforcing negative feedback loop” between the “corrosive” financial sector and the stalling economy. This had intensified, it said, and prospects for recovery before mid-2010 were receding. In October 2008 the Bank of England had already warned that the credit crisis was beginning to impact on the economy. Britain faced the prospect, it said, of large numbers of British companies failing through credit starvation. Its regular survey of credit conditions showed that there had been a sharp reduction in the availability of credit to companies over the previous three months, as part of a vicious circle in which banks cut lending to companies in response to the downturn, thus weakening the balance sheets of the companies.
Unemployment was rising. Labour-market projections for 2009 reinforced the general mood of pessimism, forecasting an unemployment increase globally of anything between 20 million and 50 million people. There was a rising tide of warnings about a repetition of the “financial dance of death” of the 1930s: falling incomes, rising unemployment, and the rising real burden of debt.
And unquestionably there were some uncomfortable parallels between the events of 1929–32 and of 2007–9. The Great Depression had also resulted from a slump in the value of assets held by the banks, which then drained the lifeblood from the economy. It, too, was not just made in America—it had spread internationally, and had cried out for international cooperation to remedy it.
But government actions and inaction had turned the crisis of 1929 into an international catastrophe. The worst government measure—indeed, one of the worst pieces of economic legislation of the entire century—had been the Smoot–Hawley Tariff Act passed by the United States Congress in 1930, and not vetoed by President Hoover despite an avalanche of protests from economists at its raising tariffs to record levels on over 20,000 imported goods. But governments also tightened monetary conditions and sought to balance their budgets. Elsewhere, inaction ruled the day. Banks failed on both sides of the Atlantic, but the response was disorganized, paralysed by ideological debate, and hopelessly inadequate.* The Fed went into paralysis. In February 1931 its Open Market Committee did not meet at all. In the end, in response to the spreading crisis of confidence, President Roosevelt had to take the drastic step of shutting every bank in America for more than a week.
In the 1930s, no country was willing to take the lead. Britain had been the preeminent financial power up until the First World War. By 1929 it was incapable of leadership, while the US—still hesitant on the world stage—was unwilling to lead. And when larger groups of countries were assembled to treat the problem, they turned out to be ineffectual. The London Economic Conference of June 1933, at which representatives of sixty-six nations met to attack global depression, revive international trade and stabilize international currencies, collapsed ignominiously.
The response to the crisis of 2007–9 has, by contrast, been hectically proactive. “We are all Keynesians now” has been the watchword. Milton Friedman coined the phrase in 1965; President Nixon popularized it years later when the Bretton Woods agreement that regulated the international monetary system broke down at the beginning of the 1970s. Keynesianism then went out of fashion in the new free-market oriented consensus of the post–Thatcher/Reagan era. But the crisis brought it back into vogue, and by the summer of 2008 it was taken up with very little hesitation, even by those who were concerned about the longer term effects on public finances.
This Keynesian recognition that, rather than let the free market take its course, it was necessary for governments to stabilize economies suffering from a lack of demand by stepping in with tax cuts and/or public-expenditure increases was a reversal of the orthodoxy of the previous two decades. The Keynesian consensus became clear in November 2008 in a G20 communiqué vowing to “use fiscal measures to stimulate domestic demand to rapid effect.” The US, the UK, China, Japan and Korea all became energetic and vocal proponents of fiscal stimulus. And as interest rates had been reduced to close to zero, central banks also turned to their weapon of last resort—quantitative easing, a practice that enabled them to pump money into the markets by buying up bonds, mortgages and other assets. Many predicted that the next challenge—given all this largesse—would be a resurgence of inflation a few years down the line: but virtually everyone agreed that the risk of inflation later was less threatening than the risk of deflation now.
And the world held its breath (and felt exhausted: when the history books are written about this period, I believe they will miss an important dimension if they do not focus on the pervasive stress and the sheer tiredness of those involved—whether policymakers, regulators or bankers). How would consumers respond to this massive exercise in economic artificial respiration? Would trade and investment reconnect? How soon would inflation rear its head again? How severe would the setback for the emerging markets be? And what were the implications for geopolitics?
Whatever the answer, it was clear that a fundamental conflict was being played out. This stemmed from the tension between the short-term imperative to minimize recession and the long-term need to adjust to a world that would be very different. In the short term, the case for adopting Keynesian measures to pump-prime the economy, cope with recession and stave off something far worse was compelling. The fear that recession could turn into deflation or even depression was far from groundless.
Yet in the medium term it was already clear by 2009 that the imbalances behind the crisis—some global, others national—needed to be resolved, and that this would require something other than Keynesian stimulus. Globally, the imbalances flowing from the macroeconomic rectangle were the most fundamental problem. How could the consumer in markets such as the US learn to borrow less and save more? Conversely, how could nations with exceptionally high savings stimulate domestic demand and reduce their dependence on exports? Nationally, it also became clear that there were imbalances to be cured, such as the sectoral bias in the UK toward financial services. There were too many engineers working in bank dealing rooms. A more stable, less geared financial market was needed in order to redress the balance.
Above all, it was certain that there would be no quick fixes: the problems of 2009 were complex and would require debate, reflection and attention to history.
Books with the benefit of a longer perspective on events will be written about the crisis unleashed in 2007. But it is safe to say this will not be the last financial crisis, for all its severity. From Edward III onward—who in 1339 repudiated his debt to his Italian creditors, thus bringing about the collapse of several Italian banks and causing widespread misery in Florence—the history of world finance could be told as a constant succession of crises.
The shorthand labels that past bubbles acquired suggest a colourful roller coaster of humanity’s hope and disappointment: the tulip mania of 1637, the South Sea bubble of 1720, the Florida speculative-building bubble of 1926, the Nifty Fifty of the late 1960s, the Poseidon bubble of 1970, the dot-com bubble of 1998. They remain hard to analyse, because collective psychology plays such a vital role: financial bubbles are never just about the mathematics of economics. Bubbles can happen even when many, or even most, participants in the market are fully aware of the correct price of assets. Their dynamics are complex, and they will always be with us.
Financial crises are often linked to excessive optimism about new technology. The dot-com bubble is a prime example of this—an equity market driven up to absurd levels on the basis of wildly optimistic estimates of the revenue-generating capabilities of Internet applications. But this is only the most recent case. In a very different era, the US railroad crisis of 1873 was essentially the same story. The US panic of 1873 was one of a succession of paroxysms that seized the US economy in the nineteenth century. It was sparked by the collapse of the Philadelphia banking firm Jay Cooke & Company. Cooke and other entrepreneurs had planned to build the Northern Pacific Railway—the second transcontinental railway in the US. Jay Cooke & Company provided the financing, and work was begun near Duluth in Minnesota in high optimism in February 1870. But credit rumours began to circulate about the firm, and in September 1873 it failed to market several million dollars worth of bonds in the railway. It was the final straw that led to bankruptcy. This came at a delicate moment for the US railway industry, at the tail end of a massive boom in construction, with 35,000 miles of new track laid across the country between 1866 and 1873. At the time the nation’s largest employer outside of agriculture, railways involved large amounts of money and risk. Speculators caused abnormal growth and too much capital was invested in projects offering no immediate returns. The collapse of Jay Cooke triggered implosion in the industry. The New York Stock Exchange closed for ten days, and one in four of the country’s more than 350 railroads went bankrupt.
The turbulence of the 1870s produced what is surely one of the greatest novels of the financial markets of all time—Anthony Trollope’s The Way We Live Now (1875). Trollope’s hero, Augustus Melmotte, arrives in London to make his mark. The cornerstone of his strategy for commercial and social success is the floatation of a project to build a railroad from the US to Mexico. It is never seriously expected to make money: the creation of an appetite for the stock is all that matters. Melmotte lives and entertains lavishly, and is lavishly generous to socially valued charities, as his paper wealth expands.
In the end, he is found out. His scheme collapses as fraud is uncovered, he is disgraced and he commits suicide. He stands for a long line of figures down to the present day who have manipulated the markets, beguiled society, defrauded investors—and all in a desperate search (at least in his and many such cases) for recognition, for admiration, for acceptance. His story ends in tragedy, as they often do, and it is a tragedy that has replayed itself again and again in the nineteenth, twentieth and twenty-first centuries. The Greeks gave his sin a name: hubris.
Nations, too, have regularly defaulted, following the path that Edward III marked out. In the late 1990s Russia was facing a comprehensive macroeconomic collapse, involving its exchange rate, the banking system and public debt. An international rescue plan was put together and launched with an immediate liquidity injection of $22.6 billion. Russia, it was believed, was “too big to fail,” and support was essential. However, fail it did. By the summer of 1998 there were billions of dollars in unpaid wages owed to Russian workers, and monthly interest payments on Russia’s debt were significantly greater than its monthly tax collections. On 17 August 1998 the government announced an immediate devaluation, with a forced restructuring of ruble-denominated public debt. This was one of two big defaults in recent times (the other being that of Argentina in 2001). But there were numerous others: an average of one a year since 1970.
A particularly problematic form of bubble that is very basic to the human psyche is the property bubble. The deep link between home and a sense of security, combined with a real fear that if you don’t get onto the property ladder in time, you never will, has frequently driven people in many countries to the limits of their spending ability in inflating property prices. Housing-price crashes are particularly painful and damaging to national economies, because of the disproportionate effect on consumer confidence and the “close-to-home” effect on behaviour. The crash of the Japanese bubble in real estate and stock prices in 1990 traumatized Japanese society for well over a decade. The experience was sufficiently scarring for President Obama to use it as a warning to those who opposed his financial stimulus package for the US economy in 2009.
Those who ignore history, it is said, are condemned to repeat it. And, on the face of it, we do learn. For example, Walter Bagehot’s proposal of a new role for the Bank of England as lender of last resort, after the failure of the major London bank Overend, Gurney & Company in 1866, was first implemented in the Barings crisis of 1890. The US Federal Reserve’s failure to prevent a series of domino collapses in the US banking industry in the wake of the Wall Street crash of October 1929 was not forgotten by leaders in more recent times. Globalization may be at root a phenomenon of the human spirit, but it also has very specific practical consequences—and nowhere more so than in the financial markets. The world is recognizing more and more clearly that in the financial markets everything is connected. All sorts of institutions, large and not so large, can be too interconnected to be allowed simply to fail. The lesson was to be painfully relearned in the wake of the bankruptcy of Lehman Brothers, whose effects were felt all the way from Wall Street to Hong Kong and Singapore.
Alphonse Karr (editor of Le Figaro from 1839 to 1848) is chiefly remembered today for coining the phrase “plus ça change, plus c’est la même chose.” He had lived through Waterloo and the revolution of 1848 by the time he wrote it, so he had certainly seen his share of change. His phrase is now one of the most widely used French phrases in English, and at one level is true for financial crises. The historical pattern repeats and repeats. Confidence is followed by foolhardiness, then by fear followed by a crash, followed by witch hunts—and eventually by renewed growth. The human emotions appear to repeat themselves: the greed, the panic, the shame and anger, remorse and sobriety—until exuberance reasserts itself.
And yet Mark Twain, too, was right: “The past does not repeat itself, but it rhymes.” There was much that was old about the events that began to unfold in 2007, but there was also much that was new. There were defining differences: the Internet, securitization, just-in-time order management, global supply chains. All these—if not completely new—had achieved a degree of intensity that meant that this was the first crisis of the global bazaar. This was a very globalized bubble, and a very globalized crisis. History moves in a spiral, not in a circle.
Thus, Alphonse Karr’s world-weariness should not blind us to the fact that the world, once it recovers, will never be quite the same again. It is said of King Solomon that he had a servant whisper to him repeatedly—when things went well and when things went badly—“This too will pass.” Crises do pass—even very intense ones. But there will be no return to the status quo ante. For the world has looked into an abyss. The experience of the 1930s led to the process of building a new world order that began at Bretton Woods in July 1944, even before the end of the Second World War. It was there that the International Monetary Fund and the International Bank for Reconstruction and Development were launched. There was to be a new world financial order for the postwar period.
After 2007–9, the manifest failure of market fundamentalism and the need for a rebalancing of the world’s economy will inevitably be the starting point for a new new world order, which will profoundly change international relationships. There may be some hard-core faithful who continue to believe that business as usual will be resumed, but the consensus is that—as the former Fed chairman and market fundamentalist Alan Greenspan has acknowledged—there was to say the least a “flaw” in the model. Society the world over demands remorse from the practitioners and action from the politicians.
In a 2009 article in the Financial Times, a professor of history and director of International Security Studies at Yale University, Paul Kennedy, imagined four towering economic intellects considering the crisis that began in 2007. Adam Smith, virtual founder of capitalist philosophy, would be appalled at the immorality of much consumer lending; Karl Marx, the great intellectual foe of capitalism, would get some frisson of Schadenfreude from the foundering of the markets; Joseph Schumpeter, popularizer of the term “creative destruction,” procapitalist but alert to the inherent volatility of its cycles, would broadly endorse “our new post-excess neo-capitalist political economy ... where the animal spirits of the market will be closely watched (and tamed) by a variety of national and international zookeepers—a taming of which the great bulk of the spectators will heartily approve,” as would Maynard Keynes.
Exactly how this taming will be done remains to be seen. There are many lessons to be learned from a crisis that has shocked and frightened the world—lessons for banks, and for governments and regulators, rating agencies, investors and borrowers. Banks—many of them—became overgeared and too dependent on wholesale funding (rather than real deposits from customers), as well as too focused on short-term profits at the expense of the creation of real long-term value. Regulators did not pay enough attention to liquidity management in banks, and so were not prepared for the storm when it broke. Rating agencies were too ready to work with financial engineers in the banks to help them create investment vehicles with apparently high credit quality which, as it turned out, did not stand the test of il-liquidity. Investors chased yield and profit growth and forgot the “too good to be true” test. And borrowers too often succumbed to the temptations of jam today which were proffered too freely by lenders.
In the public mind, banks have been at the epicentre of a storm of rage. The public standing of bankers is now at one of its lowest levels for decades. The sins of arrogance, greed, un-trustworthiness and callousness are hard to forgive. The perception that some have taken pay and bonuses in vast multiples of the remuneration of ordinary, hard-working and socially valuable people—for indulging in an alchemy that has then blown up in their faces and required huge bailouts at prodigious cost to the taxpayer—has ignited fury around the world. And then, as economies turn down, businesses fail and unemployment rises, banks—including those that have been rescued by those same bailouts—are seen to be tugging the rug from under people’s livelihoods, causing pain and further anger. Even if the truth is more complex than the headlines, reestablishing confidence in and respect for the banks will be a journey up a steep mountain.
What, then, should it look like, this new world order? There is much that is outside the scope of this book, and many books are being or will be written on the subject. But it is clear that, whatever the eventual shape of things to come, there are four key realities that will have to be taken into account.
First, there is no alternative to the market. At its worst the market is unjust, abusive, destructive and crisis-prone, as we are all now painfully aware. Yet at its best it is a highly efficient allocator of capital, and it has delivered huge advantages to humanity. The role of capitalism in creating wealth is evident in the way it has revolutionized the Chinese, Indian and other Asian economies after they introduced market-based reforms. Even if the financial crisis leads to the first fall in world GDP since the Second World War, the last two decades of globalized market capitalism have seen extraordinary gains for hundreds of millions in previously poor societies. Churchill’s famous defence of democracy—“the worst form of government, except for all those other forms that have been tried from time to time”—applies equally well to the market. It is the worst engine of economic and social development, except for all those others that have been tried from time to time.
Second, we cannot turn the clock back either for a short time or for a longer one. We cannot go back to the 1970s, to the time before globalized capital markets: the genie is out of the bottle now, and the sorts of control that were then in place even in developed countries like the UK would no longer be considered compatible with an open society. Nor can we go back further to some “golden age” of simpler, more communitarian, less connected living: this is completely unrealistic in what is now a densely populated, urbanized, communicating world. There is no alternative to progress and reform. China, for example, is perhaps halfway through its own internal reform process. It has a rapidly growing economy in which the private sector probably accounts for about half the total output, and banks have been comprehensively restructured and reformed. But there is a long way to go, and one of the economy’s major challenges lies in the fact that the domestic capital market is as yet embryonic. There is no evidence that a modern, increasingly complex and sophisticated economy can rely on banks alone to finance development. Sustained economic progress based on more efficient capital allocation requires the development of a capital market. China will certainly want to ensure that it learns from the debacle in the international markets; but the country will equally certainly not conclude that it can afford to do without a capital market. And what is true of China is true for all economies, developed or developing. The lessons need to be learned—to restrain the excesses, to ensure transparency, to align incentives—to make the markets work better, in short, not to dismantle them.
Third, therefore, government oversight, regulation and, in times of stress, intervention are essential. Markets cannot be relied on to be stable and self-regulating. Nor are they sufficient for a balanced social development (there is no evidence that societies can rely primarily on the market for the provision of such key elements of human welfare as medical care and education). The Washington Consensus will not survive this global experience. The underlying question will be whether world leaders can construct a shared vision of a global economic order that preserves the dynamism of market forces while taming their excesses (in both risk-taking and reward). It was clear by 2009 that enhanced government cooperation internationally would be needed to facilitate effective cross-border supervision of the markets. International frameworks would be needed to deal with markets that have become irreversibly porous and interconnected. A new global order will have to build stronger institutions for international partnership.
And key to this, finally, will be an acceptance that the global balance of economic power is shifting as the centre of gravity moves from West to East. The world is being rebalanced, and it has become increasingly broadly accepted that the framework of international institutions needs to be redrawn to reflect the new realities of globalization. The developed world is going to have to make space for the newly powerful emerging economies. It is impossible to ask Asian societies to play a part in rescuing the world’s financial system from collapse—to provide funds for the IMF, for example—without expecting to cede voting power to them in recognition of their new-found strength. And it is not at all surprising that they should begin to air views on the need to move away from the US dollar as the reserve currency of the world (as China has done). Such voices are going to become more and more insistent in the years to come.
The new order that will emerge—whatever its precise contours—will have to respond to these four imperatives if it is to endure. This is what is in effect recognized in the memorable statement issued in April 2009 by the London G20 summit meeting:
We start from the belief that prosperity is indivisible; that growth, to be sustained, has to be shared; and that our global plan for recovery must have at its heart the needs and jobs of hard-working families, not just in developed countries but in emerging markets and the poorest countries of the world too; and must reflect the interests, not just of today’s population, but of future generations too. We believe that the only sure foundation for sustainable globalization and rising prosperity for all is an open world economy based on market principles, effective regulation, and strong global institutions.
It is worth pausing on that last sentence. After all the turmoil, despite much public resentment of and fear of globalization in many countries around the world, the leaders of countries as politically diverse as the United States of America, the People’s Republic of China, the Russian Federation and the Kingdom of Saudi Arabia—to name but four out of the twenty—proclaimed that prosperity for all depends on “an open world economy based on market principles, effective regulation, and strong global institutions.”
Amen—so be it—to that. And indeed one of the most striking manifestations of the emerging new order is precisely the role of the G20 as an increasingly central coordinating forum for the international policy response—together with the marginalization of the G7. Time will tell exactly how this forum evolves; but what is already clear is that the world has moved on irrevocably from the times when emerging markets were either uninvited or present only as a chorus. What is also striking is the degree of consensus that has been forged in the heat of the first crisis of globalization. It is inevitably easy to point to areas of vague compromise, to the risks of gaps between rhetoric and action (perhaps particularly on protectionism), to the fences not yet taken. But the contrast between international achievement in 2008–9 and the tragically short-sighted failures of 1929–32 will strike the historians of the future forcefully.
The whole tenor of the G20 statement points to the inevitable ambiguity of the markets. They are what they are because human beings are what they are: imperfect commercial animals. If ever there was an area of human activity that exemplifies the first of the three ambiguities from Chapter 1, this is it. Nigel Lawson, a former British Chancellor of the Exchequer, put it succinctly in an article in 2009: “That capitalism has been shown, in practice, to be endemically flawed should come as no surprise. That is the nature of mankind.” But then he added this: “What is more important is that history, notably the history of the world after the Second World War, has demonstrated beyond dispute that every other system of economic organization is far worse”—note the Churchillian defence here—“so capitalism both deserves to survive, and will survive, just as it did after the even greater economic disaster of the 1930s.” The question is: Exactly what kind of capitalism?
We must ease our way forward. The new form of capitalism for our interconnected, globalized, complex and increasingly self-conscious world—the world that Teilhard de Chardin uncannily foresaw—will emerge slowly from the last one, but equipped with new tools and subject to new restraints. There will be no sweeping pendulum-swing from free-market fundamentalism back toward some form of centrally planned economy, or to some simpler, unconnected, preurban world.
The debate on the outlines of a new capitalism—more tempered and more sober—is now under way. Some have pointed to an opportunity for a “European moment” in which relatively unfettered “Anglo-Saxon” capitalism turns more toward a Continental-style harnessing of free markets, in the context of tighter rules and the provision of generous welfare systems. Even supporters of the Anglo-Saxon model have argued that the values of capitalism need to be reassessed: shareholder-value creation should not—as it has become in the last twenty years or so—be the be-all and end-all, the overarching objective of management in business. It should, rather, be the result, the hallmark, of business well done. And business well done means the profitable provision of good-value services to customers.
Amartya Sen, whom we have discussed earlier, has recently questioned the standard perception of capitalism as market-driven, profit-motivated and ownership-based, noting that all the affluent countries in the world—those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Taiwan, Australia and others—have depended for decades on transactions that occur largely outside the markets, such as unemployment benefits, public pensions and other features of social security, and the public provision of education and health care. For all their differences, these countries have in common a socioeconomic approach that does not and cannot rely solely on the market.
And many people—including, for example, the premier of China, Wen Jiabao—have argued that the new capitalism should be nourished by a vision (which owes much to Adam Smith’s Theory of Moral Sentiments) in which overspeculation is subdued by controls, and in which values other than profit (such as mutual trust and confidence) are recognized for their true worth and for their crucial role in socioeconomic well-being.
It is clear, in short, that capitalism for the twenty-first century needs to rediscover a fundamentally renewed morality to underpin it. It needs to start with a question: What is progress? Is it the accumulation of wealth, or should it involve a broader definition of the quality of life that takes into account a more integrated understanding of well-being? Surveys consistently show that economic progress has not been accompanied by the expected improved level of happiness, and that the price paid for it by many has been in the quality of human relationships. On average, people do not think of themselves as happier or better off than their parents were—even though their material standard of living is, in so many societies, unquestionably higher. And there has in particular been a marked decline in the sense of trust. The collapse in perceived trustworthiness is obvious with respect to the banking sector, but also applies to business more broadly—as well as in family life and in social relationships generally.
So it is not surprising that, in the public mind, free markets are under suspicion. The capitalist system is at its heart about trust. (Nowhere is this more true than in banking. The word “credit” derives from the Latin word credere, meaning “to believe.” So a credit crisis is, by the very meaning of the word, a crisis of confidence.)
If we are to restore trust and confidence in the markets, we must therefore address what is at its root a moral question. Trust and confidence cannot be restored overnight, and they cannot be restored by fiat: the process of renewal has to begin with a recognition of the moral dimension of what has happened. It is as if we have grown increasingly to accept the idea that the value of what we do is fully delineated by the market, by regulatory compliance and the law of contract. If the market will bear it, if the law allows it, if there is a contract, then no other test of rightness need apply. Yet we would not (or should not, at least) live our private lives this way. So why should it be acceptable in business?
What has happened is that we have succumbed to the sin of compartmentalization (see Chapter 1). The truth is that the value of our business is dependent on the values with which we do our business. Capitalism needs to integrate values with value. We have to recognize—boards, managements and owners alike—that values go beyond “what you can get away with,” and that values are in the end critical to value—to sustainable value, that is. Better risk management, enhanced regulation, codification of directors’ responsibilities in company law—all these things are necessary. But they are not, and cannot be, sufficient without a culture of values. As individuals, we do not govern our behaviour simply by what is allowed by law or regulation. We have our own codes of conduct, and hold ourselves accountable. We take responsibility for our actions. The institutions of capitalism—businesses, banks and other institutions of the financial markets—have to do the same. This is the sine qua non for the restoration of public trust in the market and is therefore essential for the overall health of society.
For companies, where does this responsibility begin? With their boards, of course. There is no other task they have that is more important. It is their job—and one that by its nature will never be complete—to promote and nurture a culture of ethical and purposeful business throughout the organization. This is true not only for banks at a time of extraordinary crisis and massive failure of public trust in the financial system, but for all businesses at all times. And the good news is that the vast, vast majority of those who work in these organizations want this. They want to be able to look at themselves in the mirror and feel confident that they and their business are making a contribution. The raw material for an ethical capitalism is present in abundance in real life. So boards and managements that take this challenge seriously will find themselves pushing on an open door.
But this soul-searching over the culture of capitalism as the world’s engine of growth will not of itself let us rest easy, for other questions remain to gnaw at our conscience. What of the marginalized of the world—those who have never benefited from the burst of economic development we have seen in the last generation? And how are we going collectively to face the challenge of climate change? Aren’t we just fretting about the means—the capitalist system—when we should be fretting about the end: economic development, in its present carbon-intensive form, with the grave threat it poses for the whole planet?
These are questions for the next chapter.