Down but not out
Down but not out
The latest financial crisis is nothing new, argues Jonathan Guthrie. Despite the general gloom, there are many upsides, such as new businesses replacing tired institutions. There is probably no answer to boom and bust, he says – only acceptance
The defining characteristic of the fictional orphan Pollyanna was her love of something called the Glad Game, which consisted of finding the silver lining in every cloud. This behaviour, while intensely irritating when practised by a freckle-faced moppet, has much to recommend it to grown-ups living through the current hiatus in economic growth in the UK. While framed in parts of the media as an unqualified catastrophe, the credit crunch and its associated slowdown have several significant upsides. Beyond this, it is as pointless to bemoan the periodic crises that are part of market capitalism as it is to bewail wet weather on an English summer bank holiday.
A few months ago I turned down an invitation from a PR to interview an entrepreneur called Pepita Diamand. I could see no respect in which her online wedding-list company Wrapit improved on conventional retailers – in the jargon of business, it lacked a ‘unique selling proposition’. This too appeared to be the view of betrothed couples, who mostly declined to sign up with Wrapit. The company, which had lost money for six years, crashed into administration in August, blaming the credit crunch.
The collapse of Wrapit is plainly a bad thing for Ms Diamand and for the 2,000 couples who were using the service she set up. But the removal of unfit businesses should be welcomed, because it creates room in the market for better companies to grow (which could, incidentally, include a revivified and better thought-out reincarnation of Wrapit). This was what Joseph Schumpeter, the swashbuckling Austrian economist, meant when he talked about ‘creative destruction’. The health of the capitalist system depends on new businesses deploying innovations in technology, products or organisation to destroy old ones. Downturns intensify the process, which gives them a hygienic value.
The lesson of current economic difficulties is that sporadic collapses of confidence are natural and inevitable. They force investors to recalibrate their appreciation of risk and regulators to catch up with evolution in markets. Hence, revived interest in Schumpeter and another economist who believed in cycles, Hyman Minsky. He theorised that long periods of stability, such as the one that ended just over a year ago, embolden investors to borrow increasingly heavily to pay for assets of progressively declining value. Financial innovation fuels the speculation. Eventually the overburdened credit system hits a stumbling block and takes a disastrous tumble, an event referred to as ‘a Minsky moment’.
This is what happened in the sub-prime housing market in the US last August. The seeds of the crisis, according to many commentators, were sown long before by the relaxed credit policies Federal Reserve chairman Alan Greenspan adopted in the wake of the dotcom crash. Lenders doled out mountains of capital to so‑called ‘ninja’ borrowers – those with no incomes, no jobs or assets. Mortgage salesmen motivated by short-term bonuses connived at fraud with some homebuyers and misled others over repayment terms. Lenders were reassured by the fact that they could package up their risks as tradeable securities and sell them on to other investors. These in turn believed the risks of the securities were sensible because they had been endorsed by credit-rating agencies whose objectivity may have been compromised by a scramble for new business. The merry-go-round twirled happily until the sub-prime business suffered its own Minsky moment in the shape of rising defaults.
The pattern is an old one. Fertile conditions for financial crises are often created by low inflation, low interest rates and steep increases in asset prices. When Bertrand Russell observed that “since Adam and Eve ate the apple, man has never refrained from any folly of which he was capable”, the philosopher could easily have been describing financial speculation. Investors have thrown away their cash on everything from tulip bulbs to ostriches.
According to research by Lehman Brothers, there were 11 banking and financial crises in the 18th century. There were 18 in the 19th century, including the collapse of Overend, Gurney & Co, a bank that had invested in the characteristic Victorian industries of shipbuilding and railways. The total rose to 33 in the 20th century, a period within which the 1929 Wall Street Crash and the ensuing Great Depression were key events. My own 20-year career as a business reporter – a brief period in the scale of things – has been punctuated by an emerging markets debt crisis, a US junk-bond debacle, the collapse of Japanese financial engineering, a UK commercial property catastrophe and credit routs in Russia, Asia and Scandinavia.
However, the pain is often no more than a little spot of local difficulty in the financial markets. For example, the spectacular collapse of communications stocks that started in 2000 – the so-called ‘dotbomb’ crisis – had little serious impact on the UK economy. Real recessions are much rarer than the popping of speculative bubbles. There have been just five of these in the UK since 1920, measured by the yardstick of falling gross domestic product between successive years.
The most recent was in 1991. According to National Statistics, national output fell 1.4% that year in the hangover following the debt-fuelled growth of the Thatcher years and the collapse of a property bubble. That recession had been presaged by the 1987 stock market crash. But by 1991, even as unemployment rose towards 2.8m, share prices were marching up again in anticipation of better times ahead. These arrived in the form of steady growth during the first 10 years of New Labour rule, now referred to nostalgically by economists as the ‘NICE’ decade, which stands for ‘non-inflationary constant expansion’. No one feels affectionately enough towards the current period of rising inflation and stalled growth to think up a snappy acronym for it. The UK economy could easily meet the minimum technical requirement for recession by recording two quarters of declining output in the last half of this year, with worse to come in 2009. UK recessions, it should be noted, rarely last more than two years. The Bank of England is meanwhile attempting to fend off inflation through its control of interest rates, while still conscious of the countervailing danger that excessive hawkishness would prolong and deepen the downturn.
Part of the problem is that many previously poor people in China and India are now a little better off. Because they can afford better meals and more fuel, world food and energy prices have risen. This is the significant upside to food shortages in countries without their own local economic miracles. It also puts into context the plight of the British consumer, who could typically do with eating less anyway. Pollyanna would surely approve.
Another positive consequence of the credit crunch is that house prices are falling. These had previously risen at an inflation-adjusted 193% in London and 160% across the UK over 12 years. High property prices had given many Britons an illusory sense of wealth – illusory because they could only capture their gains by moving abroad or to parts of the country where well-paid work was scarce. It also created a class of small-time rentiers and ‘developers’ who helped drive up prices further, thanks to easy credit. Meanwhile, many first-time buyers and lower-paid workers were frozen out of the market, with damaging consequences for labour mobility.
In a few months, first-timers should find it easier to buy properties, assuming that credit begins flowing normally again without putting undue upward pressure on prices. Lenders should have acquired a more sensible attitude to risk in the meantime and will no longer offer 125% mortgages. Nor will they base their own borrowing on high-risk, high-margin strategies of the kind that brought Northern Rock to grief.
The actual human cost of the currently modest UK downturn is, in any case, overstated by the mass media, which like the mythical heavy metal band Spinal Tap has its volume controls permanently set to 11. Wellbeing economists, who study the influence of money on happiness, say that stagnant and declining earnings do not make people particularly miserable. Shopping does not improve wellbeing, so switching to a low-consumption lifestyle does not impair it much either.
Long-term unemployment, in contrast, seriously damages joie de vivre. Work, contrary to Oscar Wilde’s aphorism, is not the curse of the drinking classes. It gives individuals a sense of purpose and interconnection with others for which there are few substitutes. The implication for politicians is that preserving jobs matters more than keeping incomes high. Often the trade-off is pretty direct, as in minimum wage policy. The financial cost of the credit crunch to taxpayers has been significant, even if their cheeriness has been little impaired. In the UK, they have been forced to guarantee Northern Rock’s deposits and support it with a £27bn loan. In the US, the Treasury stepped in to nationalise Freddie Mac and Fannie Mae, two mortgage guarantee institutions. Investment banks across the world have required emergency loans from central banks and, in the US, this support has been backed up by capital injections from sovereign wealth funds.
Critics, including legions of small business owners, bitterly interpret the bail-outs as new evidence of banks’ long-running tendency to privatise profits in good times and nationalise losses in bad. But on this occasion it has come at a cost: a general realisation that international bankers are as fallible and prone to miscalculation as everyone else. The highest-paid maths geeks in the world deploying the fanciest computer models ended up mis-pricing risk as badly as tyro bookies at Kempton Park. The idea of all-conquering multinational corporations that flourished at the end of the last century has proved false. They are far less powerful and omniscient than neolibertarians such as Kenichi Ohmae hoped, or anti-corporatists such as Naomi Klein feared. The credit crunch has reasserted the primacy of the state, which sets the terms of trade and sweeps up the mess when private entities fail. Just as well, since governments are elected – in the west at least – and company directors are not.
Having loused up, big banks deserve to be kept on a tight leash. They should be viewed as institutions that are semi-private and quasi-public, considering the preferential access to state bail-outs that their key role within the economy gives them. Their remuneration policies need regulatory oversight because quick bucks fuel hit-and-run sales tactics. Their risk-seeking needs tempering through a regime that ratchets up capital requirements in proportion to loan assets.
Will any of this forestall further financial crises and, with them, the risk of shocks to the underlying economy? Probably not. Financial regulation is a response to conditions that have already changed dramatically by the time the ink has dried on the new rulebook. Banks quickly work out how to game the regulators. Lending officers retire, packing away their first-hand experience of disaster with the desk toys and family photos. Commentators think up reasons why there is a new business paradigm, instead of just a slightly different version of the old one. There will be another market meltdown in a decade or so. Pencil it into your calendar, if you plan that far ahead.
Investments: are we getting what we want?
The RSA Tomorrow’s Investor project examines the culture of investment and the role of the citizen. For more details, visit www.theRSA.org/projects/tomorrows-business
Jonathan Guthrie is enterprise editor of the Financial Times
Share