Free Lunch
Authors: David Smith
FREE LUNCH
DAVID
SMITH
has been the Economics Editor of the
Sunday Times
since 1989. He also writes monthly columns for
Professional Investor
,
British Industry
and
The Manufacturer
, and is a regular contributor to the CBI’s
Business Voice
and other publications. Prior to joining the
Sunday Times
, Smith worked for
The Times, Financial Weekly
, the Henley Centre for Forecasting and Lloyds Bank. He is the author of several books, most recently
The Dragon and the Elephant
, also published by Profile.
FREE LUNCH
EASILY DIGESTIBLE ECONOMICS,
SERVED ON A PLATE
David Smith
This edition updated in 2008
First published in 2003 by
Profile Books Ltd
3A Exmouth House
Pine Street
Exmouth Market
London ECIR 0JH
Copyright © David Smith 2003, 2008
10 9 8 7 6 5 4 3 2 1
Typeset in Bembo by
MacGuru Ltd
Printed and bound in Great Britain by
Bookmarque Ltd, Croydon, Surrey
The moral right of the author has been asserted.
All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book.
A CIP catalogue record for this book is available from the British Library.
eISBN: 978-1-84765-139-6
For Jane, Elizabeth, Emily, Richard and Thomas
Economics everywhere
When, in July 2007, two hedge funds run by the Wall Street investment bank Bear Stearns ran into difficulty, few could have guessed at the scale of the dramatic events that would follow. The funds, which had been worth $1.5 billion at the beginning of the year, were invested in financial products linked to what quickly became the notorious American subprime market. Sub-prime loans, to US households with impaired credit histories (the joke was that they were ‘Ninja’ borrowers, with no income, no job and no assets) had been around for many years. They however, along with adjustable rate mortgages (Arms), had expanded very rapidly from around 2003 and, more significantly, had been used as the basis for financial instruments – structured investment vehicles – sold to investors and traded between the banks. Mortgage-backed securities, as their name suggests, are financial instruments based on household mortgages. Even more sophisticated instruments, so-called credit derivatives based on those securities, ‘sliced and diced’ the original securities up even further and greatly multiplied the potential losses if there were problems with the underlying asset, the mortgage. The upshot was that if enough poor American families in Cleveland, Detroit or Fort Myers fell behind with their payments or defaulted on their mortgages the consequences would be felt by investors and banks many thousands of miles away. Think of it as an inverted pyramid resting on the unstable foundations of risky mortgages.
The Bear Stearns hedge funds were, to risk mixing metaphors, the tip of a very large iceberg, an early warning of the problems that were to follow. Even in early August 2007 after American Home Mortgage had filed for bankruptcy, most experts dismissed talk of a global financial crisis and it seemed that the problems arising from America’s subprime problems would be limited. However, it became clear that an international crisis was brewing when on 9 August the French bank BNP Paribas suspended three of its investment funds because of losses related to the US subprime market. An alarmed European Central Bank responded by pumping tens of billions of euros into Europe’s money markets.
What followed was a kind of domino effect, with banks regarded as weak or excessively dependent on wholesale money markets – rather than savers’ deposits – most heavily exposed. On 13 September, 2007 it was revealed that Northern Rock, Britain’s fifth largest mortgage lender, was being supported by ‘lender of last resort’ assistance from the Bank of England. The following day saw the first run on a British bank since Overend & Gurney in 1866. (Northern Rock was eventually nationalised by Britain’s Labour government, after a five-month attempt to find a viable private-sector buyer.)
After the excitement of August and September, when money markets froze from a lack of confidence between the banks in each other, there were hopes that the worst might be over. It was, however, a vain hope. In March 2008, after months in which Wall Street investment banks and America’s other large banks had announced ever-larger write-downs and losses on their subprime-related investments, Bear Stearns was forced to sell itself at a knockdown price to competitor J. P. Morgan. The deal was only possible because it was accompanied by a $30 billion loan from the Federal Reserve, America’s central bank. Bear Stearns, founded in 1923, had been part of Wall Street’s aristocracy, surviving the infamous crash of 1929 but now unable to weather the credit crunch of 2007–8. Indeed, the problems at its hedge funds eight months earlier had first exposed the crunch; now it was a victim of it. Soon afterwards, the International Monetary Fund said that the world was facing the biggest financial shock since the Great Depression of the 1930s.
Economic history in the making
Comparisons with the Great Depression and the bank runs of the Victorian era provided confirmation that something highly unusual was happening in the global economy. Indeed, policymakers looked to Walter Bagehot, the nineteenth-century economist, social theorist and constitutional reformer, who was editor of
The Economist
during the run on Overend & Gurney in the 1860s. Apart from computer technology, the global nature of the crisis and the fact that every move was played out on twenty-four-hour television, very little appeared to have changed since Bagehot’s day. ‘Every great crisis reveals the excessive speculations of many houses which no one before suspected,’ he wrote in
Lombard Street: A Description of the Money Market
, published in 1873. And, ‘the good times too of high price almost always engender much fraud. There is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while, and long before discovery the worst and most adroit deceivers are geographically and legally beyond the reach of punishment.’ Bagehot also understood what engendered financial panics: ‘Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness.’ As for the way such panics could envelop even those regarding themselves as too good, or too big to fail he comments: ‘A panic grows by what it feeds on; if it devours these second-class men shall we, the first-class, be safe?’
People turned to history for the answers because the events of 2007–8 were so unusual in the modern era. What, for example, was a credit crunch? Defined as a sudden reduction in the availability of credit and an increase in its price, this was a modern-day rarity. Recent history is littered with examples of governments or central banks deliberately restricting the flow of credit to the economy and increasing interest rates. For such a phenomenon to occur ‘naturally’ as a result of a sudden collapse of confidence in the banking and financial system was, however, different. It resulted, for example, in a 70 percent downward slide over twelve months in mortgage approvals – the number of new loans being granted – in Britain. The consequence of that extreme mortgage rationing was a dramatic drop in house prices. The discussion of Britain’s housing market and the debate over prices in Chapter Two of this book does not, you will see, even consider this possibility. While interest rates can and do rise and fall, the idea of a sudden turning off of the credit taps did not come into the debate. This was, if not uncharted territory, outside the direct experience of policymakers. The ready availability of credit had almost come to be regarded as the economic equivalent of oxygen or running water.
As comparisons with the Great Depression were made by the IMF and others, economists scurried for their reference works. J. K. Galbraith’s
The Great Crash, 1929
first published in the 1950s, jumped back into the bestseller lists. Ben Bernanke, chairman of the Federal Reserve in succession to Alan Greenspan, suddenly appeared to be in the right place at the right time, as one of the foremost academic authorities on Depression-era economics. He had always argued that understanding the Depression was the most important challenge for economists, if only to prevent history from repeating itself. Mention of the Depression also brought John Maynard Keynes, who gets a chapter to himself in this book (Chapter Ten), to the fore.
A Drama and a Crisis
During September and much of October, 2008, it seemed that each weekend brought a new crisis that threatened to bring the financial system to its knees. The crisis that had begun more than a year earlier entered a new and more deadly phase. Suddenly, the fear of losses and counterparty risks (banks and other institutions not trusting counterparts they had previously been comfortable dealing with) reached exaggerated levels. For investment banks in particular, reliant on raising funds in the wholesale markets – unlike commercial banks they lacked retail customers – this lack of confidence was dangerous in the extreme. The drama began on the weekend of 6 September with an announcement from the US Treasury of a taxpayer-funded bailout of Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Corporation), the bulwarks of America’s mortgage market. Though owned by shareholders, both Fannie Mae and Freddie Mac are so-called government sponsored enterprises, with access to lower cost funds than commercial rivals and chartered by Congress to increase home ownership. The fact that they had to be rescued was testimony to the scale of the problem.
But, it was the non-rescue the following weekend, of the blue-blooded Wall Street investment bank Lehman Brothers, that really sent financial markets into a spin, almost producing, what for once it was not an exaggeration to call, ‘financial meltdown’. A few weeks later Mervyn King, the Governor of the Bank of England, described the recent events:
Since August 2007, the industrialised world has been engulfed by financial turmoil. And, following the failure of Lehman Brothers on 15 September, an extraordinary, almost unimaginable, sequence of events began which culminated a week or so ago in the announcements around the world of a recapitalisation of the banking system. It is difficult to exaggerate the severity and importance of those events. Not since the beginning of the First World War has our banking system been so close to collapse. In the second half of September, companies and non-bank financial institutions accelerated their withdrawal from even short-term funding of banks, and banks increasingly lost confidence in the safety of lending to each other. Funding costs rose sharply and for many institutions it was possible to borrow only overnight. Credit to the real economy almost stopped flowing.
The ‘almost unimaginable’ sequence of events described by King included a $700 billion bailout of the US banking system by America’s Treasury Department, a plan only approved after a tough battle with Congress. Even that failed to calm fevered markets. In Britain it included the nationalisation of much of Bradford & Bingley, a mortgage bank, and the emergency merger of Lloyds TSB and Halifax Bank of Scotland (HBOS) with the government waiving competition rules to allow the deal through. Banks were in trouble, and had to be rescued. Merrill Lynch, another Wall Street giant, was forced into a merger with Bank of America. AIG, America’s biggest insurer, had to be rescued by the US government. Several European banks, including the Belgian–Dutch Fortis Bank and Germany’s Hypo Real Estate Bank, got into trouble. The contagion was spreading dangerously and no institution appeared to be safe.
In the 1930s, operating on the principle that it was sometimes necessary to save capitalism from itself, Keynes had urged government intervention. When markets and economies fail, he had argued, it was necessary for the state to act. This philosophy, often thought of as a desire for ‘big’ government, was nothing of the sort. ‘The important thing for Government is not to do things which individuals are doing already, and to do them a little better or a little worse, but to do those things which at present are not done at all,’ he wrote in
The End of Laissez-Faire
. In 2008 investors were not prepared to provide undercapitalised banks with the cash injections they needed. Liquidity was scarce in the money markets and so was trust. So governments had to do what Keynes said they should in such circumstances; step in.
A British plan, championed by Prime Minister Gordon Brown, appeared to press all the right buttons of bank recapitalisation, government lending guarantees and liquidity. It included a £37 billion taxpayer-funded capital injection into Royal Bank of Scotland, Lloyds and HBOS. There were £250 billion of government guarantees of bank lending – dependent on banks accepting the need for either publicly or privately-funded additional capital. The final element was a doubling from £100 billion to £200 billion in the amount the Bank of England was prepared to pump into the system in liquidity. An exceptional crisis required exceptional measures, and other countries took similar actions. When you read this you will know how well, or badly, these rescue attempts worked.
There was more of Keynes, or his memory, in the crisis solutions offered. Britain and other governments attempted to increase elements of public spending to offset the recessionary impact of the credit crunch, this being Keynes’s remedy in the 1930s. There was talk too of a new Bretton Woods conference to establish a new framework for the global financial system; echoing the 1944 conference Keynes had dominated with his presence. Keynes, it seemed, was back.
The financial crisis of 2007–8 took economists, politicians and business people by surprise. Though many claimed with hindsight to have spotted it coming, few did. Out of a clear blue sky a financial hurricane blew, with damaging economic consequences. Some will say it showed the limitations of economics, but while economists engage in forecasting, they are not psychics or soothsayers. And, in an important sense, the crisis was when economics came into its own. As this brief introduction has tried to show, policymakers looked to the past for solutions to the difficult economic present. If the economy did the same thing, year-in, year-out, economics would be boring and few would look to economists for solutions. It is when things are exciting, even frightening, that economics comes alive. I hope this book will whet your appetite to delve further into the subject.