Earlier this month I was on a panel with a former banker and an academic in Austria discussing the lessons of the financial crisis.
At one level the crisis was mind-boggingly complex, with obscure, linked financial structures blowing up, spreading risk through the system. At another level it was pretty simple.
Indeed, in many respects we knew the lesson of the financial crisis before the financial crisis. History has given us plenty of opportunities to learn. Taking just the 20 year period before 2008, the world witnessed deep financial crises in Russia and Asia, banking crises in Sweden and Finland, Black Monday, a general equity market crash in 1987 and the dotcom collapse of 2001.
The proximate causes varied - overvalued tech stocks getting their comeuppance in 2001, a reversal of inflows of foreign capital in Asia in 1997 and so on.
But the underlying drivers are the same: cheap money, excessive debt, too much risk taking and too little information. The failure of innovative and opaque financial structures, such as Collateralised Debt Obligations (CDOs) in 2008, often plays a role.
Underpinning it all is the very human desire not to miss the next few percent of gains in buoyant markets. In 2007 Citigroup’s then CEO, Chuck Prince, described the phenomenon in relation to the Citi’s commitment to leveraged buy-outs, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
A year later, in 2008 the Paul McCulley, Chief Economist of PIMCO, a major investment management fund, put it perfectly, “Human beings are not wired to buy low and sell high; rather, they are wired to buy that which is going up in price”. Every investors needs to remember those words.
None of this is new, and writers have long sought to understand it. The book I reach for is Charles Kindelberger’s classic, ‘Manias, Panics and Crashes’. It is testimony to its enduring relevance of the subject that it has never been out of print since it was first published in 1978 – and that has gone through five editions to cope with new financial crises.
Most financial crises are preceded by a sustained period of growth and stability. The years before the 2008 saw rising prosperity, low interest rates and low inflation. It was economic nirvana. Like most booms it generated its own self-justifying narrative, the so-called Great Moderation. This held that the world had entered a new era of prosperity, aided by good policy and globalisation, with risk better managed and distributed through the financial system.
But if financial booms and busts are such a staple of the liberal economic system and have such obvious causes, why don’t investors bet against them? If asset prices are set to collapse, there’s money to be made by ‘shorting’ the market. Why aren’t financial excesses offset by selling activity?
One problem is you can never be sure if an asset which has seen strong growth is about to crash or will carry on rising. Expensive things often get more expensive. Another problem relates to incentives, something that is powerfully illustrated by the career of the prominent 1990s UK fund manager, Tony Dye. Mr Dye famously refused to buy into internet stocks during the dotcom boom on the grounds they were overvalued. This led to the loss of clients. Mr Dye was sacked weeks before the bubble burst and his strategy paid off. Mr Dye was ultimately vindicated, but his career would have been smoother had he gone with the crowd and bought internet stocks.
Regulators face different challenges. They have to balance controlling financial excess against the benefits of dynamic financial markets. Successful economies have deep, sophisticated financial markets. Innovation require risk taking in the financial economy as much in the rest of the economy.
The often-made criticism of the financial sector in the wake of the crisis was that the failures outnumbered the successes. Paul Volcker, the former Chairman of the US Federal Reserve, asserted in 2009 that the ATM had been “the only useful innovation in banking for the past 20 years”. Yet in recent years the rash of innovations, from peer-to-peer lending, to mobile banking and cryptocurrencies, suggests that the appetite for financial innovation remains alive and well.
Perhaps the most important lesson from history is that when the financial system goes wrong the effects on the rest of the economy are severe. In other industries policymakers tend to let events take their course. Such a laissez-faire approach to the financial sector, whose health is vital to the whole economy, would be ruinous.
This lesson was well understood by policymakers in 2007-09. The Chairman of the US Federal Reserve at the time, Ben Bernanke, had a life-long interest in the Great Depression of the 1930s. He believed that disaster was caused by Fed inaction in the face of deflation. Bernanke told the monetary economist Milton Friedman in 2002 that the Fed had caused the Great Depression adding, “we’re very sorry… we won’t do it again”.
Mr Bernanke was true to his word. The aggressive and coordinated action of central banks and governments averted a 1930s style depression. The recovery has lacklustre, but compared with the human cost of the Great Depression the world got off lightly.
Good regulation can help mitigate and avert future financial crises. But to prevent all crises regulation would need to eliminate the risk taking necessary for growth. Unavoidably, the business of acting against financial excess will remain a matter of judgement. Regulation is an early line of defence, just as smoke alarms are the home. But we need institutions which can respond effectively to crises, just as we continue to need a fire service.
Yet for me the biggest lesson is not about institutions, it relates to the way we think. Group think is the hallmark of all financial crises. The antidote is informed scepticism and a willingness to question received wisdom. That, perhaps, is a lesson for us all.