Financial crisis: Why and what's the reason for?

There’s an old Bob Dylan song called ‘Who killed Davey Moore?’ It’s the tale of a boxer killed by a fatal punch and the song recounts the protests of those involved – the referee, the crowd, the gambler, his manager and his opponent – that they weren’t the ones really responsible for his death. “It wasn’t me that made him fall,” they all cry. “No, you can’t blame me at all.”

That song springs to mind whenever anyone apportions blame for the 2008 financial crisis. There are no shortage of culprits. And given that the world may experience similar economic tremors in the near future, the question of who is to blame is extremely relevant.

Who really did make the system fall?

Culprit # 1 Senior Bankers

Bankers are, unsurprisingly, the most likely suspects. Adjectives like reckless and greedy have clung to banks like leeches since 2008 (which may be an apt analogy). But according to Dutch author Joris Luyendijk, the fatal flaw was not so much greed as wilful incompetence. The recently released movie The Big Short exemplifies, he says, the atmosphere in run-up to 2008. Days in which extremely clever finance geeks took advantage of the fact that senior managers in most banks had no idea what was really going on in their organisations. The impenetrable financial products they devised combined to make them vast fortunes and lay the seeds for financial meltdown.

Luyendijk quotes former UK Chancellor Alastair Darling who laments the fact that top managers in US and UK banks “failed to understand – or even ask – what was making them so much profit and what were the risks.”

He attributes this failure to lack of personal liability. In the days before the Big Bang, financial firms were organised as partnerships, rather than publicly floated corporations which any person, or hedge fund or other company could buy shares in. Partnerships ensured managers kept an unblinking eye on their organisation’s activities, says Luyendijk, because if things went awry they were personally liable for the cost of mistakes. But when partnerships were taken over by publicly floated banks or the investment divisions of major banks began marketing their own financial products, this discipline was lost.

I believe that while deliberate blindness on the part of senior managers was a factor in the financial crisis, it is far from a complete explanation. Firstly, bank executives were not as unaware as Luyendijk or The Big Short suggest. From pooled mortgages, to Libor and Forex fraud, the idea that senior executives were utterly oblivious to the machinations going on beneath them is not credible. When apologies become necessary, incompetence is always preferred to culpability.

In 2004, it was agreed that banks needed to have capital or deposits worth a mere 8% of the risky loans they had on their books. That agreement, known as Basel II, was “largely written by the banks themselves” says Mark Blyth in his book, Austerity: The History of a Dangerous Idea. Banks became massively indebted in the early 21^st century (they still are) and that was a conscious decision on the part of senior managers; a way of securing more profit by increasing the amount of money they loaned out. European banks, especially, became chronically ‘over-leveraged’ and may yet have to be recapitalised ‘on a scale yet unimagined’. To blame all this on unruly traders is way too convenient.

Second, the financial crisis was not just about the risk-laden products, the famous mortgage backed securities, collaterized debt obligations and credit default swaps, that boomeranged on the institutions that devised them. It spread across the world with such devastating effect because other institutions – other banks, companies, governments and NGOs – bought those toxic assets. And they bought them because they seem to embody the irresistible combination of low risk and high yield.

Lastly, risk-taking by banks was not merely an internal transgression. They were subject to pressure, possibly decisive pressure, from outside …

Culprit # 2 Shareholders

“In the run-up to the financial crisis, shareholders failed to control risk-taking in banks,” concluded the UK Parliamentary Commission on Banking Standards, “and indeed were criticising some [directors] for excessive conservatism. Some bank leaderships resisted this pressure, but others did not.”

So it wasn’t just that senior executives in banks failed to control super-intelligent and ambitious underlings who could reel off all the prime numbers up to 100 in 2.5 seconds. As directors of publicly floated companies, they were also under constant pressure to deliver greater and greater profits for the owners, the shareholders. And aware that if they didn’t succeed, they needed to look elsewhere for regular remuneration. In the words of Citigroup chief exec Charles O Prince in 2007, (in an article written by Luyendijk) “as long as the music is playing, you’ve got to get up and dance.”

To whose tune were the senior bank managers dancing? Other banks, primarily. Financial behemoths like Barclays, JP Morgan and Deutsche Bank top a list of 147 multinationals who literally own each other through interlocking shareholding. Other major shareholders include hedge funds, fantastically wealthy individuals and pension funds.

What these owners have in common is a need to maximise yield. According to Paul Mason, economics editor of Channel 4 News, big institutional investors such as pension funds, in their pressing need for higher returns on their investments, have become “crucial drivers of instability”. The signature products of the 2008 crisis, mortgage backed securities and collaterized debt obligations, seemed, before they exploded, low risk. So major shareholders were happy to buy them and to breezily criticise banks for ‘excessive conservatism’.

What lies at the root of this predilection for risk-taking among shareholders is the same weakness that Luyendijk criticises bank executives for – that if things go drastically wrong, they know they won’t be accountable. Just as bank executives are cushioned by a lack of personal liability, so shareholders enjoy the protection of limited liability.

Limited liability means that shareholders can lose only their investment in a company; they are never on the hook for the entirety of its bad debts. It is a right granted by the state. Limited liability first originated in Britain in the 1850s and was opposed in an earlier time by the father of market economics, Adam Smith, because of the dangers he saw in separating ownership and management.

The situation is complicated by the fact that, while shareholders seem very adept at pressurising the managers of the corporations they own to maximise profit without heed to public welfare, they are positively impotent when it comes to reining in harmful behaviour. Senior managers seem able to set their own pay which has mushroomed to 180 times that of the average worker in Britain. When shareholders do revolt over excessive executive pay – as they did at Shell in 2009 - they find that their opinion is merely advisory. In many ways, the senior management of large, shareholder-owned corporations are a law unto themselves.

So some have concluded that protecting the public from the selfishness of corporations requires removing both the limited liability of shareholders and the personal liability of company directors. “The most effective way of curbing predatory practices is to withdraw limited liability and hold the shareholders and directors of these enterprises personally liable,” argues Essex University’s Professor of Accounting, Prem Sikka.

Sikka wants alternatives to the corporate model – mutuals, cooperatives, not for profit and worker owned enterprises – to thrive and be promoted by government. “All are subjected to community pressures and control by employees, savers and consumers,” he says. “They see something beyond making a fast buck.”

The trouble is, during the crisis of 2008/9, the eyesight of these supposedly alternative enterprises seemed as myopic as anyone else’s.

Culprit # 3 the global market

The list of mutuals in Britain felled by the financial crisis is embarrassingly long. The Dunfermline Building Society, the Scarborough Building Society, the Chesham Building Society, the Derbyshire Building Society and the Cheshire Building Society all either collapsed or had to be bought by other financial institutions. In the case of the Dunfermline, the Bank of England bailed it out and ran it for a time.

Building societies don’t have shareholders. They are owned by, and in theory accountable to, their members – people who have mortgages or savings with them. But, though they didn’t create the banks’ financial ‘weapons of mass destruction’, they were just as reckless with the way they lent money.

In May last year, regulator Andrew Bailey, the chief executive of the Prudential Regulation Authority, warned building societies that they must not return to the ‘fatal’, high risk lending that helped trigger the financial crisis. He cited evidence that building societies were resuming the pre-crisis practice of making loans many times larger than their customers’ income and property.

These failings are not limited to Britain. In 2009 two of Germany’s famous state-owned Landesbanken, were forced to merge after they had borrowed too much capital and invested it in toxic US sub-prime mortgage assets. Four others had to be bailed out by state governments in Germany to the tune of millions of euros.

In Spain, savings banks, known as cajas de ahorros, are owned by non-profit foundations and dedicated to charitable activities as well as savings and mortgages. But they were at the heart of the implosion of Spain’s housing bubble. Of 45 cajas in existence at the start of the crisis in 2007, only two survived. The rest collapsed and had to be taken over by banks or the government. The effects have been catastrophic. Hundreds of Spaniards have been evicted every single day and the unemployment rate has reached a staggering 25%.

The financial crisis may have been hatched in corporate-land but it unfolded like a virus throughout the world because of markets. And allegedly alternative enterprises were as starry-eyed about these markets as anybody else.

Why then did alternative enterprises, which presented themselves as different to soulless, money-grubbing corporations, turn out to be not so different after all? Partly, because of a lack of real accountability. Though they were accountable in theory, they weren’t in practice. German Landesbanken had advisory boards that were meant to keep senior management in check but merely rubber-stamped their activities. In Britain, the Cooperative Bank’s woes can be attributed to the fact that its elected board didn’t have the knowledge or confidence to challenge the ‘incredibly optimistic’ assumptions of the management team. In this sense, the corporate and mutual sectors suffer from a similar affliction – out of control senior executives.

We don’t live in democratic societies. People don’t have the knowledge, time or inclination to hold the powerful to account. Without a conscious change in that level of knowledge and intention, mechanisms of accountability will remain empty shells.

But perhaps the problem is deeper still. The Marxist economist Andrew Kliman argues it is foolhardy, in a capitalist economy, to expect nationalised or worker controlled banks to behave differently to their corporate equivalents. “In order to survive, a state-run (or worker-run) bank must pursue the goal of profit maximisation, just like every other bank,” he says. “As long as there is capital, what are actually in control are the economic laws of capitalism.”

Those economic laws of capitalism mandated that building societies and other mutuals compete with major banks for market share and profitability. And doubtless many members, at the time, agreed with these aims. Governments in Britain have since the 1980s relied on rising house prices to ensure re-election. When that measure goes into reverse, as it did for the Conservatives in the early ‘90s, they watch as erstwhile supporters desert them in droves. Pensions funds are a ‘crucial driver of instability’, yet many millions rely on them to deliver high investment returns to fund their pensions.

This is not to descend into the ethical void and assume that everyone is equally guilty. Some people are infinitely more culpable than others. A tiny elite get to set their own pay. A tiny elite have been bailed-out by government and their wealth rescued by state action. A tiny elite get to make – and rig – the rules of the game. But, as in Dylan’s Davey Moore parable, it is the rules of the game that need altering. The blame game confers only an ephemeral pleasure. A bit like shopping.

Labour spending crashed the economy versus Gordon Brown saved the world. Two election myths that won't go away

There is something about a general election campaign that shoehorns reality into fantastical contortions. Actually, scrub that, there is something about a general election campaign that invents reality so that the resultant limpet-like myths bear absolutely no relation to actual events.

So it is with the economic story of the last few years.

As predicted in this blog, the myth of Labour over-spending as a cause of the economic crisis has come to dominate the popular narrative of the crash and its aftermath. Bringing to mind Bertrand Russell’s observation about the stupid being cocksure, while the intelligent remain beset with doubt, its giant wrongness only seems to invigorate the resolution of those clinging to it.

It is probably futile to point out (as the graph below shows) that the last Labour government spent, as a proportion of the GDP, less than Margaret Thatcher did. Labour also taxed the rich and corporations much less than Thatcher as well, although she established the direction of travel. Which goes some way to explaining why government debts and deficits remain so predominant; a situation exacerbated by the current UK government cutting corporate income tax by nearly 30%.

The George Osborne retort that the last Labour government should have mended the roof while the sun shone is strangely never applied to the blessed Margaret. And there is no reason why not. Because things got decidedly overcast when the UK dipped into deep recession in late 1989. I blame debt racked up by Margaret Thatcher’s Conservative government (that way lies insanity. Ed)

The notion that Labour was drunk at the wheel of City regulation, while true, ignores one serious, endemic flaw of regulation in a capitalist economy. It is necessarily ineffective. Truly effective regulation, whether in finance or pharmaceuticals or food production, would suffocate profit and growth and so there is always a modus operandi reached with the industries that are supposed to be regulated. Even halfway decent regulation will produce lower growth and so government revenues will inevitably be smaller.

All this may look suspiciously like making excuses for the last Labour government. But that’s not what I want to do. Because, while the over-spending myth has come to cast a pall of stupidity over the general election campaign, an opposite myth has arisen. Admittedly, one that has far less traction. But it’s no less fictional.

This narrative is best called, the Gordon Brown Saved the World myth. While other world leaders were like rabbits frozen in headlights in 2008, Gordon Brown stepped in and advocated nationalisation of the banks. This together with other interventionist measures, the story goes, ensured that growth returned and economy was ‘on the mend’ before the Conservatives got elected in 2010 and choked off this resurgence with austerity.

There are numerous aspects to this story of events that are seriously wrong. Firstly, the kind of nationalisation employed by Brown, an arms-length, business as usual nationalisation, was entirely the wrong kind of nationalisation. Secondly, this nationalisation effectively transferred massive private sector debt to the public. Thus, if it did save the world from a great depression, it did so at the expense of giving a massive shot in the arm to austerity (which now could be portrayed as necessary to pay off the debts) and, by rescuing insolvent institutions, all but ensuring future economic stagnation.

One writer on the history of austerity, Mark Blyth, has confessed that, while in 2008 he thought there was no alternative to bail out the banks, he is now “no longer sure this was the right thing to do”. “Perhaps we should have let the banks fail,” he writes in his book, Austerity: The History of a Dangerous Idea. “Yes, systemic risk says otherwise. But if the alternative produces nothing but a decade or more of austerity, then we really need to rethink whether the costs of systemic risk going bad are any worse than the austerity we have already, and continue to put ourselves through.”

The notion that real growth had returned to the UK economy at the start of 2010 (in the first two quarters of 2010 the economy expanded by 0.5% and 1%) is risible. Growth was produced by bail outs and quantitative easing (QE), an entirely artificial way of stimulating the economy that works by raising the price of shares and property. Government intervention which, by the way, direct benefits the rich and property owners. And makes borrowing more attractive; which some might say is a strange thing to do in a credit-addicted economy.

And QE always produces a temporary effect, which fades away. The Eurozone economies are expected to grow more quickly that either the UK or US in the first quarter of 2015, following the introduction of QE late last year. The US economy, which ended six years of QE last October, grew by just 0.2% in the first quarter of 2015 and has yet, according to Reuters, “to demonstrate self-sustaining resilience.” In fact, we seem to be at the beginning of a global economic downturn, as the various stimulus measures undertaken in 2008 wear off. We used to have boom-bust, now we’ve got dribble-bust. The world hasn’t been saved, in case you were wondering.

“It is possible that the world economy is so damaged that it needs permanent QE just to keep the show on the road,” said the Daily Telegraph’s independent-minded international business editor last October.

None of this is meant to justify austerity, an entirely self-defeating policy that inflicts huge suffering on the people that didn’t cause the crisis in the first place. But Labour in 2010 was in favour of austerity and has in no way diverged from the QE/ultra-low interest rates/house price bubble route to economic ‘recovery’ undertaken by the Conservatives. Private debt is enormous and getting worse. The fact so many new jobs are self-employed or zero-hours is not just because the balance of power has swung so far in the employers’ favour, but because the economy is fundamentally weak.

It does no-one any good to pretend that what happened in 2008 was a bog-standard recession effectively countered by the nimbleness of politicians in power at the time. That just won’t wash, it was far deeper than that. There are ways in which the kind of government in power after May 7 will change things, from the way disabled people are treated to the circumstances faced by private renter; however marginal that may be. Make your choice with your eyes open. But the UK economy will remain deeply, structurally flawed. That’s a certainty.