Attacking economics is a diversionary tactic

Forgive the numbered note form. For some reason it seems appropriate to me in this case

1. The financial crisis in the UK was the result of losses by banks on overseas assets, originating from the collapse in the US subprime market. It was not a result of excessive borrowing by UK consumers, firms or our government. As the Bank’s Ben Broadbent points out, “Thanks to the international exposure of its banks the UK has been, in some sense, a “net importer” of the financial crisis.” This overseas lending caused a crisis because banks were far too highly levered, and so could not absorb these losses and had to be bailed out by the government.
   
   
2. This is why UK macroeconomists failed to pick up the impending crisis. They did routinely monitor personal, corporate and government borrowing, but not the amount of bank leverage. Macroeconomists generally acknowledge that they were at fault in ignoring the crucial role that financial sector leverage can play in influencing the macroeconomy. There has been a huge increase in the amount of research on these finance-macro linkages since the crisis.
   
   
3. But supposing economists had ensured that they knew about the increase in bank leverage and had collectively warned of the dangers of excessive risk taking that this represented. Would it have made any difference? There are good reasons for thinking it would not.
   
   
4. The main evidence for this is what has happened after the crisis. Admati and Hellweg have written persuasively that we need a huge increase in bank capital requirements to bring the ‘too big to fail’ problem to an end and avoid a future banking crisis, and the work of David Miles in the UK has a similar message. I have not come across an academic economist who seriously dissents from this analysis, but it has no impact on policy at all. The power of the banking lobby is just too strong.
   
   
5. So the response of economists to the financial crisis has been as it should be. The error in neglecting bank leverage is being addressed. Economists have come up with clear proposals about how to avoid the crisis happening again. And these proposals have been pretty well ignored.
   
   
6. In terms of conventional monetary and fiscal policy, academic economists got the response to the crisis right, and policymakers got it very wrong. Central banks, full of economists, relaxed monetary policy to its full extent. They created additional money, rightly ignoring those who said it would bring rapid inflation. Many economists, almost certainly a majority, supported fiscal stimulus for as long as interest rates were stuck at their lower bound, were ignored by policymakers in 2010, and have again been proved right.
   
   
7. So given all this, why do some continue to attack economists? On the left there are heterodox economists who want nothing less than revolution, the overthrow of mainstream economics. It is the same revolution that their counterparts were saying was about to happen in the early 1970s when I learnt my first economics. They want people to believe that the bowdlerised version of economics used by neoliberals to support their ideology is in fact mainstream economics.
   
   
8. The right on the other hand is uncomfortable when evidence based economics conflicts with their politics. Their response is to attack economists. This is not a new phenomenon, as I showed in connection with the famous letter from 364 economists. With austerity they cherry picked the minority of economists who supported it, and then implemented a policy that even some of them would have disagreed with. (Rogoff did not support the cuts in public investment in 2010/11 which did most of the damage to the UK economy.) The media did the rest of the job for them by hardly ever talking about the majority of economists who did not support austerity.
   
   
9. The economic costs of Brexit is just the latest example. Critics have focused on the most uncertain and least important predictions about Brexit, made only by a few, to attack all Brexit analysis. The fact that this prediction involved an unconditional macro forecast, while the assessment made by a number of groups about the long term cost involves a conditional projection based largely on trade equations, seems to have completely escaped the critics. More important, the fact that the predicted depreciation in sterling happened, and is in the process of already causing a large drop in living standards, is completely ignored by these critics.
   
   
10. Attacking economists over Brexit is designed to discredit those who point out awkward and uncomfortable truths. Continuing to attack economists over not predicting the financial crisis, but failing to ignore their successes, has the effect of distracting people from the group who actually caused this crisis, and the fact that very little has been done to prevent a similar crisis happening in the future.
    

Economists versus bankers

Nearly a year and a half ago I wrote a post about encouraging dialogue between economists and other social scientists. I concluded with the following three paragraphs:

“Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.”

I was afterwards asked whether I had one particular UK economist, John Vickers, in mind when I wrote this. He chaired, at the government’s request, a commission on banking reform. He has become increasingly vocal about how his original commission’s proposals (pdf) are being watered down and how the Bank of England appears to be putting public money at risk once again. (For his detailed assessment, see this paper. And here is what another commission member, Martin Wolf, thinks about the financial sector. Adam Barber details how the attitude of the UK government has changed. In the US this very issue became an important point of difference between Clinton and Sanders.)

The honest answer is that I did not have him in mind. It was a fictional account designed to make a point, and so I took elements from different debates which together apply to no one country or individual. The point is that in finance good reforms are those that can best resist political or economic manipulation by banks, and perhaps economists in general have been slower to see that than some of their colleagues in other social sciences..

It would probably be fair to say that before the financial crisis economists got on pretty well with the financial sector. There was a common interest in monetary policy (although the motivation for that interest might have been different) and the sector was a useful source of funds for conferences and (for a few) consultancy. Most economists did not look too hard at what the financial sector was actually doing, although those that did often raised serious questions. Behind this nice piece by Ben Chu is an army of academic research which suggests that fees paid to manage funds are a waste of money.

The situation changed after the financial crisis, for obvious reasons. Since then economists have increasingly questioned whether the whole business model behind banking is sound. In particular they have questioned why banks should be so different from other companies in terms of the amount of equity capital they hold in relation to their assets. These economists include the previous governor of the Bank of England, Mervyn King. They have also questioned whether one of the side effects of current regulation is to maintain the monopoly power of big banks.

If all that was not bad enough, we have the influence that the financial sector has on monetary policy. Mainstream macro has put a lot of emphasis on the importance of day to day monetary policy being independent of politicians, and far too little on it being independent of the influence of finance and bankers. Paul Krugman has talked about the links between interest rates and bank profits and how that might ‘guide’ the views of bankers. If you want to see a clear case of that, read this FT op-ed by David Folkerts-Landau, chief economist at Deutsche Bank.

The article could not be more wrong. The reason the Eurozone has performed so badly compared to the US, Japan and even the UK is not because of lack of structural reform, but because of the relative reluctance of the ECB to stimulate the economy. Rates were raised in 2011, and Quantitative Easing delayed until 2015. The article is full of hopeless lapses in logic. If there is any sense here at all, it is that high unemployment is required as a political incentive to undertake structural reform. So the ECB “has become the number one threat to the eurozone” because it has allowed politicians to put that reform off.

Here I can do no better than quote Adair Turner. “Vague references to “structural reform” should ideally be banned, with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved. If the core problem is inadequate global demand, only monetary or fiscal policy can solve it.” In the Eurozone the core problem is lack of aggregate demand, as below target inflation shows.

Why this hostility from German bankers to low or negative rates? What the author does not tell you is that the profits of German banks, and the viability of other parts of the German financial system, are particularly (IMF pdf, box 1.3) vulnerable to low rates. (For those that can access it, Wolfgang Münchau in the FT provides an excellent summary.) And also that the profitability of Deutsche Bank is not great right now, as Frances Coppola notes. In the UK or US if this kind of nonsense from bankers appears in the press it gets a lot of kick back from economists - in Germany perhaps less so.

So who cares if economists have crossed swords with bankers? It matters because finance gets away with so much partly through a process of mystification. Mystification is how banks can perpetrate widespread fraud on consumers and businesses. When bankers say that being forced to ‘put aside’ more capital keeps money out of the economy it sounds plausible to many, even though it is completely false. (Admati and Hellwig (pdf) list 30 other similar false claims.) There is also a belief that because bankers are involved in financial markets, they must know something about how the macroeconomy works, a belief which the FT op-ed shows is clearly false. In all these cases, economists can provide demystification.

If we are ever to cut finance down to size (metaphorically, and perhaps also literally), economists are going to be vital in the battle to do so.

Banks, economists and politicians: just follow the money

Economics rightly comes in for a lot of stick for failing to appreciate the possibility of a financial crash before 2007/8. However it is important to ask whether things would have been very different if it had. What has happened to financial regulation after the crash is a clear indication that it would have made very little difference.

There is one simple and straightforward measure that would go a long way to avoiding another global financial crisis, and that is to substantially increase the proportion of bank equity that banks are obliged to hold. This point is put forcibly, and in plain language, in a recent book by Admati and Hellwig: The Bankers New Clothes. (Here is a short NYT piece by Admati.) Admati and Hellwig suggest the proportion of the balance sheet that is backed by equity should be something like 25%, and other estimates for the optimal amount of bank equity come up with similar numbers. The numbers that regulators are intending to impose post-crisis are tiny in comparison.

It is worth quoting the first paragraph of a FT review by Martin Wolf of their book:

“The UK’s Independent Commission on Banking, of which I was a member, made a modest proposal: the proportion of the balance sheet of UK retail banks that has to be funded by equity, instead of debt, should be raised to 4 per cent. This would be just a percentage point above the figure suggested by the Basel Committee on Banking Supervision. The government rejected this, because of lobbying by the banks.”

Why are banks so reluctant to raise more equity capital? One reason is tax breaks that make finance using borrowing cheaper. But non-financial companies, that also have a choice between raising equity and borrowing to finance investment, typically use much more equity capital and less borrowing. If things go wrong, you can reduce dividends, but you still have to pay interest, so companies limit the amount of borrowing they do to reduce the risk of bankruptcy. But large banks are famously too big to fail. So someone else takes care of the bankruptcy risk - you and me. We effectively guarantee the borrowing that banks do. (If this is not clear, read chapter 9 of the book here.  The authors make a nice analogy with a rich aunt who offers to always guarantee your mortgage.)

The state guarantee is a huge, and ongoing, public subsidy to the banking sector. For large banks, it is of the same order of magnitude as the profits they make. We know where a large proportion of the profits go - into bonuses for those who work in those banks. The larger is the amount of equity capital that banks are forced to hold, the more the holders of that equity bear the cost of bank failure, and the less is the public subsidy. Seen in this way it becomes obvious why banks do not want to hold more equity capital - they rather like being subsidised by the state, so that the state can contribute to their bonuses. (Existing equity holders will also resist increasing equity capital, for reasons Carola Binder summarises based on the work of Admati and Hellwig and coauthors.)

This is why the argument is largely a no brainer for economists. [1] Most economists are instinctively against state subsidies, unless there are obvious externalities which they are countering. With banks the subsidy is not just an unwarranted transfer of resources, but it is also distorting the incentives for bankers to take risk, as we found out in 2007/8. Bankers make money when the risk pays off, and get bailed out by governments when it does not.

So why are economists being ignored by politicians? It is hardly because banks are popular with the public. The scale of the banking sector’s misdemeanours is incredible, as John Lanchester sets out here. I suspect many will think that banks are being treated lightly because politicians are concerned about choking off the recovery. Yet the argument that banks often make - holding equity capital represents money that is ‘tied up’ and so cannot be lent to firms and consumers - is simply nonsense. A more respectable argument is that holding much more equity capital would translate into greater costs for bank borrowers, but David Miles suggests the size of this effect would not be large. (See also Simon Johnson here, John Plender here and Thomas Hoenig here.) In any case, public subsidies are bound to be passed on to some extent, but that does not justify them. Politicians are busy trying to phase out public subsidies elsewhere, so why are banks so different?

There is one simple explanation. The power of the banking lobby (and the financial industry more generally) is immense, from campaign contributions to regulatory capture of various kinds. It would be nice to imagine that the UK was less vulnerable than the US in this respect, but there are good reasons to think otherwise. [2] As a result, the power and influence of banks and bankers within government has hardly suffered as a result of the Great Recession that they played a large part in creating.

So to return to my original question, would it really have made much difference if more mainstream economists had been fretting about the position of the financial sector before the crisis? I think they would have been ignored then even more than they are being ignored now. The single most effective way of avoiding another financial crisis is to reduce the political influence of the banking sector.      

[1] The optimum amount of equity is not 100%, in part because some (subsidised) borrowing does increase discipline on bankers. For a good discussion of other measures that might reduce the too big to fail problem, see this speech from Andy Haldane. An alternative to the state picking up the bill is to inflict losses on depositors, but the economic problems with this are pretty obvious. Nicolas Véron discusses the difficulties the Eurozone has got itself into with this following the Cyprus crash: see also Simon Johnson here.

[2] In Europe, we had what Mark Blyth describes as the biggest bait-and-switch operation in modern history, where a banking crisis involving private sector debts was turned into a public sector debt crisis. While I would be the last person to defend the macroeconomics status quo, I also think there is an element of bait and switch in the ‘macroeconomics in crisis’ idea. Macroeconomic theory tells us a lot of useful things about how to get out of the recession, if only politicians would take some notice.