Connecting the dots

John Harris has an excellent article in the Guardian, listing the number of politicians in the UK and EU who have retired to lucrative jobs, often in the financial sector. He links that directly to popular distrust of our ruling elite. I want to make the same connection, but via a slightly more elaborate but perhaps more worrying route.

First, let’s think about the financial crisis. The damage caused by that crisis has been huge, and not just because of the recession it caused. In many countries it seems to have permanently reduced the growth in productivity, meaning that compared to a world in which it did not happen we are permanently poorer by a large and growing amount.

Now as an economist I get a lot of stick about my profession failing to predict this crisis. But economists have not been reticent in thinking about how to prevent the next one. The fundamental weakness of the financial sector is the relative absence of capital (equity) compared to other companies. But the adjustments forced on banks since the crisis have been marginal, and certainly not enough to prevent another crisis.

It is natural to ask why. You might think that getting very tough with banks would have been politically popular? Measures could have been phased in to avoid any short term damage to lending. So why have politicians, and the senior civil servants who advise them, been so tentative? (For that matter, why don’t we change the way multinationals are taxed?)

Or if we go to the Eurozone, the decision to stop Greece defaulting in 2010 was the result of fear that the European banking system was too weak to cope. The consequence was crippling austerity for Greece, and bailing out European banks by the back door using Troika loans to Greece. You might think that European politicians would as a result be particularly keen to ensure that this kind of thing would never happen again, but there too action has been very limited.

If we were talking about the United States, the answer to why the financial sector is treated with kid gloves despite the problems it has caused would be obvious: the financial sector provides a huge amount of funding for politicians to spend getting elected/re-elected. In Europe that does not happen so much. But the expectation of financial reward for good behaviour in the form of employment after a politician retires may be just as effective an incentive. 

So any distrust that people have in our ruling elite and the political system that supports them is not some irrational form of envy. Politicians retiring to lucrative jobs is not inevitable and largely harmless. It is a form of corruption. It strikes at the heart of why we had a financial crisis which has made almost all of us a great deal poorer, and why little has been done to prevent another. The main beneficiaries of the public's reaction to economic hardship and elite corruption may be the likes of Donald Trump and Marine Le Pen.      

What are ABC to do?

This is quite a long piece about politics, that I suspect no one will like. I have said before that I depart from my comfort zone of macroeconomics when I think an important point is being missed from the public debate. In this case the second sentence may follow from the first.

What should the strategy be for the great majority of Labour MPs who did not vote for Jeremy Corbyn (ABC=anyone but Corbyn)? They can continue to expound their misery to receptive political journalists. They can continue to stand aghast at the dislike that some now in power hold for their predecessors. But for a group that has lost two crucial elections within the space of a few months, they really need a more positive focus.

Tony Payne, director of SPERI at Sheffield University, has a suggestion which I think has a great deal of merit. They should “come to terms fully, properly and honestly with Labour’s record in government under Blair and Brown between 1997 and 2010”. This is not in some kind of masochistic, ‘what we got wrong’ kind of exercise, but rather to recognise what that Labour government got right. I was part of a group of academics that looked at economic policy under Labour, and the sense I got was that there were an awful lot of positives to note. But in looking at the negatives, one point that should be recognised is that these (e.g. Iraq, not enough banking regulation, perhaps not enough local support for inward migration) did not come from any tendency to be too populist. Instead rather the opposite.

I’ll come back to that in a second, but actually I decided to write this in response to another post by Tony Payne, which could perhaps be described as a lament for the centre-left. You can get the flavour from this passage:

“what underpins and ultimately characterises centrist politics (whether in its left or right variant) is a rejection of what I see as the easy moral simplicities of populist politics in favour of the complex, awkward and often unsatisfying and unsatisfactory world of governing, of trying to find the best way through the most difficult problems, even if that involves compromise. The latter is of course the dirtiest of words in the lexicon of the populist left (and right).”

I think that speaks to where a lot of the ABCs are right now. They say we tried to be sensible in the face of difficult problems, but we were outflanked on both sides by the moral simplicities of populist politics. I suspect (and to be fair Tony Payne does not make this link) it also passes as some sort of explanation as to why ABC lost two elections. They were the realists who lost out to the idealists and populists. As an explanation I think it is completely inadequate, and to be frank comes close to denial.

Let me take my own subject as an example, partly because austerity is also central to much else. In the end what quite a few of the ABCs wanted to do was to junk the complex and perhaps awkward truths of how to run a sensible fiscal policy in favour of the populist politics of talking about the nation’s credit card. Osborne’s fiscal charter is not supported by a single economist I know, but many of the ABC’s have advocated supporting it. In this case what those ABCs have been doing is adopting - or at least flirting with - populist politics, but the popular politics of the right rather than the left.

That in turns comes from what seems to be the dominant mantra of the ABCs, which is that only they are serious about trying to win elections. That is why, we are told, they have to adopt the populist policies of the other side, because only that way can they win. Notice first how different this is from the noble Weberian concept of the centre that Tony Payne puts forward. Notice second that these populist policies seem to come from the right rather than the left: whenever there is a populist policy from the left (like renationalising rail), then it becomes time to cast aside populism and be ‘sensible’.

I have struggled to understand what is going on here. But the thought that I keep coming back to is regulatory capture. This is the idea that the regulators of an industry become captured by the industry itself: by its objectives, values and methods. In some cases the reason for capture is straightforward (revolving doors), but in some cases it reflects the fact that regulators cannot match their industry in terms of knowledge and analysis. My idea is that in this case instead of an industry you have a Westminster discourse which, under the coalition, was dominated by the thinking of the centre-right. Most Labour MPs simply didn’t have the time or resources to find alternatives to this, and gradually became hostage to this discourse. As Paul Krugman might say, after a time all they hear are the views of Very Serious People.

Part of this Westminster discourse involves the tactic of exclusion for individuals and ideas that are deemed to be outlandish. (Outside the Overton window, if you like.) I have experienced that on a personal level recently: imagine a biologist being told that they would be ‘branded’ if they gave technical advice to a major political party!? Rather more important it leads some politicians on the centre left with strong skills and expertise reluctant to sit at the same table as those in their own party with more radical views, even when those holding more radical views have every incentive to seek compromise. You have to ask who benefits from this.

It is often said in politics that voters vote for and against incumbents, not oppositions. I doubt very much if Labour party members voted for Corbyn because they had suddenly become converted wholesale to a Bennite type platform. Instead they voted against what the parliamentary party had become. I think recognising their responsibility for their own failure is the first step to recovery. I said that the ABCs would do well to follow Tony Payne’s advice and focus on what the Labour government did right. One of those things was the regime of tax credits, which cut poverty and made it easier for people to work. They might then reflect on the reasoning, forces and processes that led so many of them this July to abstain on the bill that cut those credits.

The centre left needs to retrace its steps as a first stage to recovery, and learn from the many things it got right when in government. In the UK and elsewhere in Europe it is important this happens sooner rather than later. Hopefully in doing this it will rediscover positive virtues and ideals that go beyond simply a negation of populism. I strongly suspect a strong political centre (left or right) is vital for good governance, and that both the UK and Europe is suffering from its absence.   

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.