Getting to the root of the economic crisis

How did it all go so horribly wrong so fast? That is probably the most common question raised about the current economic crisis.

It should not be forgotten how quickly it caught up on us. As recently as June 2007 Gordon Brown, just before he became prime minister, addressed the Great and the Good of the City of London in the characteristically obsequious way reserved for City workers. He congratulated them for creating ‘an era that history will record as the beginning of a new golden age for the City of London’. It is a claim that, with the benefit of hindsight, looks absurd (1).

Even as late as the summer of 2008 the Bank of England was studiously rejecting any talk of recession. At the 13 August press conference on its quarterly Inflation Report the Bank’s governor, Mervyn King, said: ‘The central projection is one of broadly flat output over the next year.’ (2) In normal English this meant he expected the economy not to grow but he did not see it falling into recession – in other words shrinking – over the subsequent 12 months. This prediction also proved abysmal; economic output has fallen sharply since then (3).

Veteran Observer columnist Will Hutton’s explanation for why things got so bad so fast is essentially that greedy bankers lost out on the huge bets they were making in the City of London and Wall Street. In this respect, Hutton expounded on the most popular explanation for the economic crisis in his two-part Channel 4 Dispatches documentary on the crash (4). For Hutton: ‘The bankers thought they had abolished risk. The innocents paying for their folly are ordinary workers and ordinary taxpayers.’ He later related how ‘the crisis they’d create was about to turn an economic downturn into the worst recession in 60 years’.

Hutton’s documentary is worth watching because it includes interviews with many of the key protagonists on both sides of the Atlantic. He talks to senior bankers, economists, hedge fund managers, politicians and regulators in America and Britain. Many present themselves as critics of the rise of incredibly complicated financial instruments and supposedly lax regulation, despite often having been centrally involved in these developments.

The narrative Hutton presents will be familiar to anyone who has followed the discussion of the economic crisis in any detail. Over the past decade, bankers increasingly used risky financial instruments to make enormous returns. Everything seemed to be going fine until American house prices started to fall. Since many of these instruments were linked to mortgages, the problems in the housing market hit financial institutions. Credit dried up as institutions on both sides of the Atlantic became scared to lend to each other. Several large financial institutions collapsed as a result, while others were bailed out by government. A deep economic crisis has followed.

A secondary villain in Hutton’s account is the New Labour government. Rather than regulate the banks properly, he argues, the government was in awe of them and their free market ideology. ‘New Labour did not ask tough questions’, he said. ‘They were lionised as the new heroes of free market economics.’

Although Hutton’s is a popular explanation of the crisis, it is flawed on many levels. For a start, the problems that have emerged in recent months go back far longer than a few years. Hutton, like most financial commentators, focuses on the crash of recent months and the few years that preceded it. Yet the huge surge in the importance of finance and the rise of complex financial instruments date back at least as far as the late 1980s (5).

A more fundamental weakness of Hutton’s approach is its impressionism. He takes the account given to him by bankers and others more or less at face value. In broad terms they say they screwed up and Hutton agrees with them. He sees no need to probe more deeply to work out what was really going on.

In reality, the rise of complex finance was the result of an interaction of two factors. First, there was the rise of a broader culture of risk aversion in society (6). A pervasive fear of risk-taking spread across all areas of society, including finance. The complex financial instruments that Hutton and others point to emerged in response to a demand from companies and individuals to manage risk. For example, mortgage-backed securities, which played a central role in the recent crisis, were designed to take risk off the balance sheets of mortgage lenders. In effect, mortgage lenders were selling their risk on to other financial institutions. This development had the paradoxical effect of reducing the exposure of mortgage lenders to risk while spreading it more broadly around the financial system.

From this perspective, the simplistic attack on greed can be seen as misplaced. No doubt some players strove to make large profits from playing the market. But it was the desire to manage risk, rather than really to take big risks, that drove the emergence of complex financial instruments. Those who truly understood the market knew that risk could never be eliminated but it could be sliced, repackaged and transferred in numerous different ways.

The second key factor driving the surge in finance was the atrophy of the real economy. As economic activity in the Western world became increasingly sluggish it often became more lucrative for firms to play the financial markets rather than reinvest productively (7). As a result the financial markets became increasingly bloated relative to the scale of economic output.

Action by the state authorities to offset this trend towards atrophy helped create the conditions for the crisis to emerge. For example, America’s Federal Reserve kept interest rates particularly low in the aftermath of falling stockmarkets in 2000 and 2001 (8). Low rates helped create the conditions for the surge in credit that was the immediate prelude to the credit crunch. But easy credit during that period should not be seen as a simple policy error. On the contrary, it was a desperate attempt to maintain the momentum of economic activity against this long-term decline.

The West’s economic problems may only have become obvious in recent months, but its underlying weakness was long-standing. In that sense the recent economic crisis has only brought perceptions more closely in line with reality. The abnormal period was the previous boom: when a massive expansion of credit made Western economies appear more dynamic than they really were (9). The really striking question is how they managed to offset the trend towards breakdown for so long.

Accounts such as Hutton’s Dispatches documentary fail to grapple with the underlying dynamics of the economic crisis. They only see its obvious manifestations – such as collapsing financial institutions and the credit crunch – rather than its root causes. And they are oblivious to the key roles of the culture of risk aversion and a fundamentally sluggish economy in explaining the downturn.

Scapegoating bankers also absolves those who are truly to blame for the crisis of responsibility. Indeed, it can easily become part of a generalised attack on ‘greed’: the codeword for anyone with ambitions to pursue prosperity determinedly.

The real blame for the economic crisis lies with the economic and political elites of the Western world. Rather than attempt to grapple with the problem of economic atrophy, they have adapted to it. They celebrate low growth, and even falls in consumption, as welcome ‘green’ or ‘sustainable’ development. Hutton’s attack on bankers endorses this flawed narrative rather than challenging it.

Daniel Ben-Ami is the editor of Fund Strategy and author of Cowardly Capitalism (Wiley 2001). Visit his personal website here. Daniel is speaking in the session Rein in the greedy bankers? at the Post-G20 Public Summit: Battle for the Economy on Saturday 16 May, Goodenough College, London, WC1N 2AB. Buy your tickets here.

(1) Speech by the Chancellor of the Exchequer, the Rt Hon Gordon Brown MP, to Mansion House, 20 June 2007

(2) World Television: Bank of England Inflation Report 13th August 2008 (PDF)

(3) Britain’s most recent official GDP figures are available here (PDF).

(4) Available to watch on 4oD until 27 May 2009.

(5) See chapter one of Cowardly Capitalism, by Daniel Ben-Ami, Wiley, 2001.

(6) See Culture of Fear, by Frank Furedi, Continuum, 2005.

(7) For a historical study of the question see, for example, Law of Accumulation and Breakdown, by Henryk Grossmann, 1929.

(8) The official federal funds rate from 1990 can be found here.

(9) For an attempt to grapple with this phenomenon in relation to Britain see Robert Chote’s A bust without a boom?, April 2009.