The Great Crash of 2008

The world's financial institutions are gripped by fear, yet policymakers can do nothing. They are ignorant of how banks now work and have to take poacher-turned-gamekeeper Henry Paulson at his word

Of all the phantoms conjured from the financial depths in the past ten
days, the most ghastly appeared on the dark Wednesday, 17 September,
when interest on the short-term obligations of the United States
government, the one-month Treasury bill, turned negative and became a
penalty. Such terror had overtaken the markets that they were willing
to suffer a loss on their money in the hope that, in the deep bosom of
the US Treasury, some of it would be kept safe.

Yet the terror of that day was not just to do with loss: money lost,
job gone, wife fled, house foreclosed, sailboat beached. It was an
elemental panic, such as overran the financial markets on 19 October
1987, the day the Dow Jones Industrial Average fell 23 per cent. It was
a recognition that the world is not as we have been told and that the
conception of value that lies at the root of modern society is, and has
always been, a fiction.

In this panic, there is no reality in the sense of actual existence
to prices and Lehman Brothers Holdings can be worth $15bn on Monday and
nothing at the weekend. The world is held together only by instances of
agreement between two or more people. It is an education that everybody
should pass through, and my generation has done so twice, in 1987 and
2008. It is as if the gods of financial markets have been reading
Hegel, and learnt that "through repetition, that which at the beginning
appeared as merely accidental or possible, is confirmed as a reality".

Not that governments are thinking much about Hegel. Like generals
fighting their grandfathers' wars, policymakers are haunted by the
Depression of the 1930s, where a crash in financial markets was
transformed by selfish national policies into a collapse in world
trade, and unemployed men walked in droves from Sydney to Melborne,
shooting rabbits for food.

Andrew Mellon, the former investment banker who was US treasury
secretary at that time, thought to break value down to a sort of
puritan or moral core. He is said to have burst out to President
Hoover: "Liquidate labour, liquidate stocks, liquidate the farmers,
liquidate real estate! It will purge the rottenness out of the system.
High costs of living and high living will come down. People will work
harder, live a more moral life. Values will be adjusted, and
enterprising people will pick up from less competent people."

His reincarnation, Henry Paulson (also once a star investment
banker), has opted instead for expediency in which pure fear cuts
through all moral entanglements. He has won over the administration and
some supporters in Congress to his colossal plan to take $700bn or more
of bad loans on to the Federal government's books. It is the equivalent
of the entire US budget for social security. In promoting his plan,
Paulson said: "I am convinced that this bold approach will cost
American families far less than the alternative - a continuing series
of financial institution failures and frozen credit markets unable to
fund economic expansion. The financial security of all Americans . . .
depends on our ability to restore our financial institutions to a sound

Ben Bernanke, chairman of the Federal Res erve, was crisper: "There
are no atheists in foxholes and no ideologues in financial crises."

In effect, the US public will recapitalise the silly bankers at a
cost of perhaps $2,000 per American adult and child, maybe much more,
maybe much less. In Britain, the authorities are reluctant to wield
what Paulson calls the "bazooka", trying to ensure instead that the
banks continue to do business with one another. Banks, under the
so-called special liquidity scheme, can shore up their creditworthiness
by exchanging their questionable mortgage securities for Treasury
bills, securities that carry the faith and credit of the UK, which has
never failed.

Already, PS100bn has been drawn and nobody knows how much more will
be required for both schemes. In truth, bankers have little clue now
what they have (assets) or what they owe (liabilities). AIG, the
insurance group that all but bankrupted itself insuring bank loans
against default, asked the US authorities at the weekend of 13-14
September for $20bn, then for $40bn and finally $85bn.

What are we to make of a banking business that must be recapitalised
by the public every generation? That, like the nuclear power industry,
holds a gun to the public head two or three times each lifetime? And in
the intervening periods treats the public like poor relations?

In all the commentary on the crisis, certain facts have been thought
too elementary for consideration, so I shall consider them. The first
is this: the business of banking is not profitable (as you have been
told) but miserably unprofitable. It is this unprofitability rather
than the idiocy or wickedness of bankers that makes the enterprise so
unstable. The arrogance of bankers, their extravagant rewards and
public philanthropy, are the abstract counterparts of the massive
architraves and pediments of the old bank architecture, such as the
Barclays Bank headquarters in Norwich. How could they not be safe as

The fundamental business of taking in money and putting it out again
earns a wafer-thin interest margin and will only keep bankers in luxury
if it is conducted on a colossal scale. Even the most prudent banks
borrow ten times their own capital, while investment banks (who do not
take deposits from the public) borrow very much more: Lehman Brothers
30 times, and even the respectable Goldman Sachs 22 times. At that
extent of what is known in the US as leverage, a small fall in values
wipes out the bank's capital, leaving its lenders exposed to loss, and
their lenders likewise in a daisy chain of failure. Commercial banks
are not well-managed institutions and investment banks (with the
exception, it is said, of Goldman Sachs) are not managed, in the
industrial sense, at all. An unsupervised trader can wipe out a bank's
entire capital, as in 1995 at Baring Brothers, or so terrify management
that they reverse his trades at fire-sale prices, as at Societe
Generale last February.

Even at that level of leverage, profitability is still too low and
banks have sought ways to ex pand their lending through various legal
and quasi-legal means. (J K Galbraith used to say that as the
speculative waters subside, all manner of crimes are revealed to an
astonished public view.)

In a regulatory filing, AIG made no secret that some of its credit
insurance instruments were designed to help banks evade restrictions on
their lending. Another tactic was to combine packets of loans into
interest-bearing securities and sell them on to other investors. This
allowed banks to replenish their funds and originate more loans, but at
the risk of spreading the default far and wide - which is why bad debts
in run-down cities in the Midwest affected investors in London,
Frankfurt and Tokyo.

Too many banks

The second point follows from that. The banking system is not
undercapitalised for the ordinary purposes of trade, as Paulson would
have us believe, but overcapitalised to the point of obesity. A brief
walk down the high street of a county town reveals that. It was the
genius of the short-sellers, or bears, to recognise that there are far
too many banks and bankers for the use of the public - and for this
insight, like Cassandra, they are hated and shunned. Paulson wants to
maintain the banking industry in its bloated condition for fear that an
orderly reduction in banking will turn into a rout. We will then be
plunged back into the days of the Hoover administration, when 11,000
banks closed their doors for ever and business simply stopped. Yet
Paulson's attempt to maintain the banking system at the extent or level
of 2005 or 2006 may not be successful.

The reason is that the run on the banks which started at Northern
Rock in Newcastle in September 2007 has unfolded at a time of rising,
not falling, incomes and profits. The last phase of mortgage lending in
the US and UK, and also in countries such as Spain and Ireland, was
never likely to be repaid even in golden days. In the ordinary rhythm
of trade and business, business activity will eventually contract or
already is contracting. As industrial companies fall into loss and
individuals lose their jobs, debts of a more solid character than 110
per cent loan-to-value mortgages will fall into arrears. Unable to
raise capital in the markets, banks will once more need public support,
or will fail. The Paulson "bazooka" and the swap arrangements at the
Bank of Eng land may expand to the point when they impair the credit of
the nation, expressed in its currency's exchange-rate. And what of
poorer or less sophisticated countries who are also unable to borrow?
While all eyes have been on London and New York, the Russian stock
market has halved. This is the nightmare of the 1930s where the engine
of world trade simply peters out.

Yet policymakers are constrained by their ignorance of financial
markets, have no ideas of their own, and must take the
poacher-turned-gamekeeper Paulson at his word. In Britain, new Labour
shed its ancestral scepticism of the City more comprehensively than,
say, the reformed German Social Democrats. As the intoxication recedes,
Labour must recall in hot flushes its excruciating naivety. Peter
Mandelson's "We are intensely relaxed about people getting filthy rich"
is as embarrassing as Gordon Brown's hero-worship of the US central
banker, Alan Greenspan, whose stock has fallen faster than Lehman
Brothers common.

Yet if the financial chaos spreads out into the tangible world of
job centres and shuttered factories and empty office blocks - a world
where men and women, unlike bankers, must live with the consequences of
their folly - politicians will demand their pound of flesh. In the US,
both presidential candidates Barack Obama and John McCain are mining a
popular hatred of the East Coast money men that goes back deep into the
19th century. They will place restrictions on bank lending and
securities underwriting just at the point where there is no lending or
underwriting of securities. Bowing to the winds of change, both Goldman
Sachs and Morgan Stanley have abandoned their privileged position as
investment banks and submitted to regulation by the Federal Reserve,
right there alongside First Farmers & Merchants of South Succotash
with its 600 checking accounts.

William McChesney Martin, the Federal Reserve chairman in the 1950s
and 1960s, used to say that the job of the central banker is "to take
away the punch bowl just as the party gets going". Greenspan, who at
two decades at the Federal Reserve accommodated the banks in all they
required, conspicuously failed to do so. In these circumstances, there
will be a call for returning central banks to political control.
Margaret Thatcher always opposed independence of the Bank of England,
because it seemed to her an admission of political failure. She also
doubted - and even her enemies would not disagree - "whether we had
people of the right calibre to run such an institution". These central
banks, once returned to political control, will find it hard to resist
a little inflation to lighten the burden of public and private debt.

The melancholy aspect of the crisis lies not in the humbling of
proud men such as Dick Fuld of Lehman Brothers or Greenspan himself,
but in our ignorance. An entire epoch of finance passes in which we
lived, but did not understand. Truly, as Hegel said, philosophy comes
too late to teach the world how it should be, and Minerva's owl begins
her flight into gathering darkness.

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