Some notes on the crash – and the rescue
The news that the UK government has conjured up £500 billion since I last wrote about the crash to make sure its banking system didn’t self destruct is, at one level, breath-taking. £500 billion is a lot of money – something like 40% of the total value of the UK economy in any given year, even if only £50bln or so of it is to be ponied up straight away. It isn’t all “real” money (to the extent that any money is “real). It is more an extension of the hall of mirrors represented by the banking and financial system and its elusive search for confidence. And Terry Pratchett explains all of this well in his book Making Money, when Moist von Lipwig, newly appointed as the Bank chief, is trying to work out why the currency needs to be backed by the pile of gold which is said to sit deep in the bank’s vaults.
Larry Elliott even fantasised for a moment in the Guardian’s Business Blog that Gordon Brown and Alistair Darling were in fact long-term ‘sleepers’ who had burrowed deep into the system to seize the moment to fulfil the dreams of Clause IV socialists by taking control of the commanding heights of the economy. But (he doesn’t say this), of course, when the moment came they were so out of practice that they got some important details wrong – like forgetting to actually get any ownership stake in exchange for their money [Update (13/10/08): it seems they weren't completely forgetful.]
Simon Heffer of the Daily Telegraph, meanwhile, perhaps not paying attention to such detail, fulminated (in an article that read like a found object from the early 80s) that nationalisation would be a bad idea because the banks might be badly run as a result (or worse, might not be badly run). Perhaps someone at the Telegraph needs to kiss Mr Heffer to wake him from his reverie and give him some recent newspapers to read.
So here’s Pratchett in Making Money. (The following chapter, in which he tests out paper money on the shopkeepers of Tenth Egg Street, pushes this a little further). It may sound far-fetched, but I think his comic conman is as close as any of the economic commentators as explaining why the bail-out may work.
“On a desert island gold is worthless. Food gets you through times of no gold much better than gold gets you through times of no food. If it comes to that, gold is worthless in a goldmine, too. The medium of exchange in a goldmine is the pickaxe.
Hmmm. Moist stared at the bill. What does it need to make it worth ten thousand dollars? The seal and signature of Cosmo, that’s what. Everyone knows he’s good for it. Good for nothing but money, the bastard. [...]
On a desert island a bag of vegetables is worth more than gold, in the city gold is more valuable than the bag of vegetables.
This is a sort of equation, yes? Where’s the value?
It’s in the city itself. The city itself says: in exchange for the gold, you can have all these things. The city is the magician, the alchemist in reverse. It turns worthless gold into…everything.
How much is Ankh-Morpork worth? Add it all up! The buildings, the streets, the people, the skills, the art in the galleries, the guilds, the laws, the libraries… Billions? No. No money would be enough.
The city was one big gold bar. What did you need to back the currency? You just needed the city. The city says a dollar is worth a dollar.
One of the general assumptions about market economies is that because companies and industries are designed to make money (that is, their purpose is to make money) then they will. But there’s an interesting aside in a technical paper on the finance sector and its understanding of probability and risk by Nicholas Taleb. (I regard Taleb as one of the shrewdest of commentators on Wall Street and its failings even though I’m sceptical about his influential ‘black swan‘ theory). Taleb’s aside is this:
The banking system (betting AGAINST rare events) just lost > 1 Trillion dollars (so far) on a single error, more than was ever earned in the history of banking.
I hope to write about the paper later. But it got me thinking about industries which – over their entire life – have lost more money than they have made.
Banking, now obviously. The aviation industry is another candidate (the American investor Warren Buffett once said that it would have been better if a self-respecting capitalist had shot down the Wright Brothers Kitty Hawk plane, since the aviation industry hadn’t made a dime since). It’s also said about the computing industry. And it’s certainly true of the British cable television and communications business. It would be nice to tie these together with some tidy pattern which identifies their common characteristics; the only one I can see is that they have all managed to convince policy-makers of their strategic significance, and got all sorts of public and political favours as a result.
Like everyone else who’s been thinking about the crash, I’ve been re-reading JK Galbraith’s book on the 1929 crash, and the banking crash three years later, to try to understand the parallels. It’s immediately obvious that there are differences: this time around the banking system is much larger, much more complex, and much more virtual. But one of the sobering sections is when he reflects (writing in 1954) why a crash would have less effect than it did in 1929.
Towards the end of the book Galbraith notes that many of the weaknesses of the global economy have been strengthened. The distribution of income is no longer so skewed, he writes. The great investment trust promotions have been brought under control. The United States has brought its foreign balances under control. And there has been an accretion of economic knowledge.
With US inequality levels back to those seen in 1913, financial de-regulation, and the scale of American debt, only the last of these is presently true. So far, it is the one thing that seems to be keeping our heads above water. At moments like this having an introverted prime minister whose idea of a good time is staying home reading economic history books would seem to be a virtue.
And finally, the collapse of Icesave, the poster child of money advisers for much of the last year because of the generous rates of interest it was offering. I’m quite old-fashioned about this sort of thing: in practice risk-reward ratios tend towards constant, so if the reward has gone up it means the risk has gone up as well. (Some bankers started to think that HBOS might be in trouble because of the high rates it was offering to attract savers.)
But as I thought about it more I realised that the problem was more deep-rooted than investors’ naivete. Every asset bubble produces a prevailing view that “the rules have changed” (the internet bubble even produced a book called The New Rules For The New Economy). The rules had, allegedly, changed in the banking bubble because of globalisation, technology, and Thomas Friedman’s ‘flat world’. Investors are encouraged to believe this by people who should know better or who have have a financial interest in forgetting what they know. But like the Banque Royale scheme or the railway bubble of the 1840s, they turn out to have the same risk/reward ratio as before. The bumps turn out to be surprisingly familiar.