The spectacle of "moral hazard'' caught in the spotlight is not edifying. Bankers who have been seen living in morally righteous luxury are now relying on the support of the public institutions of the nations that they had become so disdainful of. What will now happen is clear: they will be bailed out, at the cost of inflation - a tax on anyone holding fixed-price assets, like cash or government bonds.
More importantly, there will be new regulation of finance. But what is really needed is that we collectively take on responsibility for the determination of economic and monetary policy. These are too important to be technocratic, and mistakes must rely on us all to be in it together if the worst populism is to be avoided. Their "moral hazard'' must not be matched by our "responsibility hazard''. We must take back responsiblity for our recessions from the faux-technocracy they now live in.
In 2001, as technology investments spectacularly lost their shine, the economy's future looked bleak. But it was 9/11 that really gave the Federal Reserve the resolve to reduce interest rates. The end of Web 1.0 combined with the attacks really did threaten the world economy. The remarkable economic news of 2003-06 was that the policy both worked spectacularly well and did not really stop working in the the sort of timeframe expected. In the normal course of events, low interest rates should quite rapidly have run into limitations of supply - people, factories, raw materials would usually rise in price, and so turn any good effects of the increased borrowing into higher prices.
The extraordinary factors are well known, but worth listing:
* China and India were just beginning to deploy their huge capacity to supply manufactured goods
* oil prices were at historic lows (remember the Economist's cover prediction of $5 oil in 2000?)
* the end of the tech boom liberated people and machinery all over the developed world, ready to take up employment in whatever new industries would be stimulated by the cheap credit
* the rich world took advantage of cheap credit to buy and build houses at an unprecedented rate - which put price pressure on houses rather than non-durable goods; thus, the stimulated activity further increased household's wealth, creating a runaway cycle in perceptions of wealth.
These factors allowed the Fed to keep borrowing high without the usual danger signals of inflation restraining it (house prices are not part of inflation because houses are considered to be an asset, part of people's wealth. Rental costs are in most consumer price indices, but these did not follow the path of the asset-price bubble).
Banking, with its newly nimble and low-profile hedge funds and special investment vehicles, was ready to thrive in this environment. When interest rates are low, any contract that returns some constant stream of cash becomes hugely valuable. So the incentives for the subprime mess were all there. Any bank or fund that had access to 2% money from the Federal Reserve developed an unlimited appetite for borrowers who might pay 5% or more. Between those two numbers was room for big commissions and fee notes for everyone along the way, from mortgage mis-sellers and imaginative lawyers who would keep the resulting loan bundles off the bank balance-sheets.
The citizenship knot
Brad DeLong, the Berkeley economics professor who writes an engaging blog, has a crisp account of what this means for finance:
"What's really going on? What's going on is that perhaps $6Tr of mortgages with a duration of a decade that had been priced at q 1% per year chance of default (with a 1/3 value haircut in the event of default) are now being priced at a 4% per year chance of default. That's a loss of $600B in market value - and if your share of that $600B is greater than your capital, or is thought to be greater than your capital and so impedes your operations, you are gone."
So what were the preconditions for this messy mis-pricing of risk? Briefly:
* monetary authorities prepared to pursue a cheap money policy right until it looked like trouble
* a banking system ready, incentivised and regulated, when the opportunity arose, to create loans without end.
All the proposals to overhaul the regulation of banking are aimed at the second of these: try to stop banks and bankers behaving like the gatecrashers at a teenage party, happy to enjoy and wreck the common environment until the reckoning comes. Banking regulation is a good thing to be doing, but it is only half the story. The Fed and other central banks put on the party in the first place, and never switched the lights out. These are administrative arms of democratic states, and the question we should ask is: "what is it in our politics that allows democracy to be so irresponsible?''
As the quote from Brad DeLong makes clear, the price of money - the risk of default - has social impacts shared by no other single price in the economy. Influence on the price of money is power. This is undoubtedly one of the of the reasons that so many traditional systems of law prohibit the charging of interest within the group. Deuteronomy's prohibition on lending against interest "to the Israelites'' is an extreme monetary policy, but it is one. The monetary policies of our own governments should similarly reflect what we want our societies to be. Monetary policy needs to become part of responsible citizenship as much as environmental policy is.
The burden of precedent
Debt-based entrepreneurship should not be condemned just because of the subprime crisis.Microfinance has been a great source for social improvement. The ability for those with business talent to borrow when they have little to lose has been a force for social mobility, especially in America. It is not surprising that it is here that we find quasi-religious attachment to debt, for example in the writing (and life) of George Gilder. However, in Gilder just as much as in Max Weber, the entrepreneur's attitude to debt is that of a trial against which his ability will be measured. Paying off debt has moral value because it proves you are good enough to do it.
This world is a far cry from the financial sector's undistinguished miasma of "moral hazard'' - all that behaviour engaged in because you know there is always some safety-net, a system of protection borne by others, that will pick up your losses while you walk off with your gains. No one is running to pay-off that $600b of losses that Brad DeLong identifies to prove their moral worth.
Debt has a social role, but it needs to live in a social context that disciplines its use. So given the power of the price of money as well as its collective, social determination, what rules should it follow? Should we have allowed our monetary authorities have made money cheap in 2001-02; and should they have kept that policy going so long? But most of all, should these not have been questions for all of us, not for an administrative machine?
The story of every bust goes back to the story of its preceding boom, and every boom has tentacles into the bust it has followed. This is one good reason why Keynes has been so often right in saying that the economists of the day are always solving the problems of the last generation. Our economists were still fighting inflation in 2001 and its aftermath. Central banks had slain inflation in the 1970s and 1980s, and this was now their role. In the case of the Bank of England and the European Central Bank, this role was even enshrined in law. So the central bankers kept their eyes firmly on measured inflation and allowed the credit boom to happen. But if it had been expressed that way in 2001: "Let's keep money cheap until inflation starts again'', there would have been at least some voices saying: "No, let's keep money cheap until the fear has lifted that 9/11 has completely changed every aspect of our world and the non-technology parts of the economy have restarted.'' The first rule has brought the sub-prime crisis, while the second - grounded in the realities of 2001 rather than the fights of the 1980s - would have appealed to non-technocrats and would have led to more expensive money earlier in the decade.
The systemic faultline
Central banks should not be depoliticised, turned into mere administrators of a rule in this way. That is because the judgments that they must make - do we give a shock to a failing economy? do we dampen exuberance? - need to be part of the social compact. Did all of us together feel that we were implicated in the 2001 decision, or in the subsequent decisions not to raise interest rates as the asset price bubble took off? Now that the expensive rescue of the financial sector is upon us, do any of the rest of us feel that this is part of a social process we controlled?
No. Many of us are now enjoying our own moment of "responsibility hazard'': while the financial system went into orbit, where were we? Were we asking our governments to discipline financial markets, or to abandon inflation targeting? Maybe we wanted to believe it was true: post-inflation, asset-owners feeling wealthier every week, the big economies of the global south soaring into advanced liberal capitalism ... And if we did not do the responsible thing then, we cannot be confident in our condemnations of the financial sector today.
There is an ultimately impossible asymmetry in a system of government that will have governments fall on economic outcomes - ''it's the economy, stupid'' - and yet makes economic policy something operated by technocrats in a language that excludes most of the population. If the system of government infantilises the governed in this way, expect populist crowd-pleasers to come now in place of honest regulation. This is when the teenage party becomes violent.
We need to take on responsibility for the business cycle, collectively. The rate of interest needs to be set by our choice, not theirs.
tony curzon price 2008-04-02
