The Great Degeneration: How Institutions Decay and Economies Die (4 page)

The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn. In this regard, the statistics commonly cited as government debt are themselves deeply misleading, for they encompass only the sums owed by governments in the form of bonds. The rapidly rising quantity of these bonds certainly implies a growing charge on those in employment, now and in the future, since – even if the current low rates of interest enjoyed by the biggest sovereign borrowers persist – the amount of money needed to service the debt must inexorably rise. But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes like – to give the biggest American programmes – Medicare, Medicaid and Social Security.

The best available estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is $200 trillion, nearly thirteen times the debt as stated by the US Treasury. Notice that these figures, too, are incomplete, since they omit the unfunded liabilities of state and local governments, which are estimated to be around $38 trillion.
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These mind-boggling numbers represent nothing less than a vast claim by the generation currently retired or about to retire on their children and grandchildren, who are obliged by current law to find the money in the future, by submitting either to substantial increases in taxation or to drastic cuts in other forms of public expenditure.

To illustrate the magnitude of the American problem, the economist Laurence Kotlikoff calculates that to eliminate the federal government’s fiscal gap would require an immediate 64 per cent increase in all federal taxes or an immediate 40 per cent cut in all federal expenditures.
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When Kotlikoff compiled his ‘generational accounts’ for the United Kingdom more than a decade ago, he estimated (on what proved to be the correct assumption that the then government would increase welfare and healthcare spending) that there would need to be a 31 per cent increase in income tax revenues and a 46 per cent increase in national insurance revenues to close the fiscal gap.
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In his
Reflections on the Revolution in France
(1790), Edmund Burke wrote that the real social contract is not Jean-Jacques Rousseau’s contract between the sovereign and the people or ‘general will’, but the ‘partnership’ between the generations. In his words:

one of the first and most leading principles on which the commonwealth and the laws are consecrated is, lest the temporary possessors and life-renters in it, unmindful of what they have received from their ancestors or of what is due to their posterity, should act as if they were the entire masters, that they should not think it among their rights to cut off the entail or commit waste on the inheritance by destroying at their pleasure the whole original fabric of their society, hazarding to leave to those who come after them a ruin instead of an habitation – and teaching these successors as little to respect their contrivances as they had themselves respected the institutions of their forefathers . . . SOCIETY is indeed a contract . . . the state . . . is . . . a partnership not only between those who are living, but between those who are living, those who are dead, and those who are to be born.

In the enormous inter-generational transfers implied by current fiscal policies we see a shocking and perhaps unparalleled breach of precisely that partnership.

I want to suggest that the biggest challenge facing mature democracies is how to restore the social contract between the generations. But I recognize that the obstacles to doing so are daunting. Not the least of these is that the young find it quite hard to compute their own long-term economic interests. It is surprisingly easy to win the support of young voters for policies that would ultimately make matters even worse for them, like maintaining defined benefit pensions for public employees. If young Americans knew what was good for them, they would all be fans of Paul Ryan.
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A second problem is that today’s Western democracies now play such a large part in redistributing income that politicians who argue for cutting expenditures nearly always run into the well-organized opposition of one or both of two groups: recipients of public sector pay and recipients of government benefits.

Is there a constitutional solution to this problem? The simplistic answer – which has already been adopted in a number of American states as well as in Germany – is some kind of balanced-budget amendment, which would reduce the discretion of lawmakers to engage in deficit spending, much as the practice of giving central banks independence reduced lawmakers’ discretion over monetary policy. The trouble is that the experience of the financial crisis has substantially strengthened the case for using the government deficit as a tool to stimulate the economy in times of recession, to say nothing of the wider case for deficit-financed public investment in infrastructure. In 2011, following a German lead, continental European leaders sought to solve that problem by resolving to limit only their structural deficits, leaving themselves room for manoeuvre for cyclical deficits as and when required. But the problem with this ‘fiscal compact’ is that only two Eurozone governments are currently below the mandated 0.5 per cent of GDP ceiling, most have structural deficits at least four times too large, and experience suggests that any government that tries seriously to reduce its structural deficit ends up being driven from power.

It is perhaps not surprising that a majority of current voters should support policies of inter-generational inequity, especially when older voters are so much more likely to vote than younger voters. But what if the net result of passing the buck for the baby-boomers’ profligacy is not just unfair to the young but economically deleterious for everyone? What if uncertainty about the future is already starting to weigh on the present? As Carmen Reinhart and Ken Rogoff have suggested, it is hard to believe that developed-country growth rates will be unaffected by mountains of debt in excess of 90 per cent of GDP.
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Anxiety about a fast-approaching ‘fiscal cliff’ may have been one reason why the US economy did not achieve ‘escape velocity’ in 2012.

Unsettling Accounts

It seems as if there are only two possible ways out of this mess. In the good but less likely scenario, the proponents of reform succeed, through a heroic effort of leadership, in persuading not only the young but also a significant proportion of their parents and grandparents to vote for a more responsible fiscal policy. As I have already explained, this is very hard to do. But I believe there is a way of making such leadership more likely to succeed, and that is to alter the way in which governments account for their finances.

The present system is, to put it bluntly, fraudulent. There are no regularly published and accurate official balance sheets. Huge liabilities are simply hidden from view. Not even the current income and expenditure statements can be relied upon. No legitimate business could possibly carry on in this fashion. The last corporation to publish financial statements this misleading was Enron.

There is in fact a better way. Public sector balance sheets can and should be drawn up so that the liabilities of governments can be compared with their assets. That would help clarify the difference between deficits to finance investment and deficits to finance current consumption. Governments should also follow the lead of business and adopt the Generally Accepted Accounting Principles. And, above all, generational accounts should be prepared on a regular basis to make absolutely clear the inter-generational implications of current policy.

If we do not do these things – if we do not embark on a wholesale reform of government finance – then I am afraid we are going to end up with the bad, but more likely, second scenario. Western democracies are going to carry on in their current feckless fashion until, one after another, they follow Greece and other Mediterranean economies into the fiscal death spiral that begins with a loss of credibility, continues with a rise in borrowing costs, and ends as governments are forced to impose spending cuts and higher taxes at the worst possible moment. In this scenario, the endgame involves some combination of default and inflation. We all end up as Argentina.

There is, it is true, a third possibility, and that is what we now see in Japan and the United States, maybe also in the United Kingdom. The debt continues to mount up. But deflationary fears, central bank bond purchases and a ‘flight to safety’ from the rest of the world keep government borrowing costs down at unprecedented lows. The trouble with this scenario is that it also implies low to zero growth over decades: a new version of Adam Smith’s stationary state. Only now it is the West that is stationary.

As our economic difficulties have worsened, we voters have struggled to find the appropriate scapegoat. We blame the politicians whose hard lot it is to bring public finances under control. But we also like to blame bankers and financial markets, as if their reckless lending were to blame for our reckless borrowing. We bay for tougher regulation, though not of ourselves. This brings me to the subject of my second chapter. In it, I shall turn from the realm of politics to the realm of economics – from the human hive of democracy to the Darwinian jungle of the market – to ask if here, too, we are witnessing a tendency towards institutional degeneration in the Western world.

In this chapter, I have tried to show that excessive public debts are a symptom of the breakdown of the social contract between the generations. In my next I shall ask if excessively complex government regulation of markets is in fact the disease of which it purports to be the cure. The rule of law has many enemies, as we shall see. But among its most dangerous foes are the authors of very long and convoluted laws.

The Deregulation Illusion

What is the biggest problem facing the world economy today? To listen to some people, you might think the correct answer is insufficient financial regulation. According to a number of influential commentators, the origins of the financial crisis that began in 2007 – and still does not seem to be over – lie in decisions dating back to the early 1980s that led to a substantial deregulation of financial markets. In the good old days, we are told, banking was ‘boring’. In the United States, the Glass–Steagall Act of 1933 separated the activities of commercial and investment banks until its supposedly fateful repeal in 1999.

‘Reagan-era legislative changes essentially ended New Deal restrictions on mortgage lending,’ the Princeton economist Paul Krugman has written. ‘It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life . . .’ It was ‘also mainly thanks to Reagan-era deregulation’ that the financial system ‘took on too much risk with too little capital’.
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In another of his newspaper columns, Krugman looked back fondly to a ‘long period of stability after World War II’. This was ‘based on a combination of deposit insurance, which eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both limits on risky lending and limits on leverage, the extent to which banks were allowed to finance investments with borrowed funds’.
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It was indeed a golden age: the ‘era of boring banking was also an era of spectacular economic progress’.
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‘Overall business productivity in America grew faster in the post-war generation, an era in which banks were tightly regulated and private equity barely existed, than it has since our political system decided that greed was good.’
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Krugman is by no means a lone voice. Simon Johnson has written a devastating account of financial recklessness in his book
Thirteen Bankers
.
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Even Chicago’s Richard Posner has joined the chorus calling for a restoration of Glass–Steagall.
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To cap it all, the architect of the behemoth Citigroup, Sandy Weill himself, has now recanted.
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The first draft of the history of the financial crisis is in, and here is what it says: deregulation was to blame. Unfettered after 1980, financial markets ran amok, banks blew up and then had to be bailed out. Now they must be fettered once again.

As will become clear, it is not my purpose to whitewash the bankers. But I do believe this story is mostly wrong. For one thing, it is hard to think of a major event in the US crisis – beginning with the failures of Bear Stearns and Lehman Brothers – that could not equally well have happened with Glass–Steagall still in force. Both were pure investment banks that could just as easily have been mismanaged to death before 1999. The same goes for Countrywide, Washington Mutual and Wachovia, commercial lenders that blew up without dabbling in investment banking. For another, the claim that the economic performance of the US economy before Ronald Reagan was superior to what followed because of the tighter controls on banks before 1980 is simply laughable. Productivity certainly grew faster between 1950 and 1979 than between 1980 and 2009. But it grew faster in the 1980s and 1990s than in the 1970s. And it consistently grew faster than in Canada after 1979. Unlike Paul Krugman, I think there were probably a few other factors at work in the changing productivity growth of the past seventy years: changes in technology, education and globalization are among those that spring to mind. But if I wanted to make his kind of facile argument I could triumphantly point out that Canada retained a far more tightly regulated banking system than the US – and as a result lagged behind in terms of productivity.

To a British reader, if not to an American, there is something especially implausible about the story that regulated financial markets were responsible for rapid growth, while deregulation caused crisis. British banking was also tightly regulated prior to the 1980s. The old City of London was constrained by an elaborate web of traditional guild-like restrictions. The merchant banks – members of the august Accepting Houses Committee – concerned themselves, at least notionally, with accepting commercial bills and issuing bonds and shares. Commercial or retail banking was controlled by a cartel of big ‘high street’ banks, which set deposit and lending rates. Within the Stock Exchange, autonomous brokers sold, while jobbers bought. Over all these gentlemanly capitalists, the Governor of the Bank of England watched with a benign but sometimes stern headmasterly eye, checking ungentlemanly conduct with a mere movement of his celebrated eyebrows.
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On top of these conventions, a bewildering range of statutory regulations had been imposed before, during and after the Second World War. The 1947 Exchange Control Act strictly limited transactions in currencies other than sterling, controls that remained in place until 1979. Even after the breakdown of the system of fixed exchange rates established at Bretton Woods, the Bank of England routinely intervened to influence the sterling exchange rate. Banks were regulated under the 1948 Companies Act, the 1958 Prevention of Fraud (Investments) Act and the 1967 Companies Act. The 1963 Protection of Depositors Act created an additional tier of regulation for deposit-taking institutions that were not classified as banks under the arcane rules known as ‘Schedule 8’ and ‘Section 127’.
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Following the report of the 1959 Radcliffe Committee, which argued that the traditional tools of monetary policy were insufficient, a fresh layer of controls was added in the form of ceilings on bank lending.
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Consumer credit (which mainly took the form of ‘hire purchase’ or instalment plans) was also tightly regulated. Banks recognized as such by the Old Lady of Threadneedle Street were required to maintain a 28 per cent liquidity ratio, which in practice meant holding large amounts of British government bonds.

Yet there was anything but ‘spectacular economic progress’ in this era of financial regulation. On the contrary, the 1970s were arguably Britain’s most financially disastrous decade since the 1820s, witnessing not only a major banking crisis, but also a stock market crash, a real estate bubble and bust and double-digit inflation, all rounded off by the arrival of the International Monetary Fund in 1976. That era also had its Bernie Madoff, its Bear Stearns and its Lehman Brothers – though who now remembers Gerald Caplan of London and County Securities, or Cedar Holdings, or Triumph Investment Trust? Admittedly, the secondary banking crisis was partly due to a botched change to banking regulation by the government of Edward Heath. But it would be quite wrong to characterize this as deregulation; if anything, the new system – named, significantly, ‘Competition and Credit Control’ – was more elaborate than the one it replaced. Moreover, egregious errors of monetary and fiscal policy were just as important in the crisis that followed. In my view, the lesson of the 1970s is not that deregulation is bad, but that bad regulation is bad, especially in the context of bad monetary and fiscal policy.
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And I believe the very same can be said of our crisis, too.

A Regulated Crisis

The financial crisis that began in 2007 had its origins precisely in over-complex regulation. A serious history of the crisis would need to have at least five chapters on its perverse consequences:

First, the executives of large publicly owned banks were strongly incentivized to ‘maximize shareholder value’ since their own wealth and income came to consist in large measure of shares and share options in their own institutions. The easiest way they could do this was to maximize the size of their banks’ activities relative to their capital. All over the Western world, balance sheets grew to dizzying sizes relative to bank equity. How was this possible? The answer is that it was expressly permitted by regulation. To be precise, the Basel Committee on Banking Supervision’s 1988 Accord allowed very large quantities of assets to be held by banks relative to their capital, provided these assets were classified as low risk – for example, government bonds.

Secondly, from 1996 the Basel rules were modified to allow firms effectively to set their own capital requirements on the basis of their internal risk estimates. In practice, risk weightings came to be based on the ratings given to securities – and, later, to structured financial products – by the private rating agencies.

Thirdly, central banks – led by the Federal Reserve – evolved a peculiarly lopsided doctrine of monetary policy, which taught that they should intervene by cutting interest rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not affect public expectations of something called ‘core’ inflation (which excludes changes in the prices of food and energy and wholly failed to capture the bubble in house prices). The colloquial term for this approach is the ‘Greenspan (later Bernanke) put’, which implied that the Fed would intervene to prop up the US equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumer-price inflation, and for some obscure reason not about house-price inflation.

Fourthly, the US Congress passed legislation designed to increase the percentage of lower-income families – especially minority families – that owned their own homes. The mortgage market was highly distorted by the ‘government-sponsored entities’ Fannie Mae and Freddie Mac. Both parties viewed this as desirable for social and political reasons. Neither considered that, from a financial viewpoint, they were encouraging low-income households to place large, leveraged, unhedged and unidirectional bets on the US housing market.

A final layer of market distortion was provided by the Chinese government, which spent literally trillions of dollars’ worth of its own currency to prevent it from appreciating relative to the dollar. The primary objective of this policy was to keep Chinese manufacturing exports ultra-competitive in Western markets. Nor were the Chinese the only ones who chose to plough their current account surpluses into dollars. The secondary and unintended consequence was to provide the United States with a vast credit line. Because much of what the surplus countries bought was US government or government agency debt, the yields on these securities were artificially held low. Because mortgage rates are closely linked to Treasury yields, ‘Chimerica’ – as I christened this strange economic partnership between China and America – thus helped further to inflate an already bubbling property market.

The only chapter in this history that really fits the ‘blame deregulation’ thesis is the non-regulation of the market in derivatives such as credit default swaps. The insurance giant AIG came to grief because its London office sold vast quantities of mispriced insurance against outcomes that properly belonged in the realm of uninsurable uncertainty. However, I do not believe this can be seen as a primary cause of the crisis. Banks were the key to the crisis, and banks were regulated.
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The issue of derivatives is important because figures as respected as Paul Volcker and Adair Turner have cast doubt on the economic and social utility of most, if not all, recent theoretical and technical advances in finance, including the advent of the derivatives market.
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I am rather less hostile than they are to financial innovation. I agree that modern techniques of risk management were in many ways defective – especially when misused by people who forgot (or never knew) the simplifying assumptions underlying measures like Value at Risk. But modern finance cannot somehow be wished away, any more than Amazon and Google can be abolished to protect the livelihoods of booksellers and librarians.

The issue is whether or not additional regulation of the sort that is currently being devised and implemented can improve matters by reducing the frequency or magnitude of future financial crises. I think it is highly unlikely. Indeed, I would go further. I think the new regulations may have precisely the opposite effect.

The problem we are dealing with here is not inherent in financial innovation. It is inherent in financial regulation. Private sector models of risk management were undoubtedly imperfect, as the financial crisis made clear. But public sector models of risk management were next to non-existent. Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.
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The question for me is not ‘Should financial markets be regulated?’ There is in fact no such thing as an unregulated financial market, as any student of ancient Mesopotamia knows. The Scotland of Adam Smith had a lively debate about the kind of regulation appropriate to a paper-money system. Indeed, the founder of free-market economics himself proposed a number of quite strict bank regulations in the wake of the 1772 Ayr Banking Crisis.
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Without rules to enforce the payment of debts and punish fraud, there can be no finance. Without restraint on the management of banks, some are very likely to fail in a downturn because of the mismatch between the durations of assets and liabilities that has been inherent in nearly all banking since the advent of the fractional reserve system. So the right question to ask is: ‘What kind of financial regulation works best?’

Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work. It puts me in mind of the great Viennese satirist Karl Kraus’s famous quip about psychoanalysis: that it was the disease of which it pretended to be the cure. I believe excessively complex regulation is the disease of which it pretends to be the cure.

Who Regulates the Regulators?

‘We cannot control ourselves. You have to step in and control [Wall] Street.’
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Those were the words of John Mack, former chief executive of the investment bank Morgan Stanley, speaking in New York in November 2009 (to audible gasps). Congress obliged Mr Mack by producing the Wall Street Reform and Consumer Protection Act of July 2010 (henceforth the Dodd–Frank Act, after the names of its two principal sponsors in the Senate and House, respectively).