Read our other exclusive online responses to Adair Turner from Tim Congdon, George Magnus, and Robert Kuttner
Lord Turner’s comments in this month's Prospect are not “crackers” (in the pregnant phrase of Boris Johnson). The FSA chairman makes weighty criticisms about the role of finance in the wider economy. But he is wrong in his diagnosis of the problem and his recommendations on how to fix it.
Competitive markets work best. A complex economy comprises the decisions of innumerable buyers, sellers, consumers, investors, borrowers and lenders. No central authority can anticipate all these decisions, which is why planned economies are inefficient. In a market economy, shifts in relative prices of goods, services and inputs are an efficient signaling mechanism. But finance is an exceptional case. Asset prices are not set in the same way: they reflect estimates about the future, and specifically the future cash flows that an investor will receive. Notoriously, asset prices are prone to overshoot, in both directions.
A large part of the financial history of this decade is a massive boom and bust in house prices, driven by an expansion of credit—and many commentators mistakenly assume that the financial crisis is about the first of these when it is in fact about the second. House prices were a symptom, not a cause, of the crisis. The cause was a decision by policymakers to keep interest rates at low levels (even negative in real terms), on the grounds that inflationary pressures were contained, despite the support this gave to the property market. The catastrophic consequences of the crash—insolvency, repossession and bitter recession—stem from that error. And the banks were the intermediaries. They made bad lending decisions. They also assumed that the complex financial products they had devised had reduced credit risks.
The outcome was the opposite of the central point of modern financial theory. Securitisation—the turning of consumer loans into marketable securities and selling them to investors—is supposed to reduce risk by diversifying portfolios. In reality, the banks succeeded in contaminating the entire financial system with bad debts.
Bad banking practice, then, has greatly aggravated the consequences of an irresponsible credit expansion. Bankers exhibited a herd-like mentality in exactly the way anticipated by John Maynard Keynes: “A ‘sound’ banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way, so that no one can really blame him.”
This is the background to Turner’s comments. It is indeed a terrible indictment of the financial system. The economic consequences of bad banking practice affect us all, in terms of a sharp decline in output and a contraction of trade volumes. But it is still a big leap from that criticism to the notion that large parts of the financial services sector comprise, as Turner suggests, “socially useless activity.”
The business of finance is to match those who have capital with those who need it and can use it productively. No one knows in advance which activities are going to satisfy that test: the only objective measure is whether a business can turn a profit, by generating revenues and controlling costs. Complex financial products can help businesses in that aim, by allowing them to manage their risks better. If a company can hedge its foreign exchange risk efficiently, then it can concentrate on the business of selling its products in foreign markets. Securitisation is a good thing in principle, because it turns illiquid assets into tradeable instruments and allows credit risk to be spread. This did not happen in the credit crunch of 2007-8. But one of the reasons that the collapse of Enron in 2001 had little effect on the real economy was that the market absorbed the shock easily, owing to an active market in credit derivatives. It enabled banks to insure against the risk that their loans to corporate clients would go bad.
So it is just too sweeping to indict the banking sector as Turner has done. His comments point to a genuine problem and he is right to make them: it is not his function to act as a lobby for the institutions that he regulates and there is no patriotic imperative to defend British banking. But the activities of the banks are far from valueless. The shame is that awesomely incompetent bankers were at the helm. Alistair Darling’s pronouncement that “too many people did not understand the risks to which they were being exposed” may sound like a hasty unloading on the bankers in order to divert attention from government culpability, but he is essentially right, and more acute in his criticism than Turner.
In short, Turner’s recommendations will not work. He acknowledges that a tax on financial transactions, if it is to work, needs to be applied globally. Otherwise traders would easily avoid it by booking the deals in other financial centres. It would also need to apply to all financial transactions, lest traders merely reclassify one type of deal (say, foreign exchange) as something else. Yet even if the main financial centres were to apply a tax consistently, what incentive would offshore tax havens have to follow suit? A small tax, inevitably inconsistently applied, would hardly disrupt financial markets, but there there is still a risk of creating distortions in the market. In 1989, there was a proposal in the US Senate to tax securities trading, under the tendentious title: "The Excessive Churning and Speculation Act." In opposing it, the Chicago economist Merton Miller made the point that transactions taxes, even at apparently low rates, can have far-reaching consequences. He cited a type of security known as a "letter stock," which traded 20 or even 30 per cent below ordinary shares in the same company. Imagine that sort of anomaly on a market-wide scale: it would create a huge new class of arbitrageurs seeking to exploit such price discrepancies. That is obviously not the way to encourage global financial stability.
The financial system is broken. But that does not mean it is parasitic on the real economy. Lord Turner’s error is to confuse the first (justified) observation with the second.
More debate on the Turner interview will be featured in the October issue of Prospect, published 24th September
Lord Turner’s comments in this month's Prospect are not “crackers” (in the pregnant phrase of Boris Johnson). The FSA chairman makes weighty criticisms about the role of finance in the wider economy. But he is wrong in his diagnosis of the problem and his recommendations on how to fix it.
Competitive markets work best. A complex economy comprises the decisions of innumerable buyers, sellers, consumers, investors, borrowers and lenders. No central authority can anticipate all these decisions, which is why planned economies are inefficient. In a market economy, shifts in relative prices of goods, services and inputs are an efficient signaling mechanism. But finance is an exceptional case. Asset prices are not set in the same way: they reflect estimates about the future, and specifically the future cash flows that an investor will receive. Notoriously, asset prices are prone to overshoot, in both directions.
A large part of the financial history of this decade is a massive boom and bust in house prices, driven by an expansion of credit—and many commentators mistakenly assume that the financial crisis is about the first of these when it is in fact about the second. House prices were a symptom, not a cause, of the crisis. The cause was a decision by policymakers to keep interest rates at low levels (even negative in real terms), on the grounds that inflationary pressures were contained, despite the support this gave to the property market. The catastrophic consequences of the crash—insolvency, repossession and bitter recession—stem from that error. And the banks were the intermediaries. They made bad lending decisions. They also assumed that the complex financial products they had devised had reduced credit risks.
The outcome was the opposite of the central point of modern financial theory. Securitisation—the turning of consumer loans into marketable securities and selling them to investors—is supposed to reduce risk by diversifying portfolios. In reality, the banks succeeded in contaminating the entire financial system with bad debts.
Bad banking practice, then, has greatly aggravated the consequences of an irresponsible credit expansion. Bankers exhibited a herd-like mentality in exactly the way anticipated by John Maynard Keynes: “A ‘sound’ banker, alas! is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way, so that no one can really blame him.”
This is the background to Turner’s comments. It is indeed a terrible indictment of the financial system. The economic consequences of bad banking practice affect us all, in terms of a sharp decline in output and a contraction of trade volumes. But it is still a big leap from that criticism to the notion that large parts of the financial services sector comprise, as Turner suggests, “socially useless activity.”
The business of finance is to match those who have capital with those who need it and can use it productively. No one knows in advance which activities are going to satisfy that test: the only objective measure is whether a business can turn a profit, by generating revenues and controlling costs. Complex financial products can help businesses in that aim, by allowing them to manage their risks better. If a company can hedge its foreign exchange risk efficiently, then it can concentrate on the business of selling its products in foreign markets. Securitisation is a good thing in principle, because it turns illiquid assets into tradeable instruments and allows credit risk to be spread. This did not happen in the credit crunch of 2007-8. But one of the reasons that the collapse of Enron in 2001 had little effect on the real economy was that the market absorbed the shock easily, owing to an active market in credit derivatives. It enabled banks to insure against the risk that their loans to corporate clients would go bad.
So it is just too sweeping to indict the banking sector as Turner has done. His comments point to a genuine problem and he is right to make them: it is not his function to act as a lobby for the institutions that he regulates and there is no patriotic imperative to defend British banking. But the activities of the banks are far from valueless. The shame is that awesomely incompetent bankers were at the helm. Alistair Darling’s pronouncement that “too many people did not understand the risks to which they were being exposed” may sound like a hasty unloading on the bankers in order to divert attention from government culpability, but he is essentially right, and more acute in his criticism than Turner.
In short, Turner’s recommendations will not work. He acknowledges that a tax on financial transactions, if it is to work, needs to be applied globally. Otherwise traders would easily avoid it by booking the deals in other financial centres. It would also need to apply to all financial transactions, lest traders merely reclassify one type of deal (say, foreign exchange) as something else. Yet even if the main financial centres were to apply a tax consistently, what incentive would offshore tax havens have to follow suit? A small tax, inevitably inconsistently applied, would hardly disrupt financial markets, but there there is still a risk of creating distortions in the market. In 1989, there was a proposal in the US Senate to tax securities trading, under the tendentious title: "The Excessive Churning and Speculation Act." In opposing it, the Chicago economist Merton Miller made the point that transactions taxes, even at apparently low rates, can have far-reaching consequences. He cited a type of security known as a "letter stock," which traded 20 or even 30 per cent below ordinary shares in the same company. Imagine that sort of anomaly on a market-wide scale: it would create a huge new class of arbitrageurs seeking to exploit such price discrepancies. That is obviously not the way to encourage global financial stability.
The financial system is broken. But that does not mean it is parasitic on the real economy. Lord Turner’s error is to confuse the first (justified) observation with the second.
More debate on the Turner interview will be featured in the October issue of Prospect, published 24th September
