Reviewed: The Bankers’ New Clothes by Anat Admati and Martin Hellwig

Profits of doom.

The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It
Anat Admati and Martin Hellwig
Princeton University Press, 392pp, £19.95

The Federal Reserve and the Financial Crisis
Ben S Bernanke
Princeton University Press, 144pp, £13.95

Historians will not be forgiving of the past 30 years. Western governments, with Britain in the vanguard, indulged an explosion in bank balance sheets supported by declining levels of equity and by borrowing that ran into many trillions of dollars, euros and pounds. This created a long and apparently impregnable private-sector-led boom; but it was a mountain of lending underwritten by a molehill of equity. Bankers claimed that they had invented new tools to handle what previous generations would have regarded as impossible risks. They were wrong. The inevitable exposure of the system’s fragility has left the world – and Britain in particular – saddled with a combination of private debt and crippled banks that, even if policy were clever and well resourced, which it is not, would take years to restore to something like normality. Instead, we have austerity and a long, barely contained depression. Never have so few lent so much to so many so recklessly, escaping the consequences while imposing hardship on others.

This raises fundamental questions about the sheer unfairness of capitalism and its vulnerability to those at the top creating dynastic personal fortunes. Nor could bankers and the high priests of modern finance – hedge-fund managers and private equity partners – ever have pulled this off without an accompanying ideology that vaunted the efficiency of private markets animated by personal selfishness and was self-serving nonsense. This was propagated by powerful, privately owned media cheerleaders, feeding off well-financed neoconservative think tanks, which persuaded the gullible public that this was the only way that wealth and jobs could be generated.

Given the scale of what has happened, the response from civil society and the left has been feeble. True, there have been groups such as UK Uncut and the Occupy movement. But even now, the left continues to take aim at the wrong targets. As I was writing this review, Cypriot banks, vastly overborrowed (mainly from the Russian superrich, allegedly laundering their money) and supported by minimal amounts of equity, were repeating the drama of RBS and Lehman Brothers. If anything was to go wrong with the assets against which they had directly or indirectly lent the borrowed money, there was too little equity to absorb the impact. Greece’s partial write-down of its debts in which Cyprus’s banks had invested was such an event, and inevitably a crisis ensued.

Yet, with dismal regularity, leading left-of-centre commentators – indistinguishable in their analysis from their counterparts on the right – decided that the culprit was not the structure of modern banking but the euro, austerity and the flint-eyed German government. In an alternative world of floating exchange rates and governments with an unfettered capacity to borrow and print money, they argued, the crisis would have passed fairly painlessly. This is yet more self-serving tosh. It is the bastardisation of Keynesian economics and the infantilisation of liberal-left thinking – a refusal to think hard about capitalism in favour of taking refuge in anti-austerity slogans and Ukip-style populism. With floating exchange rates, Cyprus, given the epic mistakes of its banks, would now be confronting hyperinflation as its currency collapsed, or else the takeover and rundown of its banks by the IMF. Rants about the euro or the reluctance of German taxpayers to foot the bill for the crisis dodge the issue. The pressing question is how western banking is to be reinvented and restored to health – in Cyprus, Britain and elsewhere – so as to relieve economies of the crushing legacy of private debt.

One of the most important contributions to answering these questions is a new book co-written by the leading German economist Martin Hellwig and his US counterpart Anat Admati. The Bankers’ New Clothes is a lucid exposition of the intellectual falsehoods deployed by banks to justify the ways in which they went about growing their business beyond any reasonable assessment of risk in the run-up to the crisis of 2008 and which they continue to peddle today.

Admati and Hellwig cut through the debates about whether it was too little or too much regulation that was to blame, whether central banks could and should have acted faster, and the rights and wrongs of securitisation or separating commercial and investment banking, and go to the heart of the matter. Western banks, they argue, borrowed far too much with far too little equity in their balance sheets to act as a buffer if things went wrong in any part of their business, from trading on their own account in the multitrillion-dollar derivatives markets to extravagant and reckless lending on real estate.

Less than 70 years ago, banks operated with between 20 and 30 per cent of their liabilities as equity; by 2008, that had shrunk to just 3 per cent. They believed that they had invented instruments that removed the risk, allowing them to run their banks with a tenth of the buffer they had before. It could only lead to disaster.

Admati’s and Hellwig’s constant refrain is that banks are no different from any other organisation or individual. In effect, managements and shareholders elected to run banks as if they were homeowners with mortgages worth 97 per cent of the value of their home, with only 3 per cent of equity. This makes sense when house prices are rising but it will only take a 3 per cent fall in house prices to wipe out your stake. Homeowners might take the risk once in their lives and hope as they steadily pay off the mortgage that any fall in house prices could be ridden out. However, banks adopted this as their standard approach, running their affairs on the finest of margins. British banks’ total liabilities are worth just less than five times our GDP – but supported by tiny amounts of equity.

Admati and Hellwig challenge all the bankers’ justifications for their behaviour. Having more equity is neither more expensive nor a deterrent to new lending. It has only been possible to grow balance sheets to such a gargantuan size with so little equity because banks have known that, in extremis, the risks would be underwritten by the state – either directly by insuring our deposits with them, or indirectly by bailing them out.

Having little equity is at the core of the one-way bet that the bankers have made: when times are good, they make fabulous profits and bonuses; when times are bad, the state picks up the pieces. As a result of this explicit subsidy and the state’s promise of underwriting the banks’ risks, banks never had to worry about their solvency: that was guaranteed. All they had to concern themselves with was their liquidity – that come what may they have enough cash to give depositors if they withdrew it. Here, central banks, with their capacity to print legal tender, enter the picture. As long as they are proactive enough to generate the cash that banks need in a crisis and at sufficient scale, through being the lender of last resort, then, with solvency underwritten and liquidity on tap, even the worst banking crisis can be managed.

Admati and Hellwig think that this is economically inefficient and unfair. After all, it is not as though periodic financial crises don’t impose huge costs on society. One could go further still. If banking relies entirely on having the state as a backstop, then society can reasonably ask for some quid pro quo in return.

One of the bitterest aspects of the lending boom of the past 30 years is that Britain has so little to show for it. We don’t have great industries or great infrastructure. Instead, we have loaded households and many firms with insupportable levels of debt. Even in good times, the banks have been unable or unwilling to support innovation, business-building and investment.

Instead, their focus has been on property lending or funding takeovers by private equity partners of perfectly good companies that did not need to be overwhelmed with debt to enrich their new owners. If more people understood what has happened and why, the outrage and clamour for change would be irresistible.

The trouble is that too few make the effort to understand and those who do are deterred by the apparent complexity of modern finance, or the unwillingness of so many practitioners and top officials to be honest about its deficiencies. In this respect, a collection of Ben Bernanke’s lectures on the role of the US Federal Reserve in the financial crisis is a classic of the genre – uninquiring, complacent and, unless you are fascinated by the minutiae of central banking, unilluminating.

Yet he is the chairman of the Federal Reserve, the most powerful central bank in the world. For Bernanke, financial crises are like hurricanes: they are just part of the climate of capitalism. If that is right, then it is imperative to have a watchful central bank led by a resourceful chairman such as Bernanke; someone who is ready to pump trillions of dollars into the system when the hurricanes occur, in order to provide crucial liquidity. And with that, the hurricane should pass.

In fairness to Bernanke, he operates in an intellectual and political environment in which suspicion of the state is so endemic that some on the Republican right want to abolish the central bank altogether. His lectures were, in part, a response to that crazed tendency, explaining in simple language why central banks’ capacity to provide the system with cash when it is in crisis is so crucial – and how the Fed set about doing that in the most recent crisis.

Bernanke skirts around the issues raised by Admati and Hellwig. Yet they are fundamental – not just to the stability of the financial system but for the question of how capitalism is to be better organised (which is surely the issue, more than any other, that the New Statesman needs to address in its centenary year).

We need banks to be run with more equity. We need them to accept that their decisions about how much they lend, to whom and on what terms have profound implications for our economy and society. That needs to be part of a wider reframing of the principles on which firms are constituted. Remuneration needs to return to earth. We need careful economic policies that offer the prospect of a sustained increase in demand and prices over time, gradually inflating away the real value of debt. Excessive private debt does not just imprison economies – it suffocates personal lives.

All of this should be part of a wider debate about what constitutes a good society. If a potential Labour government is to be successful, it will be because it is riding an intellectual tide that answers these questions. The New Statesman is one of the few catalysts for developing ideas that we have. The next two years are arguably the most important in its history: I hope it rises to the task.

Will Hutton’s most recent book is “Them and Us: Changing Britain –Why We Need a Fair Society” (Abacus, £10.99)

Photograph: Getty Images

This article first appeared in the 12 April 2013 issue of the New Statesman, Centenary Special Issue

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By refusing to stand down, Jeremy Corbyn has betrayed the British working classes

The most successful Labour politicians of the last decades brought to politics not only a burning desire to improve the lot of the working classes but also an understanding of how free market economies work.

Jeremy Corbyn has defended his refusal to resign the leadership of the Labour Party on the grounds that to do so would be betraying all his supporters in the country at large. But by staying on as leader of the party and hence dooming it to heavy defeat in the next general election he would be betraying the interests of the working classes this country. More years of Tory rule means more years of austerity, further cuts in public services, and perpetuation of the gross inequality of incomes. The former Chief Secretary to the Treasury, Seema Malhotra, made the same point when she told Newsnight that “We have an unelectable leader, and if we lose elections then the price of our failure is paid by the working people of this country and their families who do not have a government to stand up for them.”

Of course, in different ways, many leading figures in the Labour movement, particularly in the trade unions, have betrayed the interests of the working classes for several decades. For example, in contrast with their union counterparts in the Scandinavian countries who pressurised governments to help move workers out of declining industries into expanding sectors of the economy, many British trade union leaders adopted the opposite policy. More generally, the trade unions have played a big part in the election of Labour party leaders, like Corbyn, who were unlikely to win a parliamentary election, thereby perpetuating the rule of Tory governments dedicated to promoting the interests of the richer sections of society.

And worse still, even in opposition Corbyn failed to protect the interests of the working classes. He did this by his abysmal failure to understand the significance of Tory economic policies. For example, when the Chancellor of the Exchequer had finished presenting the last budget, in which taxes were reduced for the rich at the expense of public services that benefit everybody, especially the poor, the best John McConnell could do – presumably in agreement with Corbyn – was to stand up and mock the Chancellor for having failed to fulfill his party’s old promise to balance the budget by this year! Obviously neither he nor Corbyn understood that had the government done so the effects on working class standards of living would have been even worse. Neither of them seems to have learnt that the object of fiscal policy is to balance the economy, not the budget.

Instead, they have gone along with Tory myth about the importance of not leaving future generations with the burden of debt. They have never asked “To whom would future generations owe this debt?” To their dead ancestors? To Martians? When Cameron and his accomplices banged on about how important it was to cut public expenditures because the average household in Britain owed about £3,000, they never pointed out that this meant that the average household in Britain was a creditor to the tune of about the same amount (after allowing for net overseas lending). Instead they went along with all this balanced budget nonsense. They did not understand that balancing the budget was just the excuse needed to justify the prime objective of the Tory Party, namely to reduce public expenditures in order to be able to reduce taxes on the rich. For Corbyn and his allies to go along with an overriding objective of balancing the budget is breathtaking economic illiteracy. And the working classes have paid the price.

One left-wing member of the panel on Question Time last week complained that the interests of the working classes were ignored by “the elite”. But it is members of the elite who have been most successful in promoting the interests of the working classes. The most successful pro-working class governments since the war have all been led mainly by politicians who would be castigated for being part of the elite, such as Clement Atlee, Harold Wilson, Tony Crosland, Barbara Castle, Richard Crossman, Roy Jenkins, Denis Healey, Tony Blair, and many others too numerous to list. They brought to politics not only a burning desire to improve the lot of the working classes (from which some of them, like me, had emerged) and reduce inequality in society but also an understanding of how free market economies work and how to deal with its deficiencies. This happens to be more effective than ignorant rhetoric that can only stroke the egos and satisfy the vanity of demagogues

People of stature like those I have singled out above seem to be much more rare in politics these days. But there is surely no need to go to other extreme and persist with leaders like Jeremy Corbyn, a certain election loser, however pure his motives and principled his ambitions.

Wilfred Beckerman is an Emeritus Fellow of Balliol College, Oxford, and was, for several years in the 1970s, the economics correspondent for the New Statesman