The end of an error

“It is well enough that the people of this nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”  – Henry Ford.

If anyone was in doubt about the gravity of the crisis facing the West’s banks, at least two books should set them straight: George Soros’ “The new paradigm for financial markets: the credit crisis of 2008 and what it means”, and Charles R. Morris’ “The trillion dollar meltdown: easy money, high rollers and the great credit crash”. Soros’ book, unsurprisingly, is rather more philosophical in tone, and as a result somewhat light on detail. It also feels distinctly rushed. Morris’ book, despite its populist-leaning subtitle, is a useful historical summary, from a credit industry practitioner, of how the banks got into their current mire, and why. It is probably also the first detailed account of the subprime débacle to hit the bookstands, which gives it a little first-mover credibility.

What both books have in common is a profoundly fin-de-siècle feel, what the Tate Collection describes as “the apocalyptic sense of the end of a phase of civilisation” – though “civilisation” is perhaps putting it a little strong. The last quarter century or so has been a golden age for banks. There is more than a whiff in the air that suggests the golden age is over, and it may not be back for quite some time to come. Looming graduates may find that more lucrative job opportunities, for once, lie elsewhere than on Wall Street or in the Square Mile. Those investment bank employees who manage to make it unscathed through the coming months may yet decide to venture into pastures new and less financial in focus. They may not end up better off, but society might well be.

Another commonality is a palpable distrust of market fundamentalism, or what passed as laissez-faire in a previous era. Soros and Morris are not the only critics of the free market and its supposed ability to mean revert its way through crisis: Deutsche Bank’s chief executive, Josef Ackermann, recently confessed that had lost faith in the “self-healing” power of markets, a statement he later confined with reference to American mortgages. But Soros has managed to turn his own perceptions of fundamental market fallibility into both theory and money-making machine. The essence of this theory should leave economists, regulators and many market professionals profoundly uneasy. As Soros has it, market participants cannot base their decisions on knowledge alone, and so their inevitably biased perceptions of the market’s “reality” in turn influence market prices and also the supposed fundamentals that those prices are believed to reflect. Market participants seek at one and the same time both to understand their situation and manipulate it, for profit. These two functions are contradictory. The market’s sensitivity to these twin impulses is what Soros calls reflexivity:

“Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants’ and regulators’ views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the US housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble – a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism, which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable.”

There is surely no need to reiterate the horrific frailty of the banks, whether of strictly the commercial or investment variety. Whatever damage hasn’t already been wrought by exposure to a softening Anglo-Saxon housing and mortgage market will be made up by exposure to credit-related or securitisation and distribution-related business lines that probably won’t be returning. Happily, the period of dramatic “bust” is unlikely to persist for anything like the duration of the boom – though the period of wound-licking might well outlast the current bulls-in-denial. A financial system that is seeing full-scale deleveraging by banks and the speculative community has every reason to expect a slowdown in the rate of forced selling. But as Soros suggests, while the end of the credit contraction may bring some short-term relief,

“it is unlikely to be followed by a resumption of credit expansion at anything like the rates to which we have become accustomed.”

For Soros, the end of an era means the end of a long period of relative stability based on US monopoly of superpower status and on the US dollar as the primary international reserve currency. Few objective international observers are likely to disagree with that thesis. But what it means to this investor is the end of a long period of growing earnings from the financial sector at the expense of the real economy, and conceivably of altogether diminished animal spirits on the part of banks and investment banks, consistent with the higher degree of regulation that now seems inevitable. As Bloomberg’s Mark Gilbert points out, the finance industry has just passed over its baton in the market to technology: banking stocks accounted for roughly 15.8% of the S&P 500 Index in May, versus the now dominant 16.6% accounted for by the technology sector. Three years ago, banks accounted for 20% of the index; 15 years ago, roughly 11%. So it still seems trebly premature to be bottom-fishing in the banking sector: a) because the writedown and deleveraging process has some way to go; b) because economic slowdown is more likely to exacerbate existing weaknesses, and c) when the industry finally moves into recovery mode, it will be in no state to enjoy the sort of profits it has until recently taken for granted. In other words, banking sector profits may have peaked in not just a cyclical but a secular fashion. And a weakened, more heavily regulated banking sector looks substantially less attractive than plenty of businesses exposed to the secular supportive tailwind of emerging market wealth growth and rising global demand for energy, energy services and infrastructure.

What both of these books also make clear is that conflicts of interest lie at the heart of the credit crisis like worms in a rotten apple. Those conflicts lie within banks that managed to sever any economic link between themselves and the repackaged mortgages they underwrote (unless they were dumb enough to eat their own cooking – and plenty were), within ratings agencies that enjoyed monopoly oversight of the ratings game that undoubtedly is a game, and within any number of financial intermediaries and restructurers who valued the earnings that derive from a gaudy housing and credit boom more highly than those that derive from building a credible long term reputation. It would be nice to think that those investors who have been roundly bilked by agency conflicts and endemic institutional greed would remember the role played by their institutional counterparties and not end up being bitten twice. History suggests, however, that all it takes is some hefty marketing spend and a new bull market in something else, and investors’ bad memories are wiped clean. But if these books cause just one investor to reconsider their relationships with the Wall Street elite, or for that matter their own assessment of the fundamental “purity” of free markets, they will have fulfilled a valuable social function.