FSA's Lord Turner: policymakers and regulators inherited "50 year long, large intellectual policy mistake"

In a must read Telegraph column, the FSA's Lord Turner attempts to place the blame for the failure of global policymakers and financial regulators to prevent and adopt a successful policy response to the global financial crisis on an over-reliance on markets.

Five years later, and as Lord Turner prepares to leave the FSA at the end of the month, few would have thought that the unprecedented events of that fateful year [2008] would still be reverberating throughout the developed economies.

For the record, your humble blogger publicly stated in late 2007 and throughout 2008 that without the right policy response, we would be facing a long-term Japan style economic malaise if not outright contraction.  This prediction has been borne out for the last 5 years as clearly, given the economic problems that we face today, the policymakers and financial regulators have not adopted the right policy response.

But, then again, who am I to be listened to on this matter.  After all, my track record includes predicting the financial crisis and subsequently predicting on this blog with the same degree of accuracy which policies were not going to work.

But hey, who cares about a track record when the entire economics profession continues to offer up recommendations despite having not predicted the financial crisis (my apologies to William White and his group at the BIS who did foresee the financial crisis).

In previous recessions, the route back to growth has been quicker. 

This time, a toxic mix of unsustainable levels of public debt and private-sector deleveraging has left the British economy in a long-term funk....

It is not the de-leveraging that has the economy in a funk.  It is the excess debt in the financial system and the policy responses to this excess debt that are causing the financial funk.

Banks are still in the dock. The City still feels friendless.

Oh please.  The City doesn't care about friends.  It is buying and selling policymakers left and right. Witness the UK government dashing off to Brussels to try to head off a regulation limiting banker bonuses.

Remuneration is still headline news.

As it should be given that the policy response that Lord Turner is so proud of was to protect banker bonuses at all costs.

New regulations on financial services are spewing out of Parliament, Europe and the Basel III process....

The number one lesson of the financial crisis is that the combination of complex rules and regulatory oversight does not prevent a financial crisis.

If it did, we would not have had a financial crisis and the banks would have avoided it.

“If you go back to March 2009, which is the point where all of us had gone through the crisis and were coming up for air and saying 'how do we put things right for the future?’ – if you look at all the forecasts, Bank of England, Treasury, the IFS [the Institute for Fiscal Studies], IMF, World Bank, they all suggested a much faster and more robust recovery of the developed-world economies than has actually occurred,” says Lord Turner. 

“I think that’s because we were slow to realise that once an economy has become overleveraged, once either corporates or households are over-leveraged, they will devote whatever disposable income they have to trying to get their balance sheets down, and therefore the demand for credit is depressed.”

Nice example of complete intellectual capture of a regulator by the bankers.  This is not surprising as Lord Turner is trying to defend the indefensible:  protecting banker bonuses and tearing up the social contract to pay for these bonuses.

The demand for credit is not depressed because of repayment of existing debt.

Demand for credit by business is depressed because of a lack of revenue growth.  Businesses simply don't borrow to expand when they don't see revenue growing.

Demand for credit by individuals is depressed because credit is now only provided to individuals who can actually afford the debt service payments.

And until the economy recovers, the financial crisis will cast its shadow over everything that happens....

The financial crisis will continue to make economic recovery impossible so long as policymakers and regulators refuse to require the banks to recognize upfront their losses on the excess public and private debt in the financial system.

Until this is done, the burden of the excess debt falls on the real economy where it diverts capital needed for growth, reinvestment and social programs to debt service and banker bonuses.

“I think we – as the authorities, central banks, regulators, those involved today – are the inheritors of a 50-year-long, large intellectual and policy mistake,” he says. 

“We allowed the banking system to run with much too high levels of leverage, inadequate levels of capital, and we ignored the development of leverage in the financial system and in the real economy. 

“And not only did we ignore it but we had a pretty overt intellectual philosophy that we could ignore it, because we knew the financial system was just a market like any other and whatever it did was bound to be for the good because that’s what markets are. 

“That was a huge mistake. 

“People just fall into the habit of believing that the system is stable. I think, unfortunately, there was the development of a set of intellectual ideas – efficient market hypothesis and rational expectation hypothesis – which provide an apparently sophisticated intellectual argument for why this whole system is safe.

I appreciate the fact that Lord Turner just said the economics profession is worthless and that economists should not be listened to.  It is hard to argue with this given that economists did not see the financial crisis coming and they were the ones promoting the large intellectual mistake.

However, by looking under the surface just a little, one can redeem the economics profession and discover what the real cause of the financial crisis was:  the assumption of transparency in a financial system that became dominated by opacity.

Adam Smith laid out the necessary condition for the invisible hand of the market to work properly:  buyer and seller must have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed decision.

Without transparency, the rest of economics professions set of intellectual ideas is not just worthless, but downright dangerous.  As shown by the economic crisis.

However, with transparency, the financial system actually works reasonably closely to how the economics profession thinks it should work.

“[But] I think the response to it, the emergency response in Autumn 2008, was very good and I’m proud to have been a part of that process.”

The response in Autumn 2008 and since could not have been worse from the perspective of the real economy, taxpayers and society.

On the other hand, it has been great for the bankers.

When he walked into the FSA, the organisation was already changing, desperately trying to catch up with a financial-services sector that had left it for dead, a sloth trying to catch up with a tiger. 

It wasn’t until the FSA’s own, reluctantly authored, RBS report of 2011 on the collapse of Fred Goodwin’s bank that Lord Turner fully realised how dysfunctional the system had become. 

“I was very surprised that, despite the fact that we had 3,000 people, the allocation on the direct supervision of RBS was five people,” he says. 

“I was more surprised the more I looked at the liquidity standards that we’d been applying and the capital standards we’d been applying. 

“I was surprised at the supervisory approach. I’d been on the board of a bank, I’d been involved in banks, I’d dealt with banks back in the 1980s and 1990s, and I, throughout that, had accepted the existing capital regime as a given, right? 

To his credit, Lord Turner acknowledges why the combination of complex rules and regulatory oversight doesn't work as a substitute for transparency and market discipline.

With transparency, all the market participants, including banking competitors, look at a bank and not just the limited resources available to a regulator.

“I had never gone back to basics and said, 'why do we allow banks to run with 30, 40, 50 times leverage?’. And neither had anybody else, funnily.”

It is not leverage that kills a bank.  It is the risk that a bank takes that kills a bank.

Talk about bank capital ratios misses the important point that the way to prevent a bank from imploding is by restraining its risk taking.

The way to restrain risk taking as JP Morgan's Jamie Dimon has demonstrated is by letting the market see the bank's current global asset, liability and off-balance sheet exposure details.

Why not? critics may scream – or, more precisely, there were some people warning of calamity, why weren’t they listened to? 

“Well, it’s partly the frog in the boiling water, isn’t it?” Lord Turner says. “It slowly happens over time. It doesn’t happen immediately so the frog doesn’t leap out. The frog dies.” And while the frog is slowly dying, everyone is living it up on the debt-fuelled proceeds.

My question is:  why aren't we listening to the people who warned of a calamity now?

As the Bank of England's Robert Jenkins said, it is amazing that policymakers and regulators turned to and still rely on the bankers who brought about the financial crisis.

In 2009, Lord Turner famously said that a lot of banking activity was “socially useless”, a phrase that became the standard around which many critics of the City gathered. Has his opinion changed? 

“Before the crisis, there was too much trading activity in unnecessarily complicated structured credits going on,” says Lord Turner. “We have seen a very significant shrinkage in some of the trading books of our major banks. 

“And I think, when all that deleveraging of trading books is completed, we will find that the real economy never needed this stuff in the first place, and in a sense we’re better off without it. 

“Secondly, I think if you look at Barclays’ decision to radically reduce the size of its tax structuring activity, that is an end of a socially useless activity.”

All of this would permanently go away if banks were required to provide ultra transparency.