Introduction
The move of the populations of China and India from poverty to middle-class prosperity should be the great historic achievement of the century.
Freeman Dyson
On first reading you may think there are two problems with this book. First, most people already think they know why the financial crisis happened – it was the bankers. Second, this book itself is written by a banker, and so tainted with the self-interest of the guilty. Let me see if I can overcome both problems.
For most people it is obvious that the important answer to the crisis can be found in the greed and risk that characterised Western banks, particularly those in America and Britain. High risk and greed together created the toxic balance sheets that disrupted the system. Many say that the sooner we limit the possibility of both greed and risk, the better it will be for everyone.
The combination of risk and greed might have been toxic, but I think it is wrong to assume this is a sufficient answer to the problems we have experienced, and the difficulties we continue to face. This may have something to do with my career as a banker, but I think it is more than that. Greed is almost certainly a constant and while some may disagree, I assume the bankers of the past decade were no more greedy than the bankers of earlier generations. There were a lot of them, and they were well paid, but they were not extraordinary. The risk which from September 2008 overwhelmed the financial system of most developed countries, on the other hand, certainly was extraordinary. It is this extraordinary risk which is the defining feature of the crisis, not the greed. Grasping the defining features of how that risk arose is essential to understanding the crisis. Without understanding, there can be no coherent response.
I do not deny that incentives worked to encourage the greed, and that there may be useful changes to be made in that area to limit future damage. Largely, but not completely, I leave analysis of the role of bankers to someone else, not because banks are unimportant, but because the story is bigger than banks and bigger than bankers.
The focus of this book is on the areas that I am at least partially qualified to discuss: international capital flows, interest rates and derivatives. I have worked for investment banks for almost twenty-five years. For the first twelve years I mainly worked as a trader and for the remaining years as an investment analyst. This book provides an insider’s understanding of what was going on in the financial globe in the past decade or so that led to the current problems. If nothing else, there should be something worth listening to from people who were there, even if it is just a record.
But this book aims at more than simply a record. I have first-hand experience of several of the important episodes that led to the crisis, and that appear in this book. These include the Asian crisis, the demise of Long Term Capital Management (LTCM), the dot-com bust and the extraordinary monetary easing that followed. I also saw at close quarters the effects of the financial crisis on my own bank. Throughout, I have seen the massive flows of foreign capital into the US and other countries such as UK and Spain that directly contributed to the later problems. I have near experience of the mortgage and credit derivative boom that turned into crash. I would not say I am unique, but I have a certain, perhaps slightly frayed, perspective. Chapter by chapter, the book will show how we were led into being ‘fooled again’, just as others were in the Asian crisis, the bursting bubble in Japan and the demise of Long Term Capital Management.
Don’t be fooled again came about as I began to look for an explanation of how the crisis emerged. I had two reasons for wanting to understand. I worked in the European bank that had lost more than any other – UBS – and had lost a modest amount of money myself. I had an incentive to explain to myself how the collapse happened. In the light of my experience, blaming banks alone did not make sense. Banks reveal a set of preferences that society has chosen, they cannot construct an entire social system alone. The problem was always bigger than banks, whatever their shortcomings.
Of course, it is no good writing about the crisis unless there is something useful or interesting to say that has not been said elsewhere. Many of the explanations for the crisis seem deficient. They failed to consider the wider global origins of our financial problems, and they fail also to discuss the technical and social character of both the boom and the bust, plus the role of regulators. Many of these issues remain taboo and so most of the solutions currently proposed are framed without a broad understanding of the nature of the problem they seek to address. If the analysis is deficient, it is almost certain the remedy also will be deficient. That will be bad for everyone in the long run.
Then there was also the fact that the near-collapse of Western finance (in which my own company was to play a significant bit-part) was easily the most important historical event of which I had personal experience. It was a kind of duty to try to capture, and correct, a point of view about the forces at work that would contribute to a broader understanding than the one that had become popular.
From the start, I knew the crisis had its origin not in finance per se, but in global capital flows. Although some banks and some countries were affected worse than others, the global background, while not ignored, seemed to me to be considered much less deeply than it should by commentators. Key themes were missing. For instance, the present crisis seemed (to me) directly linked to problems that began around 1990, and progressed through Japan, Asia, Russia, dot-com, mortgage lending and then the global economy. It has engulfed developed and emerging economies. Why was this? How could there be such a long line of financial crises and did they have a common cause, or evident links between them? If this had been with us for so long, how was it we had missed this till we were ourselves engulfed? That is the theme of this book.
The theme I detect behind the crisis is globalisation in various forms. The tools that created the crisis were more specific; technological prowess, the ascendency of the US, mistakes by central banks and regulators, and a misunderstanding about the limitations of investment.
Of course it is a cautionary tale, but it is not a tale with a neat ending. There are more beneficial aspects of modern life that seem to have contributed to the crisis than we could usefully dispense with. Along the way, I will consider the possibility that there may be some good from the current distress. The suggestion that something beneficial can come from a crisis probably needs more explanation.
Crises – not all bad
Crises are different. Something extraordinary happens. The dates and even individual days of crises are lodged in the public mind – September 11, for instance. Universally, crises in the English language are remembered as bad.
Yet, the word ‘crisis’ has less dramatic origins. The English word derives from the ancient Greek 
meaning to judge, to separate, or to choose. A crisis is a ‘decision-time’, a fork in the road, a time to follow a new path. While there is no such thing as a ‘good crisis’ in English, in the original Greek the word could suggest qualities such as awareness of errors and a determination to change; meanings that could be neutral, and perhaps positive. Crises are not separate from everyday life after all, but are an outgrowth from everyday life that is itself evolving, sometimes abruptly. Crises represent an extreme form of everyday change. I certainly see the current financial crisis as an outgrowth of the way the world has been put together over the past twenty years or so; it was in a sense always likely, if not inevitable, and the form it took was decided by specific events.
The credit crunch has affected more countries and many more people than the Wall Street Crash of 1929 ever did. The speed of the economic decline has taken almost everyone by surprise, even those who foresaw problems ahead. Yet this is a symptom of how our modern world works. The passage of time may reveal that what was thought of as so disastrous was later interpreted as an aspect of some other development, possibly even leading to, or stemming from, generally positive developments. There seem to me to be some aspects to the current financial crisis that may be so interpreted. A secondary purpose of this book is to estimate the scale and implications of the crisis, including possible benefits that have emerged from crises in the past.
What might these benefits be? Often the recovery from a financial crisis, which might have destroyed old ways, has, over time, delivered new and better ways of doing things. The last financial crisis in Europe occurred in Scandinavia in 1989/91. At the time it was thought to have brought only destruction, yet that crisis was responsible for the rise of Scandinavia as a world force in mobile telephony and software. It changed the way Finland in particular worked, and increased the self-confidence of the Finnish people to unforseen levels. The forces behind the changes in Finland are still active. The networked world we now inhabit throws up opportunities for experimentation over a vast number of products. Just about all of what we consume is translated into information value of some sort. The spread of information processing is far from over and the opportunities that grow with it are just as far from over. The long-term effects of the Scandinavian financial crisis therefore changed some things to the good. We should not deny that disruption can lead to future benefits.
The most important cause of the 2007 crash was the long-running financing imbalances in the world, between exporting countries and those that consumed, particularly between the US and China. Benefits will certainly flow in the short term from the world adjusting to a better balance of trade. The imbalance will probably not survive, in its previous form. A move to a balance in trade should be viewed as a benefit compared with what went before. Such a balance may also provide new opportunities for both emerging and developed worlds.
Nor should we dismiss the idea that the calamity that has befallen the West might have been an accompaniment to some broader, positive trend. It is always easier to discern bad things as being separate from good, but life may be more complex than that. There may be benefits stemming from the same forces that helped shape the deep recession we are suffering; the ‘dark side’ we all wish would go away may be a consequence of other, brighter aspects of modern life. It may not be possible to gain from one without suffering from the other. The suffering will pass, leaving the benefits that preceded and succeed it. Radical change is often associated with radical disruption. Radical disruption is exactly true of the technological benefits we take for granted, yet which are a key component of the crisis.
We must have missed something
J. K. Galbraith, who wrote perhaps the most well-known explanation of the 1929 Wall Street Crash, blamed excessive speculation for the boom, and the bust of 1929:
‘The collapse of the stock market in the autumn of 1929 was implicit in the speculation that went before. The only question concerning that speculation was how long it would last. Sometime, sooner or later, confidence in the short-run reality of increasing common stock values would weaken. When this happened, some people would sell, and this would destroy the reality of increasing values… There would be a rush, pell-mell to unload. This was the way past speculative orgies had ended. It was the way the end came in 1929. It is the way speculation will end in the future.’1
Was the current crisis really all about speculation? Was it really about the repeat of some formula for disaster that cannot be escaped? Pessimists say that nothing changes and that we are destined to repeat mistakes. The crisis was a morality tale about how little humans learn. There is certainly a link between the crises that have dogged the past twenty years of global finance, but each has its peculiarities. Some of the causes are common, some are unique. I want to tease out both common and unique.
Another one of Galbraith’s sayings was that finance ‘hails the invention of the wheel over and over again, often in a slightly more unstable version’. I disagree; the results of the present crisis were a combination of particular events that, under a slightly different configuration, might have progressed without disruption perhaps for many more years. The fact that these events led to failure was due not to the lack of learning but to the unique circumstances of international capital flows in the late twentieth and early twenty-first centuries. I am not engaged in a defence of bankers, but the crisis is a geo-political event, involving technological change and changing power in the world. Although I do not aim to delve too deeply into the politics, it, too, is an undercurrent that informs much of the story.
Unfortunately, even important members of the Western establishment still seem keen to retreat into an explanation of ‘greed and risk’. Perhaps the wider implications are uncomfortable for them. But if we only look at the obvious, at most we’ll only get half the story and therefore half the understanding. For example the French and German governments want to pin blame on a group of investors who they think epitomise ‘greed and risk’: hedge funds. The regulations put forward in the European Union are a deliberate attack on these investors. Yet, hedge funds had no role in the creation of this particular crisis. What is the logic of a regulatory response that seeks to regulate behaviour that was not at fault? This is not just missing the point, it is a deliberate misrepresentation of the truth.
Even top regulators shirk a wider story in favour of the simple explanation of greed. Mervyn King, the governor of the Bank of England, blamed the 2008 collapse on ‘hubris and excessive lending’.2 As the man nominally in charge of UK bank lending during the period he identifies with ‘hubris and excessive lending’, he begs a question of himself: ‘Why did you allow such a situation to develop?’ But his unsatisfactory explanation is not alone and some variation on King’s theme is accepted by many others.
Galbraith at least had the grace to admit ‘We do not know why a great speculative orgy occurred in 1928 and 1929’, and suggested that the explanation for the crash was unknown. Better to start with an admission of ignorance, than to start with a mistaken analysis.
Explanations of crises have become more adventurous since Galbraith published his book. Robert J. Shiller published Irrational Exuberance just before the stock market bubble burst in 2000. He warned of over-extended stock prices and railed against the lack of fundamental value in the prices of many stocks. His warnings were followed by the dot-com crash. Partly as the result of this book, Shiller acquired the reputation of a financial sage; a role he was to reprise during the US housing crash of 2007–09, which he predicted. The high reputation is entirely deserved for a man who had predicted the collapse of not just one bubble, but two.
Shiller was not the only writer to predict disaster, but he was among the most convincing in explaining how it emerged. He lists twelve factors that ‘make up the skin of the bubble, if you will’. These were ‘factors that have had an effect on the market that is not warranted by rational analysis of economic fundamentals’; in other words, his reasons why the public were so blinded by circumstances that they failed to see an obvious economic incongruity in shares prices.
So, to Schiller’s list: arrival of the internet; triumphalism at the victory of capitalism; cultural changes that favoured business success – or the appearance thereof; a Republican Congress in the US and capital gains tax cuts; the post-war baby boom and its investment effects on the market; an expansion of business reporting in the media; increasing optimism by analysts; an expansion of defined contribution pension plans; growth of mutual funds; the decline of inflation; an expansion of turnover (liquidity) of stock trading; a rise in gambling opportunities.
To Shiller, the public could not see disaster coming because they were dazzled by other events. The list reflected his belief that investors had lost their focus on long-term stock earnings. There is no doubt to me that most if not all of the factors Shiller listed played an important role in sustaining the dot-com bubble.
To me, Shiller’s list could be distilled into three items: American dominance; the entry of new investors; and the effects of new technology. In many cases, the first and the last effects were largely synonymous. The internet was, after all, an American invention and the US drove its massive growth in the late 1980s; globalisation and its effects on growth and inflation were intimately linked to the triumph of America and the fall of communism in the late 1980s. Globalisation itself depended on newly expanded communication networks. From these two major effects (internet and globalisation) stemmed interest in business, expanded liquidity, increased optimism of analysts, the growth in mutual funds, a change in cultural attitudes towards business. These forces too are my starting point for the current crisis.
The effect of ‘green’ investors runs as a thread through Schiller’s book. Whether it was individual banks, traders convinced about the safety of their high-yielding debt investments, reserve managers and Japanese households who did not know, or did not care, about the effect they had on the investment landscape, or the entry of vast numbers of the general public attracted by the rewards of market gains, new entrants were a force to be reckoned with. The problem with investment information is that, unlike medical or engineering information, the more people who know it the less valuable it becomes. The greater the involvement, therefore, the more devalued the quality of information on which investment decisions are made.
Not surprisingly, then, financial disruption often seems to coincide with an information revolution that increases the reach and accessibility of information previously available only to a few. New technology or new methods of production excite investors and bring new products. For a while, the world looks permanently different, then a collapse occurs and the speculative excess is revealed. This is something that has been noted many times by economists, including Shiller. Technological change and stock market bubbles seem inextricably linked. The inherent instability in financial markets can be tipped into boom and bust by technological change.
In many cases, however, the world we glimpse during the boom is genuinely different. The crisis is, in some ways, a rite of passage into a different way of interacting and a different world, although with some constants.
To make this easier to grasp I divided the themes that we’ll be looking at into four areas. These are:
- The constants. Disruption may be inevitable from the way we understand and use money. Financial crises may be inevitable, not through greed or fraud or mistakes that can be curbed, but through the nature of the way we interact with money itself. At the same time money is both debt and a medium of exchange. The results of an unbalanced interaction of the two ways of using money are always alike: illiquidity, insolvency, recapitalisation, government guarantees and economic contraction. The emphasis in the past thirty years has been to promote money as a medium of exchange in the form of increased transactions. The downside has been at the expense of money as debt.
- Crises. Crises may emerge from new features in an economy. If symptoms are alike, the causes are also often associated with long-term developments that stand as benefits to society. The current financial crisis seems related to our technological innovations, particularly in computing and telecommunications.
- Technologies. The new technological features ran in parallel with an unprecedented opening up of the global economy. The trade/finance arrangements of Asia, primarily China and Japan, and America led directly to crisis. It is sensible, as I said, to consider the entire period from 1990 until 2008 as one large financial crisis associated with globalisation – a crisis that began in Japan and spread through the world via South-East Asia and the dot-com boom. Eventually it emerged in both America and Europe. It may be in the process of returning to its origin in Japan.
- Disruption may be positive. Just because something is uncomfortable or disruptive may not mean it does not have long-term benefits. In one later chapter I look at some of the good as well as bad results of past crises. What looks like a disaster for the US now may be proof of its continued economic dynamism and leadership – though that will only become apparent on a recovery and may not occur for several years. On the other hand, if other countries fail to learn the lessons of this episode and do not work to avoid disruption it could limit their own prosperity.
The never-ending crisis
Since 1990, a long-running financial crisis has rolled uninterrupted around the globe, beginning in Japan and spreading initially to the rest of Asia, then into the US and Europe. In time, the series of crises will be seen as running in parallel to the unprecedented opening up of the global economy – undoubtedly a positive development in itself. Europe even had a succession of currency crises in the early 1990s, which could have been included under the heading of globalisation, but were omitted for the sake of brevity. In Asia, the collapse of the ‘Tiger’ economies of Thailand, Indonesia and Malaysia grew from the interaction of their economies with global capital. There have been at least three financial crises in the US over the past decade or so which had origins in similar opening of the globe; the collapse of Long Term Capital Management, the dot-com bust and the credit crunch. Each one contained similar features and causes. It is possible to view the past ten years as a recurrence of one single financial crisis with roots in the expansion of world trade. All of these episodes are considered in this book.
The capacity for calculation, the speed of transaction and the transparency of prices that accompanied globalisation have radically changed the operation of banks and their customers – and also contributed to the way the crisis unfolded. Global capital flows, cross-border lending, electronic trading platforms, online mortgage applications, financial spread betting, derivative use and structured products all grew massively, driven by information technology. Changes have brought down costs and increased speed. Yet, these changes in many ways ran ahead of the investment opportunities the West had to offer the rest of the world. The dominance of the dollar that characterised the past twenty years had an inbuilt flaw. While most assumed the architecture of global finance could accept the many millions of extra participants with their many millions of extra dollars, the system was not able to deal with the vast amounts of money directed back to America alone. There are many opportunities for investment and some are located in the developed world, but most are in emerging economies. The diversion of colossal quantities of cash from reserve managers in emerging economies into developed countries was not just a contributor to the crisis, it was an unethical diversion of resources from those who needed them. Moral questions run through the present crisis, but perhaps not quite in the way many have appreciated.
While globalisation may be new, it is not the first time technology has delivered financial disruption. Improvements in communication in both the mid-nineteenth and early twentieth centuries were also associated with financial disruption across many nations. Communications as the harbinger of crisis is not new. Once again, the novelty today is the scale, which is nevertheless entirely in keeping with the global reach of communications technology.
Communications technologies are ‘socially constructed institutions, just as are governments, educational systems, family structures, self-help and charitable organisations.’3 The major change that communications have brought is to include many more participants in a system from which they had been excluded.
Enthusiasts would say both trade and communications have created a whole new world to develop and explore. But, there are actually too few appropriate investment opportunities. There was an incentive to invest, and an increase in investment from capital flows, but little expansion in the right opportunities. When a product is in demand but unable to be supplied, a good capitalist system will create it. The extra investment needed an investment, and in US and European housing bonds and credit derivatives it received its investment opportunity. Unfortunately, the opportunities were frequently flawed, even from their very design.
The lessons I want to draw from our troubles are not the didactic, school-masterly lessons of the moralist. They are, instead, the lessons of the unintended consequence; an altogether more unsettling and less confident sort of lesson. What may in all other respects appear to be a great enhancement to the human condition – the entry of the emerging economies into the developed world – had a cost attached that neither developed nor emerging worlds anticipated. There are also lessons in the singlemindedness of our central banks, which blinded them to serious, and obvious, distortions in the financial system. And lessons too for regulators who encouraged the structures of international finance to evolve in such a way that damage was so pervasive. Yet, the lessons are unfortunately unique and probably not transferable, or even relevant for the next great boom and bust. It is possible that the great series of financial crises the world has experienced since 1990 is far from over. After all, we have not yet discovered the limits of communication. There is no reason why we should not be ‘fooled again’.