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Economics

Masters of disaster

I had the good fortune recently to attend a presentation given by Matthew Hancock MP, at the Houses of Parliament.  Mr Hancock was giving a presentation based on his latest book, Masters of Nothing. The purpose of his book was to discuss the causes of the perennial financial crisis and provide his conclusions on what should be done to prevent further crises.  Mr Hancock spoke at length of his admiration and support of capitalism, discussing how it has raised the average family in the West from a subsistence level two centuries ago to the comfortable existence we have today, and how it is transforming other nations around the world.  Unfortunately, his proposed solutions would have done nothing to prevent the crisis and also contradict his own purported belief in capitalism.

Mr Hancock identified several failings in banks which he believed had led to the financial crisis and if remedied, would prevent further crises.  Ultimately, these failings reduce to the following: poor decision making at banks, and too few women on their boards.

It has been determined after the fact that the decision making at the banks was poor.  Thus Mr Hancock proposes several solutions, all of which are disturbing.  The first is to appoint a “public protagonist” authorised to question major corporate transactions, such as mergers and takeovers, as management is apparently highly-incentivised to deliver deals that may not be in the interests of stakeholders.  Such a protagonist would be authorised to call special shareholder meetings on behalf of the public and challenge decisions made by the firm’s management.  Leaving aside the fact that this is an egregious example of government intervention in the affairs of (nominally) free market institutions, one would question how an individual or party removed from the day-to-day affairs of a firm would be able to have any useful input into the decisions of the firm.  Given that they have not been instructed or remunerated by the company itself but rather by the government, it is unlikely that they would have the requisite experience, information, or incentive to perform the task set out for them.  On what basis can government employees evaluate business plans?  None whatsoever.

Another proposed “solution” referred to creating a new crime known as professional gross negligence. This crime would only apply to managers at “systemically-important financial institutions”.  This suggestion is rather unsettling as it appears that poor decision making (determined ex post) as a manager at a financial institution could get you locked up.  Presumably, government officials who make poor financial or economic decisions affecting the nation would also face the same penalty.

Another peculiar idea is barring directors of failed financial institutions (i.e. those that accepted public bail-out funds) from joining the boards of other companies.  In essence, if the company of which you are a director fails, you are fired, by the Government, permanently.

For a man who speaks fervently of his admiration for capitalism these are disquieting suggestions.  They appear to move us along the path towards an authoritarian regime, overseeing a society that bears a capitalist veneer, overlaying an intrinsically dictatorial system where orders flow from the government to “businesses” and where the penalties for non-compliance are severe.

Mr Hancock does not stop here.

He suggests that 30 percent of company board members should be female.  If businesses do not comply with this gender “recommendation” then they will be forced to comply.  You get further with a kind word and a gun than a kind word alone, apparently.

Mr Hancock suggested that he had uncovered researched that showed that companies with a higher percentage of female board members outperformed those with lower percentages.  If this is the case then there is no need for government coercion.  The outperforming companies will succeed and the companies with lower percentages of female board members will be marginalised or go out of business.  Market discipline will force the change without need for authoritarian government action.

Mr Hancock clearly demonstrates the benevolent but authoritarian side of democratic government.  He appears sincere in his wishes to prevent a re-occurrence of the current crisis but his proposed measures are surely another well intentioned brick in the road to Hell.  And of course, they have nothing to do with the causes of the financial crisis.  It is instructive to note that Mr Hancock essentially blames excessive risk-taking by male executives as a cause of the crisis.  However, this crisis began with a subprime bust, wherein previously AAA rated bonds defaulted.  Additionally, the current stage of the crisis concerns sovereign debt – what could be safer?  While there were undoubtedly unwise loans or investments made, banks as a group are fanatical about protecting themselves from risk.  Thus the question is, why did these supposedly conservative investments result in such catastrophic losses?

The answer has been known for decades and we have seen the same scenario played out repeatedly.  It is the very nature of the financial and economic system that governments have created in the West, to continually create this cycle of boom and bust.  The deadly combination of fiat currency and fractional reserve banking necessarily leads to crisis after crisis.  These supposedly conservative investments resulted in losses because of the chain of events that is set in process by the inflation of the central banks and fractional reserve banks.  This inflation (i.e. fundamentally printing money and holding less than a 100% reserve) distorts the capital structure of the economy, creating an illusion of greater capital for investment than there actually is.  No value is created, merely the illusion of value.

This illusory capital is invested into the project of the day (subprime mortgages, commercial real estate, sovereign debt, etc.) inflating asset prices, which leads bankers to project ever higher capital returns and governments to project ever higher tax revenues.  As profits continue to increase, banks, entrepreneurs, and governments become ever more confident and ever more ambitious with new projects.  This leads to a greater appetite for risk at the same time that the assessment of risk is underestimated.

The probability of default is underestimated and recoveries from bankruptcies are overestimated while at the same time, general market interest rates are artificially low.  The default probabilities and recoveries are in error because generally, risk models are biased upwards by the recent positive data.  Furthermore, it is impossible for them to predict such a financial collapse.  Artificially low interest rates lead to lower discount rates for projects, thus encouraging managers to invest in projects that otherwise would have been dismissed.  This is why the rating agencies made poor risk assessments.

Consequently, reality will assert itself.  Businesses will make losses on projects begun that the market cannot support.  Projects will be cancelled and employees made unemployed.  Unemployed people will default on their mortgages – it is notable that the crisis began in the subprime market where the mortgagees were financially unstable.  New houses and office buildings are created but stand empty; other building projects remain uncompleted as new capital is unforthcoming.  Banks begin to make catastrophic losses in their formerly conservative asset portfolios as large numbers of bonds default simultaneously.  Governments find that as business profits fall their tax revenues also fall sharply, putting pressure on their ability to repay sovereign debt.

This has little to do with poor decision making at banks.  Bankers made rational decisions based on the information available to them.  However, they could not account for the business cycle which is an intrinsic part of the financial system in which they operate.  Mr Hancock’s “solutions” will increase the authoritarian nature of our government and introduce further distortions into the economy, but they will do nothing to prevent a further crisis.   This, of course, is the great danger of our political and economical system.  It goes beyond merely financial crisis and recession.  It leads to calls by wilfully ignorant politicians with the support of the confused and battered masses to increase the size and power of the State to interfere with the mechanisms of free and voluntary exchange, with disastrous and serious consequences for liberty.  It has its roots in the government control of money and its symbiotic relationship with fractional reserve banks.  This disaster will continue to unfold over time until money production is returned to the market and the practice of unethical banking is ended.

2 comments to Masters of disaster

  • mrg

    Good article, Robert.

    I agree that, at its core, the recent crisis was a crisis of government — the predictable result of monetary socialism.

    However, I don’t think we should let the bankers off the hook. Various obfuscatory devices were invented by clever chaps in the banking industry. Yes, they were exploiting a highly-regulated system, but we shouldn’t pretend that they didn’t know they were up to no good.

    Nor does it seem plausible that risk managers in banks were completely unaware of the dangers of subprime. If they took everything the ratings agencies said at face value, they were grossly negligent. It seems more likely that they knew some dodgy deals were going on, but were hoping to pass the risk to greater fools. Or perhaps they just didn’t care about the long-term health of the banks they managed, so long as the bonus cheques kept rolling in.

    “Wilfully ignorant” seems an apt description of bankers as well as politicians.

    All that said, I agree that the only real solutions lie in markets that are more free, not less.

  • Duncan

    Does “money production is returned to the market” support Hayek’s proposal for the denationalisation of money?