The Left-wing response to the financial crisis


5:47 pm - September 24th 2008

by Luis Enrique    


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Some bloggers have been asking what the left wing response to the current banking crisis ought to be. Here’s what I predict it will be.

The crisis will be slotted effortlessly into the existing left-wing narrative about the evils of capitalism, neoliberalism, and the ‘myth of free markets’. The bailouts will be commonly referred to as hand-outs to the greedy bankers who created all the trouble in the first place [1], and the headline figures (say the $85bn to AIG) will be spoken of as if this is money taken from taxpayers and given to banks/insurers [2]. We will see lots of talk of parasitic financiers who produce nothing and indulge in nothing but speculation.

There will be calls for bankers to return their bonuses (to whom?). Oh, and the left-wing story of ‘how this happened’ will be hopelessly garbled, and will generally get no further than blaming aforementioned greedy speculation in opaque financial instruments. You can see examples here, here and to an extent here [3].

So what should the left’s response be?

Well, I don’t know for sure, because I don’t really know what’s gone wrong (perhaps the first thing the left should do is find out). The general picture on the left appears to be that the banks took speculative trading positions (in opaque financial instruments) that went wrong (much like one might borrow money to buy a stock that you expect to rise). But I struggle to believe either of these is enough to explain what’s happened [4].

From what I can gather, the truth is closer to banks having unwittingly built their balance sheets on assets that they thought were solid, but have turned out not to be, and this sparked off some sort of market failure, rather like the classic market for lemons story. Here used car prices fall because nobody can be sure the cars aren’t wrecks (lemons) so only owners of lemons are prepared to sell at the going price and, knowing that, nobody wants to buy a wreck, so the market collapses. Something similar has happened in the money markets. Another dynamic is that if everybody is doing it at the same time, selling assets to raise capital depresses asset prices and falling asset prices increase the need to raise capital.

Market failures are well-known phenomenon, and addressing them is not the preserve of the left. But right-wingers have a tendency to pretend they don’t happen, so one left-wing response is to lay claim to being the bunch best relied upon to identify market failures and find ways of curing them. The market for lemons story isn’t very realistic (it’s only a parable), because you can get a reasonable idea of a car’s quality by looking at it, and remedies are fairly obvious – some independent auditor of quality (say, the AA) and some mechanism for buyers being able to return cars that turn out to be wrecks. The long-term solution to the current problem will look different to that (the finance industry already has an AA – the credit rating agencies – and that didn’t help).

Fixing this market failure will probably entail keeping some financial functions under state control (the short-term solution certainly does) and in the private finance sector, constraining who can do what, and building some fire-breaks into the system.

A related idea is looking at the incentive structures within banking that encourage the system to inflate bubbles and build up concentrations of risk in such a way that periodic crisis are inevitable. Again this is not an exclusive preserve of the left – Martin Wolf has written about regulatory reform of salary and bonus structures in banking (here’s that column, he’s also worth reading here, here and here) – and everybody from The Economist leftwards knows more regulation is needed [5]. In this sense, how the left ought to respond need not differ from how everybody else responds.

What does the crisis tell us about free markets?

Yes, a “free market” in finance has self-destructed, and millions of people who played no part in it, are going to suffer because of it. But the free market in finance failed in a fashion that hasn’t much to do with the popular left-wing anti-market story (other than it involves ‘greed’). The left-wing anti-markets story is usually applied to markets that are working healthily (at least as far as an economist would consider). Here we have a market that has collapsed. Nobody foresaw exactly this (although plenty of people were worried about the housing bubble and derivatives) but anybody familiar with market failures ought not have their world view turned upside down, even if they are surprised at the scale. Nor does this crisis tell us much about the wisdom of appropriately regulated free markets in most goods and services, and labour.

Of course, the left has different priorities from the right, and although this crisis is in great part a technical problem with a technical solution, even technical solutions involve trade-offs, and different priorities can mean different choices. What does a distinctly leftish solution look like? The answer should follow from what the left wants from capital markets. I think capital markets are there to facilitate investment and improve asset allocation in the economy, to spread ownership, to enable citizens to protect themselves against risk, save and borrow at the best possible rates. But again, that’s not really a left or right answer. So I have to end with restating the question – what does the left want out from capital markets?

It may just reflect my centrist, left-capitalist inclinations, but I can’t think of much that’s distinctly left-wing. Brad De Long and Paul Krugman are heavyweight centre-lefties (the takes on this question can be read here and here and here – the last mentioning pay caps for bankers) De Long channels Marx on financial crisis here. Ah, here is a resounding left-wing response – a fund to help workers who lose their jobs because of all this. That’s something I had omitted, having been thinking directly about responding to the narrow capital markets problems. I favour temporary government job creation, such as heavy investment in renewable energy and transport infrastructure (which will have the added bonus of cutting long run energy costs). And finally, as ever, Chris Dillow is vital reading on this question

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[1] When a business blows up, let’s say there are 3 sets of people who could be bailed-out: the owners, the company directors and the workers. In the main these bailouts have seen the owners lose everything, the directors paid according to their pre-existing, regrettably absurdly generous, employment contracts, and many of them fired and their stock options/holdings wiped out, and some workers losing their jobs and others keeping them. It makes almost no sense to think of these bailouts and handouts to the bankers themselves – other than that because the bailouts are intended to limit the collateral damage of this mess, which involves trying to keep some of these banks afloat, so hence keeping some bankers and workers in their jobs. Of course it may turn out that the terms of big bailout are too generous; it make equally turn out they are too miserly. UPDATE – although it looks like the actual plan being drawn up, sucks. See here for why, and links to further critical commentary by economists.

[2] The bailouts so far have sometimes been loans, usually from the monetary rather than fiscal authorities, or sometimes involve the acquisition of assets at knock-down prices. For example, it’s quite possible AIG will not see a dime of that $85bn, and anything it does borrow it will have to repay at exorbitant rates. Of course the taxpayer is being saddled with risk and from what I can gather most economists do expect there to be an ultimate direct cost to the taxpayer from all this – on the other hand, there’s potential for the taxpayer to gain.  See here and here (I read an IFS report saying the UK govt may end up profiting from the Northern Rock nationalisation, but I can’t find the document). This is possible because financial assets and the equity of these companies may have fallen below (to use a problematic term) ‘fair value’, because of the market failure currently in progress, and in due course the state will find itself with assets worth more than it paid for them.

[3] If that Guardian piece is the best bunch of intellects the leading publication of the left can come up with, the left is screwed. Am I being unfair and constructing a straw man out of the anti-markets fringes of the left? Perhaps so, but everywhere I look, in blog comments, newspapers and on telly, this is what left wing opinion largely resembles, as far as I can see.  

[4] I could be wrong about this. It could be that the banks did take speculative trading positions without realising how great their exposure was, if things went bad, because the degree of inter-connectedness was underappreciated. Which isn’t a market failure so much as a market participants’ mistake with unanticpated consequences.  

[5] Another simplification to be avoided is that this happened because bankers had too much freedom, and the solution is thus “more regulation”. Frannie Mae and Freddie Mac were about as regulated as regulated gets. Sometimes regulation can have the peverse effect of encouraging the use of derivatives, that end up concentrating risks and creating crisis. Also, it’s wrong to assume that state provision is necessarily less risky – governments can get themselves into a mess, and face some screwy incentives too. It’s a commonplace that capitalism entails booms and busts, but crisis may be a feature of any system of economic organisation.

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Reader comments


“because I don’t really know what’s gone wrong (perhaps the first thing the left should do is find out)” Maybe, it would be best if YOU found out before writing a long post making alot of assumptions!

You would then find a long list of critics of the ‘management’ of derivatives trading that would be hard to categorise as Trotskyites (George Soros, Warren Buffer – who labelled the more exotic derivtive products as ‘financial weapons of mass destruction’ – see http://news.bbc.co.uk/1/hi/business/2817995.stm – et al). You could have a look at Satyajit Das’s ‘Money, Guns and Traders’. The big lie is that nobody foresaw the crisis.

“… we ought to wake up to the reality that business greed is subverting the American way of life—and hurting the image of American capitalism and democracy—more effectively than the ploys of any foreign enemy.

When even Martha Stewart is ethically suspect and her company’s stock has plummeted—though not quite to the depths of Enron, Global Crossing, Tyco, Dynergy, Wal-Mart and Rite Aid—it is time to return to the wisdom of Franklin Delano Roosevelt, the Depression-era president who saved capitalism from itself.

Wealthy from birth, FDR had a healthy awareness of the tendency of the upper classes to destabilize society and even destroy themselves with their greed and hubris. Unlike Karl Marx, however, he believed the unraveling of capitalism was not inevitable if these excesses could somehow be corralled. Thus was born the idea of government regulation as the vital support structure for the powerful, fertile but unstable free market.

Unfortunately, greedy people and institutions don’t like being monitored, and they have the means to corrupt governments and skirt laws.

Since the so-called Reagan Revolution, powerful corporate interests have succeeded in profoundly damaging the foundation of a properly regulated economy.”
Robert Scheer, LA Times, June 2002
——————————————————————————————————————-
U.S. gross domestic product (GDP) is about $15 trillion.
The GDP of all nations combined is approximately $50 trillion.
The total value of all the real estate in the world is estimated at $75 trillion and the Total value of all the world’s stocks and bonds is about $100 trillion.
The derivatives market is around $500 trillion (Marketwatch).

Contrary to your statement, the collapse was widely predicted. Sadly the predictors were bloggers such as Bonddad on dKos, New Deal Democrat at Economic populist, Jerome a Paris and Chris Cook at European Tribune, who understood what they were talking about, but were not traditional media journalists entirely reliant on friday night drops for their “analysies”. Krugman, whom you mention, was late to the party but he did catch up eventually early last year

As Bonddad put it today “In other words — everybody who should have seen this coming is now shocked we’re in this mess. The only people to get this right were the bloggers — or as NDD says, the “dirty hippies.” Now, these same people who have gotten nothing right over the last year are desperately seeking money to help stave off a disaster. These people have no credibility on this issue. None. Nada. Zip. Zero.”.

The mechanics are known and understood. Again the bloggers mentioned have explained it exhaustively but right now the main culprit to worry about are Credit Default Swaps (look ’em up – there’s a good explanation on Moon of Alabama).

I guess I’m disappointed. It’s one thing to berate the Guardian for publishing articles that really don’t get to the heart of the problem, but then again your proposals are vague and conditional laden. The problem right now is that, whatever we might think of the responses happening across the pond in the US, our exposure to this crisis is far greater and we need better analysis than vague mumblings about perhaps finding out what went wrong. These analysies exist, but they aren’t happening in the UK, so the left here had better start getting an international focus if they want to respond cos the parochial stuff won’t cut it.

and if you think that brown and Darling are going to be of any use in getting us out of the mess they created, then I refer you to Bonddad’s comment above “These people have no credibility on this issue. None. Nada. Zip. Zero”

helen

Perhaps I’m being thick, but I fail to see the difference between these two statements:

the banks took speculative trading positions (in opaque financial instruments) that went wrong (much like one might borrow money to buy a stock that you expect to rise)

and

banks having unwittingly built their balance sheets on assets that they thought were solid, but have turned out not to be

My understanding is that people had loans made to them with the house as collateral, these were sold on, sliced up into CDOs, guaranteed by ratings agencies, traded, hedged against, and put off balance-sheet in special purpose vehicles etc. etc. in a process that quickly became very “opaque.” Then big institutions leveraged themselves up to the nines (“borrowed money”, I believe is the conventional term) to jack up the profits they were making fro all these fancy new instruments. Which is fine, unless the housing markets go down and your magnified profits start turning into magnified losses.

So I don’t think there’s anything intrinsically wrong with “talk of parasitic financiers who produce nothing and indulge in nothing but speculation.” If these people were meant to be accurately pricing risk, they seem to have done a spectacularly bad job of it.

And I agree with commenters #1 and #2 that loads of people saw this coming. Some were dirty hippies, some were libertarian nut-jobs. If you’d given the issue some attention and didn’t think that Alan Greenspan was the single smartest man on the planet, the odds were you harboured some grave reservations about the financial system.

I do like the idea of “temporary government job creation, such as heavy investment in renewable energy and transport infrastructure (which will have the added bonus of cutting long run energy costs)”, though. I’ve been upset that the “Green New Deal” is getting less play than you’d hope.

4. Mike Killingworth

I’m with Chris Dillow. One possible outcome would be for a regulatory régime that encouraged financial institutions to operate on a not-for-profit basis, as the Co-op Bank does and the TSB and building societies used to. God knows there are enough regulatory levers available.

Presumably the objection to this would be that much of the City would up sticks and leave, thereby knocking a further hole in the economy. To which two answers are possible: a lot of it may well do so anyway if Salmond leads Scotland out of the UK so a little contingency planning would be sensible, and more generally the City represents too high a proportion of the economy (too many eggs in one basket).

I know, I know, I’ll have the Friends of David Ricardo hissing at my economic illiteracy. But I think Ricardo would have been the first to recognise that the products/services in which comparative advantage exists (or not) will change over time, and in any case there’s a hidden assumption that all financial services represent a single “product” which is at least arguable – why isn’t insurace a different product from retail banking, for example? The benefits of vertical integration are a contingent factor, not a theoretical derivative.

You seem not to have been reading Tony Curzon Price over at openDemocracy
eg:
http://www.opendemocracy.net/blog/yes/tony-curzon-price/2008/09/22/the-cost-of-mistrust

“From what I can gather, the truth is closer to banks having unwittingly built their balance sheets on assets that they thought were solid, but have turned out not to be, and this sparked off some sort of market failure, rather like the classic market for lemons story.”

The fact that the banks were making so much money on these assets should have clued them in to the fact that the assets were, in fact, not stable. I mean, I’m certainly not an expert on financial markets but I do have a memory. Every time I hear on the news about the next hot market, and people making money hand over fist on some asset or resource, it doesn’t take a genius to realize a crash is inevitable. When you look at a graph of the price and it’s skyrocketing upwards, it’s almost a foolproof indication that a crash will happen.

7. douglas clark

Anthony,

I am no economist, but I do agree with Tony Curzon Price, if I have understood him correctly, that the ultimate outcome of any investment – including one by the state – ought to be that any upside should be there to be had. Anything less than that, it seems to me, is simply handing good money to folk that have already displayed their incompetence.

The Administrations’desire to keep this away from public scrutiny ought to set alarm bells ringing, I’d have thought….

I’m divided on whether to blame this financial crisis incompetent politicians and regulators or a conspiracy of wealthy individuals who combined to undermine the system of politics and the (relatively) peaceful world order.

What the hell, it probably doesn’t matter anyway, conspirators and incompetents most likely combined to magnify the effects of each other. The rest of us just have to adjust to the circumstances – such is progress!

Very interesting article and lots of useful links.

I don’t think Luis is saying that no one saw this coming. Even the Economist has been warning about the complexity of the financial instruments and the risks of Greenspan’s interest rate policy for years. It is, nevertheless, a fair point to make that no one knows how far this thing is going to unwind because we have never experienced anything like it before.

Oh, just to add in another point, the outcome of the current mess is going to be costly, which means that eventually goverment spending must be cut or taxes must rise (or both). Presumably the left wing response to this should be “tax the rich”, which seems quite reasonable.

Conor, we have experienced plenty of things of a similar nature before. The fact that virtually all similar circumstances are beyond effective living memory shouldn’t discount the fact that we can learn from history – that’s why we recorded it and why we have historians to remind us of it.

FWIW I think probably the best example is the panic of 1907 which ultimately resulted in the creation of the federal reserve and an interventionist monetary policy in 1913.

Whether there is enough political will and accountablility to strengthen the present global financial system, how best to do it and whether this is actually desirable is still contestable.

I tend to agree that the opaque links between the central banks and politicians exacerbate problems when things go wrong and that the pain spreads as a result. But I also think that this need not be so provided the central bankers get their houses in order.

So what the correct response (not the left or right response) should be is not to call for drastic shifts in fiscal policy which destabilise confidence further, but to tighten up the enforcement of regulation and shift the burden of tax onto the wealthy in as close to a neutral way as possible.

Spending cuts in this situation would be bad not because of the hardships and suffering that would be forced on the poorest (though those of us effected by cuts would obviously shout loudly), but because this would have a negative impact on the wider economy when stability is at a premium. Tax rises at this time would be worse because this would have the double impact of reducing any growth while reinflating the economy.

If all this sounds strikingly close to the new LibDem plans then I think they should be listened to on this subject.

The person – on the left indeed – who really saw this coming was Soros. The person who said none had “any idea” was Alastair Darling!

I agree it’s necessary but not sufficient just to blame greedy speculation. In fact, the bigger picture is much more serious. Us taxpayers have just realied we’ve been taking over the responsibility of the risks of the financial sector.

So why can Bush implement measures that we were ridiculed for proposing them before it got any worse? When the left warned that the financial sectors’ ability to avoid taxation probably affects social cohesion more than a teenager spraying graffiti on your wall? Would we have been more credible if it had been the “too big to fail” City saying this rather than the social democratic left?

When both the European left & right talk about the “myth of free markets”, don’t we have a “progressive consensus”? Of course not, it’s easy for the right which holds power in most European countries to blame the markets now when they themselves didn’t do anything about it before. But let’s move beyond the “we told you so” and the “I believed this all along” and look how we can get out of this mess.

If taxpayer’s money is conributing to cover the highly increased risks the financial institutions has been making, isn’t it only fair that those financial institutions contribute more to insure citizens against the risks that they face?

You might argue that the problem’s gone global but the solution can only be national given how complex and different tax structures are in each country. So how about a transaction tax, like for example the Tobin Tax?

What’s the Tobin Tax? It taxes currency conversions in foreign exchange markets which reduces the incentives to speculate in the short term. How does this add up? Given the turnover in these markets is around $3.2tn, even if you went for a very cautious 0.05% tax, you would create a revenue of at least $400bn a year.

But won’t the financial sector complain about this new tax? Maybe, but are they complaining about the money the taxpayer is bailing them out with?

OK so now what do we do with that money? We could start by using it to help insure our residents from life risks. And then we could making the system more transparent.
Now that doesn’t sound too radical does it?


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