The economics of occupation

As we picked our way through the tents outside St Paul’s Cathedral this Monday one thing was clear: anarchists are not an easy bunch to organise. Not a surprise, perhaps, but add to this a passionate belief in not telling others what to do, and suddenly you find yourself voting about whether to vote… We visited the makeshift campsite for a couple of hours, waiting for the General Assembly at 7pm. The meeting didn’t get under way for another half hour while some organisers politely asked the crowds to take a seat by the cathedral’s imposing steps. The whole effort was like herding cats but where the cats are dead. Throughout the meeting, organisers repeated and repeated how everything was “just a suggestion”. But while this disorganisation was all rather cute and harmless, it slightly undermines the message that people in this country ought to hear – our economy needs change.

These protests are for a reason – the world’s economy is still in a mess. Banks and global financial institutions are powerless to solve this crisis. Governments are even more impotent. How much of this can really be a surprise? We have more or less the same economic system today as that which brought the economy to its knees just three years ago; we built an engine that we didn’t know how to fix and no-one has come up with anything different.

Banks and global financial institutions are powerless to solve this crisis

In 2008 policy makers could at least plead naivety; who could have seen the sudden collapse of the world’s largest banks? And who could have known the full effect of this on our interconnected companies and countries?

Well actually Joseph Stiglitz, that’s who. This professor of economics and Nobel laureate was our Cassandra. He was preaching long before the housing bubble and credit default swaps of the inherent dangers posed by lax legislation and misaligned incentives. His 2010 book Freefall, recently updated, is his victory lap. But more than “I told you so”, Stiglitz offers a way out of the mire. Politicians would do well to head his advice. For all their vague talk about “justice”, the St Paul’s protestors could too.

Market Failure

Stiglitz lays the blame for the crisis squarely at the feet of free markets and their ideologue proponents. Key to the collapse of the financial system was the problem of externalities, he argues. Externalities are by-products of business for which there is no market mechanism to account - sometimes positive, sometimes negative. If I own a bee farm and an orchard sets up next door, the orchard benefits significantly from my bees’ pollination without affecting me. But should the orchard owners not pay for this privilege? This is an externality - the market provides no way of paying me. A negative externality would be global warming – harm is caused by business but not in a way penalised by the markets.

Stiglitz argues that banks, with their light touch regulations, posed huge negative externalities on the economy as a whole in a number of ways: the misunderstanding of risk, performance related pay and implicit government subsidy.

Risky Business

Before making a loan, banks need to understand the risk associated with the borrower defaulting and adjust the interest rate accordingly. But to further decrease risk, banks started to package loans together with assumption that the more loans one had, the more the risk was spread out. This was fine, provided defaults weren’t correlated. But when house prices started to fall across the country, defaults became very correlated indeed. Because many of these loans had been packaged together in highly complex ways, banks suddenly realised that they couldn’t really tell which loans were safe and which weren’t. They also couldn’t trust the safety of other banks and so stopped lending to each other, resulting in the credit crunch. Stiglitz’s verdict is clear – commercial banks shouldn’t be allowed to create products they don’t fully understand. As US Treasury Secretary Henry Paulson quipped, “the only useful financial innovation in recent decades has been the cash machine”.

Performance related pay and other oxymorons

Performance related pay was abandoned by most professions when it became clear that it rewarded quantity, not quality and encouraged short term results. These are precisely the problems plaguing modern banking. Bonuses are paid for gains but pay is not docked for losses, promoting excessive risk taking as bankers just couldn’t lose. Mortgage vendors were rewarded according to the number of mortgages issued, not their quality, leading to the phenomenon of “liar loans” for which borrowers required no proof of income. Even after the Crunch, the flow of bonuses continued, making a mockery of the claim that they were performance based.

Bankers on benefits

But perhaps the strongest externality was the implicit guarantee that the government would always save the biggest banks to protect the rest of the economy. This safety net enabled banks to take much greater risk at much lower interest rates - a subsidy of billions of dollars, greatly distorting the market. When the bailouts were received, very little was loaned on to small and medium sized business, the risks of speculation were still too tempting.

What’s to be done?

Unlike some of London’s protesters, Stiglitz is no communist and recognises the importance of markets - the key is regulation. As the world sits on the brink of what may well be a double dip recession, here are his suggestions for policy changes to make a difference:

1. Separate commercial banks from investment banks - banks shouldn’t be taking huge risks with ordinary households’ money.
2. Require banks to keep some of the mortgages they sell on their books to ensure they have a vested interest on providing loans to those how can afford them.
3. Give share holders greater say over executive pay and stop payments in stock options - they encourage short-term thinking.
4. Require bailout funds to go to small and medium sized business. Much of it is their money, after all. This is Stiglitz’s manifesto for change. As protesters endure the biting winds outside St Paul’s, they could do worse than adopt it too. Free markets have failed but markets can still work within sensible rules. But this isn’t the whole story. The protestors are also campaigning against the erosion of our democracy, in which government rules in the corporate interest rather than the public interest (the trickle-down myth used to pretend that the two are one and the same), and they are also protesting the enormous inequality in our society.

2008 should have been our wakeup call. Instead policy-makers decided that it was just part of the normal capitalistic boom and bust. It’s clear that there has been a much deeper shift. We need to re-evaluate how we run our society, and to whose advantage the current system is geared. Failure to change in 2008 brought around the current difficulties. The world cannot afford to make the same mistake twice.