The Great Degeneration: How Institutions Decay and Economies Die (5 page)

The rule of law has many enemies. One of them is bad law. Formally intended to ‘promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail” [institutions], to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes’, Dodd–Frank is a near-perfect example of excessive complexity in regulation. The Act requires that regulators create 243 rules, conduct 67 studies and issue 22 periodic reports. It eliminates one regulator and creates two new ones. It sets out detailed provisions for the ‘orderly liquidation’ of a Systemically Important Financial Institution (SIFI). It implements a soft version of the so-called Volcker rule, which bans SIFIs from engaging in ‘proprietary trading’, or sponsoring or owning interests in private equity funds and hedge funds. But that is not all.

Section 232 stipulates that each regulatory agency must establish ‘an Office of Minority and Women Inclusion’ to ensure, among other things, ‘increased participation of minority-owned and women-owned businesses in the programs and contracts of the agency’. Unless you believe, with the head of the International Monetary Fund, Christine Lagarde, that there would have been no crisis if the best-known bank to fail had been called ‘Lehman Sisters’ rather than Lehman Brothers, you may well wonder what exactly this particular section of Dodd–Frank will do to ‘promote the financial stability of the United States’. The same goes for Section 750, which creates a new Interagency Working Group, to ‘conduct a study on the oversight of existing and prospective carbon markets to ensure an efficient, secure, and transparent carbon market’, and Section 1502, which stipulates that products can be labelled as ‘DRC conflict free’ if they do not contain ‘conflict minerals that directly or indirectly finance or benefit armed groups in the Democratic Republic of the Congo or an adjoining country’. Conflict diamonds are bad, of course, as are race and sex discrimination, not forgetting climate change. But was this really the appropriate place to deal with such things?

Title II of Dodd–Frank spends nearly eighty pages setting out in minute detail how a SIFI could be wound up with less disruption than the bankruptcy of Lehman Brothers caused. But in the final analysis what this legislation does is to transfer ultimate responsibility to the Treasury Secretary, the Federal Deposit Insurance Corporation, the District of Columbia district court and the DC court of appeals. If the Treasury Secretary and the Federal Deposit Insurance Corporation agree that a financial firm’s failure could cause general instability, they can seize control of it. If the firm objects, the courts in Washington have one day to decide if the decision was correct. It is a criminal offence to disclose that such a case is being heard. How this extraordinary procedure is an improvement on a regular bankruptcy is beyond me.
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Perhaps, on reflection, SIFI should be pronounced ‘sci-fi’.

As I have suggested, it was the most-regulated institutions in the financial system that were in fact the most disaster-prone: big banks on both sides of the Atlantic, not hedge funds. It is more than a little convenient for America’s political class to have the crisis blamed on deregulation and the resulting excesses of bankers. Not only does that neatly pass the buck it also creates a justification for more regulation. But the old Latin question is apposite here:
quis custodiet ipsos custodes?
Who regulates the regulators?

Now consider another set of regulations. Under the Basel III Framework for bank capital standards, which is due to come into force between 2013 and the end of 2018, the world’s twenty-nine largest global banks will need to raise an additional $566 billion in new capital or shed around $5.5 trillion in assets. According to the rating agency Fitch, this implies a 23 per cent increase relative to the capital the banks had at the end of 2011.
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It is quite true that big banks became under-capitalized – or excessively leveraged, if you prefer that term – after 1980. But it is far from clear how forcing banks to hold more capital or make fewer loans can be compatible with the goal of sustained economic recovery, without which financial stability is very unlikely to return to the US, much less in Europe.

Lurking inside every such regulation is the universal law of unintended consequences. What if the net effect of all this regulation is to make the SIFIs more rather than less systemically risky? One of many new features of Basel III is a requirement for banks to build up capital in good times, so as to have a buffer in bad times. This innovation was widely hailed some years ago when it was introduced by Spanish bank regulators. Enough said.

Unintelligent Design

In the preceding chapter, I tried to show the value of Mandeville’s
Fable of the Bees
as an allegory of the way good political institutions work. Now let me introduce a different biological metaphor. In his autobiography, Charles Darwin himself explicitly acknowledged his debt to the economists of his day, notably Thomas Malthus, whose
Essay on the Principle of Population
he read ‘for amusement’ in 1838. ‘Being well prepared’, Darwin recalled, ‘to appreciate the struggle for existence which everywhere goes on[,] from long-continued observation of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. Here, then, I had at last got a theory by which to work.’
¹⁸
The editor of the
Economist
Walter Bagehot was only one of many Victorian contemporaries who drew the parallel back from Darwin’s theory of evolution to the economy. As he once observed: ‘The rough and vulgar structure of English commerce is the secret of its life; for it contains the “propensity to variation”, which, in the social as in the animal kingdom, is the principle of progress.’
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We shall hear more from Bagehot below.

There are indeed more than merely superficial resemblances between a financial market and the natural world as Darwin came to understand it. Like the wild animals of the Serengeti, individuals and firms are in a constant struggle for existence, a contest over finite resources. Natural selection operates, in that any innovation (or mutation, in nature’s terms) will flourish or will die depending on how well it suits its environment. What are the common features shared by the financial world and a true evolutionary system? As I have argued elsewhere,
²⁰
there are at least six:

• ‘genes’, in the sense that certain features of corporate culture perform the same role as genes in biology, allowing information to be stored in the ‘organizational memory’ and passed on from individual to individual or from firm to firm when a new firm is created;
  
• the potential for spontaneous ‘mutation’, usually referred to in the economic world as innovation and primarily, though by no means always, technological;
  
• competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist;
  
• a mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance – that is, ‘differential survival’;
  
• scope for speciation, sustaining biodiversity through the creation of wholly new ‘species’ of financial institutions;
  
• scope for extinction, with certain species dying out altogether.
  

Sometimes, as in the natural world, the financial evolutionary process has been subject to big disruptions in the form of geopolitical shocks and financial crises. The difference is, of course, that whereas giant asteroids come from outer space, financial crises originate within the system. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with ‘mass extinctions’ such as the bank panics of the 1930s and the Savings and Loans failures of the 1980s. A comparably large disruption has clearly happened in our time. But where are the mass extinctions? The dinosaurs still roam the financial world.

The answer is that, whereas evolution in biology takes place in a pitiless natural environment, evolution in finance occurs within a regulatory framework where – to adapt a phrase from anti-Darwinian creationists – ‘intelligent design’ plays a part. But just how intelligent is this design? The answer is: not intelligent enough to second-guess the evolutionary process. In fact, stupid enough to make a fragile system even more fragile.

Think of it this way. The regulatory frameworks of the post-1980 period encouraged many banks to increase their balance sheets relative to their capital. This happened in all kinds of different countries, in Germany and Spain as much as in the United States. (We really cannot blame Ronald Reagan for what happened in Berlin and Madrid.) When property-backed assets fell in price, banks were threatened with insolvency. When short-term funding dried up, they were threatened with illiquidity. The authorities found that they had to choose between a Great Depression scenario of massive bank failures or bailing the banks out. They bailed them out. Chastened by ungrateful voters (who still do not appreciate how much worse things could have got if the ‘too big’ had actually failed), the legislators now draw up statutes designed to avoid future bail-outs.

Dodd–Frank states clearly that taxpayers will not pay a penny the next time a SIFI goes bust. It is rather less clear about who will pay. Section 214 is (mercifully) unambiguous: ‘All funds expended in the liquidation of a financial company under this title shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments.’ So what about secured creditors, the bank bondholders whom so much was done to protect from loss in 2008–9? Prudently, Dodd–Frank commissions a study on that one. After all, if the net effect of the legislation really is to rule out any public funding for a seriously bankrupt SIFI, it is hard to see how those bondholders can avoid a sizeable loss. But if that is the case, then the cost of capital for big banks must rise, even as their return on equity is going down. You wanted to reduce instability, but all you did was increase fragility.

Another and related way of thinking about the financial system is as a highly complex system, made up of a very large number of interacting components that are asymmetrically organized in a network.
²¹
This network operates somewhere between order and disorder – on ‘the edge of chaos’. Such complex systems can appear to operate quite smoothly for some time, apparently in equilibrium, in reality constantly adapting as positive feedback loops operate. But there comes a moment when they ‘go critical’. A slight perturbation can set off a ‘phase transition’ from a benign equilibrium to a crisis. This is especially common where the network nodes are ‘tightly coupled’. When the interrelatedness of a network increases, conflicting constraints can quickly produce a ‘complexity catastrophe’.

All complex systems in the natural world – from termite hills to large forests to the human nervous system – share certain characteristics. A small input to such a system can produce huge, unanticipated changes. Causal relationships are often non-linear. Indeed, some theorists would go so far as to say that certain complex systems are wholly non-deterministic, meaning that it is next to impossible to make predictions about their future behaviour based on past data. Will the next forest fire be tiny or huge, a bonfire or a conflagration? We can’t be sure. The same ‘power law’ relationship seems to apply to earthquakes and epidemics.
²²

It turns out that financial crises are much the same. And this should not surprise us. As heterodox economists like W. Brian Arthur have been arguing for years, a complex economy is characterized by the interaction of dispersed agents, a lack of any central control, multiple levels of organization, continual adaptation, incessant creation of new market niches and no general equilibrium. Viewed in this light, as Andrew Haldane of the Bank of England has argued, Wall Street and the City of London are parts of one of the most complex systems that human beings have ever made (see Figure 2.1).
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And the combination of concentration, interbank lending, financial innovation and technological acceleration makes it a system especially prone to crash. Once again, however, the difference between the natural world and the financial world is the role of regulation. Regulation is supposed to reduce the number and size of financial forest fires. And yet, as we have seen, it can quite easily have the opposite effect. This is because the political process is itself somewhat complex. Regulatory bodies can be captured by those whom they are supposed to be regulating, not least by the prospect of well-paid jobs should the gamekeeper turn poacher. They can also be captured in other ways – for example, by their reliance on the entities they regulate for the very data they need to do their work.

Figure 2.1 Network connectivity balloons for the international financial system

Source: Andrew Haldane, Bank of England (see note 23 for full reference).