Measuring the Economy – A Knotty Problem

A change in focus is needed to make a real difference when measuring economic growth

Measuring the economy can be a bit like estimating the length of the proverbial piece of string.  Even pinning down what to measure before taking out your tape measure is tricky.  What is measured takes on even more importance when it is tied into government policy which aims to make us all better off.  This is a sobering thought at a time when improvements according to the traditional yardstick of GDP often fail to make a difference to the lives of many of us.  Changing what is used as a gauge for economic improvement can have significant consequences for the outcome of economic policy.

Being strung along by GDP

Rising inequality is a hot topic among economists at the moment.  Data shows that the wealth of the rich has increased considerably faster than for the less well-off over the past few decades.  Much of this can be attributed to the forces of globalization - a shortage of

skilled workers in the global marketplace has pushed up their pay while the opening up of countries such as China has resulted in a glut of low-skilled workers which has depressed their wages.  Technology has also added to this trend with computers reducing the clerical and administration work that had been a source of jobs for middle class workers.

Some see inequality as a necessary part of a capitalist economy with industrious people earning more due to their own hard work.  Others point to the social costs of inequality such as higher crime and more health problems and call for more policies to stem this trend.  The lack of advances in the earning power of a large portion of the population will inevitably have serious political consequences such as the rise of populist movements or a growing mistrust of capitalism among young people.  The issue is all the more urgent as it comes at a time when Western countries are struggling to maintain their place at the top of the global pecking order.

The combination of austerity measures and loose monetary policy in most countries is not doing much to address this issue and may be making the situation worse.  Cuts to government spending disproportionately hurt the less well-off while the wealthy have benefitted as quantitative easing has driven up stock prices.  These policies are based on the premise that creating growth in the overall economy will benefit us all.  But the data shows that, for example, while GDP in the UK is expected to reach its previous 2008 high this year, it will take a few more years for average earnings to recover lost ground. 

A different piece of string

The overall size of the economy is becoming increasingly difficult to measure.  So it might be better to focus more on the bit that matters most to people – what they earn and can spend.  Using median (real) earnings as a gauge of the economy would mean that economic growth would be more tangible for more people.  It is also a more simplistic measure which would require less manipulation although it would require some adjustments (to take into account changes in what we spend our money on and whether those goods change in price).

It would be a simple alteration that would have major implications for economic policy.  The welfare of normal people would be the central focus with other related issues such as unemployment also taking on greater importance.  Yet, this would not be a license for wages to rise inexorably as businesses would suffer and any artificially manufactured gains would only be temporary.  On the other hand, measures to help companies, such as lower corporate taxes, would also need to have a positive effect on wages. 

Increasing the median wage would have a more profound effect on the health of the economy and would involve more than simply boosting spending through an increase in debt.  Making progress on this goal would require more long-term policies such as investment in education and reskilling workers in declining sectors.  Lifting earnings would be hard work but the positive results would be genuinely worth the effort.

Banking – Let Financing Flourish

Banks have had to prune back their lending but other forms of finance have found space to blossom

Spring is in the air as a dark winter for the banking sector has allowed new forms of financing to take root.  A range of financing options has sprung up to service businesses left out in the cold by banks.  This is more than just a temporary reprieve from the current dearth of funds from banks.  It could instead be part of a bigger shift whereby banks are no longer the main source of lending.  This development appears to be a good thing for the economy but the full ramifications will only become clear with time.

Diversification in financing

Banks had long been the big trees in the financial jungle.  Their network of branches spread far and wide and claimed the bulk of the chances to provide funds to the economy.  Few opportunities filtered through to other forms of funding, which remained small in comparison.  The global financial crisis has opened up the possibility of change with banks having been poisoned by toxic debt.  Access to credit all but withered away after the crisis cut down a few banks and clipped many others.

The problems in the banking sector are mostly self-inflicted.  There is a glut of cash available for loans but banks are too concerned with their own survival to be in a position to facilitate lending.  A range of companies have sprouted up between the cracks to provide the funding needed to nourish the economy.  These new firms have been labelled as the shadow banking sector and tap into money from a range of sources such as pension funds and businesses outside of the finance sector, as well as from people like you and me through peer-to-peer lending sites. 

The diversity of routes for lending solves one of the problems with the banking sector.  Deposits were not enough to provide banks with all the money that was needed in the lead up to the global financial crisis.  Instead, banks sucked up funds from the money markets where it was possible to borrow for a few months.  This is not an issue when funds flow freely but the money dried up when the crisis struck.  On the other hand, the money being put to use by the new firms comes via an assortment of different arrangements and many, such as pension funds, are willing to offer up cash for longer periods.

When more is better

The growth of the many new sources of financing seems to be positive.  As in nature, higher levels of biodiversity help to build a more robust funding ecosystem.  Such funding operations are still just saplings.  Yet, there is the potential for a future forest of financing options.  Some parts of the new setup may even grow to rival the lending capabilities of banks.  This has only come about through the irony of banks jeopardising their long-term prospects and opening up opportunities for others due to their need to lend less to ensure short-term survival.

There is a further benefit in that any shrinking of banking operations should be beneficial over the long term.  This is because the current rules for banking mean that banks have too much scope to get themselves into trouble.  Not all is rosy however, with some of the new firms facing criticism from the public despite seemingly meeting a genuine need (such as Wonga).  The new range of financing options may also include potential problems lurking under the surface.  But this could be somewhat accommodated by central banks and other regulators broadening their oversight. 

The flowering of new funding options may be one of the few bright spots in the aftermath of the global financial crisis and could help to ensure that the economy won’t have to go through a drought in finance again.

The Economics behind Populist Parties in Europe

Voters kick up a stink in the European elections but mainstream politicians only have themselves to blame

The success of anti-EU parties in the European elections has been in the news over the past week but it is economics that provides much of the backstory.  Voters in Europe have flocked to political parties offering the illusion of a way of opting out of the changes that threaten their livelihoods.  Such frustration is understandable considering that the more established parties have only offered up piecemeal measures as a solution.  Acceptance of the limited options available will be the first step to making real progress.

Going with the flow

The economic prospects of those with few skills are dire.  Many of the sectors that provided jobs for workers in earlier generations have shrunk due to the double whammy of technology and globalization.  Gains in technology have seen a rise in the mechanization or computerization of many tasks.  Globalization has allowed firms to search the world to find the cheapest workers.  These are not trends that are expected to change anytime soon.

Despite the large number of those put out by these trends, the benefits for the economy as a whole have been unprecedented.  Technology has brought a wealth of information and possibilities to our fingertips and outsourcing has made the bulk of things we buy much cheaper.  There is no one who has not gained in some way with the overall gains far outweighing the costs.  The problem is that these costs are borne by a relatively limited number.

In an ideal world, some of the wide spread benefits would be used to compensate those missing out due to the rise of technology and globalization.  However, governments in the Western world have been moving in the opposite direction.  People are increasingly left to fend for themselves with few hand-outs from the government.  The affected workers need money during periods without work as well as help with reskilling to move into growing industries.  Yet, unemployment benefits are being trimmed back and education is becoming more expensive. 

Instead, governments look to shield themselves from the blame, and since no one is going to come out against technology, globalization is the obvious fall guy.  The EU takes the blame in Europe as the epitome of the uncontrollable external forces pushing for more open borders.  Rather than admit that they are almost powerless in the face of outside influences which are part of globalization, politicians offer temporary reprieves.  Typical responses include attempts to limit immigration, moves to block factory closures, railing against takeovers by foreign firms, or moaning about a strong currency hurting exports.  The failure of such actions to have any substantive effect leaves governments open to criticism.  Hence, the rise of political parties proposing to do more.

A dose of honesty

The policies of populist parties will not offer any long-term respite.  It is possible for an economy to shut itself off from the global economy.  However, fighting against the tide of history is not a long term option - a faster pace of economic growth in other countries which are more open will inevitably reveal the folly of such isolation.  Instead of being a viable alternative, the anti-immigration political parties tend to function as a form of protest for voters to vent their frustration at the status quo.  But there is still the possibility of one of these protest parties snatching power, likely with dire consequences.

The main remedy might be something as simple as a bit of honesty.   Politicians need to be more open with voters about the limits of their policies.  This would give them the scope needed to deal with the negative effects of technology and globalization which need more than ad hoc measures.  Long term investment in education and infrastructure will be key in terms of both dealing with the negative and reaping the most benefits.  Now is the time for governments to step up and act or else face a more rapid tumbling down the global pecking order.  Politicians and voters need to come to their senses.  And soon.

Central Banks – false illusion of power

The Bank of England shows how little central banks can do with their limited resources

Everyone looks to central banks as the custodians of the economy.  Once upon a time, central banks were regarded as having almost mythical powers to control the forces of the economy.  However, this fairy tale was shattered by the global financial crisis and central banks have since been trying to regain their previous status as economic titans.  Central banks have fought back with extra powers such as quantitative easing which have helped bolster their popularity.  In contrast, the trouble that the Bank of England is having in dealing with the conflicting problems of a fragile recovery and a booming housing market shows central banks at their most impotent.

The myth and the reality

Much of what central banks do relies on creating a belief in their resolve and ability to call on seemingly unlimited resources.  Chronic inflation in the 1970s was reined in by central banks flexing their muscles and inflation has stayed low ever since.  Even in the throes of a crisis, the European Central Bank kept the Eurozone together merely by proclaiming that it was willing to do “whatever it takes” to do so.

With the power to print money, central banks have the godlike ability to create something out of thin air.  It is often only the ideas of economics that keep central banks from unleashing the full force of their powers.  The ability to summon money from the ether is of limited use when most economists are scared of rising inflation following an increase in the supply of money.  Economics has also restricted central banks to operating only in a small arena, which reduces their capacity to act as a power for good.

One example of this is quantitative easing which helped ease the pain over the downturn but came with side effects.  The purchases of bonds through quantitative easing helped to shore up the financial markets but did little to alleviate a chronic shortage of demand in the actual economy.  A slightly different way of using quantitative easing could have had more punch with less mess but also came with the possibility of some inflation. 

Like something from Greek tragedy 

The Bank of England operates in this world of possibilities, but with only limited options.  It has made use of what was available (low interest rates and quantitative easing) but the economic recovery has struggled to gain much traction even after five years.  Yet, the consequences of its policies have shown up as a housing market boom at a time when the Bank of England still has its hands full nursing the economy.

One thing that the Bank of England is missing is a bit of help from the government.  Not only is the government dragging down the economy with its austerity measures, but it is creating problems with policies such as Help to Buy which stoke up the property market just as the central bank is praying for it to cool down.  For all of their potential power, central banks still have to steer clear of politics putting any criticism of government policy out of bounds.  The government with all of its populist tendencies still trumps an institution established to look out for the long term health of the economy. 

Instead, the Bank of England and its governor, Mark Carney, have tried to use the media to communicate their concerns about the property market.  However, this is having little effect as the Bank of England can be ignored since there are few actions it could actually take to back up its words.  Its main weapon would be higher interest rates but the economic recovery is seen as not yet being strong enough.  It would be a shame to see the Bank of England fall from grace battling a wayward government and a run-away property market but it will take a heroic feat to stop that happening.

UK Interest Rates – putting off the inevitable

Higher interest rates are on their way but are still too scary to talk about

An economic recovery is a timid creature that can be scared away merely by saying the wrong thing.  That is the implication behind statements coming out of the Bank of England which has played down the possibility of higher interest rates.  The Bank of England cut interest rates to a record low more than five years ago, but improvements in the UK economy mean that we are nearing a time when interest rates will have to return to “normal” levels.  This may still be a fair way off considering that the Bank of England seems to think that the subject is too frightening to even discuss.

Why are higher interest rates needed?

It may seem funny to talk about fears in the market at a time when UK stocks are near record highs.  However, many of the gains over the last few years have come with the support of central banks.  Low interest rates coupled with quantitative easing have prompted investors to dive into the stock market in search of better returns.  The property market has also benefited with asset prices in general booming despite the weak economy.

The hope has been that the extra wealth generated as a result of rising asset prices would prompt people to spend more.  This plan has worked to a certain extent with consumer spending being one of the main drivers behind the economic recovery in Britain.  Yet it has also created a problem in that a reversal in this new-found wealth will have the opposite effect and send consumers running for cover.  This line of thought suggests that it would be great if interest rates could be kept at the current low levels.  However, an increase is inevitable.

The main concern for any central bank is that cheap borrowing will create excessive demand and push up inflation.  Your Neighbourhood Economist has argued that these worries about inflation tend to be overblown.  A more pressing problem comes from the UK property market.  Housing prices have surged upward, recovering at a rate considerably faster than that of the overall economy.  This suggests that such gains in property prices are likely to be unsustainable and may cause trouble in the future.  This situation is made worse by the UK government being unwilling to offer much help in stimulating the economy.

What is so scary?

The central bank is caught at a junction where the long-term costs of low interest rates are becoming more obvious relative to the short-term benefits.  Acting too soon could damage a still fragile recovery while problems such as the booming property market could get out of hand if interest rates stay low for too long.  There will be a point where the Bank of England decides that worries about a premature interest rate hike outweigh that of the potential long-term costs but we haven’t reached that stage yet.

The caution shown by Carney in his recent statements suggests that the UK has yet to approach a point where higher interest rates can even be discussed as a possibility.  This partly reflects the possible outcomes facing the Bank of England.  A stalled economic recovery that results from a hike in interest rates would be one of the most dreaded outcomes for a central bank.  On the other hand, the effects of problems such as a housing bubble or excessive debt are only felt years later.

Low inflation adds to the reasons why the Bank of England might take a more cautious approach.  Inflation is not likely to cause trouble anytime soon given weak gains in wages and a strong pound.  A further factor to consider is that the Bank of England will feel the need to forewarn both borrowers and investors that higher interest rates are on their way.  All this points to a hike to interest rates being a bogeyman for some time to come.

Banking – Back to Basics

Time for banks to return to their bread-and-butter operations after having almost poisoned the global economy

Banking is like food – best kept simple with as little processing as possible.  This is because, in their role as the intermediaries controlling flows of money in an economy, banks provide the nutrients which help the economy grow.  What was supposed to be a straightforward process became convoluted as banks cooked up ways to move loans onto others.  The resulting concoctions were devoured by investors around the globe, resulting in serious indigestion once the toxic nature of the ingredients was discovered.  Given that the packaging of dodgy debt was one reason for the scale and severity of the global financial crisis, the common sense move would be to change back to a plain vanilla variety of banking.

A recipe for trouble

We rely on food getting from the farms where it is grown to our supermarket shelves every day.  Too much or too little food would cause problems as would food ending up in the wrong places.  We also rely on banks to look after our money in the same way.  Savers leave their surplus cash in banks who make it available for others to borrow.  This simple analogy is how we tend to perceive the role of banks but, as with many things, the reality is more complicated.

Banks have access to a growing range of funds allowing them to lend as much as demand allows.  This gives them a substantial amount of control over how much money there is in an economy.  Central banks look to control lending using interest rates but the global financial crisis has shown that this is insufficient.  Interest rates tend to be too low when economic growth is booming, giving banks scope to lend more than is optimal.

This problem has been exacerbated with banks being able to sell on loans to investors in the form of bonds.  By passing on the risk associated with lending to others, banks circumvented the normal limits on lending and levels of debt exploded as a consequence.  Debt from banks was sold on as bonds such as CDO and MBS with this alphabet soup of financial instruments eventually proving sickening to the financial system.  Banks had our cake and ate it and the result has been years with the economy being starved of credit.

Creating these nauseating bonds was like using MSG to flavour food – an easy way to get an immediate boost but not good in the long term.  Most of us would steer clear of extra nasty additives in our food for fear of the future consequences.  Bankers, on the other hand, gobbled up any magic pills which boosted their profits in the knowledge that it would not be the banks themselves that would pay the price.  This is a problem which is endemic to banks operating without sufficient regulation.

Smaller is better

Considering the propensity for banks to poison the entire economy, their operations should be pared back to a more traditional and wholesome role.  One means to do this would be to limit the activities of banks and break up larger financial institutions that have parts which operate like conventional banks.  Banks should be limited to a scope within which they cannot get into trouble and need to rely on the government for support.  More speculative aspects of their business should be left to others who should be prevented from accessing our deposits.  Other forms of financing are flourishing and this is already replacing part of what banks do.

The basic idea behind this is already out there and is known as the Volker rule.  It has been endorsed in principle by many in politics including President Obama.  Yet, the implementation of this idea has stalled due to opposition from an unsurprising source - the banking sector.  This highlights another benefit of having smaller banks – a reduction in the dominance of the finance sector.  The wealth generated by banks has given them the political clout to push for more freedom to chase profits.  Banks have built themselves up to be the champagne in the economy (providing skilled jobs and lots of tax revenues).  Yet, since it is all too easy for the bubbles to go flat, a return to a bread-and-butter setup would be preferable.

Growth in China: Steel vs Butter

Diverging fortunes of countries down under illustrate how China is changing

Trading with China can be like a roller coaster ride – lots of ups and downs without knowing what is coming next.  At a time when most of the global economy has been in the doldrums, tapping into the Chinese market has lifted the economies of a lucky few.  Australia and New Zealand are among the fortunate ones, but the diverging fortunes of these two countries highlight a shift in China’s development which will have profound effects for many others.

Riding out the twists and turns

Economic development of any country is never a smooth ride.  Growth in China has been bumpier than most with its economy jumping into life at a time when the world was becoming a much smaller place due to globalization.  The Chinese economy has expanded at an unprecedented pace due to its role as a manufacturing base built on access to foreign markets and funds from overseas. This has resulted in greater scarcity of many of the basic commodities extracted from or grown in the ground.

Countries fortunate enough to possess an abundance of natural resources, such as many in South America and Africa, gained a boost from high commodity prices at a time when the global economy is weak.  But these benefits are likely to be a temporary upturn with demand for commodities shifting as China develops.  The initial stages of the growth in China came through investment amid a building frenzy as firms rushed to put up factories to produce goods for exporting.  This has continued as the Chinese government has ramped up spending on infrastructure to counteract the weak global economy. 

The result has been a prolonged period of China sucking in resources such as iron ore, coal, and natural gas.  However, spending on investment was surging ahead at a pace which could not continue and has shown signs of an inevitable tailing off over the past year or so.  The government has instead eyed consumption as a new source of economic growth and as a means to keep the population happy.  This change in focus in China will be felt throughout the global economy.

Good and bad of changes in China

China was at the forefront of the mind of Your Neighbourhood Economist during a recent visit back home to New Zealand and a side trip to Australia.  Demand from China helped both countries to avoid a downward spiral following the global financial crisis, with Australia racking up an astounding 22 years without a recession.  Yet, it is Australia that is looking nervously at developments in China while New Zealand is looking to raise interest rates due to a booming export industry. 

The reason for concern among Australians is that its mining boom is starting to peter out.  Exports to China are still hitting record highs even as growth in the Chinese economy slows.  But investment in the mining industry has dropped off as commodity prices have fallen.  This leaves Australia in a tricky position as money from mining has pushed up the cost of living, resulting in wages that are too high to be competitive.  Employment may be starting to suffer - Your Neighbourhood Economist struggled to spot many Australians among the cabin crew on the Qantas flights to and from London.

Two gauges of economic health augur tougher times ahead.  The central bank in Australia has pledged to keep interest rates at a record low of 2.5% for some time.  Along with this, the exchange rate for one Australian dollar has dropped below parity with the US dollar after having been worth more than its US counterpart in 2011 and 2012.  In contrast, New Zealand has seen its dollar continue to climb in value with the NZ central bank already having lifted interest rates twice to 3.0% in 2014.  It is milk and cheese that is driving the upturn in the New Zealand economy with the Chinese developing a taste for dairy products as their levels of wealth expand.

The shifting fortunes of Australia show that tapping into a growing Chinese economy has its downs as well as ups.  Despite this, New Zealand shows how change in China can be turned into a positive.  With China as one of the few bright spots in the global economy, this is a story that a lot of countries will be interested in.

US Monetary Policy – Investors face stormy future

US investors have been blessed with calm seas of late but their good luck is unlikely to last

Monetary Policy has entered a period of calm after enduring something of a turbulent passage through the global financial crisis.  The unprecedented tempest which buffeted the banking sector led central banks to trial a number of measures never seen before.  Yet, since tapering of quantitative easing was launched at the end of 2013, it has been relatively smooth sailing.  Tapering has been implemented in steady waves so as to not shake the delicate stomachs of investors.  However, rather than signalling the end of the choppy weather in the financial markets, the current lull could just be the eye of the storm.

Skies clear following predictable monetary policy

Investors prefer favourable conditions in the same way as sailors.  A view far ahead to the horizon is prized in the financial markets as well as by mariners.  One element that helps investors to better plan a course for the future is having a predictable monetary policy as a guide.  Investors had come to rely too much on the Federal Reserve as a steady hand at the helm using quantitative easing to put some wind back in the sails of the US economy.  Problems thus arose when the Federal Reserve first floated the idea of trimming back its expansive monetary policy in the middle of 2013.

What was a stiff breeze for the US hit many emerging markets like a financial hurricane.  This is because a considerable portion of the money printed in the US had travelled the globe in search of more bountiful returns.  Some developing countries had become a haven for the extra cash but the money left in a whirlwind once the prospects for returns in the US picked up.  The resulting market turbulence pushed some countries to the brink of going under, but investors eventually settled down again after adjusting to the new forecasts.

The outlook for US monetary policy has brightened considerably with the steady progression of tapering.  The Federal Reserve has cut back its purchasing of bonds by US$10 billion at each of its meetings, which happen almost every month.  As a result, bond purchases have been reduced a few times already in 2014 and fell from US$85 billion in late 2013 to US$45 billion at the most recent meeting at the end of April.  The predictability of US monetary policy also survived the potential shipwreck that was the change in skipper from Ben Bernanke to Janet Yellen at the beginning of the year.

Forecast for storms ahead

All is well for now.  However, there may be trouble on the horizon as tapering is just the start of the Federal Reserve relinquishing its role of propping up the economy.  A bigger storm may be coming next year as interest rates have to be raised from their current record low levels.  The Federal Reserve has pledged not to change interest rates for a while as it monitors the economic recovery.  Interest rate hikes must happen sometime in the next year or so especially in light of the surprising improvements in the US job market.

The end of quantitative easing and higher interest rates are all part of a voyage back to normality.  It has been a strange new world in terms of both the financial markets and monetary policy following the waves of financial havoc over the past several years.  The recent squalls that hit emerging markets can be seen as a necessary part of this journey.  Nevertheless, other rough patches may still lie ahead considering that it is far from normal for US stocks to be pushing on record highs despite slow economic growth. 

While it is tough to gauge what normal should look like in terms of the financial markets, the signs indicate that rough seas lie ahead.  Emerging markets have already taken a beating which makes it likely that the next storm may strike US investors closer to home.  

No mystery behind banks behaving badly

Banks were misbehaving in the lead up to the global financial crisis but the blame lies elsewhere

Many fingers have been pointed (and fists waved) at the banking sector.  Bankers have been receiving massive pay-outs despite having acted irresponsibly in getting us into trouble.  While they deserve much of the blame for our current woes, it is like blaming students who are left in charge of running their own school.  Bankers were left to run their own affairs on the mistaken assumption that they could do so responsibly.  But the few rules in place to keep banks from acting out proved insufficient.  This raises the question – why were banks given so much leeway in the first place?

A recipe for trouble

Banks are in business to make money.  The most common way for a bank to do this is to loan out money at a higher interest rate than they pay to get access to the funds.  Given these basic guidelines, anybody running a bank would lend out as much money as possible.  This would not be a problem if there was only a relatively fixed amount of cash to go around.  To make more loans, a bank would have to get its hands on more cash which would involve higher costs if spare funds were in short supply.  The extra charges for banks would then result in higher interest rates and this would put off some potential borrowers.

Unfortunately, this is not how things work in finance.  Instead, using tricks such as electronic money, banks can create as much money as they want.  Any limits to lending have been further diluted as banks have come up with ways of getting loans off their books.  Financial wizardry has enabled loans to be repackaged as bonds and sold off to investors.  Such bonds (known as mortgage-backed securities) were popular due to a combination of a decent rate with seemingly little risk.  With lots of money sloshing around the global economy before the financial crisis, investors did not bother to delve into what the bonds actually entailed.

Banks had reduced their lending standards to include sub-prime borrowers as they no longer had to worry about whether the loans were actually repaid.  So what investors got were bonds that would drop in value once the debt-fuelled property boom came to its inevitable end.  The situation was made worse by the way in which bankers were paid.  Their substantial remuneration packages were linked to profits giving bankers an extra impetus to undertake risker actions.  Levels of pay got out of hand as it was easy to make money by tapping into the demand for credit. 

Even if bankers themselves were motivated to cash out after quick gains, it was thought that prudent business practices would keep banks running through thick and thin.  Yet, the number of banking bailouts showed that bankers favoured short-term profits (and big bonuses) over long-term survival.  With the government and the central bank expected to step in if banks got into trouble, it was worth taking extra risks as there were millions to be made and only the possibility of losing their jobs if things backfired.

No one in charge

With it seemingly obvious that bankers were heading for trouble, there was a glaring need for oversight and regulation.  Despite this, banks were increasingly given a free rein following a couple of decades of deregulation of the finance industry.  A wave of free market ideology had convinced a generation of politicians that any government interference would hamper the industry.  The result was that the finance sector was put on a pedestal and afforded the status of teacher’s pet as a source of tax revenues as well as jobs for skilled workers.

Any attempt at oversight typically succumbed to something known as “regulatory capture” where the government agencies designed to monitor the banking sector are too closely intertwined with the banks.  This is because personnel move back and forth between government and finance, always keeping the industry’s best interests at heart.  Even the central banks that were charged with ensuring financial stability did not find fault with the banks.

Instead of taking on the inherent problems in the banking system, central banks developed a narrow focus on inflation.  Interest rates were the main tool with which central banks attempted to rein in the vagaries of the finance sector.  But higher interest rates only target the demand for loans rather than the supply of credit from banks (who actually make more money when interest rates rise).  Interest rates went up too slowly to stave off the credit boom as easy loans from banks opened the way for us to get ourselves deeper into debt.  Given too much freedom, we can all get into trouble and banks have shown themselves to be no exception.