There are times when certain decisions have an unusual impact on subsequent events. We reach, in other words, a ‘fork in the road’, and the choices taken – or not taken – have an incalculable impact on the future.
The weekend of 13/14 September 2008 represented precisely one of those forks in the road. At just past 7am on Saturday 13 September 2008, Jamie Dimon, the CEO of JP Morgan, walked into his home library and dialled into a conference call with his management team. Here is what he told them:
You are about to experience the most unbelievable week in America ever, and we have to prepare for the worst case. Here’s the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11 bankruptcy protection]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.
There was a collective gasp on the phone. Unsurprisingly so, since what Dimon was envisaging amounted to an extinction level event for Wall Street.
The US authorities had reached that fork in the road: To shore up Lehman Brothers – and the rest of the investment banks? Or let them fail and allow the tender mercies of the free market to do their worst?
Our own fork in the road came just three weeks later.
The journalist Ian Fraser takes up the story. The following brief extract is from his book Shredded: Inside RBS:
[Then chancellor] Alasdair Darling landed in Luxembourg at 7.15am on Tuesday 7th October for a meeting with other EU finance ministers. He had only been in the meeting for a few minutes when his special advisor, Geoffrey Spence, called him out. RBS shares were in freefall and had already been suspended twice that morning.
Darling went back into the meeting, only to be called back out again an hour later. RBS chairman Sir Tom McKillop was on the line. Darling, who was looking out over a rain-swept industrial estate, says: “He sounded shell-shocked. I asked him how long the bank could keep going.” His answer was chilling. “A couple of hours, maybe.”
Once again, our monetary authorities were faced with the same decision. Bail out RBS? Or let the free market take its scalp?
In both cases, the administrations elected (after the messy collapse of Lehman Brothers, at least) to step in and salvage the banking systems. In doing so, they initiated a course of events that has changed financial history and the entire focus of modern economic theory.
Whether it was the right thing or not to bail out the bankers is now a purely academic issue – there is no counter-factual, so we will never know what the consequences of free market practice might have been. For what it’s worth, I side with the journalist and author and former bond salesman Michael Lewis. On the fifth anniversary of Lehman Brothers’ bankruptcy, Lewis was asked in an interview with Bloomberg BusinessWeek whether he thought the company had been unfairly singled out when it was allowed to fail – given that every other investment bank would then be quickly rescued by the US taxpayer. His response:
Lehman Brothers was the only one that experienced justice. They should all have been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would all have paid the price. It’s a close call, but I think the long term effects would have been better.
What are some of the long term effects that arose after the bail-out of the banking system?
In the first instance, we now live with explicit financial repression. Interest rates have been driven down towards zero and in some cases, below it. Danish mortgage-holders, for example, are now being paid to borrow money – Alice in Wonderland economic policy if there ever was.
In a world of zero interest rates, strange things happen. You might think that economic activity would swiftly rebound. That is not what has transpired. The blogger MarkGB (whom you can follow on Twitter via @MarkGBblog – and I recommend that you do) addresses the problem:
Beyond a certain level of indebtedness, which we reached earlier this decade, the psychology of the markets shifted…not as in ‘gear change’…but as in ‘tectonic plate’. This is how the shift has affected behaviour:
- a) Consumers refuse to buy any more crap that they don’t need with money that they don’t have. So they ‘make do’ with what they’ve got. This used to be called ‘common sense’.
- b) Business people – who lose their jobs unless they return earnings to shareholders – realise that an economy where the cost of money is zero is artificial and sick. The last thing they have felt emboldened to do, for years now, is to invest in a glowing future that is nowhere in sight. So instead, they borrow to buy back their own shares, which boosts earnings per share and keeps them sitting round the boardroom table…for now, anyway.
- c) Savers – a selfish bunch of responsible human beings who are thoroughly disapproved of by economists (a selfish bunch of irresponsible human beings who thoroughly approve of themselves) – rather than thinking ‘what’s the point in saving at these rates, I’ll buy stuff’…think: I’d better save even more to make sure I can support myself in retirement’.
- d) Banks, who can make billions from front-running the Federal Reserve, who can park their QE back at the Fed for interest, have no imperative to provide loans to the diminishing number of smaller businesses who are still looking to expand.
In short…QE (Quantitative Easing), ZIRP (Zero Interest Rate Policy) and NIRP (Negative Interest Rate Policy) have been deflationary, not inflationary.
If MarkGB is right, and I am minded to believe that he is, it is beyond a disgrace that the implementation of QE as monetary policy implemented by our central banks has not been more vocally challenged. It is now a commonplace to lament the economic inequality that austerity has brought in its wake. But what if economic inequality had been massively reinforced by the very QE that central banks have forced into the system? By printing trillions of dollars, pounds and euros out of thin air and then pumping that cash into the financial markets, our central banks have inflated the prices of stocks, bonds and property. Mark 4:25:
For he that hath, to him shall be given; and he that hath not, from him shall be taken even that which he hath.
For those who already possessed financial assets before the crisis, QE has made them effortlessly richer. For those who had nothing by way of financial assets before the failure of Lehman Brothers and the implementation of global QE programmes, they are now undeniably worse off. They earn nothing by way of savings, jobs are more difficult to come by, wage growth is derisory, and housing has become far more unaffordable. Thanks, Mark Carney, for doing your bit for social cohesion.
The extraordinary monetary support given to the banks has had other consequences too. It has led to an oblique war on cash. It is now increasingly difficult to transact in physical currency at all. Our monetary authorities would far prefer us to engage in purely electronic transfers. I’m no Luddite and I can see the convenience of electronic cash, but I prefer not to relinquish physical cash absolutely. If our authorities persist in forcing us down an exclusively electronic-only payments system, they can then force negative interest rates on savers, safe in the knowledge that there is no way to evade them.
The ultra-low bond yields that are a function of QE also have consequences. Pension schemes are now laden with government debt at its most expensive levels in world history. By the Bank of England’s own data, interest rates have not been lower for 5,000 years. At the same time, interest rates are slowly in the process of nudging higher (the US Federal Reserve is far further along the process of interest rate normalisation than we are). But there is one iron law in finance: if interest rates go up, bond prices go down. So a generation of savers and pensioners could see most of their assets go up in smoke in the event that a rising rate environment gives rise to a pronounced bear market in bonds. It’s worth checking what’s in your own pension fund, given that I would describe the bond markets today as utterly uninvestible.
There are other consequences, too. Just about every central bank is in the process of conducting currency wars, but clearly not everyone can devalue their currency at the expense of everyone else – there have to be relative winners and losers.
It is also unclear whether the future might involve stagflation – a messy throwback to the 1970s – or perhaps even an uncomfortably high inflation if the central banks finally and conclusively lose control of the printing press.
So be careful what you wish for. In “saving” the banking system, our authorities may have actually done precisely the opposite.
The remedy? There are no silver bullets, but a well diversified portfolio including defensive value stocks, uncorrelated ‘absolute return’ funds, and a healthy exposure to real assets, including the monetary metals, gold and silver, does not strike me as the worst way of trying to navigate what will surely be some challenging months and years to come. Merry Christmas, he said, somewhat ironically.