The Berry | Whatever your political colours

[Hugo Hadlow]
The banking crisis is not a result of market failure. It is the result of two things: the ownership structures of investment banks, and government intervention in the money market.

Most investment banks are owned by dispersed shareholders, and their shares are traded on the stock market. Management is divorced from ownership, with the result that the shareholders can exert little
control over fund managers. This separation of ownership from control means that traders are free to gamble with other people’s money. In a growing economy, everyone does well on average and traders enjoy large bonuses. But if investments turn out to be bad, traders face almost no sanction. It is not their money that is lost; the most a trader loses is his job. This leads to excessive risk taking.

Three of the big five Wall Street investment banks have gone under. Yet hedge funds, which before the crisis were thought to be much riskier, have not been hit nearly as hard. This shows that the problem is not with markets, but with the structure of investment banks.

Hedge funds are privately owned, often as partnerships. Fund managers usually invest their own money as well as others’, so they have incentives not to take huge risks. The small size of hedge funds
allows managers to assess fund manager performance more closely. It also means that if bad decisions are made, they cannot have such large effects. If a hedge fund goes bust, the effect on the economy is less significant.

Big banks are therefore looking at changing their business structures. UBS is considering splitting its asset-management and investment banking businesses.

The second, bigger problem is government intervention in the lending market. A simple example is legislation in America which discourages lenders from denying mortgage applications from fear of being accused of racism. The Community Reinvestment Act has coerced lenders into allowing riskier mortgages, ultimately leading to more repossessions when borrowers couldn’t make their repayments.

But the central banking system is a more systemic problem. Governments keep the interest rate artificially low by lending money at a lower rate than the going market rate. A small player wouldn’t have much effect, but because governments can print money, they exert a large enough influence on the market to change the interest rate. After years of inflating the money supply, most of the pounds and dollars in circulation are lent by the central banks. As well as being the cause of inflation, this allows investments in riskier activities which wouldn’t be allocated resources by a free market. It creates bubbles or inflates certain markets, such as the housing market.

The debt bubble that has been built up over the last decade or so is the real cause of the current economic crisis, and central banks are to blame. They provided the cheap money which underpinned the growth of debt. The so-called “Greenspan put” refers to twenty years of US Federal Reserve policy to cut government interest rates aggressively every time drops in market confidence threatened the long economic boom. The 1987 stock market crash; the Gulf War; the Mexican crisis; the Asian crisis; the Long Term Capital Management hedge fund debacle; Y2K; the internet bubble burst; 9/11; and now: every time, US rates were slashed. Often, US government interest rates were actually lower than the inflation rate: real interest rates were negative. That is really cheap money.

Investors in the UK and US increasingly believe that when things go bad, the government will inject liquidity until the problem gets better. Governments do so every time, and the perception has become
firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking. The end result has been moral hazard in risk taking and has caused bubbles in equities,
credit, real estate, and commodities.

The knowledge that the government will bail out any business distorts the market: it encourages rash decisions in the short term, and in the long term stupefies the market from adjusting to changes in demand and technology. Ultimately, “capital injections” do not prevent credit crunches. They exacerbate business cycles and make the crunches bigger when they inevitably do come.

Bad ownership structures are not a long term problem. As long as their shareholders are not bailed out, banks will fix themselves. But government intervention is a long term problem. Central banks should be abolished. Government should not interfere with the market interest rate. The only way to long-term economic health is to trust the markets.