What went wrong? In the last Economic View every year, I look back at what I
predicted here in early January, to try to shed some light on the events of
the previous 12 months. This is nearly always a humbling experience that
brings to mind J.K. Galbraith's oft-quoted remark when he was asked about
the outlook for interest rates: “There are two kinds of economists - those
who don't know the future and those who don't know they don't know.” This
year, however, the routinely humbling experience has turned into a ritual
humiliation. How else can I describe the public confession that I am now
compelled to make:
I hereby confess that on or about January 14, 2008, acting of my own free
will, not under the influence of any drug and aware of the consequences of
my actions, I wrote the following statements in The Times: “The global
credit crisis, far from taking a turn for the worse, is now almost over” and
“There will be no US recession” and “Stock markets around the world will
rise in 2008”. Some of my other points now seem less stupid: that Britain
and Europe would suffer worse housing and consumer slumps than the United
States and that sterling would fall against every leading currency. However,
these pale in comparison with my basic misjudgment and I must apologise to
anyone misled by my analysis.
Having admitted my guilt, now let me enter two pleas in mitigation.
First, the predictable excuse that others were also guilty. Almost everyone
underestimated this year's disasters - apart from the Jehovah's Witness
economists who had been predicting the end of the world every year for the
past decade. Even people with enormous personal stakes and access to inside
information failed to see what was going on. Most obviously this was true of
James Cayne and Dick Fuld, the chairmen of Bear Stearns and Lehman Brothers,
who lost their entire fortunes overnight. But consider even George Soros. In
his book The New Paradigm for Financial Markets, Soros precisely anticipated
and described the dynamics of a gigantic “super-cycle”, driven not only by
too much borrowing but also by too much faith in deregulated market forces.
Yet Soros bought shares in Lehman just days before its collapse.
An even more spectacular case came to my attention in an e-mail I received in
mid-November, when global stock markets hit their low-point (so far). Royal
Bank of Scotland, my reader pointed out, spent $100 billion to buy ABN Amro,
the second-biggest bank in the Netherlands, in October 2007. If only the
directors of RBS had been a bit more patient, this is what they could have
bought for the same $100 billion a year later: Citibank ($22 billion) plus
Goldman Sachs ($21 billion) plus Merrill Lynch ($12 billion) plus Morgan
Stanley ($11 billion) plus Deutsche Bank ($13 billion) plus Barclays ($13
billion). And RBS would still have had $8 billion left over to buy a golden
parachute for Sir Fred Goodwin, its discredited chief executive.
However, “everyone else was doing it” is hardly a justification. So let me
move on to my second, more substantial, excuse. Almost all predictions for
2008 turned out to be wrong because economics ultimately is driven by
unpredictable human behaviour, not by fixed scientific laws - and this is
especially true in a crisis. The biggest surprise this year lay not in
economic events but in the reactions of financiers, businessmen, regulators
and politicians.
As the charts show, economic activity, consumer confidence and even housing
and financial conditions all began to stabilise in March, when the rescue of
Bear Stearns ended the first phase of the credit crunch.
It was only in mid-September that “the world changed completely”, as Mervyn
King and other policymakers subsequently admitted. The reason for this
change was perfectly clear: the sudden seizure of Fannie Mae by the US
Treasury and the even more unexpected decision to put Lehman Brothers into
bankruptcy triggered a collapse of confidence in every major financial
institution in the world. Suddenly all the banks and insurance companies
previously considered “too big to fail” were exposed - not only to a
deterioration in economic conditions, but also to an attack of bearish stock
market sentiment or even to an unexpected change in regulatory demands.
It was only when the entire world financial system suffered this unprecedented
nervous breakdown that the real economy of consumption, jobs and industrial
orders fell off a cliff. The corollary is that the world economy might well
have avoided a serious recession had it not been for the Fannie and Lehman
blunders, which triggered the greatest banking panic the world had ever
seen.
To say this is not to deny that financial conditions in many economies had
become dangerously unstable and that drastic reductions in debt and leverage
were required. But most of the excess borrowing had been undertaken by banks
and hedge funds - and not by households and non-financial companies. It was,
therefore, possible for most of the deleveraging to be achieved by financial
institutions repaying their enormous debts to one another, instead of
strangling the non-financial economy with a much tighter credit squeeze.
Indeed, this orderly unwinding of debts within the financial sector was
exactly what happened between the Bear Stearns rescue and the meltdown of
mid-September.
Why, then, did everything go so disastrously wrong at that point? I would
suggest three reasons, all related to accidents of human behaviour rather
than to irresistible economic pressures.
The first big accident was the surge in oil and food prices in spring and
early summer. This actually did more harm than the original credit crunch to
consumer and business confidence and, therefore, to the prospects for
economic recovery. We now know that this surge in commodity prices was a
purely speculative phenomenon, unrelated to any real shortages of supply.
But because of the quasi-religious faith that “the market is always right”,
politicians and regulators refused to intervene directly in the oil market
to curb speculation, leaving consumers and businesses severely weakened when
the Lehman crisis hit.
The second accident was the series of regulatory blunders that climaxed with
the Lehman fiasco but began several years earlier with the adoption of “mark
to market” accounting and the perverse incentives created by “market-based”
capital requirements determined by private rating agencies' potentially
corrupt judgments. These blunders, all of them ultimately motivated by the
fundamentalist credo that “the market is always right”, continued throughout
the credit crunch. Instead of quickly implementing a government-led Plan B
to end the credit crunch, as I had expected, politicians kept waiting for
implausible market solutions and refused to intervene until it was almost
too late.
The third and perhaps most damaging misjudgment has been to subsume
macroeconomic management into political morality. As a result of moralistic
witch-hunts against debt and consumption, pragmatic Keynesian solutions to
the credit crunch have been thwarted by an unholy alliance of ideological
monetarists who believe that the market is always right and ideological
Marxists who believe that it is always wrong. Even worse, consumers and
businesses have started to see recession as a moral retribution for past
excesses, rather than a technical problem that macro-economic policy could -
and should - readily resolve.
Behind all these misjudgments was the naive belief that markets are always
right and that interfering with market forces is always wrong. This boom in
“market fundamentalism”, which Soros brilliantly described in his book, has
now turned to an equally dangerous bust in capitalist self-confidence, just
as he predicted.
My biggest mistakes this year all came down to the disagreement with Soros
that I described here in January: I believed that the instinct of
self-preservation among politicians would prove much more powerful than
market fundamentalist ideology. The credit crunch would, therefore, be ended
quickly by a government-led Plan B, involving wholesale credit guarantees,
bank nationalisation, regulatory forebearance and debt forgiveness. This is
now happening, but only after the boom in market fundamentalism brought the
world much closer to disaster than I ever imagined possible.
For what I imagine possible next year - rightly or wrongly - please return to
this column on January 12.
