Banking Luddites threaten to wreck the engine of recovery

http://www.telegraph.co.uk/finance/c...-recovery.html

Banking Luddites threaten to wreck the engine of recovery
The thirst for revenge over 'greedy bankers', and calls for a return to a 'back-to-basics' approach in banking risks undoing the financial innovation that underpins our long-term growth prospects.

Like the Luddites after the industrial revolution, or those who opposed the spread of the railways in the US and the UK, the campaign against modern banking does have some justice on its side. Rewards for top bankers were grossly inflated and, as it turns out, largely unwarranted given the industry's failure to predict, prevent or ease the global recession that we have now entered, at huge cost to the livelihoods of ordinary people. One only has to think of dark satanic mills or robber barons to see the connection.

But if the Luddites or those who opposed the railroads had won the day, we would all be far less wealthy now. The same is true with the financial services industry today. Like it or not, we are going to need its help to get out of this mess.

Business cycles are often led by technological innovations. True innovation, whether it is the steam engine, the railways, electricity, information and communication technology or, most recently, the raft of supposedly risk-reducing derivative-based diversification strategies through financial markets, implies that we can all expect to be wealthier in future than we were in the past.

The problem is human greed and impatience. Faced with the prospect of windfall gains sometime in the future, human nature is inclined to begin spending some of that right away. Spending runs ahead of the productivity shock that caused it. And financial markets are always more than happy to facilitate, by allowing consumers and investors to borrow against these expected returns.

Hence, as John Vickers, the former chief economist at the Bank of England once observed in the context of the dot.com boom, we often see a boom in demand ahead of any increase in productive supply.

Typically, people will greatly overestimate the impact of the innovation on their future income, hence they borrow and consume too much.

If the authorities and regulators fail to lean against the prevailing wind of optimism enough to dampen that excessive demand before it takes on a logic of its own, asset prices – the key market measure of expected future income – will form a bubble.

Both of these things happened in the recent cycle. First equities and then house prices entered a bubble in which key ratios such as the equity price to earnings ratio or the house price to rent ratio rose to ridiculously high levels. Both were justified by appeal to a brighter future, in which profits would soar, house prices would only ever rise and risk had been traded away.

A correction, first in equity prices (one of the triggers of the 2001 global recession) and then in house prices (the proximate cause of the current recession), was inevitable. Correction has now become recession, and perhaps worse. And the cost of all this has been laid at the taxpayer's feet.

None of which, however, means that there was no logic to the boom in the first place. Despite the booms and busts that accompanied the spreading of the railways to the US in the 1830s to the 1870s, the idea that railways would transform the new country was essentially right.

Similarly, we may not be living in the "new economy nirvana" that some over-excited analysts predicted we would be 10 years ago, but the impact of computers is everywhere. Financial innovation really should mean that we can reduce risk via diversification in a way that had previously been impossible. Risk, like matter, may not be created or destroyed by mathematical formulae, but properly used, financial derivatives do offer a means by which it can be more efficiently spread and hence contained.

Too much, however, was claimed of these new and poorly understood methods of risk-spreading. They were poorly applied − at times fraudulently so. By the summer of 2007, market pricing was suggesting that risk had more or less been eliminated for ever. And regulators took the market's word for it.

The current recession can only be made worse and more prolonged, though, if in a fit of pique we undo the financial market reforms that triggered the cycle in the first place. Put starkly, we need them to get us out of this mess. The financial market reforms of the 1980s triggered a wave of financial innovation, which led to a surge in banking stocks relative to the rest of the market – a surge that reached its pinnacle in 2006. That entire surge has now been reversed. The market's current valuation of the banking sector suggests that the Big Bang was all for nothing.

The markets are pricing in a grim mixture of heavy regulation, state ownership and 'back-to-basics' banking into the foreseeable future. If that is accurate, the Luddites will have won. We will have thrown out the baby of financial innovation with the bath water of excessive compensation, weak governance and poor regulation. It would be the modern equivalent of ripping up the railways back in the late 19th century.

Such a victory would come at a heavy price, reducing trend growth by at least 0.1% to 0.2% per year. That impact would come through the contraction of the financial services industry itself and through the permanently higher interest rates we will have to live with if the innovations of the last two decades are scrapped.

At a time when our governments have, on the behalf of generations to follow, taken on massive contingent liabilities, the last thing we need is a moribund financial sector unable or unwilling to shoulder that risk.

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