Ideology, Paving the Road to Financial Ruin

"A fool and his money are soon elected" - Will Rogers

An Emergent Crisis

In Ending the Divine Right of Bankers we looked at the way in which democratic governments have become subject to the whims of markets: and how markets may soon find themselves bowing to the dictats of voters. However, this is only half the story because it would be a mistake to see this as an orchestrated outcome by a cabal of shadowy figures. Instead it’s just happened, an emergent property of the interaction of democracy and capitalism.

Of course the road to ruin is littered with good intentions and what we’re now seeing is the natural tendency of trends to overshoot. It’s the result of a nasty combination of free market ideology taken to extremes and the self-interest of corporations, exploiting any opportunity to enhance profitability and bonuses. It is, as ever, an outcome of combinatorial human behavioral errors rather than a set of deliberate policies.

Busting Unions and Inflation

We can trace the beginning of the economic problems that we’re now suffering from to the introduction of neoliberal market reforms in the early 1980’s by the Reagan administration in the United States and the Thatcher government in the United Kingdom. In both cases these leaders were driven by a belief that free markets were the best way of ensuring economic prosperity and the best possible outcome for the largest number of people.

In the UK this found its expression in mass privatisation of publically owned companies and an attack on restrictive trade union practices which ended in near civil war as the government took on the mining unions and, at huge cost to both sides, won. In the US a similar stand-off with air-traffic controllers led to a swathe of sackings. These upheavals were accompanied by economic reform as the Volker Fed led an attack on inflation, eventually driving out the psychological expectation that it was inevitable – whereupon it no longer was: as we related in Revisiting Volker.

Johin Williamson's paper on What Washington Means For Policy Reform  is probably the best statement of neoliberal ideology in practice, covering ten key policies: low fiscal deficits, protection of property rights, limitation of pork barrel subsidies, floating exchange rates, managing tax rates to encourage innovation, deregulation, a reduction in trade barriers, privatisation of the state, freedom to move money overseas and so-called financialization - essentially a method of deriving the financial value of pretty much anything.  Most of us will probably think all of these things as being generally good but the problem is that if you push any idea to its limits you end up with unforeseen consequences.

Liberalisation Good, Ideology Bad

Although the disruption implementing these policies caused was painful the turbulent seventies were transformed into the long boom years of the eighties and nineties – the longest period of economic growth in history. However, humans learn some lessons quickly and not particularly well; and the lesson our leaders took on board was that if free markets led to economic growth then freeing them more would be even better. In essence, a clear-sighted understanding of the benefits of neoliberalisation gave way to a dogmatic, ideological belief that removing all shackles and constraints on corporations was the way to achieve a better world.

Ideology, unfortunately, is a poor basis for engineering change. There's evidence that we're poor at ignoring our preconceptions at the best of times, even in experimental conditions where we're encouraged to do so: it's what Charles Taber and Milton Lodge call "partisan reasoning", although we know it rather better as confirmation bias:

"When citizens evaluate evidence in ways that allow them to maintain or even bolster their attitudes in the face of contradictory evidence".

This seems to be a social effect, rather than just an internalised set of irrational biases. As Jost, Ledgerwood and Hardin express it in  Shared Reality System Justification and the Relational Basis of Ideological Beliefs:

"Humans excel at believing what they wish to believe, sometimes even in the face of disconfirming evidence and the individual’s thoughts, feelings, and behaviors are influenced by others much more than is typically recognized"

In essence, prior convictions of all kinds, including political convictions, work to determine behavior, rather than rational thought processes weighing and evaluating new evidence on its own merits.  In part this seems to be motivated by a need to defend existing relationships and social networks: we're just not very good at changing our minds.

Glass-Steagall

Perhaps the defining moment of hubris for economic liberalisation came with the repeal of the second Glass-Steagall Act, put in place during the Great Depression to ensure that banks couldn’t cause endemic crises across the US financial system. Glass-Steagall enforced barriers between commercial banks and investment banks, following the experience that allowing the latter to gamble on securities had led to the failure of the former, while they were still twinned.  Following a concerted campaign by financial institutions the Act was largely repealed in 1999 because it was limiting their ability to expand – which, of course, was precisely the reason it was introduced in the first place.  Given free rein the banks promptly repeated the errors of the 1920's.

The UK has its own Glass-Steagall moment: the introduction of light-touch regulation of financial institutions. Which, in essence, meant that they were allowed to regulate themselves. The ideological argument behind this was simple: no organisation would allow itself to become so indebted that it would risk its very existence – so there was no point in tight supervision. This is the Titanic Effect writ enormous: what’s the point in putting lifeboats on a ship that can’t sink? Unfortunately the designers of this system, like the designers of the Titanic, missed the point that humans aren’t very good at predicting the past, let alone the future.

These, and a whole set of other pro-market reforms, were the result of the ideological capture of the political classes. If free market reforms led to greater economic growth – and more votes – then surely even more far-reaching free market reforms could only be better. Politicians in particular took note of the death throws of the Reagan-Bush and Thatcher-Major administrations – brought down by economic failures, rather than political ones.

Regulate Me - Lightly

In this environment governments were an easy touch for financial institutions looking for more and faster growth through lighter regulation; which in turn led to ever higher levels of personal debt. And the faster the growth the happier the politicians as successive governments spent their burgeoning tax returns on ever bigger public sectors, conflicts in faraway foreign lands, tax giveaways and whatever pet projects they could think of next; and the happier the voters as they immersed themselves in whatever they desired, backed by the ever-easier availability of debt, or 'credit', as it was cunningly renamed.

So when economic turmoil arrived, in the wake of the dotcom crash, it was no great surprise to see markets bailed out through the Greenspan Put, as interest rates were slashed to promote economic growth. Indeed, as the dotcom crisis was a pure bubble helping to deflate it safely with minimal collateral damage may well have been the correct move at the time. However, once markets get the idea that they’re onto a free-ride then they tend to pro-cyclicality – each time you save the world with government cash you set yourself up for the next bust, when you’ll need even more money to bail it out.

Of course, when the sub-prime bust came, as a result of ever more lax and negligent supervision, the amount of cash needed to rescue the world’s financial institutions was astronomical. At the time this was justified in terms of Keynesian economics, but the promoters of this policy have rather ignored the fact that John Maynard Keynes argued that fiscal policy needed to be directed to preventing booms just as much as busts: you need to save money in the good times in order to fund the bailouts in the bad, not run up debts in the former like a child let loose in a toyshop with someone else's credit card.

Regulate Me - Later

By this time governments had become so addicted to a free market ideology in which they were essentially funded by the financial sector that it was pretty much impossible to tell the two apart, a fact not helped by the rapidly revolving door between commerce and politics. Government desperation to boost economic growth lies behind their recent travails, and much of the resistance to introducing regulation to prevent a further bust: pushing Basel III banking regulations out into the far distance is a way of trying to balance the wish for economic growth now against the desire to introduce more control later.

Underlying this is the issue that more regulation means banks holding more capital – which means them lending less – which means less economic growth. Unfortunately the banks aren’t actually lending very much anyway, being too busy taking back all the umbrellas they lent out when the sun was shining. As economic stagnation starts to set in the underlying ideology is beginning to crumble, politicians are gradually getting the idea that economic growth is no longer an option and that they need to find some other new idea rather than expressing free market views with which people are no longer happy. There are hints of such ideas around, which we'll revisit shortly, but it will take a major shift in public consciousness to bring them into the mainstream.

A Rail Crash Waiting To Happen

All of which argues that ideology is a poor basis upon which to run economic policy. Freer markets are better than regulated ones, but only up to the point at which you compromise safety. In the UK we actually have a single moment that defines this: the rail crash at Hatfield in 2000. In this a train came off the tracks and careered into a station; by a miracle only 4 people died. The national rail companies had been privatised, and the company responsible for running the rail network and ensuring its safety was incentivised to maximise its profits.

Profit is the responsibility of private corporations; safety that of public bodies. We need both and any ideology that argues otherwise is mad, bad and founded in a range of psychological misunderstandings that ensure the people who hold it should never, ever be allowed near the levers of power. Otherwise the global economy is just a rail crash waiting to happen.

Related articles: Basel, Faulty?, Game On: Basel III, To Predict the Next Bust Ask An Austrian, The Business of Capital is Bust