"What the bourgeoisie therefore produces, above all, are its own grave diggers” – Karl Marx, ‘The Communist Manifesto’, 1848.
Toward the end of the movie ‘The Big Short’, the oleaginous Deutsche Bank salesman played by Ryan Gosling tells how swathes of bankers get jailed for bringing the US economy to its knees. It is, of course, a canard. The movie finishes with Gosling reflecting that the debt-money-go-round is still turning and that financiers had not only escaped largely scot free, they were still at the controls.
The past is a different country. During the French revolution, the Bourbon finance minister, Joseph Foullon de Doué, was hanged from a lamppost. His decapitated head was then paraded through the streets of Paris on a spike, his lifeless mouth stuffed with hay and horse shit. If we believe the bankers, demands for higher capital buffers, complex new regulations, fines and general meddling, make regulators akin to a baying Parisian mob. That is delusionary thinking.
The privatization of gains and socialization of losses in the run up to and aftermath of the global financial crisis (GFC) spawned a righteous anger. The aftershocks are still being felt today: the Brexit vote and election of Donald Trump have left the neoliberal elites dazed and confused. The GFC and political events since have been like earthquakes; the underlying tectonic plates of history have been shifting over many decades. Inequality has been rising inexorably.
In his recent book, ‘The Great Leveller’, Stanford professor Walter Scheidel charts the history of inequality from the dawn of settled societies to the modern day. It should be required reading for ‘Davos man’ and the delegates at the IMF/ World Bank meetings. At some point, Scheidel argues, inequality becomes unsustainable and begets its own destruction. The result is one of four apocalyptic outcomes: war, violent revolution, societal collapse, or pandemic disease.
The twin peaks of inequality over the last millennium have been medieval Europe on the eve of the Black Death and 1914, as the great empires teetered on the brink of World War I. The latter date has particular resonance today.
The belief that unfettered markets and self-regulation were universal goods reached its apex during Alan Greenspan’s long tenure (1987 to 2006) at the helm of the US Federal Reserve System. Chairman Greenspan was a key player in the repeal of the Glass-Steagall Act (1999) and the Commodity Futures Modernization Act (2000), which freed swathes of over-the-counter derivatives, including credit default swaps, from the scrutiny of regulators.
Greenspan’s memoirs, a paean to his intellectual mentor Ayn Rand and the merits of deregulation, hit the bookshelves just as the credit crunch began to bite in September 2007. When Bear Stearns was rescued on March 14, 2008, there were some bankers that showed a hint of humility. Josef Ackerman, then chief executive of Deutsche Bank, said: “I no longer believe in the market’s self-healing power. Deregulation has reached its limits.”
|Jamie Dimon, JPMorgan’s CEO has reverted to bankers’ default setting of denial|
Bankers have largely since reverted to their favoured default setting: denial. Jamie Dimon, CEO of America’s biggest bank, JPMorgan, is an enthusiastic supporter of president Trump’s declared intention of turning back regulations put in place since the GFC. On a conference call with analysts in January 2015 he railed against the layers of regulators he had to deal with. Dimon asked rhetorically: “How American is that?”, as if the Dodd-Frank Wall Street Reform and Consumer Protection Act had somehow despoiled the vision of the Founding Fathers.
More recently, in April this year, he declared the too-big-to-fail issue as essentially “solved”. Just five years previously, a London-based JPMorgan trading division reporting directly to Dimon suffered losses that have been estimated at more than $7 billion. It may be that too-big-too-fail has been “solved”, but as JPMorgan’s London Whale trading debacle shows, its ugly twin, too-complex-to-manage, is in rude health.
That has not stopped bankers crying foul about the burden of new regulations. The minutiae of what is good and what is bad regulation is an issue for another day. Boiled down to their essentials there are two main strands of regulation that have emerged since the GFC: a demand for more capital, liquidity and scrutiny and a resolution mechanism in the event of failure.
Banks take risks. If those risks go wrong, there should be enough equity capital to absorb the losses. If those risks go very badly wrong, due to recklessness, cupidity, stupidity, or some toxic cocktail thereof, that bank should disappear without taxpayers paying a penny. Most rational, well-informed observers would say that is fair enough.
But wait a minute, the bankers plead, have you seen the effect on our return on equity? It is true that, industry-wide, this has more than halved since the GFC. But whether ROE is an appropriate measure of a bank’s performance is also highly questionable as it takes no account of the debt and risks taken to achieve those returns.
The amount of equity a bank uses is determined, to a degree, by regulators. The Basel rules simply codify the common-sense principle that riskier activities should be matched by greater capital. But even the new rules cap leverage at 33 times (typically tier-1 capital of 3% of non-risk-weighted assets). That is more than 10 times the average leverage employed by hedge funds.
It is the job of asset managers and other shareholders to weigh both risk and return. Most will rightly conclude that ROEs in the 20s achieved by some banks before the GFC were a direct result of risk taking. This rewarded bankers in the short term through their salaries and bonuses.
Ultimately, shareholders and, in some instances, taxpayers, paid the price. It is no surprise that higher valuations are placed on firms focused on relatively low-risk activities such as wealth management, or that analysts at Berenberg still believe banks are “uninvestable”.
Bank CEOs complaining about regulation can readily be called out for speaking from narrow self-interest. Unfortunately, there is also a revolving door between banks and the regulators, and increasingly Wall Street and the political sphere. Two of president Trump’s most influential economic advisers are his treasury secretary, Steven Mnuchin, and Gary Cohn, director of the National Economic Council. Both are alumni of Goldman Sachs.
Cohn is widely tipped as the most likely successor to Janet Yellen as the chair of the Federal Reserve next year. Before they consider his credentials to lead America’s principal banking supervisor, members of Congress should read a speech Cohn made at the World Economic Forum in Davos in 2011.
Josef Ackerman, then chief executive of Deutsche Bank, said: 'I no longer believe
in the market’s self-healing power. Deregulation has reached its limits.'
The setting, the annual jamboree of the neoliberal establishment (for which ‘partners’, including most of the world’s biggest financial institutions, pay more than $500,000) was appropriate. Cohn warned that the greater regulation of banks would push risky activities into the “opaque” and “unregulated”, “shadow banking sector”.
At the time, this was interpreted as an attack on hedge funds (average three-times leveraged). Almost all hedge funds are, in fact, regulated in the same way as mainstream fund management companies. They act as agents in markets on behalf of clients, as well as putting their own capital at risk. When hedge funds go bust, clients and general partners bear the losses. Many thousands of hedge funds were crippled by the GFC; no ordinary taxpayer paid one penny of those losses.
Compare their activities to the banks (up to 33 times leveraged under ‘onerous’ new regulations). They act as principals. They take risks that are sometimes foolish and they do not understand. During the GFC, taxpayers had to bail many of them out. The next financial crisis will not be the same as the last. But it is fatuous to pretend that hedge funds are a greater systemic risk than the big banks.
In spite of reregulation, the GFC has arguably increased the systemic risk from banking via the sovereign-bank nexus or ‘doom loop’. The increase in global debt by around a third since the crisis is in part a reflection of government debt-to-GDP ratios rising to support the banking sector, particularly in the UK and the eurozone periphery. The zero-risk weighting given to government debt under Basel rules means sovereign distress is felt by the banking sector and vice-versa. It has the potential to be a danse macabre.
Global central banks have also debauched their balance sheets by buying $15 trillion of debt in a desperate attempt to roll the reflation dice once more. Quantitative easing may have helped the global economy recover, as central bankers intended. But we still do not know what the negative externalities are. There is, at the very least, frothiness in asset prices. Keeping interest rates at record lows has also encouraged a debt-fuelled consumption binge.
The US equity market trades at 25 times trailing earnings, compared to a long-term average of 15. Robert Shiller’s cyclically-adjusted measure stands at levels last seen prior to the dot-com bust in 2000 and the 1929 crash. Argentina, a serial defaulter, can issue century bonds at a yield of 8%. The UK popular press has recently reported that homeowners have been taking equity out of their houses to punt on financial markets.
Cov-lite leveraged loans almost disappeared after the GFC, but made up 67% of all new issuance in the first quarter of 2017. According to Wells Fargo, there has already been more than double the amount of money raised for collateralized loan obligations so far this year than during the whole of 2016. The mountain of debt just keeps growing. The Institute of International Finance recently reported that debt reached 327% of global GDP, the highest ever, in the first quarter.
It is all too eerily reminiscent of the summer of 2007 when the VIX languished and the S&P500 soared to new records. Leverage, carry trades and the alphabet soup of structured credit all screamed of risk-seeking behaviour run riot across markets, even as likely future returns fell. Then in August, lightning struck as if from a clear blue sky.
But if markets look disturbingly familiar, many other things have changed. Perhaps the most enduring legacy of the crisis is a loss of faith. Bankers (or journalists) have probably never ranked highly on people’s list of the most trusted professions. But belief in the ability of governments to deliver on their promise of prosperity was becoming entrenched after more than a decade of low inflation and robust growth. Greenspan was known as “the maestro”.
Political differences were about nuance. Tony Blair’s Labour Party gave the Bank of England independence, munched prawn cocktails in the City, declared itself intensely relaxed about people getting filthy rich and supported George W Bush’s disastrous foreign adventures. For some this era signalled an end to ideology. In fact, it marked the almost universal triumph of a single world view: neoliberal globalized capitalism.
In a thought-provoking report, Barclays has called this period “hyperglobalization”. The foundations were put in place by the post-World War II Bretton Woods system (the World Bank and IMF), the early rounds of the General Agreement on Tariffs and Trade (Gatt), increasing European integration and the falling cost of transportation.
Hyperglobalization began in the early 1990s after the collapse of the Berlin Wall, the signing of the Maastricht Treaty, the creation of the World Trade Organization and the integration of China and eastern Europe into global trade networks and supply chains. It has been supported by capital account liberalization, rapid technological advances and the free flow of money, people and ideas.
As well as facilitating capital flows, banking has been among the most globalized of all sectors of this new economic order. But, since the global financial crisis, it has also led its retreat. The McKinsey Global Institute reports that global cross-border capital flows have shrunk by 65% since 2007, from $12.4 trillion to $4.3 trillion. Half of that decline can be attributed to a drop in cross-border lending and other banking activities.
In Europe, tensions within the eurozone have created a Balkanized banking system where lenders have retreated to national boundaries and look to ‘match-fund’ within those borders. It is ironic that the enablers of hyperglobalization may now herald its limitations.
Pervasive discontent with the neoliberal agenda is not hard to find. Gatt has gone nowhere, the Trans-Pacific Trade Partnership is unlikely to be signed and the Transatlantic Trade and Investment Partnership is dead on the vine. Brexit suggests the high-water mark of European integration has already ebbed. President Trump calls the North American Free Trade Agreement a “bad deal”, while hostility toward China is growing.
There is a further irony that is probably lost on the nabobs of neoliberalism that gather at the World Economic Forum. Davos is also the setting for Thomas Mann’s novel ‘The Magic Mountain’. Mann began writing in 1912. This was the apex of what Barclays calls the “golden age” of globalization. The book’s main protagonist, Hans Castorp, fittingly, is the son of Hamburg merchants. At the end, he sets off for the slaughter of World War I. What followed was the Great Depression and economic nationalism.
Globalization, as measured by Barclays, did not return to its pre-World War I levels until the current era. The Great War also overlaps with Scheidel’s most recent peak of inequality.
Coincidence? Perhaps. But the hooves of his four horsemen are becoming audible. It would be wise to listen to what they could portend and act to spread the benefits of hyperglobalization more evenly before they gallop over the horizon.
Andrew Capon has worked as an analyst, strategist, communications specialist and financial journalist for more than 20 years. He has won multiple awards for commentary on markets, investment and asset management. The views expressed are the author’s own.