A Review of ‘Chasing Goldman Sachs: How the Masters of the Universe Melted Wall Street Down…and Why They’ll Take Us to the Brink Again’ by Suzanne McGee (2010, Crown Business)
This book is an excellent complement to the academic stuff I’ve read on the causes of the financial crisis. These latter accounts are very detailed in terms of ‘what’ happened but tend to be light on the ‘why’. ‘Chasing Goldman Sachs’ goes a long way to filling that gap.
The academic consensus view seems to be that driven by an increase in demand for safe places to save there was a huge increase in deposits held by financial institutions and collateralised by Asset-Backed Commercial Paper (ABCP). A significant proportion of this paper was comprised of securitised mortgages – many packaged in such a way that their quality was opaque. The toxicity of these was enhanced by dodgy ratings and shuffling to off-balance-sheet vehicles. When problems with some of these mortgages arose it took a while for holders of these ‘shadow-banking’ deposits to sort out whether or not their deposits were collateralised by bad assets or good ones. There was a panic and large-scale dumping of these deposits which led to loss of liquidity in the market for short-term interbank loans. Without these loans banks find it very difficult to balance their books at the end of each day as they are obliged to. (A good guide to all this from the academic point of view and to further more technical reading is at http://www.nber.org/papers/w17778.)
So the ‘why’ questions become:
- Why was there so much additional demand for large chunks of saving that required collateralisation?
- Why were poor-quality mortgage assets allowed to find their way into supposedly high-quality collateral?
- Why was the nature of these poor-quality assets hidden by the approach of the financial institutions and the rating agencies?
Englebert Stockhammer of Kingston University, UK, has argued that the answer to Q1 can be found in a combination of rising inequality and international financial deregulation. McGee’s book does a good job in answering Qs 2 and 3. There were opportunity and motive to make enormous short-term gains from the huge wave of money flowing around looking for a home – much more than could be recycled into productive investment. The potential gains going to individuals were so large that the long-term fate of their institutions, let alone the financial system as a whole, was of no consequence even if they ever thought about these.
Deregulation of banks allowed them increasingly to use assets on their own balance sheets to leverage large, risky and profitable transactions. Their operations were increasingly about maximising the returns on transactions in which their own capital was at risk, rather than fees earned for safely managing the capital of others. Thus it is hardly surprising that their diligence in looking after the interests of their clients/counterparties dramatically decreased. ‘Chasing Goldman Sachs’ documents well the pressures brought to bear on any individuals who were less happy about these developments!
My own main research interest is in the real (rather than the theoretical) working of the monetary system and its relationship to economic processes that involve real people, goods and services. According to my reading of the way bank lending works, the existence of large quantities of savings looking for a profitable home is actually the result of a dysfunctional economy; one in which banks are creating money in excess of genuine consumption or investment needs. Why should banks do this – since a failed loan results (eventually) in a hit to their equity capital via the profit and loss account? One semi-rational reason is that loans are riding on the back of speculative bubbles, and every lender is hoping they will be repaid before the bubble bursts. Less rational (from the institutional point of view) is reckless fee and bonus-generation activity by managers and employees. Third I guess is just stupidity. All of these appear in Suzanne McGee’s account!
One might predict (hope, anyway) that the stupidity would have been flushed out of the system by the financial crisis, but there is of course no reason to suppose that the incentives driving the first two reasons for excess loans and money creation have changed much.
As this book rightly and repeatedly emphasises, the financial system is a utility primarily for allocating purchasing power where it generates most welfare. Bank loans create that purchasing power for the purpose of allowing production, consumption time-shifting (especially of housing services) and asset re-allocation. That purchasing power actually disappears when the loan is repaid, which allows the quantity of money in the economy to fluctuate in line with the quantity of goods and services being produced and additional value being created. Inevitably, because mistakes are made and because individuals want to save despite the paradox of thrift in the aggregate, not all money created finds its way back to the banks as anticipated. In which case institutions can ‘intermediate’ between these savers and firms needing money to repay loans (or, in practice, other immediate purposes) and reduce the inefficiency resulting from the lending mistakes and saving desire. Because money mainly exists as bank deposits the mechanisms of payment between individuals, firms and the government also take place through the banking system. Any other activities banks get involved in are essentially secondary to these primary purposes.
Thus it is essential and appropriate that banks are prevented from doing anything that puts these primary roles at risk. But how to do so without limiting their ability to provide purchasing power where and when needed, or their ability to intermediate efficiently? McGee describes the regulations aimed at doing this as well as several instances of individuals trying to run their (small) institutions in this way. I think she is quite correct in her views of the limitations of all this.
My view is that the best way to tackle this is to internalise the externalities, by changing the governance of banks to a much more social model by ensuring employee, customer and community representation in their governance. In some ways this model recalls George Bailey’s institution in ‘A Wonderful Life’ but modern versions actually exist in Europe and no doubt elsewhere. The German Sparkasse system was remarkably resilient during and after the financial crisis – maintaining its loan issuance much better than the big German banks. On the other hand similar institutions in Spain apparently made quite a lot of local property and construction loans that went bad – governance has to be competent whoever is doing it.