1 March, 2010Issue 11.4Economics

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Everything Must Go

Mike Jakeman

foerJohn Lanchester
Whoops!: Why Everyone Owes Everyone and No One Can Pay
Allen Lane, 2010
240 Pages
ISBN 978-1846142857

If it is possible for anyone to have benefited from the global financial crisis, then book publishers may have a stronger claim than most. Understanding the crisis as it unfolded was almost impossible, given the speed with which a series of monumental events occurred, the amount of new terminology that suddenly sprang up, and the fact that not even those in the stricken banks, building societies, and insurers (never mind the industry regulators and their respective governments) seemed to have a clue what was going on.

In the 18 months since the crisis reached its peak, canny publishers have bailed out befuddled readers with a plethora of new books on the subject, ranging in tone from the sardonic (F.I.A.S.C.O.—note the sardonic use of acronyms) to the self-flagellating (Confessions of a Sub-Prime Lender). Given the number of titles, choosing the right tour guide to pick through the debris of the ruined financial landscape can seem an onerous task. It makes sense to choose one of the (surprisingly few) commentators who suggested that such a catastrophe was possible. As such, Financial Times columnist Gillian Tett has emerged from the crisis with her reputation enhanced, and her book, Fool’s Gold, has become the set text on the subprime crisis.

However, another less obvious figure can also claim to have seen what was coming. A novelist by trade, John Lanchester was drawn to the City as a possible setting for a new piece of fiction. Instead, struck by the lack of understanding of modern finance (he describes the City as equivalent to “a far-off country of which we know little”), he dug a bit deeper. He discovered how a combination of mathematical ingenuity and blind-eyed regulation had resulted in the widespread use of financial instruments that were capable of delinking bankers from the risk inherent in their investments. In an essay for the London Review of Books in January 2008 he showed how this moral hazard led to the run on Northern Rock, and concluded that “if our laws are not extended to control the new kinds of super-powerful, super-complex and potentially super-risky investment vehicles, they will one day cause a financial disaster of global-systemic proportions.”

Within nine months, Lanchester enjoyed the dubious pleasure of being proved right. His latest book, Whoops!, extends the argument of his original essay, plotting the entire course of the crisis, from its origins (which he locates, contentiously, in the collapse of communism in Europe at the end of the 1980s) to the range of unhappy options we face in financing the cost of the bailouts and stimulus. Within 200 pages he manages to cover the behaviour of bankers, governments, regulators, consumers, and even money itself, each of which, he argues, was an important factor in the crisis. Lanchester’s position as a City outsider enables him to adopt the pose of an outraged everyman, as aghast at the more sensational elements of the crisis as his imagined reader, the average taxpayer on the street.

Whoops! aims to break down the complicated elements of the crisis so they can be understood by everyone. Lanchester’s description of the mystery of the City also hints at another, loftier aim: that of making the country’s financial centre less obscure, in the hope that bankers will then be made to be more accountable. To make the economics less daunting, however, Lanchester fills the book with heavy-handed references to pop culture. It seems a stretch to link the financial crisis to The Wire, The Simpsons, and Zoo and Heat magazines, and so it proves. This is a shame, because Lanchester is not only capable of explaining complex financial operations, he excels at it. His coverage of derivatives, an instrument so misunderstood that it broke the entire banking system, is cleverly explained in terms of personal finance, and is delivered with such clarity that it should be photocopied and stuck to the desks of every new investment banker.

Yet this is not to suggest that Whoops! is a dry read. Lanchester’s incredulous response to the crisis is most effective and entertaining when he comes across moments of true absurdity; moments when it seemed that the whole industry had become so focused on maximising profits and divorcing itself from risk that it threatened to separate from reality entirely and float off into space. There are plenty of these moments, but three stand out. First, Lanchester describes how in 2000 the US Congress was so seduced by the country’s banking sector that it passed legislation to exempt credit-default swaps (CDSs, contracts whereby the buyer assumes the risk of the seller defaulting on its debt in exchange for a fee) from the kind of regulation that is applied to other, similar instruments, such as options and futures. It also guaranteed that CDSs could continue to be traded over the counter, rather than through a monitored exchange. The result was the Commodity Futures Modernisation Act, “a law that actually banned legislation”.

Another is the development of securitisation, which enables swaps that contain different levels of risk to be grouped together and sold. By interspersing high-risk investments with safer ones, the sting is supposedly taken out. The result was a whole new market for lenders, as investments that were previously considered too risky to touch could now be reconsidered. Suddenly, the age-old relationship between lender and borrower was reversed. Potential homeowners no longer went to the bank for a mortgage, the bank came to them, and it came in the hope of signing them up to unusually high interest rates so that the debt that they had created could be pooled and sold on. That there was no accounting for what might happen if the new owners couldn’t pay leaves Lanchester “reeling with incredulity”.

The third moment was a change in the way that ratings agencies were funded. Before the mid-1970s, ratings that assessed the riskiness of different types of debt were accessed through a subscription service. However, the US regulator, the Securities and Exchange Commission, decided that the debt-issuer should pay the agency for its ratings. This meant that the more ratings the agency produced, the more it earned. In addition, agencies were paid three times as much for assessing mortgage-backed securities as for regular corporate bonds. Furthermore, “the banks were not shy about saying that if an agency would not give them the rating they wanted, they would go shopping elsewhere.” Unsurprisingly, this led to the highest grades being awarded to the riskiest debt, a complete perversion of the rating system.

Lanchester’s pose as an outraged taxpayer enables him to examine the crisis from almost every angle, but he is weaker on possible macroeconomic factors. The idea that sub-prime mortgages were only made possible thanks to a prolonged spell of low US interest rates, which in turn was enabled by the purchase of enormous amounts of US government debt by China, is dismissed in a couple of paragraphs, although he does confess that the China-US relationship “gives me the willies”. In fact, part of the trap that befell US house buyers is that low interest rates caused house prices to rise, which meant that buyers not only had to take on bigger mortgages, but also that property came to be regarded as a risk-free investment. Both of these are among the many factors responsible for the crisis. To lay the blame, however, at the door of Asian central bankers for failing to encourage consumption instead of saving would run counter to Lanchester’s argument. For him, the crisis is an indication of the need to re-examine Western ideology and to learn to recognise when we have had ‘enough’. The motivation to do this is provided by this concise but stirring account of the crisis.

Mike Jakeman graduated in 2006 with a BA in English from Keble College, Oxford. He now works for the Economist Intelligence Unit.