Money for nothing - crisis for free

Leslie Budd, Reader in Social Enterprise, Open University Business School

Leslie Budd, Reader in Social Enterprise at The Open University Business School, was an academic consultant on the BBC documentary The Love of Money. He discusses the causes of one of the worse financial crashes in living memory.

For Pink Floyd money was a gas; in the film Cabaret it made the world go round and for Abba it was funny in a rich man�s world. It would then seem appropriate that the recent BBC three-part series, co-produced by the Open University, which analysed the causes of the financial crisis should be titled Love of Money. This excellent series developed a strong central narrative based on the interviews with the key players to observe the causes of the crisis. What were these causes? Was it greed pursued by latter-day Ivan Boeskys and Michael Milkins, the formerly disgraced masters of the financial universe, on who the Michael Douglas character and his catchphrase �greed is good� in the film Wall Street seems to have been based?

Although initially appealing, greed, like sin, seems part of the human condition and is thus not exceptional. What is exceptional about this crisis was that it is so explicable. A catenation of events came together to burst a financial bubble and bury the myth that the business cycle (boom and bust) had been conquered once and for all. What this showed was that financial crises are endemic to market economies, and thus it ever was as any student of financial history should know: 17th century Tulipmania; 18th century South Sea Bubble; 20th century Great Crash and East Asian Crisis: and the dot.com crash at the turn of the millennium represent the pantheon of this self-evident fact. Will it happen again? Almost certainly: just the timing, scale and scope will be unknown until it is upon us.

There appear to be some general rules about the nature of conditions from which financial crises will develop and those prevailing in the world�s largest economy at the onset of the 2007 crisis were no different. These include: a large trade deficit; a large fiscal deficit, which is mainly funded externally; and very overvalued currency. The fundamental underlying processes which allowed these conditions to be fulfilled include:

Global imbalances between creditor and debtor nations reinforced the role of the US as the consumer of last resort in fuelling global demand. This was underpinned by large external and internal deficits of the US funded by countries with large trade surpluses, such as China, who bought private and public US$ denominated assets;
Global imbalances fuelled a commodity and other asset booms, as financial institutions sought to exploit the rising demand for natural resources in the emerging economies. The �financialisation� of a range of economic activities over the last two decades further exacerbated imbalances in the world economy;
A global deflationary environment brought about the expansion in the supply of goods produced in the emerging economies which lowered the cost of capital and encouraged financial institutions to seek higher investment returns from riskier assets;
Regulatory changes (for example governments in the US and parts of Europe encouraged the extension of home ownership) and financial de-regulation (including the scrapping of the Glass-Steagall Act introduced in the US after the Great Crash of 1929 which had separated the functions of commercial and investment banks) encouraged more speculative behaviour;
Changes in international accounting rules which introduced �fair valuing� accounting and the unwitting impact of the introduction of new capital asset ratio rules under the Basel II Accord authored by the International Bank of International Settlements which allowed riskier capital to be held by banks in their reserves. The Value-at-Risk models (VARs) that were developed to measure the risk of these changes failed to measure the scale of systemic risk in the financial system. Consequently, banks were able to put �bad� or �toxic� assets into off-balance sheet vehicles;
A low cost of capital encouraged financial institutions to lend to consumers with low creditworthiness and encourage them to apply for mortgages they had no hope of repaying. In the US, loans to this section of the population became known as �Ninjas�: no income, no Job and assets. The assumption was that a continuing rise in house prices would generate a wealth effect that could be capitalised into an income stream that would cover loan re-payments;
The bundling and mixing of mortgage-backed assets (especially Ninja ones) with different risk profiles to produce new financial assets (for example, Structured Investment Vehicles (SIVs) and Collateralized Debt Obligations (CDOs)) which were sold by investment banks with the highest credit ratings. Thus investors in these assets were often unaware of their underlying risk exposure because the credit rating agencies scored them as less risky due to the reputation of the investment banks which issued them � for example, the failed US investment Bank, Lehman Brothers.

All these conditions were underpinned by the belief that the masters and mistresses of the finance universe had developed the means to manage away risk and uncertainty. These means included innovative instruments which used complex mathematical models to measure their risk. The latter ultimately failed to deliver because of the underlying assumption that financial markets are efficient and rational. What these instruments and models cannot ever do is to anticipate the impact of a �Black Swan� moment when a random event overturns all previously conceived notions, for example the 9/11 attack on the New York World Trade Centre in 2001.

For many commentators the bankruptcy of the US investment bank, Lehman Brothers, in September, tipped the global economy into recession. The turning point of the whole financial crisis rests on what is called a �Minsky Moment� named after the late American economist, Hyman Minsky. He developed a five-stage model of financial crises:

Displacement: An external shock leads to profitable opportunities in one sector leading to boom, for example the dot.com and commodities booms;
Boom: Expansion in money supply leading to rapid expansion of channels of credit, which, in turn create, opportunities for speculative investment;
Overtrading: Over-trading in financial assets created by over-borrowing and over-investment;
Revulsion: The perception that the top of market has been reached leads to large and rapid selling of assets which creates a stampede and mania leads to crisis and panic;
Tranquillity: Lender of last resort role of central banks and government monetary easing creates the perception that the crisis can be managed. The Minsky Moment occurs between stages three and four, but we can add two more stages which appear to describe current circumstances:
Retribution: The �fictional� markets created among the financial institutions themselves through new instruments (SIVs etc.) are in free-fall. This leads to a blame game aimed at central bankers as they exercise their �lender of last resort� function and as the power of the financial regulators rapidly reaches its limits The financial system descends into chaos as the new instruments unravel because the underlying assets are found to be close to worthless;
Revisionism: The ideology is promoted that it is not market irrationality, but �Big Government� distorting market behaviour, creating the potential inflationary impulse of rise in budget deficits and national debts as the state underwrites the losses incurred in the system. The financial institutions at the heart of the crisis seek to return to �business as usual�.

Part of the �business as usual� ideology includes the assumption that banks can take public money and run by deciding who they will lend to, irrespective of governmental support and pressure. The total of public support for the global financial system, including: capital injections; government guarantees; asset purchases; and liquidity provisions reached 29% of total world income in 2008. As with any major upheaval, the central question for the post mortem of the crisis is �what is to be done�. This was the concern of the recent International Monetary Fund meeting in Istanbul, to whom the financial journalist Martin Wolf suggested five �Rs�: rescue; recovery; re-balancing; regulation; and reform. Whether the IMF and governments around the world can implement this proposal is open to question, but we should all ask whether the desire has gone out our relationship with finance.

The famous economist, John Maynard Keynes, noted that �bankers are the most romantic and least realistic of men�. Has the flame died in our tryst with money? The financial system has a near-promiscuous ability to find other fish in the sea which suggests that it will always read the last rites for its first love. The one lesson for us all from our love of money is that, if you get money for nothing, you get crisis for free.

For further information, please contact:
Dr Leslie Budd, Reader in Social Enterprise, at the Open University Business School on
t: 01908 653343
e: l.c.budd@open.ac.uk
w: www.open.ac.uk/oubs

About the Open University Business School

The Open University Business School was founded in 1984 and is now the largest triple-accredited business school in the world. It offers a broad spectrum of qualifications, with courses ranging from undergraduate certificates, foundation and honours degrees to the well-established MBA programme, which is accredited by AMBA, EQUIS and AACSB. Courses employ a blend of learning methods including study books, e-mail discussion, internet resources, DVDs, face-to-face online tutorials and residential schools.

The Open University Business School�s alumni include Bart Knols, AMBA student of the year 2007; Air Chief Marshal Sir Brian Burridge; Lieutenant Commander Phil Parvin of the Royal Navy, who was AMBA student of the year in 2002 and Maggie Miller, chief information officer of the Warner Music Group. Companies sponsor more than 45% of the students on its courses, and more than 20% of FTSE 100 companies sponsor members of staff. Clients include Rolls-Royce, Pfizer and the NHS.