Storm, The (2 page)

The commodity price shock coincided in Britain, the USA, Spain and elsewhere with the creation, and now the bursting, of a
bubble in the housing market. Indeed, the two things are probably linked through the same process of monetary expansion and
contraction. But in addition, a new generation of home buyers, property investors and builders had persuaded itself that prices
only ever go up, and that property was a guaranteed way to accumulate wealth. All historical experience should have taught
us otherwise. There were regular building cycles in the UK throughout the eighteenth century, which were measured by historians
as having an average of sixteen years from peak to peak, with continuing boom and bust cycles in the nineteenth century.

There is room for debate about the precise speed of the metronome, but a contemporary analyst, Fred Harrison, looking at the
twentieth century has come up with a figure of nineteen years. And throughout modern economic history, the bursting of property
bubbles has been one of the key trigger factors leading to earlier periods of recession: Britain in the 1990s; Japan at the
same time and for longer; and now the USA and the UK, again. By now, governments should have worked out how to recognize and
anticipate these bubbles, and, at least, deal with them in a rational manner. Yet the British and American governments are
treating the problem as if it were being encountered for the first time. Moreoever, their instinctive reaction to deflation
in commercial
and domestic property prices has been to reinflate the markets. Any sign that the fall in house prices is being arrested is
treated as a triumph and proof of recovery, even though it merely provides yet another fix, feeding the drug habit of property
speculation.

The bursting of the house price bubble has been linked in turn to the so-called ‘credit crunch’, around which much of this
book centres. Bank credit has been drastically curtailed in the wake of a collapse of confidence in the financial system.
Markets have become fearful of contamination by bad debt, originating in US sub-prime mortgages, but now more widely diffused.
The idea that financial markets are prone to excess, instability and panic is hardly new. The experience has been endlessly
repeated throughout history. If we go back to John Stuart Mill, his analysis of irrational market expectations, based on a
dramatic financial crisis in 1824–6 (and earlier events in 1712, 1784, 1793, 1810–11, 1814–15 and 1819), describes very precisely
what happens when a ‘frenzy’ of ‘over-trading’ leads to a cycle of intense speculation, crisis and depression: ‘the failure
of a few great commercial houses occasions the ruin of many of their numerous creditors. A general alarm ensues and an entire
stop is put for the time being to all dealings upon credit: many persons are thus deprived of their usual accommodation and
are unable to continue their business.’

Today, illiquid small businesses, and people trying unsuccessfully to remortgage their houses, will know exactly what Mill
meant by the loss of ‘the usual accommodation’ by their once-friendly local bank managers. That earlier crisis was eventually
stopped by borrowing money from France and by distributing a stash of old banknotes found to have been hidden away in the
Bank of England. Today’s crisis is very much more complicated, but has the same basic architecture.

The history of financial bubbles should now be well understood. However, successive generations of financiers and investors
have deluded themselves that they have, at last, found a foolproof way to manufacture riches without undue exertion: tulips
in the
seventeenth century; South Sea stocks in the eighteenth; various manias over emerging markets in the nineteenth; through to
Wall Street in the 1920s. Then, more recently, there has been Latin American sovereign debt in the 1970s, Japanese land in
the 1980s, British and Scandinavian housing in the 1980s (again), the Asian Tigers in the mid-1990s, new communications technology
in the late 1990s, as well as our latest excitements.

A generation ago, Hyman Minsky described the mechanisms by which financial markets regularly overreach themselves, through
excessive leverage, excessive risk-taking, greed and folly, leading to panic and then to ‘revulsion’: the stopping of credit.
He would have recognized the contemporary commentators, bankers and politicians who, as with each preceding generation, have
solemnly asserted that the world has changed and financial crises have become less likely, thanks to new technology and their
own collective cleverness. Of course, they have not. And it is precisely the high level of technological sophistication and
international economic integration that makes the recurrence of financial mania and crashes now so far-reaching and worrying.

I start with the past, since it reminds us that, whatever the contemporary uncertainties, there are lessons to be learned
from what has gone before. This does not mean that I am a deterministic fatalist. Every stock exchange crash and banking crisis
does not need to be followed by a Great Depression. Every burst property market bubble does not need to be followed by a Japanese
decade of stagnation. Every boom in food prices does not mean that poor people should go hungry. There are better and worse
ways of dealing with these problems, and hopefully historical perspective and comparative experience should help us to find
the better ways.

It is especially important to reflect on the wider historical context, since the current combination of circumstances is particularly
dangerous and potentially very destructive. The management of a collapsing housing market combined with a severe crisis of
confidence in financial markets and institutions,
as in the USA and the UK, would be difficult at the best of times. But, coincidentally, policy has been complicated by the
need to respond to an inflationary commodity price shock, particularly in oil (and gas). And the commodity price shock originated
with booming demand in emerging countries, led by China, whose economies are no longer dominated by the Western world and
which are only tenuously integrated into the rules and institutions overseeing the world economy. Indeed, there is a plausible
argument, discussed in detail in
chapter 4
, that China’s emergence, and the imbalance in trade and in domestic savings and
investment between the USA and China, explain the financial bubbles of this century. The unifying thread of common interest
is being frayed to breaking point, as we have seen with the collapse of the world trade talks and the attempts being made
to blame the current crisis on American self-indulgent weakness or manipulative Chinese Communist authorities.

Yet if there is one lesson above all to be learned from historical experience, it is that nothing is more beguiling or more
destructive than the siren voices of nationalism and its contemporary variants. Inter-war fascism has disappeared, but there
are more subtle voices seeking to scapegoat foreigners, especially yellow and brown ones, or migrant workers in our midst,
or else setting out a protectionist programme in the name of food or job or energy security. Less potent, but also dangerous,
are those who, under a red flag – and sometimes under a green flag – work to destroy the liberal economic order and suppress
markets and capitalism altogether.

This conjuncture of extreme events and an increasingly hostile political environment has been described as a ‘perfect storm’.
This short book tries to describe how that storm originated and where it might lead.

Economic storms, like those in nature, come and go. They cannot be abolished. But, as with hurricanes and typhoons, they can
be anticipated and planned for and a well-coordinated emergency response, involving international cooperation, can mitigate
the
misery. They also test out the underlying seaworthiness of the vessels of state. The fleet has been plying a gentle swell
for some years and making impressive progress. But big waves have already exposed some weaknesses. SS
Britannia
, said to be unsinkable, has sprung a serious leak, and the vast supertanker
USA
is listing badly. Passengers and crews have noticed that most of the life rafts are reserved for those in First Class. Extraordinary
seamanship has kept most of the fleet afloat, however; and the big Chinese and Indian container ships managed to keep out
of the eye of the storm. How many ships will finally make it back to port in good order after the storm is, however, still
in doubt.

On 13 September 2007, exceptionally long queues started to form outside branches of the Northern Rock bank across Britain.
They were not queuing to pay their bills or to talk to the bank manager about a new loan. They were frightened. They wanted
to withdraw their savings. The Bank of England had announced that it was supporting the bank, which was in financial difficulties.
Depositors, far from being reassured, were alarmed. And as the television broadcast pictures of worried savers queuing to
take out their money, others joined them. On one day £1 billion was withdrawn. A few days later, the panic ended when the
Chancellor of the Exchequer fully guaranteed all the bank’s deposits. But Britain’s financial establishment had been shaken
to the core. Britain had experienced its first ‘run’ on a bank since Overend Gurney in 1866.

A country that prided itself on being in the forefront of financial innovation and sophistication had been shamed by the kind
of disaster normally experienced in the most primitive banking systems. The only visual images most British people had of
banking panics were television pictures of bewildered and angry Russian
babushkas
impoverished by pyramid-selling schemes disguised as banks in the chaotic aftermath of communism, or ancient black and white
photographs of Mittel-Europeans desperately trying to force the doors of imposing but barricaded buildings in the 1920s. But
this was Britain in the twenty-first century!

For those not caught up in the panic there was a collective national embarrassment, like that experienced when Heathrow Airport’s
Terminal 5 didn’t work or when a national sports team is humiliated. But there was a deeper anxiety when it gradually emerged
that those managing an economy built in substantial measure on success in financial services had no effective system for protecting
bank deposits, no set of principles governing bank failure and no clear idea what the mantra of ‘lender of last resort’ actually
meant. It was a little like discovering that one of the country’s leading obstetricians didn’t have the first idea how to
effect the delivery of a large baby because all his experience had been with small ones.

The full saga of Northern Rock has been well described elsewhere and I do not need to repeat the story, even though I was
involved in it as a politician. The reason why Northern Rock was important in the wider context was not merely that it exposed
the inadequacy of regulation and regulators, but that it was the first major institutional victim of a global banking crisis
and the credit crunch. (Arguably, BNP–Paribas was hit a few weeks earlier and had closed two of its funds, and HSBC had, with
some prescience, warned of large losses on US sub-prime lending some six months before – but it was Northern Rock that brought
home, very publicly, the existence of a serious banking problem.)

The Rock had once been a highly regarded, Newcastle-based building society, with a long-standing reputation for financial
prudence and a strong commitment to its Tyneside community. Its origins lay in the tradition of Victorian self-help which
produced friendly societies and other mutual institutions – owned collectively by those who deposited money with them – channelling
savings into mortgage lending and other investments. The Conservative government legislated for the demutualization of building
societies as part of a wider deregulation of financial markets, in the belief that access to shareholders and freedom
from traditional restraints would permit the societies to expand more rapidly and to compete directly with banks. I was one
of those who campaigned at the time to stop demutualization, on the grounds that the traditional mutual model offered something
different, and more financially attractive to investors and borrowers, from the banks. A decade later demutualization was,
effectively, stopped. But Northern Rock had already escaped the constraints of mutuality in 1997, following the Abbey National,
the Halifax and others.

When it converted from a mutual to a commercial bank, it initially sought to maintain its community focus, and the new PLC
was launched alongside a charitable foundation with a guaranteed share of the bank’s profits. The foundation has subsequently
done much valued work in the north of England. But the management team, led from 2001 by Mr Adam Applegarth, had bigger ambitions
for the bank – and themselves – than remaining as a small to middle-ranking player in the banking industry, known to the public
mainly for its sponsorship of Newcastle United. They hatched an ambitious plan to capture a lion’s share of the UK mortgage
market. There were two problems. The first was how to raise the money to lend, since building societies traditionally accumulated
funding by the slow process of attracting deposits. The second was how to persuade house buyers to take mortgages from Northern
Rock rather than their competitors. They hit upon an audacious business plan designed to solve both problems.