21
Doing a Caporetto
Outside Italy, the name of Luigi Capello is not well-known, which is a pity. Anyone who really stands out in their particular line of work deserves all the fame—or notoriety—their actions have earned. And Luigi Capello, an Italian general of World War One, stands out equally for his smug overconfidence, his calamitous decisionmaking, and the vast losses he inflicted on his own side.
His story is this. Up until late autumn 1917, Capello was regarded as one of the finest leaders of the Italian army, personally brave and tactically astute. The Austrian invaders had been held at bay. The Italian army had ceded very little territory. The enemy was, in many ways, on the verge of collapse. The German commanders, seeing the gravity of the situation, chose to send fresh troops to reinforce their Austrian allies and mount an attack on Italy.
Capello’s duty at Caporetto was clear and simple: to resist the attack. He didn’t need to do or achieve anything else. Simply to maintain the status quo would count as a wonderful victory. Furthermore, Capello was blessed with reliable intelligence. He knew that an attack was coming, and where, and when. His superior officer ordered Capello to take up a defensive position to resist the assault, but Capello—smugly overconfident—decided he’d set up an offensive one instead. If the German assault had been a feeble one, that would have been a clever move. As it was, however, it proved disastrous.
German forces ripped through Capello’s line. More than thirty thousand Italian troops were killed or wounded. More than quarter of a million were taken prisoner. Over three thousand artillery pieces—more than half the Italian stock—were lost. To this day, Italians use the term ‘a Caporetto’ to signify a disastrous reverse. We’re going to start counting our own lost artillery pieces in the next chapter, where we’ll survey the extent of the coming damage to the world’s financial system. But before we do that, we should spare a thought for our generals. After all, they were the ones who led us here: to towering governmental debt, a broken financial system, a colossal, job- and savings-destroying recession.
You can, if you like, regard these things as the outcome of mere ignorance. Not many politicians have had a background in finance. President Obama was a law professor. His predecessor was theoretically speaking an oilman (though practically speaking an idiot). Angela Merkel was a chemist, Gordon Brown a history lecturer, Nicolas Sarkozy a family lawyer. On the other hand, politicians need to grasp many more subjects than economics. Like the current German chancellor, Margaret Thatcher was a chemist by profession. Unlike the current German chancellor, however, Thatcher was never frightened of making a tough decision.
Perhaps, instead, we should focus on our leaders’ most senior advisors. In the US particularly, there’s come to be a tradition whereby each new leader recycles a gallery of failed, or evidently biased, advisors. Larry Summers, for example, has advised Ronald Reagan, Michael Dukakis, Bill Clinton, and Barack Obama. Summers was one of the key players who torpedoed the better regulation of financial derivatives, a decision so bad that it should have prevented him from ever having an influence over policy again. Timothy Geithner reportedly refused his president’s order to develop a plan for the winding-up of Citigroup—a failing which, if the accusation is true, should be regarded as no less treasonous or destructive than a battlefield general refusing a direct order from his commander-in-chief. Since Geithner regarded the banks as ‘his longtime constituents,’ however, maybe he figured his loyalties lay elsewhere.1
Or perhaps we would do better to focus on the conflicts of interest: the torrent of Wall Street lobbying cash and the revolving doors between Wall Street and Washington, Wall Street and the regulators. These conflicts are at their worst in the US, but they’re present in the UK, where the Conservative Party is essentially the City of London’s lapdog.
In the end, however, it comes down to the simple matters of transparency, accountability and enforcement of the rules.
Transparency first. It remains extraordinary that governments are prepared to issue accounts that barefacedly deny the existence of countless real liabilities. Politicians should not accept that. The media should not accept that. Voters should not accept that.
It’s also astonishing that the accounting rules applied to banks allow them to record assets at values billions of dollars distant from their real worth. If a financial system is allowed to hide its losses in this way, it’s tough for any regulator to gain the political support needed to address its flaws. These things are true at the corporate level, but they’re no less true at the level of every individual subunit. If the mortgage desks that pumped out their toxic crap had been forced to hold their leftover assets at realistic values, those desks would have crumbled long before the crisis grew to the extent that it did.
Transparency should apply at the level of entire markets as well. Michael Lewis calls the bond market a ‘pit full of pythons’ because it is so opaque. Yet the equity market functions fine with a very high level of transparency. Nothing bad happens. Companies aren’t suddenly unable to raise money, investors aren’t deterred, market-makers don’t go out of business. So the simple discipline of price discovery should be brought into as many markets as possible. The worthwhile markets will succeed. So too will traders and investors who bring some added value to those markets. Everyone else will be driven out of business, financial markets will be less volatile—and the world will be the better for it.
While we’re still talking about things that ought to astonish us, we have to take note of the amazing fact that the US monetary authorities have long been prepared to live with the system as it stands today. The Fed is happy to lend hundreds of billions of dollars to crisis-struck banks without any real economic return. It’s incredible that the European Central Bank should fight for its right to accept bankrupt Greek debt as collateral for its loans. Any real banker would fight for the exact opposite. It is (to use a fine Britishism) gobsmacking that the Bank of England is willing to further debauch the pound by quantitative easing, at a time when long-term bond yields, the target for such nontraditional measures, are already at record lows.
‘Moral hazard’ is a term much used in economics. It means that if you reward people for ineptitude or remove penalties from failure, you will encourage precisely the behaviors that you least want to see. Central bankers and regulators should be the fierce guardians of moral hazard: the angels with the flaming swords. They’ve become the exact reverse. One congressional inquiry, for example, saw the following interchange between Representative Alan Grayson and Elizabeth Coleman, the Fed’s Inspector General. (You can see the whole thing on YouTube, if you care to.)
Q: You are the Inspector General. My question is specifically do you know who received that $1 trillion plus that the Fed extended and put on its balance sheet since last September? Do you know the identity of the recipients?
A: I do not. No. We have not looked at that specific area …
Q: What have you done to investigate the off-balance-sheet transactions conducted by the Federal Reserve which according to Bloomberg now total $9 trillion in the last eight months?
A: I’ll have to look specifically at that Bloomberg article. I don’t know if I have seen that particular one.2
Q: That’s not the point. The question is have you done any investigation or auditing of off-balance-sheet transactions conducted by the Federal Reserve?
A: At this point we are conducting our lending facility project at a fairly high level and have not gotten to a specific level of detail to really be in a position to respond to your question.3
Wow! These guys overseeing the Fed are so high-level they can’t even screw their eyes up enough to find the odd few trillion that they’ve been throwing around.
This extraordinary laxity is the inevitable result of a system designed to be as opaque, as untruthful, as possible. Accountability is the flipside of transparency. If politicians were obliged to present honest government accoun
ts, they couldn’t escape the voters’ judgment on any mismanagement. If banks were forced to present honest accounts, their bosses could hardly justify their lavish remuneration or even, often, remain in their jobs. If traders’ profits were linked to proper accounts, they’d be a lot more careful about prudent risk management. If markets were transparent, not opaque, investors too would be exposed to the cold blast of truth.
Since these things are both obvious and largely costless to achieve, it’s bewildering that it hasn’t yet happened. And in the end, we have to come back to the generals, to the Luigi Capellos who have led so many different governments in so many different parts of the world to their own Caporettos. It’s hard to avoid believing that politicians would rather snuggle up close to special interests, give way to the lobbyists, and avoid challenging their legislators, activists, or voters. Perhaps politicians think they’re more likely to be re-elected that way. Perhaps they’re right to think so. I wouldn’t know.
But presumably people enter politics originally to bring about change. To lead the country to something better, not something merely comfortable. Margaret Thatcher was a crucial leader for Britain because she didn’t give a damn about what was comfortable or what lobbyists wanted from her. She knew what was right, did it, and was prepared to reap the consequences, good and bad.
By contrast, the political leaders of today seem to lack almost any desire to lead. That’s been comically obvious in Italy and saddeningly so in Japan. But Chancellor Merkel, who is neither a buffoon nor an incompetent, presents another version of the same basic deficiency. Her timidly evasive approach to the eurozone crisis has done nothing but exacerbate the problems. She hasn’t even had the courage to kick the can down the road; she’s insisted on nudging it, a centimeter or two at a time—and you can imagine for yourself how much the financial markets love that approach. A bolder leader would, two years ago, have propelled Greece into formal default, ring-fenced Italy and Spain, and placed Portugal and Ireland on probation. That action, taken swiftly, properly explained, and fully committed to, would have snuffed out the crisis. Some creditors would have lost money, which would have reminded them of the importance of trying harder next time. Some banks would have gone bust, which would have reminded bank boards and shareholders that their job is to ensure their charge is properly managed. Those outcomes would have been painful but good—a phrase in the lexicon of every true leader, but one that has slipped from use today.
In the United States, it’s hard even to single out individuals for blame. Do I cite Bill Clinton for abolishing the Glass–Steagall Act and systematically opposing any real constraint on Wall Street’s power to destroy trillions of dollars’ worth of value? Or George W. Bush for his countless fiscal follies? Or Barack Obama for his changeless change, his stimulus plans that have stimulated little but the flow of red ink? Or Nancy Pelosi for her refusal to contemplate entitlement cuts of any kind? Or Messrs Greenspan and Bernanke for their love of the bailout and the printing press? For their inability to keep track of their trillions? Or the entire Tea Party movement for its obdurate attitude to tax reform? Truth is, all these people stand guilty as charged; but the real issue is a political atmosphere so corroded, so poisoned with partisan posturing, that the poor old truth is left wheezing and battered in a corner. If a political leader had the guts to speak the truth, it’s doubtful that anyone would even hear it. Politicians react to the environment by throwing up smokescreens. The intense wars of class, culture, ideology, and party function as a way to distract everyone—voters, media, Congress—from the fundamental reform issues which we have discussed in these pages.
The only country on Planet Ponzi that actually seems to have some leadership is Britain. I’m not by any means a fan of the country’s leadership over the last couple of decades. Britain is, as I’ve argued previously, in many ways a contender for the dubious accolade of World’s Most Indebted Nation, which tells you all you need to know about its management in the recent past. But if its leaders (of both political persuasions) led the country into its current mess, its leaders of both political persuasions seem ready to lead it out. To slash spending, to take a pragmatic approach to taxation, to restrain the banks, to do what needs to be done.
And the truly weird thing about this? These things are not unpopular. The exact same politicians who are doing all these terrible things are not unpopular. It’s way too soon to call the next election, but the low political calculation which seems to sway politicians from Yosemite to Yokohama could simply be based on a false assumption. Maybe lying, dissembling, and evasion are not the most effective ways to win an election. Maybe transparency, accountability, and leadership are. You won’t know until you’ve tried it—and in Tokyo, Berlin, Paris, Rome, Madrid, and Washington it might by now be time for a new approach. It’d have my vote.
22
Crunching the numbers
It’s time to add up. This book has thrown around so many huge numbers that you may be feeling a bit dizzy. So let’s summarize.
Twenty or thirty years ago, the world went crazy. Wall Street started to turn itself into a giant Ponzi scheme. Washington started to rack up uncountably large—and wholly unpayable—obligations that now total somewhere between $80 and $200 trillion.1 The other nations of the world chose, more or less, to follow suit. As the Ponzi scheme started to collapse, it inaugurated what is certainly the greatest and most dangerous recession since the 1930s.
In normal recessions, output tends to spring back to its ‘core’ level fairly swiftly. That is, though the recession causes injury for a few years, output tends to spring back to its original trajectory, thanks to an extra spurt of growth in the first year or two of recovery. Recessions caused by banking crises tend not to be like that. Output is permanently stunted. Although growth will one day resume, there’s no extra spurt, no return to that original trajectory. It’s hard to measure the present value of that lost output, but what is absolutely certain is that it is staggeringly huge. One estimate prepared by the Bank of England puts the figure at somewhere between $60 trillion and $200 trillion. As the author of that paper dryly comments, ‘to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy.’ Quite so. Only bankers can destroy that much value. Black holes are wimpish by comparison.2
That measure of loss affects us all—or rather, it affects almost everyone who isn’t collecting a Wall Street bonus. But, important as it is, it’s not the measure we’ll focus on in this chapter. Our concern now is to understand just how bankrupt the world’s financial system is. If it seems strong enough to get through the current crisis, we can have some expectation of having seen off the worst, of limping through to better days ahead. If, on the other hand, the system has been more gravely weakened by what has happened so far, then, the worst is yet to come; the destruction is not yet over. So let’s examine some facts.
The world’s banking system holds approximately $100 trillion in assets. Those assets are supported by $5.4 trillion in capital. The banking system as a whole earned pretax profits of around $700 billion in 2010, which means that if banks were able to stop paying dividends to their shareholders, you’d expect bank capital to grow by approximately that amount each year. That’s the global picture. This book, however, has not been interested in tracing developments in China, Brazil, or other key markets of the future. Our interest has been with Planet Ponzi, and the key data for Planet Ponzi are as shown in table 22.1.3
Table 22.1: The vital statistics
Source: ‘Top 1000 World Banks,’ The Banker, July 1, 2011.
In summary, then, the banking system on Planet Ponzi has approximately $3.3 trillion of capital as a buffer against possible losses. It has $66.6 trillion of assets, from which those losses are liable to come. Readers of a superstitious bent will note that 666 is the number of the beast, but I’m not superstitious.
We’re about to start examining t
he scale of possible losses still to come in the current credit crisis; but before we do so, I need to make a couple of important points. They cut two ways. First, it is not only the banking system which holds poor-quality assets. Many of those assets will have ended up with insurance companies, pension funds, and central banks, for example. In the 2008–9 phase of the credit crunch, about two-thirds of the total losses ended up being absorbed by the banking system, and about a third by insurance companies and other investors.4 In the absence of a better guess, I’d say that the same division of probable losses to come still holds true.
That first point is helpful. Systemic risks stem largely from the banking sector, so if losses are shared more widely, the banking sector is that little bit more robust. The second point, however, pushes us in the opposite direction. Looking at total bank capital is helpful in the sense that it quantifies the total size of the buffer available, but that can also be misleading. Because institutions are not all equally weak, some strong ones will be impaired but broadly unaffected by a wave of losses. Others will go under. When those weak ones go under, their creditors in turn will start to endure losses. Some of those creditors (already hit by sovereign debt losses and the other problems we’ve spoken about in this book) won’t be able to take the additional hit and will go under themselves, triggering a further wave of insolvencies. Again, you only need to think back to 2008, when financial meltdown was triggered by Lehman Brothers with its net losses of just $129 billion. In a more ordinary climate, those losses wouldn’t have triggered disaster, but in a system weakened by heaps of other losses, they proved catastrophic.
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