by Gillian Tett
And as the twentieth century wore on, this sense of an economic priesthood became more intense. In the 1970s men such as Tucker had been able to join the Bank with “just” a degree in philosophy and math. By the end of the twentieth century it was assumed that a BA or PhD in economics was an essential qualification for working at a Western central bank or finance ministry. “[Former Bank governor] Eddie George and I wanted to recruit more economists because we needed people who could match the [British] Treasury in terms of economic analysis,” King later explained. “We realized we had to have people who understood how things worked and were not scared of analysis.” The same pattern was at work at the Federal Reserve and U.S. Treasury. In the middle decades of the twentieth century, the American central bank had sometimes recruited officials who had law degrees, science degrees (or sometimes no degree at all). By the end of the century, however, its junior recruits invariably had degrees in economics, if not doctorates, and its leaders were expected to be equally well qualified. Alan Greenspan was typical of the new breed. When he was appointed chairman of the Federal Reserve in 1987, he arrived with a PhD in economics.8 It had been acquired fairly late in his career, and it did not carry quite the same intellectual prestige as some of the doctorates of his successors. But Greenspan clearly felt that having a PhD in economics was an important—if not essential—tool to gain credibility. And in subsequent years Greenspan was at pains to highlight his passion for economic models. Indeed, he loved creating economic models so much that even after he arrived at the Fed he continued to construct his own private models in his spare time. He liked to describe it as his “hobby.”9
IN 2002, TUCKER WAS promoted to run the market surveillance division of the Bank of England, or the piece of the Bank’s bureaucracy that oversaw how the financial system operated. On paper, it seemed a big honor since running the markets team had traditionally been a high-status job. “Eddie George used to grab the best economists and put them into the markets team, because everyone thought it was so important,” King recalled. “Before 1992 . . . the Bank’s entrée into monetary policy was through ‘markets,’ although Eddie realized the importance of economic analysis.” Indeed, the promotion was so symbolic that it left Bank staff speculating that Tucker could end up becoming governor of the entire Bank one day; beneath his bluff, jolly exterior, he was an ambitious man.
However, as Tucker settled into his new, high-ceilinged office at the Bank, there was one big catch to his promotion. By the early twenty-first century, the status of the market surveillance department had declined. In 1997, a new British government came to power, and decided to overhaul how the central bank was run. The Bank was given formal independence for setting monetary policy and became a much more specialist organisation.10 Most notably, the task of selling government debt was handed to a different government agency, called the Debt Management Office, and the job of supervising individual banks was handed to yet another body, known as the Financial Services Authority. That left the Bank with just a vague mandate to maintain “financial stability.”
There was a second, more subtle issue. Economists were becoming less interested in money, and by default, in financial markets. In some respects, this shift might sound odd; after all, most noneconomists assume that money is at the heart of any modern economy, and the task of analyzing it central to what economists do. But in the second half of the twentieth century, as more economists started to imagine the economy as a “system” governed by universal laws—or the vision of rational expectations that Lucas developed—a shift occurred in terms of how economists viewed money. Instead of regarding it as an interesting topic in its own right, it became a mere transmission device. The only reason that money was considered to be interesting was that it emitted price signals about supply and demand, comparable to the electrical wires on a circuit board. And insofar as economists studied money, they did so to understand what was happening with other interesting parts of the “real” economy (such as consumer demand or productivity). This shift could be seen on the bookshelves of the Bank or LSE. Back in the middle of the twentieth century, when men such as Tucker had joined the Bank, new recruits studied books such as Money, Interest and Prices by Don Patinkin. Another popular text was a book that the LSE professor Charles Goodhart himself had written called Money, Information, and Uncertainty. However, by the start of the twenty-first century, the iconic text for new graduates was a tome called Interest and Prices by Michael Woodford. The word “money” had vanished from the titles. “There wasn’t a manifesto claiming that we must push money out of the models, but it was almost instinctive—money had become passive, like a veil. More or less everyone assumed that all the forces of the economy are elsewhere, on the real side of the economy, and money just responds,” Tucker said. Or as Adair Turner, the man who later ran the Financial Services Authority, echoed: “In the 1970s and 1980s you had a big change. Economics became much more mathematical—everything had to be put in a model, and it became hard to put credit or money into those models. Banking courses were removed from undergraduate economics courses.”
The man appointed as Bank governor in 2003, a year after Tucker’s promotion, reflected this trend. A seemingly mild-mannered man with an impish sense of humor and owlish glasses, Mervyn King was a renowned economics professor at the LSE,11 before he was appointed into a part-time role as an adviser in 1990. He then became chief economist before he was appointed governor. It was a move greeted with delight inside the City of London. King commanded great academic respect, and was determined to make the Bank independent and “professional.” But though King was interested in monetary policy and macroeconomics, he was perceived to be less interested in how money worked. He knew the contours of financial history and had written academic papers about stock market contagion. He had even established a group at the LSE when he was a professor to analyze finance. “One of the things I did [in the 1990s] was force all of our recruits to do courses on financial history, and then I set up a dining society to talk about financial history,” he related. But he did not have much passion for studying the minutiae of modern markets. “Mervyn was a macro [economics] man,” his colleague Goodhart recalled. That stance partly reflected expediency: King believed that the Bank’s primary responsibility was to keep inflation low. But his views also reflected an intellectual bent: most economists believed that the grubby machinations of bankers sat in a different mental box from high-status economics. “There was this strong sense in the Federal Reserve that economics and finance were two quite different things,” Charles Calomiris, a professor at Columbia Business School, observed. “The people looking at markets sat in an entirely different department from the macroeconomic researchers.” A similar split was found at universities. “Pure” economic analysis tended to take place in dedicated economics departments, while finance was studied in business schools. The media reflected this divide and reinforced it. (On my own newspaper, the Financial Times, the economics department sat in a different section from the markets team. And as I have described elsewhere, a similar pattern was seen at The Wall Street Journal, Bloomberg, and Reuters, and almost every other large news group.12) “Almost everywhere you looked across the economic policy world, many of the people studying markets just felt like second-class citizens compared to people looking at economics,” Tucker observed. “Some correction had been needed from decades in which markets were at the center of things, but it overshot.”
This schism frustrated Tucker. So, in 2002, after he was promoted inside the Bank to the run the markets team, he started to hunt for ways to put his department on the map. Twice a year the 120-strong market surveillance team wrote a comprehensive report on the financial system, known as the Financial Stability Report, which tried to understand how banks and other financial entities were performing. It also wrote more regular quarterly reports. Traditionally this research had focused on banks or stock markets, since these were the most visible and regulated institutions in the system. However, Tucker and hi
s colleagues decided that they wanted to widen the lens, not least because the FSA, not the Bank, was now in charge of regulating the banks on a day-to-day basis. The FSA staff there did not want the Bank to step on its turf. So Tucker encouraged his team to start poking into the pieces of the financial system that lay outside the banks, or the areas the FSA did not control.
This research revealed something striking. Traditionally, when central banks and regulators had monitored the financial world, they had focused on regulated banks, since these appeared to be the most important parts of the system. Then, in the latter part of the twentieth century, regulators (and journalists) had started paying more attention to entities outside the banking world, such as hedge funds. This focus intensified after the Long-Term Capital Management hedge fund in New York almost collapsed in 1998.13 But as the Bank staff widened their lens away from the banks after 2002, they spotted something important: although hedge funds tended to spark headlines, they were not the only beasts in the hinterland of finance that lay outside the regulated banks. A whole host of new entities and products were also emerging that carried strange names unfamiliar to people outside finance. Some of these new products were CDOs (the type of financial structures that I described in the last chapter). Others were “conduits” or “structured investment vehicles” (SIVs), which were essentially investment vehicles that could buy securities such as CDOs.
Those entities did not fit into the usual classification system that central bankers and regulators had previously used to classify the world. They were not like traditional banks; they did not take deposits or make loans. Instead the people running these vehicles raised money by selling short-term bonds to investors, and invested that cash in long-term securities, often bonds backed by American housing loans. But these entities were not hedge funds either. Hedge funds were best known for raising money from private individuals and wealthy institutions to invest in risky assets. But SIVs and conduits tried to look as dull as possible, buying instruments that were supposed to be ultra-safe, such as AAA-rated CDOs.
From time to time, Bank officials would debate what these shifts in finance might mean. Over in America, officials such as Greenspan tended to assume that the new innovations were good. They showed, he argued, that bankers were creating more efficient and innovative ways to move money around the economy. Over in Europe, some observers took a different view. In Basel, Switzerland, two leading economists at the Bank for International Settlements, Claudio Borio and William White, warned that the innovations might be dangerous, since nobody knew where they were spreading credit risk. Some of Tucker’s colleagues, such as economist Andy Haldane, expressed unease about excessive levels of borrowing. But inside the Bank of England, most officials were either unaware of what was happening or reluctant to speak out in public. They assumed that it was the job of regulators—such as the Financial Services Authority—and not the economists to watch the new financial trends, since it was the FSA that had the authority to keep banks under control. Moreover, as King sometimes pointed out to his colleagues, the Bank did not have the policy tools to curb any potential bubble. The only thing it was formally allowed to do in relation to the banks was issue the financial stability reports, or tell the Financial Services Authority about its concerns, in private. “Even if we had spoken up [about what we saw], we couldn’t have done anything since we just did not have the powers,” King recounted. He was not somebody who liked to break bureaucratic rules or try to redefine the Bank’s mandate. Instead he preferred to focus his attention on what he thought was his primary mandate: worrying about the “real” economy.
IN LATE DECEMBER 2006, some four years after he had been promoted to run the markets surveillance team, Tucker traveled to the City of London headquarters of the Honourable Artillery Company, created by Henry VIII in 1537. He had been asked to give a speech to a collection of British grandees about the outlook for the economy. It was a routine task. However, Tucker was feeling baffled.14 To most observers, the West seemed to be experiencing an economic golden age. Indeed, conditions seemed so upbeat that economists had christened the first decade of the twenty-first century the era of “Great Moderation” or “Great Stability.” “The characteristics of the Great Stability, as some economists call it, are by now familiar. Essentially low inflation on average . . . and much lower volatility in both output growth and inflation,”15 Tucker declared, as he stood in the historic wood-paneled hall. “Private sector demand growth has been reasonably robust and looks . . . to continue to be robust for a little while at least. World growth weighted for its significance to UK trade has remained solid. . . . Business investment appears to be recovering. And consumption . . . looks most likely to grow close to its average rate.” Translated out of central bank jargon, that meant that if you imagined that the economy was like an airplane, it was heading in the right direction, with most of the dials on the pilot’s instrument board signaling that all was well. Everyone could relax.
But there was one other economic statistic, or dial on that instrument board, that made Tucker uneasy. This was the statistical series called “broad money,” or M4, which showed how much cash and credit was floating around the economy. Classic economic theory suggests that when economies are expanding fast, broad money in the economy grows in tandem with the price of goods, or inflation. Conversely, when growth is slowing, the pace of broad money expansion slows too, which often reduces inflation. Indeed, that relationship has been so well defined that in the middle of the twentieth century, central bankers often decided whether to raise interest rates on the basis of what the broad money data showed.
But in December 2006, this long-standing relationship had broken down. The British inflation rate was low, running at around 2 percent, and the growth rate seemed healthy but not excessive. The M4 data dial on the instrument board of the economic airplane, however, was spinning out of control. “UK broad money is up around 15 per cent on a year and more than 25 per cent since the beginning of 2005,” Tucker declared.16
Did this mismatch matter? A few months earlier, Tucker had asked some of his staff to carry out some detective work, to work out why M4 was expanding so fast. His team had told him that the main reason was a rapid increase in the amount of borrowing and lending by a group of entities labeled “Other Financial Corporations” in the statistics. This OFC bucket was essentially the “miscellaneous” box, where statisticians put anything that did not fit into the normal classification system. These were entities that were defined by what they were not—i.e., not banks, brokers, insurance companies, or the other entities that statisticians knew well.
Tucker asked his staff to dig into that miscellaneous OFC box. They uncovered a second miscellaneous category of unidentified entities inside the OFC box called “Other Financial Intermediaries.” That was where statisticians placed the misfits of the misfits, or things that sat even further out of the classification system. The data on these entities was sketchy. But Tucker’s colleagues guessed that the entities in this box were mostly the CDOs, SIVs, conduits, or the strange new beasts in the jungle that Tucker’s team had first spotted back in 2002. “Over the past year, the largest contributions to OFC money growth have, in fact, come from . . . what the statisticians label ‘Other Financial Intermediaries’ (contributing a whopping seventeen percentage points),”17 Tucker explained to the crowd in the Honourable Artillery Company hall. “Collectively, [OFIs] . . . have been growing at an annual rate of over forty per cent for the past two years.”18
Did that have any significance for the economy as a whole? It seemed impossible to tell, since the people doing macroeconomic analysis had not tried to link the trends in the core economics statistics to what was happening in this murky OFC world. “It is extremely difficult to judge the macroeconomic significance of what the growth of broad money—or OFC money—might mean” Tucker lamented. “There is relatively little research on the macroeconomic significance of OFC money.”19 The area was a blank space on the map; or like the nondancers
in Bourdieu’s village hall. The economists were looking at what they presumed that they were supposed to watch, namely models of “real” economy statistics. But they did not look at the bits of the economy that sat outside that world, or try to connect the different realms. Indeed, the split between finance and economics was so deeply ingrained that many economists barely noticed it at all. They spent hours questioning the finer details of their mathematical equations. However, they rarely pondered the classification system they used. Or noticed the boundaries this imposed.
“Did anyone try to link what was happening in CDO land to the macroeconomy? With hindsight, the answer is not enough,” King said. “But the question is what follows from that? It was not because people were not studying CDOs. . . . [But] there were too many people focused on detail and there was so much paper produced that it was impossible to see the woods for the trees.” Indeed, when King later tried to work out what had gone wrong, he tended to think that the Bank had too much intelligence sitting inside its walls, not too little. However, those brilliant minds were simply not focusing on the right thing. Men such as King knew about the existence of all the new financial innovations. Indeed, soon after Tucker’s speech King referred to them in a talk to an audience at the Mansion House, another venerable City of London institution. But men such as King did not spend much (if any) time pondering what the appearance of these strange financial beasts might mean for monetary policy. “Most public sector institutions suffer from the problem of an excess of bright young people and too few experienced people with the ability and perspective to see what detail matters and what does not,” he lamented. “Our biggest problem with analysis was the difficulty in persuading young people to see the big picture and their managers to draw out the big picture.” Including, some of his colleagues might have added, the top managers at the central banks, such as King himself.