FT's Year in Finance 2009

8/9/2019 FT's Year in Finance 2009

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World counts truecost of the rescue

A fter a near-deathexperience, manyof the worlds lead-ing banks discov-

ered in 2009 that there waslife after the global finan-cial crisis.

For the walking wounded

and there were plenty the spellbinding returns of the credit bubble remaineda distant memory. Theirbusiness was about sur-vival. But for the strongerf inancia l in s t i tut ions Goldman Sachs, JP Morgan,Deutsche Bank, and Bar-clays Capital the level of r evenues, p ro fi ts andbonuses suggested it wasback to business as usual.

We a r e d o i ng G o dswork, declared LloydBlankfein, Goldmans chair-man and chief executive, ina g lo rious ly unsc r ip tedcomment. The feisty MrBlankfein was soon back onmessage, offering a broadapology for Goldmans rolein the financial crisis andproducing a $500m chequefor assisting small business.

Critics immediately dis-missed the gesture as per-functory, a reflection of theinflamed public mood. Buteven aside from the wind-fall tax on bankers bonusesin the UK, 2009 marked areckoning of sorts after thenear meltdown of the finan-

cial system in 2008. Thissense o f per spec tive drawn from a selection of FT articles published in thepast 12 months is what wehave sought to capture inthis special report.

In intellectual terms, asRobert Skidelsky writes, theglobal financial crisismarked the collapse of theefficient market hypothe-sis, which said economicactors behave rationallyand markets efficiently. Infact, the world discovered

(again) that economicactors can behave irration-ally and markets can beanything but efficient.

P ro f Skide lsky, theacclaimed biographer of John Maynard Keynes, dis-sec t s the p roblem wi thcharacteristic elegance. It[the hypothesis] led bankersinto blind faith in theirmathematical forecasting models. It led governments

and regulators to discountthe possibility that finan-cial markets could implode.It led to what Alan Green-span called (after he hadstepped down as chairmanof the US Federal Reserve)the underpricing of riskworldwide. It has also led

to the discrediting of main-stream macroeconomics.

Gi l li an Te t t , t he FTsaward-winning markets edi-tor and author of a best-se l l e r abou t the c red i tderivatives business ( FoolsGold: How Unrestrained Greed Corrupted a Dream,

Shattered Global Marketsand Unleashed a Catastro- phe ) argues that intellectualfailures led directly to man-agerial failures in financialinstitutions. In her columnThe dangers of silo think-ing, Tett draws on her ownbackground in anthropol-ogy to illuminate the defec-tive parts of the system.

In political terms, 2009marked the beginnings of abacklash. Gideon Rachman,the FTs ch ie f foreignaffairs columnist, purports

to see a closing o f theThatcher era which pio-neered policies copied inthe rest of the world: priva-tisation, deregulation, tax-cutting, the abolit ion of exchange con trol s, anassault on the power of thetrade unions, the celebra-t ion o f wea lth c reat ionrather than wealth redistri-bution.

But Rachman cautionsthat, as yet, no leading political figure in the west-ern world has really articu-lated a coherent alternativeto the free-market princi-ples inherited from Thatch-erism. Therefore, it wouldbe premature to write themoff, despite the damagedone to the Anglo-Saxonmodel.

In regulatory terms, theGroup of 20, the new group-ing of leading economiesfrom the developed anddeveloping world, agreednew principles of govern-ance for the financial sec-tor. I ts agenda included

Economic theoriesand public pursesare both looking rather bare, writesLionel Barber

Inside this issueBalance of risk Regulatorsmay have to invent newtools or revive old ones,says George Soros Page 2

Capitalism Victory in thecold war was a start and anending, saysMartin WolfPage 4

Thatcher-ism All themain policiesare beingreversed butis the

Thatcher era really over?Gideon Rachman looks atthe evidence Page 4

Banking Goldman Sachsshould be allowed to fail,says John Gapper Page 6

The lessonsA deal tosaveLehman

would nothave savedus, writesNiallFergusonPage 7

Continued on Page 3

THE FTSYEAR IN FINANCEFINANCIAL TIMES SPECIAL REPORT | Tuesday December 15 2009

www.ft.com/finance-2009

InsideThe financial crisis hashighlighted with painfulclarity just howdangeroustunnel visioncan be, saysGillian TettPage 7

The worlddiscovered (again)that economicactors can behaveirrationally


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2 FINANCIAL TIMES TUESDAY DECEMBER 15 2009

The FTs Year in Finance

Do not ignore the need for financial reform

T he philosophy that hashelped me both in mak-ing money as a hedgefund manager and in

spending it as a policy-orientedphilanthropist is not aboutmoney but about the compli-cated relationship betweenthinking and reality. The crashof 2008 has convinced me that itprovides a valuable insight intothe workings of the financialmarkets.

The efficient market hypothe-sis holds that financial marketstend towards equilibrium andaccurately reflect all availableinformation about the future.Deviations from equilibrium are

caused by exogenous shocksand occur in a random manner.The crash of 2008 falsified thishypothesis.

I contend that financial mar-kets always present a distortedpicture of reality. Moreover, themispricing of financial assetscan affect the so-called funda-mentals that the price of thoseassets is supposed to reflect.T ha t i s t he p ri nc ip le o f reflexivity.

Instead of a tendency towardsequilibrium, financial marketshave a tendency to develop bub-bles. Bubbles are not irrational:it pays to join the crowd, atleast for a while. So regulatorscannot count on the market tocorrect its excesses.

The crash of 2008 was causedby the collapse of a super-bub-ble that has been growing since1980. This was composed of smaller bubbles. Each time afinancial crisis occurred theauthorities intervened, tookcare of the failing institutions,and applied monetary and fiscalstimulus, inflating the super-bubble even further.

I believe that my analysis of the super-bubble offers clues to

the reform that is needed. First,since markets are bubble-prone,financial authorit ies mustaccept responsibility for pre-venting bubbles from growing too big. Alan Greenspan andothers refused to accept that. If markets cannot recognise bub-bles, the former chairman of theUS Federal Reserve asserted,neither can regulators and hewas right. Nevertheless authori-ties have to accept the assign-ment.

Second, to control asset bub-bles it is not enough to controlthe money supply; you mustalso control credit. The bestknown means to do so are mar-gin requirements and minimumcapital requirements. Currentlythey are fixed irrespective of themarkets mood because marketsare not supposed to have moods.They do, and authorities need tocounteract them to preventasset bubbles growing too large.So they must vary margin and

capital requirements. They mustalso vary the loan-to-value ratioon commercial and residentialmortgages to forestall real-estate bubbles.

Regulators may also have toinvent new tools or revive onesthat have fallen into disuse.Central banks used to instructcommercial banks to limit lend-ing to a particular sector if theyfelt that it was overheating.

Another example of needing new tools involves the internetboom. Mr Greenspan recognisedit when he spoke about irra-tional exuberance in 1996. Hedid nothing to avert it, feeling that reducing the money supplywas too blunt a tool. But hecould have devised more spe-cific measures, such as asking the Securities and ExchangeCommission to freeze new shareissues, as the internet boom wasfuelled by equity leveraging.

Th i rd, s ince marke t s a reunstable, there are systemicrisks in addition to the risksaffecting individual market par-ticipants. Participants mayignore these systemic risks,believing they can always selltheir positions, but regulators

cannot ignore them because if too many participants are onthe same side, positions cannotbe liquidated without causing adiscontinuity or a collapse. Thatmeans the positions of all majorparticipants, including hedgefunds and sovereign wealthfunds, must be monitored tode tec t imba lances . Cer t ainderivatives, like credit defaultswaps, are prone to creating hid-den imbalances so they must beregulated, restricted or forbid-den.

Fourth, financial marketsevolve in a one-directional, non-reversible manner. Financialauthorities have extended animplicit guarantee to all institu-tions that are too big to fail.Withdrawing that guarantee isnot credible, therefore theymust impose regulations to

ensure this guarantee will notbe invoked. Such institutionsmust use less leverage andaccept restrictions on how theyinvest depositors money. Pro-prietary trading ought to befinanced out of banks own capi-tal not deposits. But regulatorsmust go further to protect capi-tal and regulate the compensa-tion of proprietary traders toensure that risks and rewards attoo-big-to-fail banks are aligned.This may push proprietary trad-ers out of banks and into hedgefunds, where they belong.

Since markets are intercon-nected and some banks occupyquasi-monopolistic positions, wemust consider breaking them

up. It is probably impractical toseparate investment banking from commercial banking as theGlass-Steagall act of 1933 did.But there have to be internalcompartments that separate pro-prietary trading from commer-cial banking and seal off trading in various markets to reducecontagion.

Finally, the Basel Accordsmade a mistake when they gavesecurities held by banks sub-stantially lower risk ratingsthan regular loans: they ignoredthe systemic risks attached toconcentrated positions in securi-ties. This was an important fac-tor aggravating the crisis. It hasto be corrected by raising therisk ratings of securities held bybanks. That will probably dis-courage the securitisation of loans.

All these will cut the profita-bility and leverage of banks.This raises an issue about tim-ing. It is not the right time to

enact permanent reforms. Thefinancial system is far fromequilibrium. The short-termneeds are the opposite of whatis needed in the long term. Firstyou must replace the credit thathas evaporated by using theonly source that remains credi-ble the state. That meansincreasing national debt andextending the monetary base.As the economy stabilises youmust shrink this base as fast ascredit revives otherwise, defla-tion will be replaced by infla-tion.

We are still in the first phaseof this delicate manoeuvre.Banks are earning their way outof a hole. To cut their profitabil-ity now would be counterpro-ductive. Regulatory reform hasto await the second phase, whenthe money supply needs to bebrought under control and care-fully phased in so as not to dis-rupt recovery. But we cannotafford to forget about it.

George Soros is author of TheCrash of 2008 .

This article was first published on October 25, 2009.

BALANCE OF RISKRegulators may have to invent new tools or revive disused ones,says George Soros

Bubble trouble: if markets cannot recognise bubbles, neither can regulators, said Alan Greenspan Getty

I contend thatfinancial marketsalways present adistorted picture ofreality

George Soros


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FINANCIAL TIMES TUESDAY DECEMBER 15 2009 3


World counts the true cost of the banking rescue

demands for higher capitallevels, living wills setting out how financial institu-tions would wind up theiraffairs; and new strictureson executive remuneration,especially for those banksin government ownership.

The G20 forum marked arecogn i t ion tha t g lobalbanking requires globalgovernance. But nationalpolitics still intruded on thebest-laid plans and princi-ples. The Labour govern-ment discovered that theneed to be seen to be clamp-ing down on bonuses atstate-controlled banksclashed with the imperativeof ensur ing those samebanks made the returns

required to pay back thetaxpayer. Royal Bank of Scotland was not the onlyfinancial institution to com-plain that a ban on bonuseswould lead to an exodus of investment banking talentthat threatened to put thosereturns at risk.

More broadly, thanks inpart to Lord Turner, thecerebral chairman of theFinancial Services Author-ity, a debate began aboutthe balance of risk in thefinancial services sector.George Soros, the renownedinvestor and philanthropist,wrestles with this centralquestion in his column, Donot ignore the need fo rfinancial reform.

How far should banksabandon casino-styleinvestment banking andreturn to the role of a util-ity, reliant on deposits tosupport retail and commer-c ia l l ending? To wha tdegree did the authorities,on both sides of the Atlan-

t i c , miss the chance toinsist on so-called narrowbanking. Or put anotherway, how far has a globalrescue operation running into hundreds of billons of dollars restricted competi-tion and cemented the privi-l eged pos i t ion o f a f ewselect banks as too big tofail.

John Kay, the FT busi-ness columnist who oncesat on the board of a Britishbuilding society, makesclear his support for narrowbank ing . In h i s words , Too b ig to f a i l i s toodumb to keep.

But Martin Wolf, chief economics commentator,who spent several columnsfulminating against irre-sponsible risk-takers in thebanking industry, as well asthe authorities privatising the gains and socialising t h e l o s se s i n c ur r ed b y

b an ks , t ak es a m or enuanced view. Taken to itsconclusion, it [narrow bank-ing] would eliminate mone-tary policy. Public debt heldby banks would set themoney supply, he writes,A more profound issue iswhether a financial systembased on narrow banking could allocate capital effi-ciently.

John Gapper, ou r USbusiness columnist, arguestha t we a re , i n e ffec t ,repeating the mistakes of the Bourbons who learntnothing and forgot nothing.Gapper takes on the famil-iar refrain from top bank-ers, including GoldmansMr Blankfein, who insistedthat their extraordinarygains were due to extraordi-nary talent rather than theadvantages drawn fromfavourable markets influ-enced by temporary butoverwhelming governmentintervention. In Gappersview, similar to John Kays,i t is wrong for financialinstitutions such as Gold-man to become so big that

they pose systemic risksand therefore are too big tofail.

Goldman was describeda s a va mp ir e s qu idwrapped around the face of humanity in a memorableif conspiratorial polemic byMatt Taibbi published in Rolling Stone magazine. Inessence, Goldman founditself accused of gaming thesystem, exploiting its tieswith former executives inpositions of power such asHank Paulson, former UStreasury secretary. For asobering antidote, readersshould turn to Niall Fergu-son, the Harvard historianand FT contributing editor,who points out that even if Lehman had been saved,the world would still haveexperienced a financial cri-sis.

In the end, the systemwas saved but only throughoverwhelming governmentintervention at massive costto the public purse. In 2009,those costs became clearer.In 2010, governments willhave to turn to repairing the public finances.

Bankers be warned: thereckoning will be severe.

Continued from Page 1

Contributors

Lionel BarberEditor

John GapperUS Business Columnist

Gideon RachmanChief Foreign AffairsColumnist

Gillian TettGlobal Markets Editor

Martin WolfChief EconomicsCommentator

Niall FergusonContributing Editor

John Kay Business Columnist

Robert Skidelsky Professor of PoliticalEconomy, University ofWarwick

George SorosChairman of Soros FundManagement.

Steven BirdDesigner

Ingram PinnIllustrator

Andy MearsPicture Editor

For advertising contact:Chris Nardi+44 020 7873 [email protected] your usualrepresentative

How to rebuild a newly shamed subject

I t was to be expectedthat our present eco-nomic traumas wouldcall into question the

state of economics. Whydid no one see the crisiscoming?, Queen Elizabethreportedly asked one practi-tioner. A seminar at theBritish Academy tried toanswer and the FT hastaken up the discussion.

The Queens question isunderstandable. Ever sincemodern economics startedin the 18th century it haspresented itself as a predic-tive discipline, akin to anatural science. Since thefuture a year ago includedthe present slump, it is nat-ural that the failure of theeconomics profession with

a few exceptions to fore-see the coming collapseshould have discredited itsscientific pretensions. Eco-nomics is revealed to haveno more clothes than othersocial science. One cannotimagine the Queen nextyear asking a leading politi-cal scientist: Why did noone tell me that Labour wasgoing to win the election?She would understand thatthis was not a predictionthat any political scientistcould make with convic-tion.

Nevertheless, the Queensquestion accepted at facevalue the predictive claimof economics a featurethat has distinguished itfrom all other social sci-ences. Karl Popper pro-duced a famous argumentagainst the possibility of prediction in human affairs:one cannot anticipate a newinvention because, if onecould, one would alreadyhave invented it. However,this objection can be over-come if one assumes a sta-ble and repetitive universein which rational actorsmake efficient use of theinformation available to

them. In this environment,uncertainty disappears tobe replaced by calculablerisk. Shocks and mistakesmay occur but these will

cancel each other out, sothat, on average, people getwhat they expect.

An important implicationof this view is that sharesare always correctly priced.This is the basis of the so-ca l l ed e ff i c i en t marke thypothesis that has domi-

nated financial economics.It led bankers into blindfaith in their mathematicalforecasting models. It ledgovernments and regulatorsto discount the possibilitythat financial marketscould implode. It led towhat Alan Greenspan called(after he had stepped downas chairman of the US Fed-eral Reserve) the under-pricing of risk worldwide.

It has also led to the dis-crediting of mainstreammacroeconomics. The effi-cient market hypothesis issimply an application of therecently-triumphant NewClassica l schoo l, wh ichpreaches that a decentral-i sed marke t sys tem i salways at full employment.In their obsession with get-ting government out of eco-nomic life, Chicago econo-

mists claimed that any con-sistent set of policies will belearnt and anticipated by apopulation, and will there-fore be ineffective. Sincepeople apparently includ-ing the 10 per cent or sounemployed are already

in their preferred positionbecause of their correctanticipations and instanta-n eo us a dj us tm en t t ochange, stimulus policiesare bound to fail and evenmake things worse. Reces-sions are optimal.

icy to anticipate or dealwith stagflation in the1970s. It reflects a persistentbias in economics towardsan idea l i sed accoun t o f human behaviour; what

Joseph Schumpeter calledthe Ricardian Vice of excessive abstraction.

It is only by imagining amechanical world of inter-acting robots that econom-ics has gained its status asa hard, predictive science.B ut h ow m uc h d o i tsmechanical constructions,with their roots in Newto-nian physics, tell us aboutthe spr ings o f humanbehaviour?

One of the most interest-ing contributions to theFT.com deba te was theargument that, after Key-nes , economis t s shou ldhave aligned their disci-pline with other social sci-ences concerned withhuman behaviour. Keynesopened the way to politicaleconomy; but economistsopted for a r eg ress iveresearch programme, dis-guised by sophisticated

mathematics, that set i tapart. The present crisisgives us an opportunity totry again.

The reconstruction of eco-nomics needs to start withthe universities. First ,degrees in the sub jectshould be broadly based.They should take as theirmotto Keyness dictum thateconomics is a moral andno t a na tu ra l sc i ence .They should contain not just the standard courses inelementary microeconomicsand macroeconomics buteconomic and political his-tory, the history of eco-

nomic thought, moral andpolitical philosophy, andsociology. Though somespecialisation would beallowed in the final year,the mathematical compo-

nent in the weighting of thedegree should be sharplyreduced. This returns to thetradition of the Oxford Poli-tics, Philosophy and Eco-nomics (PPE) degree andCambridge Moral Sciences.

Beyond this, the postgrad-uate study of macroeconom-ics might with advantage beseparated from that of micr-oeconomics . Courses inmicroeconomics should con-ce rn themse lves , a s a tpresent, with building andtesting models based on anarrow set of assumptions.Their field of applicabilitylies in those areas where wehave reliable views of thefuture. Macroeconomics,though, is an essential partof the art of government,and should a lways betaught in conjunction withsubjects bearing on this.

The obvious aim of such areconstruction is to protect

macroeconomics from theencroachment of the meth-ods and habits of the math-ematician. Only throughsome such broadening canwe hope to provide a propereducation for those whoseusefulness to society will lieas much in their philosophi-cal and political literacy asin their mathematical effi-ciency.

Lord Skidelsky is author of Keynes: The Return of theMaster

This article was first pub-lished on August 5, 2009.

ECONOMIC THEORY

Economics has nomore clothes thanany other social

science, writesRobert Skidelsky

The mathematicalcomponent in theweighting of thedegree should besharply reduced

How far shouldbanks abandoncasino-styleinvestmentbanking?

Most of those unversed inNew Classical economicsassume that John MaynardKeynes exploded these falla-cies 70 years ago. Their re-emergence is not just theresult of the failure of Key-nesian macroeconomic pol-


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Cold war victory was a start and an end

A crisis is a strange way to cel-ebrate an anniversary. Thisis the wry judgment of ErikBerglf, chief economist of

the European Bank for Reconstruc-tion and Development.* Yet a crisis iswhat we see in countries that beganthe march from communism two dec-ades ago. So, has capitalism failed, ascommunism did?

In a word, no. Some transitioncountries are in crisis; transition isnot.

The same judgment applies else-where: capitalist countries are in cri-sis; capitalism itself is not. But reformis necessary. The great virtue of lib-

eral democracies and market econo-mies is their ability to reform andadapt. They have shown these quali-ties before. They must do so onceagain.

For those born, like me, shortlyafter the second world war, the coldwar was the defining intellectual andpolitical struggle of our lifetimes.With the collapse of communismended a catastrophic epoch of millena-rian politics and the delusion of arationally planned economy. The free-dom offered by democracy and theprosperity supplied by markets won.The fact that communism expired notwith a bang, but with a whimper, weowe largely to Mikhail Gorbachev.

Yet 2009 is a sobering year fromwhich to look back. A year ago, capi-talism careered over a cliff. With vasteffort, states have put it back on theroad. According to Piergiorgio Ales-sandri and Andrew Haldane of theBank of England, in a superb paper**,the total gross value of interventions

on behalf of banks has been $14,000bn.This is state capitalism.

What then does the crisis mean forthe countries that exited from social-ism two decades ago? What, too, doesit mean for the world?

For the former, it has meant big falls in output. According to theEBRD, the fall in the gross domesticproduct of transition countries willaverage 6.2 per cent in 2009. Declinesvary widely: from 18.4 per cent inLithuania, 16.0 per cent in Latvia, 14.0per cent in Ukraine and 13.2 per centin Estonia depression numbers to7.8 per cent in Slovenia, 6.5 per cent inHungary, 6.0 per cent in Slovakia and4.3 per cent in the Czech Republic.Polands economy is forecast to growthis year, by 1.3 per cent.

In general, notes the EBRD, thesize of the output declines correlateswith pre-crisis credit booms and exter-nal indebtedness. The bursting of bubbles hurts.

These collapses are real and worry-

monetary systems. Some of these fail-ings are inescapable. The future isinherently uncertain. Big mistakeswill be made. Where prevailing para-digms lead to risk-taking on an exces-sive scale, corrections are likely to bebrutal. Where risk-taking involveslarge-scale leveraging of the balancesheets of the financial sector, correc-tions are likely to mean a collapse inboth intermediation and the economy.

Should collapse not be prevented, theconsequences may, history tells us, bedramatic.

Happily, governments and centralbanks have learnt the lessons of the1930s and decided, rightly, to preventcollapses of either the financial sys-tem or the economy. That is preciselythe right kind of piecemeal socialengineering. Similarly, big effortshave been made to rescue the crisis-hit countries of central and easternEurope. Thus, support from the Inter-national Monetary Fund and theEuropean Union has been between 4and 6 per cent of GDP (or more) forthe four eastern European countriesthat have accepted IMF programmes.

A similar pragmatism must now beshown in completing the escape fromthe crisis.

That will require substantial rebal-ancing of global demand. It will also

require further reforms. For transi-tion countries, a reversal of financialintegration is likely to be costly andunnecessary. The principal goals of reform must, instead, be to make theeconomy less vulnerable to shocksand to curb excessive credit growth infuture.

Similarly, at a global level, radicalreforms must be made in the financialand monetary systems. To put i tbluntly, the banking system has beengaming the taxpayer on an intolerablescale. This must end, in one of twoways: the sector must be made subjectto the market or become a heavilyregulated ward of the state. Again,the curbing of huge credit bubblesmust be an integral element in theformation of regulatory and monetarypolicies.

Finally, the dependence of the glo-bal monetary system on the currencyof an over-indebted superpower is nei-ther desirable nor sustainable.

Anniversaries are a good time fortaking stock.

The collapse of Soviet communismwas a glorious moment. It remains so,despite mistakes and disappointmentsalong the way. But todays crisis tellsus of the failings of a euphoric capital-ism. Capitalism will not now perish,as communism did. But the signalability of liberal democracy is to learnand adapt. We learnt from the 1930s.We must now learn the lessons of the2000s.

* Transi t ion Repor t 2009 , www.ebrd.com/pubs/econo/tr09.htm** Bank ing on the S ta te, www.bankofengland.co.ukThis article was first published on November 10, 2009.

CAPITALISM

The end of the Soviet era felled an ideology. This financial crisis will not,says Martin Wolf

The closing of the Thatcher era

The British people hadgiven up on socialism. The

30-yea r experiment hadplainly failed and theywere ready to try some-thing else.

S o m us ed M ar ga re tThatcher on the eve of herfirst general election vic-tory on May 3 1979. But inthe run-up to the 30th anni-versary of the Iron Ladysarrival in Downing Street,many British people haveconcluded that once againa 30-year experiment hasplainly failed. This time,however, it is the experi-ment with Thatcherism.

T he c lo si ng o f t heThatcher era is an event of global significance. Many of the policies pioneered byher government in Britainwere copied in the rest of the world: privatisation,deregulation, tax-cutting,the abolition of exchangecontrols, an assault on thepower of the trade unions,the celebration of wealthcreation rather than wealthredistribution.

Mrs Thatcher came topower 18 months beforeRonald Reagan and the twoswiftly developed an ideo-logical love affair. But thereal triumph came when

Thatcherite ideas started tocatch on in improbable andinhospitable environments such as the Soviet Unionand France.

In the early 1980s, whileMrs Thatcher pioneered pri-vatisation, France underPresident Franois Mitter-rand pushed through whole-sa le na t iona l i sa t ions o f

banks and industrial con-glomerates. But while shesailed determinedly on withher free-market policies,famously proclaiming theladys not for turning Mit-terrand was forced into aU-turn in 1982. At the end of his period in office, he toowas a privatiser.

By t he end of t heThatcher era, free-marketreforms were being pursuedin China, eastern Europe,India and the Soviet Union.On her last visit as primeminister to Mikhail Gor-b ac he vs R us si a, M rsThatcher noted wryly thatthe new mayor of Moscowseemed to be a disciple of her own economic guru,Milton Friedman. Two of her closest advisers pub-lished a book with the exu-berant title of Privatisingthe Wor ld . S h e h e r s e lf exulted: People are nolonger worried about catch-ing the British disease.They are queuing up toob ta in the new Br i t i shcure.

But, almost 20 years aftershe left Downing Street, theBritish economy is onceaga in in deep t roub le .

Almost everything that MrsThatcher opposed nation-alisation, raising taxes,Keynesian economics isback in fashion. One byone, the signature policiesand achievements of theThatcher years are being dismantled in Britain.

Her celebrated decision tocut the top tax rate to 40

per cent has been reversed.There will now be a top rateof 50 per cent and opinionpol ls suggest that thechange is very popular.Britain has also now, ineffect, nationalised its largebanks, just as the Frenchonce did under Mitterrand.

No reform captured the

spirit of the Thatcher eramore completely than theBig Bang of financialderegulation in 1986, whichset the stage for the inexo-rable rise of the City of Lon-don. But the City is now inthe doghouse and there is arush to r e - regu late thefinancial services industry.Mrs Tha tcher once p ro -claimed that printing money is no more. But theprinting presses are rolling again except that thesedays it is called quantita-

tive easing. Forbiddenfrom public speaking by herdoctors, Lady Thatcher is inno position to defend herl egacy o r ins truct herremaining disciples.

Thatcherism is also out of fashion internationally.When Nicolas Sarkozy waselected president of Francein 2007, he quietly encour-

aged the idea that he wasthe French version of LadyThatcher. But these days helikes to be photographedclutching a copy of Das Kapital . Mrs Thatcher ven-erated the free enterprise of the US. But the new USpresident seems strangelyenamoured of the Europeansocial system.

Perhaps mos t damag-ingly, Thatcherism has lostthe moral high ground. TheIron Lady once proclaimed,slightly sinisterly: Eco-nomics is the method. Theob jec t i s to change thesoul. She meant that Brit-ish people had to rediscoverthe virtue of traditional val-ues such as hard work andthrift. The something fornothing society was over.

Bu t the idea tha t theThatcher era re-establishedthe link between virtuouseffort and just reward hasbeen destroyed by the spec-tacle of bankers driving their institutions into bank-r up tc y w hi le b ei ng rewarded wi th mi l l ion-pound bonuses and munifi-cent pensions.

The same problem hasdogged the international

versions of Thatcherism.Pr iva ti sa t ion in Russ iadegenerated into a morallydubious grab for assets by anew class of oligarchs. Out-rage about executive payhas been building for yearsin the US.

So is the Thatcher eradefinitively over? The eco-nomic cataclysms and pol-

i cy r eve r sa l s o f r ecen tmonths sugges t tha t i tsurely must be.

And ye t the re i s s t i llroom for doubt. When MrsThatcher came to power,she and her advisers hadbeen thinking for yearsabout the policies and ideasthey intended to pursue. Bycontrast, todays politicalleaders are fighting the eco-nomic crisis with whatevertools come to hand. Thedecisions to nationaliseBritains banks and to printmoney were emergencymeasures not the productsof a carefully thought-outideology or political pro-gramme.

One of Mrs Thatcher smost famous phrases was:There is no alternative.As yet, no major politicalfigure in the UK or the restof the western world hasreally articulated a coher-ent alternative to the free-market principles inheritedfrom Thatcherism.

Until that happens, theThatcher era will not bedefinitively over.

This article was first pub-lished on April 28, 2009.

THATCHERISM

All the signaturepolicies are being reversed, saysGideon Rachman

Perhaps mostdamagingly,Thatcherism haslost the moralhigh ground

Not for turning: Margaret Thatcher arrives at Downing Street in 1979 Roger Taylor

Output in European ex-communist countries

2009 & 2010 = forecasts

Real GDP, 1990=100

1990 95 2000 05 1040

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Source: EBRD1990 95 2000 05 10

40

60

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100

120

140

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1990 95 2000 05 1040

60

80

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EstoniaLatvia

LithuaniaPolandCzech RepublicSlovak RepublicHungary

RussiaUkraineRomaniaBulgaria

ing. But they need to be put in con-text.

First, many countries in transitionexperienced big increases in outputafter the initial and largely inevitablepost-Soviet collapse (see charts).Poland was the star. In general, thesuccessful countries were those thatreformed most seriously.

Second, surprisingly perhaps, tran-s i t ion coun tr i e s have made fewreversals of reforms. As the EBRDreport notes, government changessince early 2008 have either led to nochange with respect to the reformstance, or indeed favoured pro-reformparties. This is quite consistent withwhat is happening in the emerging world, more broadly. The absence of acredible alternative economic model isevident. Populist adventurism alsoseems unattractive.

As recovery begins to gather forceacross the world economy, the greatlegacies of the collapse of the Sovietempire the integration of much of Europe and the concomitant spread of freedom to Russias borders, if notbeyond remain intact.

Yet the crisis brings important les-sons. The philosopher Karl Popperlaid down the right approach. He dis-tinguished the piecemeal social engi-neering intended to ameliorate spe-cific ills from the utopian social engi-neering intended to transform soci-ety in its entirety an aim that, inpractice, has led only to the use of violence in place of reason.

The reformer must identify thecause of the malady before attempting treatment. In the case of this crisis,the failure lies not so much with themarket system as a whole, but withdefects in the worlds financial and

To put it bluntly, thebanking system has beengaming the taxpayer onan intolerable scale. Thismust end


5/6



Narrow banking alone is not the answer

W hat entered the cri-s i s was , we nowknow, an ill-managed, irrespon-

sible, highly concentrated andundercapitalised financial sec-tor, riddled with conflicts of

interest and benefiting fromimplicit state guarantees. Whatis emerging is a slightly better-capitalised financial sector, butone even more concentrated andbenefiting from explicit stateguarantees.

This is not progress: it has tomean still more and bigger cri-ses in the years ahead.

My friend and colleague, JohnKay, is aware of these dangers,as readers of his column knowwell. His answer, laid out in apamphlet for the London-basedCentre for the Study of Finan-cial Innovation, is narrowbanking*.

Mr Kay rejects the notion thatregulation can solve the prob-lem created by state-guaranteedfinance. Supervision, he notes,is always subject to regulatorycapture. Moreover, banksentered the crisis with capitalgenerally in excess of regulatoryrequirements. These provisionsproved not just inadequate butmassively inadequate for theproblems faced. Worse, manyof the dangers notably thegrowth of off-balance-sheetfinance reflected attempts to

circumvent regulation. Regula-tion, then, has not been theanswer, but hitherto has beenpart of the problem.

So what is the answer? Divi-sion of banking into a utilityand a casino is Mr Kaysanswer. The big idea is thatinsu red depos i t s should bebacked by genuinely safe liquidassets known as 100 per centreserve banking. In practice,these assets would be govern-ment bonds. This is the mostrigorous form of narrow bank-ing . Bu t he i s no t c l ea r on

whether he would insist on this.It seems he might accept looserconstraints.

For the sake of clarity, how-ever, let us focus on 100 per centreserve banking, an idea alsodiscussed in Austrian econom-ics. Is it workable? What mightit imply? To answer, we need tounderstand how we entered ourworld of credit-based money.

Suppose someone came upwith the following design forthe core institutions of ourfinancial system: they would bemainly financed by deposits,redeemable on demand; theywould invest in a wide range of often illiquid and opaque assets;they would engage in complextrading activit ies; but theywould have a wafer-thin equitycushion. Surely, people wouldconclude, this is fraudulent.They would be right. Such as t ruc tu re can on ly endurebecause central banks act aslenders of last resort. The gov-e rnment s ab i li ty to c reatemoney is put at the disposal of private interests. Right at themoment, the ability to borrowfrom the government at zero

interest is a licence to printmoney.

In practice, however, we havegone much further than this.We have also explicitly guaran-teed many deposits and implic-itly guaranteed many more lia-bilities. Indeed, in the crisis, pol-icymakers guaranteed all theliabilities of institutions deemedsystemically significant. Today,the core financial institutionsare, beyond doubt, a part of thestate.

Mr Kays proposal is, in sum,to end the fraud: banks wouldbe forced to hold assets as safeand liquid as their liabilities.We know there are other waysof making a system of fraction-al-reserve banks relatively safe:a stable domestic oligopolyachieves much the same thing.Bu t tha t does seem h igh lyregressive.

Is Mr Kays the answer? Oneobvious objection is that i tw ou ld i mp os e a m as si veupheaval in finance. But, giventhe crisis, such an upheaval isthe l eas t we shou ld f ea r.Another objection (though, to

some an advantage) is that,taken to its conclusion, it wouldeliminate monetary policy. Pub-lic debt held by banks would setthe money supply.

A more profound issue iswhether a financial systembased on narrow banking couldallocate capital efficiently.

Here there are two opposing risks. The first is that the sup-ply of funds to riskier, long-termactivities would be greatlyreduced if we did adopt narrowbanking . Aga ins t th i s , onemight argue that, with publicsector debt used to back the lia-bilities of narrow banks, inves-tors would be forced to findother such assets.

The opposite (and greater)risk is that the fragility of bank-ing would be re-invented, viaquasi-banks. This is what has just happened, after all, withshadow banking. In the end,those entities, too, have beenrescued. The big point is that afinancial structure character-ised by short-term and rela-tively risk-free liabilities andlonger-term and riskier assets is

highly profitable, until it col-lapses, as it is likely to do.

The answer to the seconddilemma is to make banking illegal. That is to say, financialintermediaries, other than nar-row banks, would have thevalue of their liabilities depend-ent on the value of their assets.Where assets could not be val-ued, there would be matching lock-up periods for liabilities.The great game of short-termborrowing, used to purchaselonger-term and risky assets, onwafer-thin equity, would beruled out. The equity risk wouldbe borne by the funds inves-tors. Trading entities wouldexist . But they would needequity funding.

Christophe Chamley of BostonUniversity and the Paris Schoolof Economics, and LaurenceKotlikoff of Boston University,proposed such radical ideas inthe FTs Economists Forum onJanuary 27, 2009. It is the sim-plest way I can see of avoiding the danger that narrow banking would shift the risks inherent insuch activities elsewhere.

The most important point isthat where we are now is intol-erable. Todays concentrationsof state-insured private wealthand power must surely go. Theofficial sector believes thattighter regulation, particularlyhigher capital requirements, cancontain these risks. But this islikely to fail.

If it does, we will need to beradical. Yet narrow banking would still not be enough. Wewould need to rule out quasi-banking. Otherwise, we wouldsoon return to the world of fra-gility and bail-outs. Funds thatreplace banks would have topass the risks directly on to theoutside investors.

The authorities will not enter-tain such radical ideas rightnow. But the financial system isso inherently fragile that radicalreform cannot be pronounceddead. It is only dormant.

* Narrow Banking: The reformof banking regulation, www.csfi.org.uk.This article was first published on September 29, 2009.

FINANCIAL SECTOR

If tighter regulation fails we will need to be really radical, writes Martin Wolf

The great game ofshort-term borrowing,to buy longer-termand risky assets, onwafer-thin equity,would be ruled out

Goldman Sachsshould beallowed to fail

A decade ago, when Goldman Sachswas a private partnership, it had$6.5bn in equity and its 220 part-ners, most of whose money wastied up in the firm until theyretired, took good care of their potof gold.

The banks trading and principalinvesting division the part thattook the most risks with partnerscapital was balanced with its fee-based investment banking andasset management divisions. Trad-ing contributed about a third of itsrevenues in the two years leading up to its 1999 initial public offering.

After it sold shares in the IPO tooutside investors pension andmutual funds hold about 80 percent of i ts equity i t steadilyincreased its appetite for risk. Its

fixed-income and currency divisionhas become dominant, bringing intwo-thirds of Goldmans revenuesin 2006 and 2007 (and 78 per cent inthe first nine months of this year).

In last years crisis, the US gov-ernment made clear that it standsbehind Goldman and other big investment banks. Goldmanreceived a $10bn capital injectionfrom the Treasury (since returned)and $21bn of its debt is backed bythe Federal Deposit Insurance Cor-poration. It is now a financial hold-ing company whose regulator andlender of last resort is the FederalReserve.

So, if Goldman Sachs took onmore risk when its equity was heldby outsiders than with its partnersown money, what can we expectnow that the government implicitlyaccepts that it is too big to fail?Goldman has an even bigger incen-tive to risk other peoples money.

It is a problem if the most power-ful broker-dealer on Wall Street hasthe same privileges as the mostmundane commercial bank. Notonly does the fact that it may pay$23bn in bonuses this year upsetpeople, but also its incentives areskewed.

Solving this requires two thingsto be addressed. First, Goldmansintention to operate as a institu-tional Wall Street firm complete

with its own hedge and privateequity funds while having govern-ment and Fed support. Second, itstradition of setting aside half itsrevenues each year for employees.

On the first point, Goldmans sta-tus strikes me as untenable. It maybe better regulated by the Fed thanthe Securities and Exchange Com-mission but counting it as justanother bank, with the same privi-leges and obligations as retailbanks and credit card companies,makes little sense.

This is not to accuse it of being reckless, or insouciant about how itoperates. It navigated the crisisbest of all the investment banksand does not run itself as if it isbound to get bailed out. It is wellcapitalised and holds $170bn of cash and liquid assets to hand, justin case.

Nor is it merely a giant hedgefund. Its pure proprietary activitiesmake up about 10 per cent of itsrevenues. Market-making in bondsand equities, now its main busi-ness, serves companies and inves-tors, although it is a capital-inten-sive and sometimes risky activity.

But its business is different fromthe banks for which the discountwindow the Fed facili ty thatallows its regulated banks to bor-row cash in exchange for securitiesin extremis was invented. Untilrecently, no one would have sug-gested that Goldman deserved aplace with them.

Mervyn King, governor of theBank of England, put it well. Theutility aspects of banking where

we all have a common interest inensuring continuity of service, arequite different in nature from someof the riskier activities that banksundertake, such as proprietarytrading.

One possibility is for Goldman tospin off its activities that comeunder the latter heading: the hedgefunds and private equity invest-ments in which it risks capital.That would leave its market-mak-ing activities and investment bank-ing divisions as a high-class finan-

cial utility. Even then, it should notbe treated by the Fed like a retailbank which has its deposits guaran-teed and is, as Mr King phrases it,too important to fail. Goldmanmust be structured and regulatedin such a way that it could safelybe allowed to fail in any futurefinancial crisis.

This would address some of the justifiable public anger about WallStreet firms having been bailed outby taxpayers, but what about thesecond point: Wall Streets lavishrewards to its senior employees?

The bonus problem in investmentbanking is not the absolute size of the rewards (although shareholdersought to ask themselves if theemployees really are worth it) butthe incentives they create.

Goldman probably has one of themost partner-like pay structures forits managing directors. About two-thirds of bonuses are in restrictedstock that vests over four years andits most senior partners have to

hold 75 or even 90 per cent of thestock until after they retire.

That is one reason Goldman hasnavigated the financial crisis betterthan others, but it could still learnfrom its past. By returning to thesystem of locking up all (or 90 percent) of its managing directorsbonuses until they retire, it wouldmake them even more careful.

If taxpayers could see not onlythat Goldmans bonuses were aform of equity partnership, but alsothat the bank would be allowed tofounder in a future crisis, it mightsap some simmering resentment.

Alternatively, Goldman couldkeep its old riches and newfoundofficial status, keep on taking morefinancial risk, and try to square thecircle by convincing people that itis a utility that operates in the pub-lic interest. That might be a strug-gle.

This article was first published onOctober 21, 2009.

BANKING

The Fed-regulated

investment banks statusis untenable, writes John Gapper

Utility aspects ofbanking are quitedifferent from some ofthe riskier activities thatbanks undertake

Too big to fail is too dumb to keep

In the 2007-08 crisis, manydifferent kinds of financialinstitution failed or weresaved only by state inter-vention. Large financialconglomerates Citigroupand Royal Bank of Scot-land. Investment banks Bear Stearns and LehmanBrothers. Smaller retailbanks without investmentbanking arms (but withactive treasuries) North-e r n R o c k a n d S a c h se nLandesbank. Diversifiedbanks, such as Fortis, andspecialist lenders, such asHypo RE. Public agencies,such as Fannie Mae andFreddie Mac. Americaslargest insurer, AIG. Tax-payers will be footing thebills for a generation.

All these bus inessesexemplified managementhubris and, in almost all,

the failure was the result of losses in activit ies thatwere peripheral to theircore business. Otherwisethey had little in common.

The variety of institutionsis matched by the variety of regulators. The list of agen-cies supervising failed busi-nesses is much longer thanthe list of institutions.

There a re peop le whobelieve that, in future, bet-ter regulation, co-ordinatedboth domestically and inter-nationally, will preventsuch failures. The interestsof consumers and the needsof the financial economywill be protected by suchco-ordinated intervention,and there will never againbe major calls on the publicpurse.

There are also people whobelieve that pigs might fly.Mervyn King, governor of the Bank of England hasmade enemies by pointing out that they will not.

It is impossible for regula-tors to prevent businessfailure, and undesirable topursue that objective. Theessential dynamic of themarket economy is thatgood businesses succeed

and bad ones do not. Therei s a sense in which thebankruptcy of Lehman wasa triumph of capitalism, nota failure. It was badly run,it employed greedy andoverpaid individuals, andthe services i t providedwere of marginal socialvalue at best. It took risksthat did not come off andwent bust. That is how themarket economy works.

The problem now is howto have greater stabilitywhile extricating ourselvesfrom the too big to failcommitment and taking arealistic view of the limitsof regulation. Too big tofail exposes taxpayers tounlimited, uncontrolled lia-bilities. The moral hazard isnot just that risk-taking within institutions that aretoo big to fail is encouragedbut that private risk-moni-toring of those institutionsis discouraged.

Interconnected systemstoo complex and dangerousto fail are not unique to

financial services. Failurecould a lso have ca ta -strophic consequences inelectricity networks andnuclear power stations.Interconnectedness is han-dled by building robust sys-tems. If the failure of indi-vidual components mightdestroy the whole, systemsare redesigned to eliminatethe problem.

The paradox is that everyfinancial institution haselaborate procedures to dealwith a technological failure,but neither they nor thefinancial system as a wholehave measures for organisa-tional failure. We need toachieve that by setting upfirewalls between activities,within compan ies anda c r os s s e c to r s , a n d b ybreaking down large insti-tutions into parts so prob-lems of individual elementsdo not risk the whole.

The best way to safeguardthe real economy while pro-tecting the public purse is

to ensure essential financialservices to individuals andbusinesses are regulatedbut to refuse to underwriterisk-taking. Some includ-ing Martin Wolf arguet hi s r es ul t c ou ld b eachieved by higher capitalrequirements and living wills. If these require-ments were sufficientlydemanding , they wouldachieve the same outcomesas the separation involvedi n n ar ro w b an ki ng because they would amountto much the same thing.The capital requirementswould have to be not justhigher, but much higher,while an effective living wi ll w ou ld n ee d t oringfence retail operationsand assets to enable anadministrator to take themover seamlessly in a crisis.

Their activit ies under-written by implicit andexplicit government guar-antee, i t is increasinglybusiness as usual for con-glomerate banks. The politi-c i ans they lobby soundincreasingly l ike theirmouthpieces, espousing the

revisionist view that thecrisis was caused by badregulation. It was not: thecrisis was caused by greedyand inept bank executiveswho failed to control activi-t ies they did not under-stand. While regulatorsmay be at fault in not hav-ing acted sufficiently vigor-ously, the claim that theycaused the crisis is as ludi-c rous a s the c l a im thatcrime is caused by the indo-lence of the police.

The governor of the Bankof England is one of the fewpubl i c o ff ic i a ls to havegrasped that the primarypurpose of regulation is toprotect the public, and notto promote the interests of the financial services indus-try. When the next crisishits, and it will, that frus-trated public is likely toturn, not just on politicianswho have been negligentlylavish with public funds, oron bankers, but on the mar-ket system. What is at stakenow may not just be thefuture of finance, but thefuture of capitalism.

This article was first pub-lished on October 28, 2009.

FINANCIAL SECTOR

Trying to prevent failures is itself doomed to failure,says John Kay

Distorted: lumping Goldman with commercial banks is a stretch Bloomberg

The crisis was

caused by greedyand inept bankexecutives


6/6

FINANCIAL TIMES TUESDAY DECEMBER 15 2009 7


A Lehman deal would not have saved us

I f o nl y. L aw re nc eMcDonald begins hisinsider s account of the f a l l o f Lehman

Brothers with seven whatif scenarios, speculating onhow different decisionsmight have saved h isformer employer. If onlyDick Fuld, Lehmans chief executive, had listened tot ho se w ho w ar ne d o f impending losses on thebanks property portfolio. If only Mr Fuld had not antag-onised Hank Paulson, thethen Treasury secretary.And so on.*

Mr McDonald is far fromt he o nl y p er so n w hobelieves that the Lehmanbankrup tcy cou ld havebeen avoided. Alan Blinder,the former Federal Reservevice-chairman, has calledthe decision to let the bank

fa i l a co lossa l e r ro r .Chr i s t ine Lagarde , theFrench finance minister,denounced it as a horren-dous mistake. When anevent is followed by suchupheava l the b igges tfinancial panic since 1931,the worst recession sincethe war it is only humanto imagine how the milkmight not have been spilt.When, at Januarys WorldEconomic Forum in Davos,I argued that this was wish-ful non-thinking, I foundfew supporters.

If only. If only Lehmanhad been saved, the rewould have been no creditcrunch. No near-Depres-sion. The S&P 500 wouldnot have sunk to 682 (itsnad ir l as t March). Wewould probably be back to1,500 by now.

If only Lehman had beensaved, Republicans mightmuse, there would havebeen no Democratic land-slide in November s USelections. Instead of Presi-dent Barack Obama, wewould have John McCain inthe White House. After all,the presidential race wasstill pretty close in the sum-mer of last year. It was theseverity of the economic cri-sis after September 15 thatreally doomed Mr McCain not least because he himself had earlier confessed hisignorance of economics.

A McCain presidency, of course, would have hadvery different priorities: noKeynesian stimulus bill, nopubl i c op t ion in anyhealthcare reform. If onlyLehman had been saved,there would be no threat of Obamacare and no townhall hysteria about socialistdeath panels.

Why stop there? If onlyLehman had been saved

and Mr McCain had won,the Green Revolution inIran would have had Ameri-can support and MahmoudAhmadi-Nejad would nolonger be president.

If only Lehman had beensaved and the stock markethad not tanked, MichaelJackson would not haveneeded to commit to those50 comeback gigs in Lon-don. He would not have feltso stressed and would nothave taken all those seda-tives. If only Lehman hadbeen saved, Jacko wouldstill be alive.

If only.Actually, no. All would

not have been for the bestin the best of all possibleworlds if only Lehman hadbeen saved. On the con-trary, a decision to bail outMr Fuld would almost cer-tainly have had worse con-sequences than letting himand his company go under.

In a parallel universe, nodoubt, another Mr Fuldmight have made a seriouseffort to sell Lehman. Hav-ing seen the fate that befellBear Stearns, he had sixmonths to find a buyer.There were at least threepoten t ia l su itor s: t heKorean Development Bank,Bank of America and Bar-clays.

But in this universe, Leh-mans chief executive per-sistently overplayed his

hand, overvaluing the prop-erty assets on the banksbalance sheet by as muchas $25bn-$30bn. Mr Fuldwas adamant: As long as Iam a l ive th i s f i rm wi l lnever be sold. And if it issold after I die, I will reachback from the grave andprevent it.

In another parallel uni-verse, another Treasury sec-

retary and Fed chairmanmight have come up withthe money to incentivise abuyer of Lehman (as theyhad when JPMorgan Chasebought Bear Stearns withthe help of a $30bn loan).

But there was a reasonwhy no buyer cou ld befound in this universe. Leh-man was a firm in its deaththroes. It had lost $6.7bn inthe space of six months. Ith a d d e b ts i n e x c e ss o f $600bn. Its assets were col-l aps ing in va lue . Evenwhen a deal with Barclaysseemed within reach, theBritish Financial ServicesAuthority vetoed it. AlistairDarling, the chancellor of the exchequer, made i tclear: We are not going to

import your cancer.So, in a third and final

parallel universe, an alter-nate Mr Paulson and analternate Ben Bernankecould have nationalisedLehman outright as theyhad already nationalisedFannie Mae and FreddieMac on September 7, andwould nationalise AIG theday after Lehman filed forbankruptcy. These surelywere the kind of unusualand exigent circumstancesthat permit the Fed to takeemergency action.

In this universe, however,Mr Paulson had resolved tostop being Mr Bail-out.More than once, he statedbluntly that there would beno taxpayer money on theline for Lehman. When MrFulds lieutenants warnedthat their banks failurewould unleash a financialt su na mi , M r P au ls onaccused them of talking their own book.

It is clear that he under-estimated the consequencesof l e t t ing Lehman fa i l .Maybe, as a former Gold-man Sachs chief executive,he did let his prejudiceagainst Mr Fuld get the bet-ter of him. In one respect,however, Mr Paulson didthe r igh t th ing a lbe i tunwittingly. By showing Americans and particu-larly their legislators inCongress just what could

happen if even the fourth-largest investment bankfailed, he created what hadhitherto been lacking: thepolitical will for a wholesalebail-out of the US financialsystem.

The critical point is that,like Bear Stearns, Lehmanwas just an extreme case of a general phenomenon. Arelatively small number of very large financial institu-tions had become danger-ously leveraged and wereon a fast track to insol-vency as their propertyinvestments imploded. Reli-ant on misleading risk-man-agement models, and count-ing on the vastly over-ex-

tended insurer AIG to payout if their counterpartiesdefaulted, they were likelemmings in a line, going over the cliff one by one or rather being pushed off by short-sellers.

What was needed was nota succession of ad hoc gov-ernment-backed takeovers.As Ken Lewis , Bank o f Americas chief executive,came to realise when helooked more closely at Mer-rill Lynch, todays buyerrisked being for sale tomor-row, since no ones balancesheet was safe. Bob Dia-m on d m us t t ha nk h ismaker every day that theFSA did not approve a deal

that might have destroyedBarclays; instead, he gotwhat he wanted Lehmanscore investment banking business dirt cheap fromthe bankruptcy court.

What was needed was ahuge bail-out across theboard. And that was whatthe $700bn troubled assetrelief programme (Tarp)ended up being.

Recall that even afterLehmans failure i t st i l ltook two attempts to getTarp passed. If Mr Paulsonand Mr Bernanke had takenover Lehman on their owninitiative, there would havebeen an outcry in Congressagainst yet another hand-

out to a manifestly misman-aged ins t i tu t ion . Theremight very well have beenno Tarp. That surely wouldhave been a death sentencefor Citigroup, an institution

three times larger than Leh-man.Like the executed admiral

in Voltaires famous phrase,Lehman had to die pour encourager les autres toconvince the other banksthat they needed injectionsof public capital , and toconvince the legislature toapprove them.

Not everything in historyis inevitable; contingenciesabound. Sometimes it istherefore right to say if only. But an imagined res-cue of Lehman Brothers isthe wrong counterfactual.The right one goes like this.If only Lehmans failureand the passage of Tarp hadbeen followed not immedi-ately, but after six months by a clear statement to thesurviving banks that noneof them was henceforth toobig to fail, then we mightactually have learnt some-

thing from this crisis.The real tragedy is that

the failure of Lehman hasleft Wall Streets survivorsbo th b igger in r e l a tivete rms and more securepolitically. As long as thebig banks feel confidentthat they can count on thegovernment to bail themout for who would nowrisk another Lehman? t h e y c a n m o r e o r l e s signore calls for lower lever-age and saner compensa-tion.

If only we had learnt fromLehman that no bankshould be too big to fail,we might still have a realcapitalist system, instead of the state-guaranteed mon-strosity that is the real leg-acy of last years crisis. If only.

* Lawrence G. McDonald and Patrick Robinson, AColossal Failure of CommonSense: The Inside Story of the Collapse of Lehman.

This article was first pub-lished on September 14, 2009.

THE LESSONS

Niall Fergusonexplores alternativeoutcomes

In one respectHank Paulson didthe right thing albeit unwittingly

The dangers of silo thinking

When Larry McDonald, a former bondtrader at Lehman Brothers, wrote anexpos of that brokers collapse, itseems that his main intention was toreveal the extraordinary folly andineptitude of the former Lehmanbosses.

In practice, though, his colourfultale also highlights almost inadver-tantly another crucial problem thathaunts the modern financial world:the curse of silos.

For, as McDonald narrates, severalyears before the Lehman collapse inthe autumn of 2008, its own fixed-income department was already soalarmed by the American real estatemarket that they were hunting forways to go short.

However, while one department of Lehman was exceedingly bearish,other departments, such as the mort-gage securitisation team, were soaggressively bullish that they wereincreasing their exposure and thedifferent departments were in suchrivalry that they barely knew whatthe other was doing, with disastrousconsequences.

It is a saga that raises a widermoral, not just for bankers, but forinvestors too.

Vat s o f ink have been sp i lt t oexplain all the macro-economic andregulatory reasons for the financialcrash.

But one issue that has received lessattention is the trend towards frag-mentation in the financial industry,not just in a structural sense (iedepartments that do not talk), but amental sense too (ie financiers operat-ing in tunnel-vision mode).

This fragmentation fuelled many of

the recent failures of public policy.Just look at how the activitivies of groups such as AIG fell through thecracks because there were numerouscompeting regulatory bodies in theUS. Look too at how British policy-makers tried to separate out the con-duct of monetary policy (managed bythe Bank of England) from financialregulation (handled by the FinancialServices Authority) with equally dis-astrous effect.

However, the problem of fragmenta-tion has also been central to the disas-ter in private-sector institutions. Leh-man was certainly not the only bankmarked by internal tribalism. Institu-

tions such as UBS, Merrill Lynch andCiti demonstrated similar problems.And this sense of fragmentation has

not just hampered information flowsaround banks, but has also preventedinformation flowing across the markettoo. That, in turn, has fuelled a sense

of tunnel vision among some inves-tors, with equally dismal results.

Back in the years of the creditboom, for example, many equityinvestors were only dimly aware of what was happening in the creditdefault swap world. Similarly, thosecorporate treasurers who were pour-ing cash into money market fundsoften had only a hazy idea aboutevents in the structured credit world.Complex credit was considered a silo,that was best left to the geeks or,at least, those who were experts inthat field.

But the financial crisis has high-lighted with painful clarity just howdangerous such tunnel vision can be.And the good news is that some finan-

ciers, investors and policymakers arebelatedly trying to combat it.

The hot new fad among regulators,for example, is macro-prudential sur-veillance (a posh phrase for proactiveregulation that tries to join up all thedots). Investment banks are scurrying to beef up their risk managementfunctions, and stressing the impor-tance of holistic oversight.

Meanwhile, a host of asset manag-ers are champions of lateral thought,and are trying to understand what ishappening in seemingly disconnectedsilos be that in the Chinese autoindustry, carbon trading markets orcredit default swaps.

The bad news is that the curse of silos will not be easy to beat. For onebizarre paradox of the modern age isthat while techology is integrating theworld in some senses (say, via theinternet), it is simultaneously creat-ing fragmentation too (with people inone mental silo tending to only talk toeach other, even on the internet.) Andas innovation speeds up, this is creat-ing a plethora of activities that areonly understood by experts in a silo be that in finance or in numerousother fields.

That pattern implies there is now abig need for cultural translators,who can explain what is happening inthose silos to everyone else. But thecadre of cultural translators in todaysworld is pitifully small (and may evenbe shrinking, as institutions such asmedia organisations and rating agen-cies find their business models underthreat).

Therein lies one of the essentialchallenges for investors today: namelyhow to understand the micro-detailsof the silos, and see how all the mac-ro-pieces add up. The challenge islikely to intensify, not diminish, inthe coming years precisely becausewe now live in an era where bothinterconnections and tribalism holdsway.

This article was first published onOctober 8, 2009.

THE LESSONS

Cultural translators areneeded if we are to avoidmissing important clues,says Gillian Tett

No other way: the reason no buyer could be found for Lehman was that it was in its death throes Brendan McDermid/Reuters

Vats of ink have been spiltto explain all themacro-economic andregulatory reasons for thefinancial crash

FT's Year in Finance 2009

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