Financial Crisis

  • An Open Letter to Finance

    September 19th, 2018 by ewalsh
    Photo by Aditya Vyas

    Photo by Aditya Vyas

    Ten years have passed since the U.S. Federal Reserve Bank allowed Lehman Brothers to file for bankruptcy, attempting to signal to the market that no firm is too big or important to fail. That mistaken belief triggered panic across the global financial system. The next day, a chastened Fed decided to rescue AIG, the insurance colossus ensnarled in a credit default swap tsunami that threatened to bring down much of the financial system with it, beginning with Goldman Sachs.

    The media waves are filled with analyses of causes and expert testimony on what’s changed, and questioning if it can happen again. Unfortunately, most of this decade on analysis fails to go deep enough to assess true root causes that lie in issues like purpose and systems design principles. Without such analysis, we can say with confidence, as many pundits agree, that it can and will happen again.

    To avoid such an outcome, to which governments are far less capable of responding than they were ten years ago (perhaps one of the most dangerous consequences of the crisis), we must fully internalize four fundamental lessons from the crisis:

    Lesson 1: Finance is a sacred trust upon which societies rise and fall, and the modern global financial system is inexorably dependent upon the support of Central Banks, and the U.S. Government (and China) in particular.

    The unprecedented, multi-trillion-dollar rescue of finance largely worked as hoped. And any pretense of a “free market” financial system is a fraud. We should understand the global finance system as contingent socialism. The system, when in crisis—which is the only time the socialist part is relevant—is fully backstopped by the full faith and credit of the world’s major governments. There can be no other way, so we must think and act accordingly.

    While many bankers lost their jobs, including some fat cats, few lost everything, and most recovered just fine. The real human costs of the financial crisis have been born by ordinary citizens in the real economy. Trauma of this magnitude causes damage that reverberates for generations. Millions lost their jobs and homes with profound consequences on families’ life-long emotional and financial well-being. Billions more around the world had their livelihoods profoundly shocked or worse. More have been permanently scarred from the cascading effects of the credit crunch on consumers, businesses, towns, schools, hospitals, indeed the entire real economy and with it, the social fabric of society. Local, State, and National Governments have had their financial positions damaged, leaving them far less resilient to weather the many interconnected crises arriving at an accelerating rate, from bridge collapses to storm devastation, from the opioid addiction to the mental health crisis affecting our children.

    Such costs should be seen as unacceptable by modern governments with an interest in survival, no different than invasion by an enemy power. The scale of government response must reflect this reality. This is the implication of a contingent socialist financial system.

    Lesson 2: The global response to the financial crisis was wrongly focused on saving finance to save the economy.

    It is true that a financial collapse would destroy the economy, but it does not follow that saving finance will save the real economy. In the contingent-socialist finance that we have, like it or not, it is incumbent upon governments of the leading powers to create structures and institutions that protect economies from catastrophic loss. Finance has lost the opportunity to self-govern itself in such a way to make it safe for society. All actions have consequences. Similarly, it was necessary following WWII to conceive of NATO to protect Nation States (and society) from themselves.

    The lesson is that Finance is embedded in, and inseparable from, the real economy and society as a whole. Any notion of a “financial sector” apart from the broad economy is, in reality, a fiction, useful to clever financiers who exploit the contingent socialist contract for massive gains, on the backs of the citizens without their knowledge or consent. The speculators even have a name for it: The “Fed put” which allowed them to actually increase risk-taking focused on banks, knowing full well that the Fed would not allow the system to collapse. Heads I win, tails society loses, while the speculators’ bet has a floor under it. It’s like free insurance, and financiers understand the value of free. The aggressive ones load the boat on “free” to the direct detriment of society.

    Modern Finance extracts by design, and therefore undermines the health of the host within which it is embedded (the real economy). In fact, “to extract value” is an ordinary and unquestioned term within the practice of finance. The distribution of costs and benefits from financial activity is asymmetrical and extreme. Finance takes a disproportionate share of the winnings when times are stable, while distributing the losses across society during crisis: this is contingent socialism.

    Lesson 3: Malfeasance coupled with injustice has consequences.

    The injustice of the bailout has been seared into our collective psyche. None of the worst offending fat cats went to jail. Few were held accountable in any meaningful way. No doubt the political tribalism here at home and across Europe is, to a significant degree, a result of the financial crisis and associated human misery, made worse by the ill-informed austerity policies the crisis brought in its aftermath. Then, to make a terrible situation unpalatable, there has been a complete lack of accountability for those responsible (private sector and public sector alike). The public knows in their guts that this contingent socialist system (referred to now as simply “Wall Street”) is fundamentally unfair, they are understandably angry, and the western political order is in great peril.

    Lesson 4: Without a fundamental strategic reassessment, we cannot change the nature and ideology of finance. Indeed, it has not changed.

    Many of the regulatory responses to the financial crisis were tactically correct, but, as can be expected, they had unintended consequences. It was correct to increase the capital and liquidity buffers of banks (it arguably should have been more). It was correct to tackle the off-balance sheet derivative exposure through the use of centralized exchanges for much of the counterparty risk. It was correct (but unrealistic) to attempt to create “living wills” for banks. It was correct to attempt to reign in speculation with the Volcker Rule. Nevertheless, all these changes have been heavily negotiated by the banks who retain too much power to determine their own fates. And some of these good intentions have proved to be practically very difficult (Volcker Rule in particular). And the cost of dealing with all this new regulation means greater fixed costs for all, harming the smaller banks we need more of, while creating further economies of scale for the very largest. Indeed, the too big to fail banks of today are much larger than during the financial crisis a decade ago. Even if they are better capitalized, they most certainly remain too big to fail, and they are far from fail-proof.

    Tactical responses to the flaws of the last crisis without a fundamental strategic reassessment about what is the purpose of finance, and what kind of financial system do we as a society want (and in fact need), can only deliver incremental improvements. Tactical responses cannot change the nature and ideology of finance. Indeed, it has not changed.

    A strategic assessment of what went wrong a decade ago (and what went wrong on the hundreds of prior financial crises) must begin with two questions:

    First, what is the purpose of finance?

    And second, will we accept any financial activity that is deemed by society not to be in the interest of the health of the whole system (the real economy within which finance is embedded)?

    I would suggest a thorough and serious evaluation of the first question is long overdue. And I hear virtually no real discussion by those in power about the second question beyond some bashing and shaming the villains in finance. What is missing is an evaluation of our finance ideology and the grip it has on us as a society. We must find the right questions to ask.

    Questioning financial activity and its consequences for society, like the fact that much of modern finance emanating from Wall Street is dedicated to short-term speculation which we confuse with “investment” rather than in service to the real economy. Or like the predatory nature of much of the rush to securitize assets in what has become known as financialization or even the positive-sounding and implied “market completion” by financial economists. Let us be clear: the subprime crisis was never primarily about extending home ownership to low-income households as we would be led to believe by the “market completion” narrative. It was about manufacturing massive quantities of securities with high yields that could be sold to yield hungry investors with correspondingly massive fees taken out in the middle by financial predators. The tail wagging the dog with horrendous human consequences. We as a society can and must decide whether we need to allow anything just because it’s possible (we don’t). Yet we do allow it.

    To begin a conversation about these important questions and more, I plan to release “Regenerative Finance”. The thought piece asks a singular question: what would finance look like if it were to operate in service to the economy and a healthy biosphere? Such an approach to finance is one that is aligned with the principles of regenerative economics as articulated in my previous work, “Regenerative Capitalism: How Universal Principles and Patterns Will Shape the New Economy” (2015).

    We will take a living-systems view of what the design principles of systems that sustain themselves for long periods of time actually look like, and use this as an objective, ideology-free lens to assess finance strategically, rather than reactively and from engrained ideological positions which is the conversation one usually sees in the Financial Times and the Wall Street Journal. Political difficulties with policy implementation are suspended while we get clear on where we actually need to go.

    We will present the project in the coming weeks and months in four acts following an introduction to provide context:

    Act I: Implications of the Regenerative Paradigm for Finance
    Act II: The Failures of Finance
    Act III: Towards Regenerative Finance and a New Investment Theory
    Act IV: Agenda for the Genuine Financial Reform We Need

    Your feedback and suggestions are not only welcome but they are also a vital part of the project. So please send your thoughts in writing to feedback(at)capitalinstitute(dot)org and accept our sincere gratitude in advance. You can also share your suggestions on social media using the hashtag #DearFinance. Our aim is to revise the draft based on your input before publishing a final product by year-end.

    I sincerely hope this project will be worthy of your good energies and can be shared among your networks. Collectively we can begin to shift the conversation on Finance, an ideology that has come to hold a grip on us, and even absent bad behavior by financiers, threatens all we hold dear in the process.

  • Broken Trust

    January 27th, 2017 by ewalsh


    At this year’s World Economic Forum gathering in Davos, Switzerland, PR firm Edelman shared its comprehensive annual Trust Barometer, confirming what we all know: global trust in institutions and leaders is at an all-time low.  Fully two-thirds of countries are now considered “distrusters” (under 50% trust in the mainstream institutions of business, government, media and NGOs to do what is right), compared to about half a year ago.  This is a stunning collapse in trust, even from last year’s low base.

    Trust in leadership is equally low. Only 37 percent of the general population believe CEOs are credible, even worse for government officials – 29 percent credible.  A paltry 15 percent believe the system is working.  Ironically, it was Chinese Premier Xi, in his first address at Davos, who stood in defense of globalization (quoting Abraham Lincoln, it should be said), arguing that the system is sound, but it is (Western democratic) governance that has failed.  Note China ranked second on the trust index, second only to India.

    Talk about a humbling moment (if that’s possible) at the annual gathering of the global economic and political elite.

    There was lots of talk this year at Davos about “inclusive capitalism” (Jack Ma actually puts substance behind the slogan in his must-watch interview — a great example of Alibaba’s seemingly regenerative business model in service to its network partners rather than extracting from them, and a sharp contrast to Amazon’s model, as Ma explains).  But the “inclusive capitalism” talk included little honest analysis of the root cause of this stunning collapse in trust, why it is so dangerous (the rise in extreme forms of authoritarian populism rooted in emotion more than evidence and its unpredictable path), and what if anything can be done about it at this late date.  Nobel Economist Joseph Stiglitz wrote a prescient piece on this topic in 2013, and called for strong regulation and bold regulators to enforce the laws.  Clearly, we have failed.  And without a culture that not only values trust but demands it, I am not optimistic about better regulation and stricter enforcement.

    The decline in trust pervades all four institutions studied in the Edelman survey. Unfortunately, Edelman did not single out finance and report on it separately from business.  Surely few would doubt that the finance sector (Wall Street mega banks, in particular) would rank at the bottom of the trust barometer within the business category.  In fact, research confirms that bankers are more likely to cheat than the rest of us. (As a former banker, this is upsetting to me!)

    Nothing defines banking’s breach of public trust better than the 2008 financial collapse.  Being told to move on, It is easy to forget how much of the world’s current social and economic woes can be traced to the financial bubble and subsequent 2008 systemic collapse, either directly or indirectly.

    Recall that the financial collapse destroyed $19 trillion of economic value in the U.S. alone, permanently destroying the economic security of millions of families across America.  An estimated 34 million jobs were destroyed globally in the process.

    The rise of today’s dangerous brand of authoritarian populism—manifesting first in Brexit and now Trump—is directly connected to Wall Street’s breach of trust.  It’s not just because of “globalization” or “technology” taking our jobs as if it were all inevitable.  We cannot forget that compounding and exacerbating these legitimate and complex challenges, and more (climate change-induced drought driving immigration, linked to the Syrian carnage comes to mind) was the willful act of dropping a bomb into an already vulnerable society.  The Goldman Sachs/John Paulson Abacus trade was the Hiroshima of modern financial history.

    The mortgage fiasco was a massive, reckless act of violence, perpetrated upon global society by an industry failing in its critical purpose while instead proving itself willing to do just about anything to make grotesque profits through fraud and egregious deceit.  The efficient market narrative of bringing home ownership to the masses was all a cynical cover.  And the industry’s ongoing fraudulent activities post the crisis, from the LIBOR scandal to FX price rigging, to wrongful foreclosure with robo-signers to Wells Fargo’s opening millions of fake accounts out of its “community banking” division of all places (where the do-gooders are supposed to work), sealed the fate of the industry as devoid of trust for some time to come, unfair as that may be for the many honest bankers out there.

    Blaming populism on bankers’ unparalleled breach of trust is a strong claim.  But think about it:

    Less speculative finance, less speculative real estate lending.  Less boom created from unsustainable misallocation of human, physical, and financial capital to speculative real estate. Less wasted carbon in the atmosphere and less farmland destroyed, exacerbating the drought-driven migrations.  Less unearned wealth for bankers and less resulting inequality, and less power for the sector to rig the rules, buy off and brainwash the politicians and even regulators, resulting in asymmetric risks only the opportunist bankers truly understood.  (Trump once referred to the bankers—now his advisors—as “killers” on the campaign trail, and he’s had to cross them more than once, so he knows).   Less demand on the public sector to socialize the losses to “save the system” and therefore less public debt and no need for the misguided austerity driving society further into despair.  That means more resources available to address the consequences of globalization and automation, and greater acceleration of investment into the transition to renewable energy and into rebuilding our aging yet vital infrastructure.  More assets channeled into education, perhaps even into the revival of civics classes!  We know how this narrative continues.  We know it does not end with the election of a fraud to the most powerful office in the land.

    Donald Trump, whose ethics seem guided by the probability of winning lawsuits, is about as unlikely a remedy for broken societal trust as one can imagine, as his hopeful supporters are sadly about to learn.  Coal is not coming back, sorry.  So the consequences of lost trust will only amplify in dangerous and unpredictable ways that now stunningly include the Orwellian introduction of “alternative facts” into the Trump Administration’s everyday narrative.

    The so-called “activist investor” Carl Icahn is Trump’s fellow bully buddy and now Special Advisor on Regulatory Reform.  He has defended the need for Dodd-Frank banking reform in the past and held the banks responsible for the financial crisis in public statements.  That is a testament to his common sense and refreshing objectivity as a Wall Street insider.  Time will tell whether a man who has spent half a century as an opportunist (bully) stock speculator can come to see that an ideology that conflates speculation with investment and means (finance and the stock market) with ends (a healthy economy) can guide us to a more enlightened and still desperately needed financial system reform and begin the long process of rebuilding trust in Wall Street, and in the process within society.

    Not holding my breath.

  • How Finance Can Help Save Our Planet

    March 23rd, 2015 by John Fullerton

    Screen Shot 2015-03-23 at 4.23.50 PM

    The following post was adapted from a chapter I wrote for John G. Taft’s new book, A Force for Good, published just this past week by Palgrave Macmillan. John is the CEO of RBC Wealth Management, and I am proud to be in the illustrious company of individuals like Mary Schapiro, Robert Shiller, Sheila Bair, Roger Martin, and Dominic Barton, who were invited by John to contribute to this book. I think you will find A Force for Good a fascinating read as it explores, from a variety of experienced perspectives, how the financial industry can marshall, for the long-term public good, the creative energies and brainpower it has deployed in the past to develop derivatives, high-frequency-trading technologies, and other engineering complexities.

    In 2011, the Economist declared that civilization had entered into what is known as the Anthropocene era – a geologic period in which human activity is altering the health of earth. The piece contended that if we continue to operate as we have, we will cause irreversible damage to the life-supporting systems of the planet. What the Economist failed to point out, however, was the critical role that finance plays in shaping this outcome. Our relentless pursuit of the exponential growth of financial capital, hardwired into our economic system, will bring us to the brink of collapse if we don’t change course. Science tells us that our planet, along with all of its complex, interconnected biochemical systems that enable life to exist, are fixed in scale. Yet our dominant economic theories assume that our path to prosperity requires limitless, undifferentiated, exponential growth of the economy’s metabolism – defined as raw materials in and waste materials out. The emergence of the Anthropocene era requires a seismic shift in our economy. We must transition to a more sustainable and inclusive economic system that serves the needs of people while respecting the earth’s physical limits. The financial crisis of 2008-09 provided us with the perfect impetus for this shift, prompting even mainstream economists to question as never before the very foundations of our finance-driven economic system. What they and policymakers should consider is a holistic approach that takes a deeper look into the practice of finance, and in particular, long-term decision making that affects the flow of trillions of dollars of real investment in the decades ahead. In this, the Anthropocene era, large-scale investment decisions simply must be considered a vital part of the public interest and on the agenda of an informed, democratic process. The top 1,000 global corporations represent half of the total market value of the world’s 60,000 public companies and, undoubtedly, an even greater share of capital investment budgets. What demands our attention, therefore, are the decades-long impacts of the capital expenditure decisions these larger corporations make. The same goes for the impacts of large government capital expenditures like investments in infrastructure. Corporations generally make their investment decisions using an internal rate of return framework that compares a project’s expected financial return with the firm’s cost of capital. Concerns about the systematic impact on social and natural capacity rarely enter the analysis. That must change. There are three possible paths – all interconnected – to prompt that shift:

    1. We can work within the existing economic paradigm to shift the flow of investment by making commercial enterprises begin to pay the true social and environmental cost of their operations and by subsequently passing those costs on to consumers;
    2. Business, government and large pools of private capital can begin leading, through enlightened real investment in resource productivity and alternative energy to save money and accelerate the shift to a Regenerative Economy; And
    3. The public can demand a new set of rules and regulations – some local, some regional, some global – to establish the necessary guardrails and mandates to force the transition.

    That said, the scale and complexity of the necessary shift in thinking is unparalleled and time is not on our side. No economic system in the history of civilization has ever had to contemplate such a restraint. But the sooner we acknowledge the implications of this immense challenge, the better.

  • High-Frequency Trading is a Blight on Markets. Tobin Tax Can Help.

    April 4th, 2014 by John Fullerton

    This blog post previously ran in The Guardian’s Business section.

    A tax on financial transactions can calm the frenzy of speculation fuelled by computer-driven >> Read more