THE FT’S
Inside
YEAR IN FINANCE
FINANCIAL TIMES SPECIAL REPORT | Tuesday December 15 2009
World counts true
cost of the rescue
Economic theories
and public purses
are both looking
rather bare, writes
Lionel Barber
A
fter a near-death
experience, many
of the world’s lead-
ing banks discov-
ered in 2009 that there was
life after the global finan-
cial crisis.
For the walking wounded
– and there were plenty –
the spellbinding returns of
the credit bubble remained
a distant memory. Their
business was about sur-
vival. But for the stronger
financial institutions –
Goldman Sachs, JP Morgan,
Deutsche Bank, and Bar-
clays Capital – the level of
revenues, profits and
bonuses suggested it was
back to business as usual.
“We are doing God’s
work,” declared Lloyd
Blankfein, Goldman’s chair-
man and chief executive, in
a gloriously unscripted
comment. The feisty Mr
Blankfein was soon back on
message, offering a broad
apology for Goldman’s role
in the financial crisis and
producing a $500m cheque
for assisting small business.
Critics immediately dis-
missed the gesture as per-
functory, a reflection of the
inflamed public mood. But
even aside from the wind-
fall tax on bankers’ bonuses
in the UK, 2009 marked a
reckoning of sorts after the
near meltdown of the finan-
cial system in 2008. This
sense of perspective –
drawn from a selection of
FT articles published in the
past 12 months – is what we
have sought to capture in
this special report.
In intellectual terms, as
Robert Skidelsky writes, the
global financial crisis
marked the collapse of the
“efficient market hypothe-
sis”, which said economic
actors behave rationally
and markets efficiently. In
fact, the world discovered
(again) that economic
actors can behave irration-
ally and markets can be
anything but efficient.
Prof Skidelsky, the
acclaimed biographer of
John Maynard Keynes, dis-
sects the problem with
characteristic elegance. “It
[the hypothesis] led bankers
into blind faith in their
mathematical forecasting
models. It led governments
Inside this issue
Balance of risk Regulators
may have to invent new
tools – or revive old ones,
says George Soros Page 2
Capitalism Victory in the
cold war was a start and an
ending, says
Martin Wolf
Page 4
Thatcher­
ism All the
main policies
are being
reversed but
is the
The financial crisis has
highlighted with painful
clarity just how
dangerous
tunnel vision
can be, says
Gillian Tett
Page 7
and regulators to discount
the possibility that finan-
cial markets could implode.
It led to what Alan Green-
span called (after he had
stepped down as chairman
of the US Federal Reserve)
‘the underpricing of risk
worldwide’. It has also led
The world
discovered (again)
that economic
actors can behave
irrationally
to the discrediting of main-
stream macroeconomics.”
Gillian Tett, the FT’s
award-winning markets edi-
tor and author of a best-
seller about the credit
derivatives business (Fool’s
Gold: How Unrestrained
Greed Corrupted a Dream,
Thatcher era really over?
Gideon Rachman looks at
the evidence Page 4
Banking Goldman Sachs
should be allowed to fail,
says John Gapper Page 6
The lessons
A deal to
save
Lehman
would not
have saved
us, writes
Niall
Ferguson
Page 7
www.ft.com/finance­2009
Shattered Global Markets
and Unleashed a Catastro-
phe) argues that intellectual
failures led directly to man-
agerial failures in financial
institutions. In her column
“The dangers of silo think-
ing”, Tett draws on her own
background in anthropol-
ogy to illuminate the defec-
tive parts of the system.
In political terms, 2009
marked the beginnings of a
backlash. Gideon Rachman,
the FT’s chief foreign
affairs columnist, purports
to see a “closing of the
Thatcher era” which pio-
neered “policies copied in
the rest of the world: priva-
tisation, deregulation, tax-
cutting, the abolition of
exchange controls, an
assault on the power of the
trade unions, the celebra-
tion of wealth creation
rather than wealth redistri-
bution”.
But Rachman cautions
that, as yet, no leading
political figure in the west-
ern world has really articu-
lated a coherent alternative
to the free-market princi-
ples inherited from Thatch-
erism. Therefore, it would
be premature to write them
off, despite the damage
done to the “Anglo-Saxon”
model.
In regulatory terms, the
Group of 20, the new group-
ing of leading economies
from the developed and
developing world, agreed
new principles of govern-
ance for the financial sec-
tor. Its agenda included
Continued on Page 3
2 ★
The FT’s Year in Finance
Do not ignore the need
for financial reform
BALANCE OF RISK
Regulators may have
to invent new tools –
or revive disused ones,
says George Soros
T
he philosophy that has
helped me both in mak-
ing money as a hedge
fund manager and in
spending it as a policy-oriented
philanthropist is not about
money but about the compli-
cated relationship between
thinking and reality. The crash
of 2008 has convinced me that it
provides a valuable insight into
the workings of the financial
markets.
The efficient market hypothe-
sis holds that financial markets
tend towards equilibrium and
accurately reflect all available
information about the future.
Deviations from equilibrium are
caused by exogenous shocks
and occur in a random manner.
The crash of 2008 falsified this
hypothesis.
I contend that financial mar-
kets always present a distorted
picture of reality. Moreover, the
mispricing of financial assets
can affect the so-called funda-
mentals that the price of those
assets is supposed to reflect.
That is the principle of
reflexivity.
Instead of a tendency towards
equilibrium, financial markets
have a tendency to develop bub-
bles. Bubbles are not irrational:
it pays to join the crowd, at
least for a while. So regulators
cannot count on the market to
correct its excesses.
The crash of 2008 was caused
by the collapse of a super-bub-
ble that has been growing since
1980. This was composed of
smaller bubbles. Each time a
financial crisis occurred the
authorities intervened, took
care of the failing institutions,
and applied monetary and fiscal
stimulus, 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 authorities must
accept responsibility for pre-
venting bubbles from growing
too big. Alan Greenspan and
others refused to accept that. If
markets cannot recognise bub-
bles, the former chairman of the
US Federal Reserve asserted,
neither can regulators – and he
was right. Nevertheless authori-
ties have to accept the assign-
ment.
Second, to control asset bub-
bles it is not enough to control
the money supply; you must
also control credit. The best
known means to do so are mar-
gin requirements and minimum
capital requirements. Currently
they are fixed irrespective of the
market’s mood because markets
are not supposed to have moods.
They do, and authorities need to
counteract them to prevent
asset bubbles growing too large.
So they must vary margin and
capital requirements. They must
also vary the loan-to-value ratio
on commercial and residential
mortgages to forestall real-
estate bubbles.
Regulators may also have to
invent new tools or revive ones
that have fallen into disuse.
Central banks used to instruct
commercial banks to limit lend-
ing to a particular sector if they
felt that it was overheating.
Another example of needing
new tools involves the internet
boom. Mr Greenspan recognised
it when he spoke about “irra-
tional exuberance” in 1996. He
did nothing to avert it, feeling
that reducing the money supply
was too blunt a tool. But he
could have devised more spe-
cific measures, such as asking
the Securities and Exchange
Commission to freeze new share
issues, as the internet boom was
fuelled by equity leveraging.
Third, since markets are
unstable, there are systemic
risks in addition to the risks
affecting individual market par-
ticipants. Participants may
ignore these systemic risks,
believing they can always sell
their positions, but regulators
cannot ignore them because if
too many participants are on
the same side, positions cannot
be liquidated without causing a
discontinuity or a collapse. That
means the positions of all major
participants, including hedge
funds and sovereign wealth
funds, must be monitored to
detect imbalances. Certain
derivatives, like credit default
swaps, are prone to creating hid-
den imbalances so they must be
regulated, restricted or forbid-
den.
Fourth, financial markets
evolve in a one-directional, non-
reversible manner. Financial
authorities have extended an
implicit guarantee to all institu-
tions that are too big to fail.
Withdrawing that guarantee is
not credible, therefore they
must impose regulations to
‘I contend that
financial markets
always present a
distorted picture of
reality’
George Soros
ensure this guarantee will not
be invoked. Such institutions
must use less leverage and
accept restrictions on how they
invest depositors’ money. Pro-
prietary trading ought to be
financed out of banks’ own capi-
tal not deposits. But regulators
must go further to protect capi-
tal and regulate the compensa-
tion of proprietary traders to
ensure that risks and rewards at
too-big-to-fail banks are aligned.
This may push proprietary trad-
ers out of banks and into hedge
funds, where they belong.
Since markets are intercon-
nected and some banks occupy
quasi-monopolistic positions, we
must consider breaking them
FINANCIAL TIMES TUESDAY DECEMBER 15 2009
up. It is probably impractical to
separate investment banking
from commercial banking as the
Glass-Steagall act of 1933 did.
But there have to be internal
compartments that separate pro-
prietary trading from commer-
cial banking and seal off trading
in various markets to reduce
contagion.
Finally, the Basel Accords
made a mistake when they gave
securities held by banks sub-
stantially lower risk ratings
than regular loans: they ignored
the systemic risks attached to
concentrated positions in securi-
ties. This was an important fac-
tor aggravating the crisis. It has
to be corrected by raising the
risk ratings of securities held by
banks. 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. The
financial system is far from
equilibrium. The short-term
needs are the opposite of what
is needed in the long term. First
you must replace the credit that
has evaporated by using the
only source that remains credi-
ble – the state. That means
increasing national debt and
extending the monetary base.
As the economy stabilises you
must shrink this base as fast as
credit revives – otherwise, defla-
tion will be replaced by infla-
tion.
We are still in the first phase
of this delicate manoeuvre.
Banks are earning their way out
of a hole. To cut their profitabil-
ity now would be counterpro-
ductive. Regulatory reform has
to await the second phase, when
the money supply needs to be
brought under control and care-
fully phased in so as not to dis-
rupt recovery. But we cannot
afford to forget about it.
George Soros is author of The
Crash of 2008.
This article was first published
on October 25, 2009. Bubble trouble: if markets cannot recognise bubbles, neither can regulators, said Alan Greenspan Getty
FINANCIAL TIMES TUESDAY DECEMBER 15 2009 ★ 3

The FT’s Year in Finance

How to rebuild a newly shamed subject

ECONOMIC THEORY icy to anticipate or deal
with “stagflation” in the
Economics has no 1970s. It reflects a persistent
more clothes than bias in economics towards
an idealised account of
any other social human behaviour; what
science, writes Joseph Schumpeter called
the “Ricardian Vice” of
Robert Skidelsky excessive abstraction.
It is only by imagining a
mechanical world of inter-
nomic thought, moral and
political philosophy, and
sociology. Though some
specialisation would be
allowed in the final year,
the mathematical compo-
nent in the weighting of the
degree should be sharply
reduced. This returns to the
tradition of the Oxford Poli-
tics, Philosophy and Eco-

I
t was to be expected
that our present eco-
nomic traumas would
call into question the
state of economics. “Why
did no one see the crisis
coming?”, Queen Elizabeth
reportedly asked one practi-
tioner. A seminar at the
British Academy tried to
answer and the FT has
taken up the discussion.
The Queen’s question is
understandable. Ever since
modern economics started
in the 18th century it has
presented itself as a predic-
tive discipline, akin to a
natural science. Since the
future a year ago included
the present slump, it is nat-
ural that the failure of the
economics profession – with
a few exceptions – to fore-
see the coming collapse
should have discredited its
scientific pretensions. Eco-
nomics is revealed to have
no more clothes than other
social science. One cannot
imagine the Queen next
year asking a leading politi-
cal scientist: “Why did no
one tell me that Labour was
going to win the election?”
She would understand that
this was not a prediction
that any political scientist
could make with convic-
tion.
Nevertheless, the Queen’s
question accepted at face
value the predictive claim
of economics – a feature
that has distinguished it
from all other social sci-
ences. Karl Popper pro-
duced a famous argument
against the possibility of
prediction in human affairs:
one cannot anticipate a new
invention because, if one
could, one would already
have invented it. However,
this objection can be over-
come if one assumes a sta-
ble and repetitive universe
in which rational actors
make efficient use of the
information available to
them. In this environment,
uncertainty disappears to
be replaced by calculable
risk. Shocks and mistakes
may occur but these will
The mathematical
component in the
weighting of the
degree should be
sharply reduced
cancel each other out, so
that, on average, people get
what they expect.
An important implication
of this view is that shares
are always correctly priced.
This is the basis of the so-
called efficient market
hypothesis that has domi-
nated financial economics.
It led bankers into blind
faith in their mathematical
forecasting models. It led
governments and regulators
to discount the possibility
that financial markets
could implode. It led to
what Alan Greenspan called
(after he had stepped down
as chairman of the US Fed-
eral Reserve) “the under-
pricing of risk worldwide”.
It has also led to the dis-
crediting of mainstream
macroeconomics. The effi-
cient market hypothesis is
simply an application of the
recently-triumphant New
Classical school, which
preaches that a decentral-
ised market system is
always 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 be
learnt and anticipated by a
population, and will there-
fore be ineffective. Since
people – apparently includ-
ing the 10 per cent or so
unemployed – are already
in their preferred position
because of their correct
anticipations and instanta-
neous adjustment to
change, “stimulus” policies
are bound to fail and even
make things worse. Reces-
sions are “optimal”.
Most of those unversed in
New Classical economics
assume that John Maynard
Keynes exploded these falla-
cies 70 years ago. Their re-
emergence is not just the
result of the failure of Key-
nesian macroeconomic pol-
acting robots that econom-
ics has gained its status as
a hard, predictive science.
But how much do its
mechanical constructions,
with their roots in Newto-
nian physics, tell us about
the springs of human
behaviour?
One of the most interest-
ing contributions to the
FT.com debate was the
argument that, after Key-
nes, economists should
have aligned their disci-
pline with other social sci-
ences concerned with
human behaviour. Keynes
opened the way to political
economy; but economists
opted for a regressive
research programme, dis-
guised by sophisticated
mathematics, that set it
apart. The present crisis
gives us an opportunity to
try again.
The reconstruction of eco-
nomics needs to start with
the universities. First,
degrees in the subject
should be broadly based.
They should take as their
motto Keynes’s dictum that
“economics is a moral and
not a natural science”.
They should contain not
just the standard courses in
elementary microeconomics
and macroeconomics but
economic and political his-
tory, the history of eco-
nomics (PPE) degree and
Cambridge Moral Sciences.
Beyond this, the postgrad-
uate study of macroeconom-
ics might with advantage be
separated from that of micr-
oeconomics. Courses in
microeconomics should con-
cern themselves, as at
present, with building and
testing models based on a
narrow set of assumptions.
Their field of applicability
lies in those areas where we
have reliable views of the
future. Macroeconomics,
though, is an essential part
of the art of government,
and should always be
taught in conjunction with
subjects bearing on this.
The obvious aim of such a
reconstruction is to protect
macroeconomics from the
encroachment of the meth-
ods and habits of the math-
ematician. Only through
some such broadening can
we hope to provide a proper
education for those whose
usefulness to society will lie
as much in their philosophi-
cal and political literacy as
in their mathematical effi-
ciency.
Lord Skidelsky is author of
Keynes: The Return of the
Master
This article was first pub-
lished on August 5, 2009.

World counts the true cost

of the banking rescue
Continued from Page 1
demands for higher capital
levels, “living wills” setting
out how financial institu-
tions would wind up their
affairs; and new strictures
on executive remuneration,
especially for those banks
in government ownership.
The G20 forum marked a
recognition that global
banking requires global
governance. But national
politics still intruded on the
best-laid plans and princi-
ples. The Labour govern-
ment discovered that the
need to be seen to be clamp-
ing down on bonuses at
state-controlled banks
clashed with the imperative
of ensuring those same
banks made the returns
Contributors
Lionel Barber
Editor
John Gapper
US Business Columnist
Gideon Rachman
Chief Foreign Affairs
Columnist
Gillian Tett
Global Markets Editor
required to pay back the
taxpayer. Royal Bank of
Scotland was not the only
financial institution to com-
plain that a ban on bonuses
would lead to an exodus of
investment banking talent
that threatened to put those
returns at risk.
More broadly, thanks in
part to Lord Turner, the
cerebral chairman of the
Financial Services Author-
ity, a debate began about
the balance of risk in the
financial services sector.
George Soros, the renowned
investor and philanthropist,
wrestles with this central
question in his column, “Do
not ignore the need for
financial reform”.
How far should banks
abandon “casino-style”
investment banking and
return to the role of a util-
ity, reliant on deposits to
support retail and commer-
cial lending? To what
degree did the authorities,
on both sides of the Atlan-
How far should
banks abandon
‘casino­style‘
banks, takes a more
nuanced view. “Taken to its
conclusion, it [narrow bank-
ing] would eliminate mone-
tary policy. Public debt held
by banks would set the
money supply,” he writes,
“A more profound issue is
whether a financial system
based on narrow banking
could allocate capital effi-
ciently.”
John Gapper, our US
business columnist, argues
that we are, in effect,
repeating the mistakes of
the Bourbons who learnt
nothing and forgot nothing.
Gapper takes on the famil-
iar refrain from top bank-
ers, including Goldman’s
Mr Blankfein, who insisted
that their extraordinary
gains were due to extraordi-
nary talent rather than the
advantages drawn from
favourable markets influ-
enced by temporary but
overwhelming government
intervention. In Gapper’s
view, similar to John Kay’s,
it is wrong for financial
institutions such as Gold-
man to become so big that
they pose systemic risks
and therefore are too big to
fail.
Goldman was described

Martin Wolf
investment
Chief Economics banking?
Commentator
Niall Ferguson
Contributing Editor tic, miss the chance to
insist on so-called “narrow
John Kay banking”. Or put another
Business Columnist way, how far has a global
rescue operation running
Robert Skidelsky into hundreds of billons of
Professor of Political dollars restricted competi-
Economy, University of
tion and cemented the privi-
Warwick
leged position of a few
George Soros select banks as “too big to
Chairman of Soros Fund fail”.
Management. John Kay, the FT busi-
ness columnist who once
Steven Bird sat on the board of a British
Designer building society, makes
clear his support for narrow
Ingram Pinn
Illustrator banking. In his words,
“‘Too big to fail’ is too
Andy Mears dumb to keep”.
Picture Editor But Martin Wolf, chief
economics commentator,
For advertising contact: who spent several columns
Chris Nardi fulminating against irre-
+44 020 7873 4311 sponsible risk-takers in the
chris.nardi@ft.com banking industry, as well as
or your usual the authorities privatising
representative the gains and socialising
the losses incurred by
as a “vampire squid
wrapped around the face of
humanity” in a memorable
if conspiratorial polemic by
Matt Taibbi published in
Rolling Stone magazine. In
essence, Goldman found
itself accused of gaming the
system, exploiting its ties
with former executives in
positions of power such as
Hank Paulson, former US
treasury secretary. For a
sobering antidote, readers
should turn to Niall Fergu-
son, the Harvard historian
and FT contributing editor,
who points out that even if
Lehman had been saved,
the world would still have
experienced a financial cri-
sis.
In the end, the system
was saved but only through
overwhelming government
intervention at massive cost
to the public purse. In 2009,
those costs became clearer.
In 2010, governments will
have to turn to repairing
the public finances.
Bankers be warned: the
reckoning will be severe.
4 ★ FINANCIAL TIMES TUESDAY DECEMBER 15 2009

The FT’s Year in Finance

Cold war victory was a start and an end

CAPITALISM
The end of the Soviet era
felled an ideology. This
financial crisis will not,
says Martin Wolf
eral democracies and market econo-
mies is their ability to reform and
adapt. They have shown these quali-
ties before. They must do so once
again.
For those born, like me, shortly
after the second world war, the cold
war was the defining intellectual and
political struggle of our lifetimes.
on behalf of banks has been $14,000bn.
This is state capitalism.
What then does the crisis mean for
the countries that exited from social-
ism two decades ago? What, too, does
it mean for the world?
For the former, it has meant big
falls in output. According to the
EBRD, the fall in the gross domestic
ing. But they need to be put in con-
text.
First, many countries in transition
experienced big increases in output
after the initial and largely inevitable
post-Soviet collapse (see charts).
Poland was the star. In general, the
successful countries were those that
reformed most seriously.
monetary systems. Some of these fail-
ings are inescapable. The future is
inherently uncertain. Big mistakes
will be made. Where prevailing para-
digms lead to risk-taking on an exces-
sive scale, corrections are likely to be
brutal. Where risk-taking involves
large-scale leveraging of the balance
sheets of the financial sector, correc-
require further reforms. For transi-
tion countries, a reversal of financial
integration is likely to be costly and
unnecessary. The principal goals of
reform must, instead, be to make the
economy less vulnerable to shocks
and to curb excessive credit growth in
future.
Similarly, at a global level, radical

A
crisis is a strange way to cel- With the collapse of communism product of transition countries will Second, surprisingly perhaps, tran- tions are likely to mean a collapse in reforms must be made in the financial
ebrate an anniversary. This ended a catastrophic epoch of millena- average 6.2 per cent in 2009. Declines sition countries have made few both intermediation and the economy. and monetary systems. To put it
is the wry judgment of Erik rian politics and the delusion of a vary widely: from 18.4 per cent in reversals of reforms. As the EBRD bluntly, the banking system has been
Berglöf, chief economist of rationally planned economy. The free- Lithuania, 16.0 per cent in Latvia, 14.0 report notes, “government changes gaming the taxpayer on an intolerable
the European Bank for Reconstruc- dom offered by democracy and the per cent in Ukraine and 13.2 per cent since early 2008 have either led to no To put it bluntly, the scale. This must end, in one of two
tion and Development.* Yet a crisis is prosperity supplied by markets won. in Estonia – depression numbers – to change with respect to the reform banking system has been ways: the sector must be made subject
what we see in countries that began The fact that communism expired not 7.8 per cent in Slovenia, 6.5 per cent in stance, or indeed favoured pro-reform to the market or become a heavily
the march from communism two dec- with a bang, but with a whimper, we Hungary, 6.0 per cent in Slovakia and parties”. This is quite consistent with gaming the taxpayer on regulated ward of the state. Again,
ades ago. So, has capitalism failed, as
communism did?
owe largely to Mikhail Gorbachev.
Yet 2009 is a sobering year from
4.3 per cent in the Czech Republic.
Poland’s economy is forecast to grow
what is happening in the emerging
world, more broadly. The absence of a
an intolerable scale. This the curbing of huge credit bubbles
must be an integral element in the
In a word, “no”. Some transition which to look back. A year ago, capi- this year, by 1.3 per cent. credible alternative economic model is must end formation of regulatory and monetary
countries are in crisis; transition is talism careered over a cliff. With vast In general, notes the EBRD, “the evident. Populist adventurism also policies.
not. effort, states have put it back on the size of the output declines correlates seems unattractive. Finally, the dependence of the glo-
The same judgment applies else- road. According to Piergiorgio Ales- with pre-crisis credit booms and exter- As recovery begins to gather force Should collapse not be prevented, the bal monetary system on the currency
where: capitalist countries are in cri- sandri and Andrew Haldane of the nal indebtedness”. The bursting of across the world economy, the great consequences may, history tells us, be of an over-indebted superpower is nei-
sis; capitalism itself is not. But reform Bank of England, in a superb paper**, bubbles hurts. legacies of the collapse of the Soviet dramatic. ther desirable nor sustainable.
is necessary. The great virtue of lib- the total gross value of interventions These collapses are real and worry- empire – the integration of much of Happily, governments and central Anniversaries are a good time for
Europe and the concomitant spread of banks have learnt the lessons of the taking stock.
Output in European ex-communist countries freedom to Russia’s borders, if not 1930s and decided, rightly, to prevent The collapse of Soviet communism
beyond – remain intact. collapses of either the financial sys- was a glorious moment. It remains so,
Real GDP, 1990=100
Yet the crisis brings important les- tem or the economy. That is precisely despite mistakes and disappointments
200 200 200 sons. The philosopher Karl Popper the right kind of “piecemeal social along the way. But today’s crisis tells
180 Poland 180 180 Russia laid down the right approach. He dis- engineering”. Similarly, big efforts us of the failings of a euphoric capital-
Lithuania
Czech Republic Ukraine tinguished the “piecemeal social engi- have been made to rescue the crisis- ism. Capitalism will not now perish,
160 160 Estonia 160 neering” intended to ameliorate spe- hit countries of central and eastern as communism did. But the signal
Slovak Republic Latvia Romania
140 140 140 cific ills from the “utopian social engi- Europe. Thus, support from the Inter- ability of liberal democracy is to learn
Hungary Bulgaria
neering” intended to transform soci- national Monetary Fund and the and adapt. We learnt from the 1930s.
120 120 120 ety in its entirety – an aim that, in European Union has been between 4 We must now learn the lessons of the
100 100 100 practice, “has led only to the use of and 6 per cent of GDP (or more) for 2000s.
violence in place of reason”. the four eastern European countries
80 80 80 The reformer must identify the that have accepted IMF programmes. * Transition Report 2009, www.
60 60 60 cause of the malady before attempting A similar pragmatism must now be ebrd.com/pubs/econo/tr09.htm
treatment. In the case of this crisis, shown in completing the escape from ** Banking on the State, www.
40 40 40 the failure lies not so much with the the crisis. bankofengland.co.uk
1990 95 2000 05 10 1990 95 2000 05 10 1990 95 2000 05 10 market system as a whole, but with That will require substantial rebal- This article was first published on
Source: EBRD 2009 & 2010 = forecasts defects in the world’s financial and ancing of global demand. It will also November 10, 2009.

The closing of the Thatcher era

THATCHERISM
All the signature
policies are being
reversed, says
Gideon Rachman
“The British people had
given up on socialism. The
30-year experiment had
plainly failed – and they
were ready to try some-
thing else.”
So mused Margaret
Thatcher on the eve of her
first general election vic-
tory on May 3 1979. But in
the run-up to the 30th anni-
versary of the Iron Lady’s
arrival in Downing Street,
many British people have
concluded that once again
“a 30-year experiment” has
“plainly failed”. This time,
however, it is the experi-
ment with Thatcherism.
The closing of the
Thatcher era is an event of
global significance. Many of
the policies pioneered by
her government in Britain
were copied in the rest of
the world: privatisation,
deregulation, tax-cutting,
the abolition of exchange
controls, an assault on the
power of the trade unions,
the celebration of wealth
creation rather than wealth
redistribution.
Mrs Thatcher came to
power 18 months before
Ronald Reagan and the two
swiftly developed an ideo-
logical love affair. But the
real triumph came when
Thatcherite ideas started to
catch on in improbable and
inhospitable environments
– such as the Soviet Union
and France.
In the early 1980s, while
Mrs Thatcher pioneered pri-
vatisation, France under
President François Mitter-
rand pushed through whole-
sale nationalisations of
banks and industrial con-
glomerates. But while she
sailed determinedly on with
her free-market policies,
famously proclaiming “the
lady’s not for turning” Mit-
terrand was forced into a
U-turn in 1982. At the end of
his period in office, he too
was a privatiser.
By the end of the
Thatcher era, free-market
reforms were being pursued
in China, eastern Europe,
India and the Soviet Union.
On her last visit as prime
minister to Mikhail Gor-
bachev’s Russia, Mrs
Thatcher noted wryly that
the new mayor of Moscow
seemed 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 Privatising
the World. She herself
exulted: “People are no
longer worried about catch-
ing the British disease.
They are queuing up to
obtain the new British
cure.”
But, almost 20 years after
she left Downing Street, the
British economy is once
again in deep trouble.
Almost everything that Mrs
Thatcher opposed – nation-
alisation, raising taxes,
Keynesian economics – is
back in fashion. One by
one, the signature policies
and achievements of the
Thatcher years are being
dismantled in Britain.
Her celebrated decision to
cut the top tax rate to 40
per cent has been reversed.
There will now be a top rate
of 50 per cent – and opinion
polls suggest that the
change is very popular.
Britain has also now, in
effect, nationalised its large
banks, just as the French
once did under Mitterrand.
No reform captured the
Perhaps most
damagingly,
Thatcherism has
lost the moral
high ground
spirit of the Thatcher era
more completely than the
“Big Bang” of financial
deregulation in 1986, which
set the stage for the inexo-
rable rise of the City of Lon-
don. But the City is now in
the doghouse and there is a
rush to re-regulate the
financial services industry.
Mrs Thatcher once pro-
claimed that “printing
money is no more”. But the
printing presses are rolling
again – except that these
days it is called “quantita-
tive easing”. Forbidden
from public speaking by her
doctors, Lady Thatcher is in
no position to defend her
legacy or instruct her
remaining disciples.
Thatcherism is also out of
fashion internationally.
When Nicolas Sarkozy was
elected president of France
in 2007, he quietly encour-
aged the idea that he was
the French version of Lady
Thatcher. But these days he
likes to be photographed
clutching a copy of Das
Kapital. Mrs Thatcher ven-
erated the free enterprise of
the US. But the new US
president seems strangely
enamoured of the European
social system.
Perhaps most damag-
ingly, Thatcherism has lost
the moral high ground. The
Iron Lady once proclaimed,
slightly sinisterly: “Eco-
nomics is the method. The
object is to change the
soul.” She meant that Brit-
ish people had to rediscover
the virtue of traditional val-
ues such as hard work and
thrift. The “something for
nothing” society was over.
But the idea that the
Thatcher era re-established
the link between virtuous
effort and just reward has
been destroyed by the spec-
tacle of bankers driving
their institutions into bank-
ruptcy while being
rewarded with million-
pound bonuses and munifi-
cent pensions.
The same problem has
dogged the international
versions of Thatcherism.
Privatisation in Russia
degenerated into a morally
dubious grab for assets by a
new class of oligarchs. Out-
rage about executive pay
has been building for years
in the US.
So is the Thatcher era
definitively over? The eco-
nomic cataclysms and pol-
icy reversals of recent
months suggest that it
surely must be.
And yet there is still
room for doubt. When Mrs
Thatcher came to power,
she and her advisers had
been thinking for years
about the policies and ideas
they intended to pursue. By
contrast, today’s political
leaders are fighting the eco-
nomic crisis with whatever
tools come to hand. The
decisions to nationalise
Britain’s banks and to print
money were emergency
measures – not the products
of a carefully thought-out
ideology or political pro-
gramme.
One of Mrs Thatcher’s
most famous phrases was:
“There is no alternative.”
As yet, no major political
figure in the UK or the rest
of the western world has
really articulated a coher-
ent alternative to the free-
market principles inherited
from Thatcherism.
Until that happens, the
Thatcher era will not be
definitively over.
This article was first pub-
lished on April 28, 2009. Not for turning: Margaret Thatcher arrives at Downing Street in 1979 Roger Taylor
6 ★ FINANCIAL TIMES TUESDAY DECEMBER 15 2009

The FT’s Year in Finance

Narrow
banking
alone is not
the answer
FINANCIAL SECTOR circumvent regulation. Regula-
tion, then, has not been the
If tighter regulation answer, but hitherto has been
fails we will need to part of the problem.
So what is the answer? Divi-
be really radical, sion of banking into a “utility”
writes Martin Wolf and a “casino” is Mr Kay’s
answer. The big idea is that
insured deposits should be

W
hat entered the cri-
sis was, we now
know, an ill-
managed, irrespon-
sible, highly concentrated and
undercapitalised financial sec-
tor, riddled with conflicts of
interest and benefiting from
implicit state guarantees. What
is emerging is a slightly better-
capitalised financial sector, but
one even more concentrated and
benefiting from explicit state
guarantees.
This is not progress: it has to
mean still more and bigger cri-
ses in the years ahead.
My friend and colleague, John
Kay, is aware of these dangers,
as readers of his column know
well. His answer, laid out in a
pamphlet for the London-based
Centre for the Study of Finan-
cial Innovation, is “narrow
banking”*.
Mr Kay rejects the notion that
regulation can solve the prob-
lem created by state-guaranteed
finance. Supervision, he notes,
is always subject to regulatory
capture. Moreover, banks
“entered the crisis with capital
generally in excess of regulatory
requirements. These provisions
proved not just inadequate but
massively inadequate for the
problems faced.” Worse, many
of the dangers – notably the
growth of off-balance-sheet
finance – reflected attempts to
backed by “genuinely safe liquid
assets” – known as 100 per cent
reserve banking. In practice,
these assets would be govern-
ment bonds. This is the most
rigorous form of narrow bank-
ing. But he is not clear on
whether he would insist on this.
It seems he might accept looser
constraints.
For the sake of clarity, how-
ever, let us focus on 100 per cent
reserve banking, an idea also
discussed in Austrian econom-
ics. Is it workable? What might
it imply? To answer, we need to
understand how we entered our
world of credit-based money.
Suppose someone came up
with the following design for
the core institutions of our
financial system: they would be
mainly financed by deposits,
redeemable on demand; they
would invest in a wide range of
often illiquid and opaque assets;
they would engage in complex
trading activities; but they
would have a wafer-thin equity
cushion. Surely, people would
conclude, this is fraudulent.
They would be right. Such a
structure can only endure
because central banks act as
lenders of last resort. The gov-
ernment’s ability to create
money is put at the disposal of
private interests. Right at the
moment, the ability to borrow
from the government at zero
interest is a licence to print
money.
In practice, however, we have
gone 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 the
liabilities of institutions deemed
systemically significant. Today,
the core financial institutions
are, beyond doubt, a part of the
state.
Mr Kay’s proposal is, in sum,
to end the fraud: banks would
be forced to hold assets as safe
and liquid as their liabilities.
We know there are other ways
of making a system of fraction-
al-reserve banks relatively safe:
a stable domestic oligopoly
achieves much the same thing.
But that does seem highly
regressive.
Is Mr Kay’s the answer? One
obvious objection is that it
would impose a massive
upheaval in finance. But, given
the crisis, such an upheaval is
the least we should fear.
Another objection (though, to
The great game of
short­term borrowing,
to buy longer­term
and risky assets, on
wafer­thin equity,
would be ruled out
some an advantage) is that,
taken to its conclusion, it would
eliminate monetary policy. Pub-
lic debt held by banks would set
the money supply.
A more profound issue is
whether a financial system
based on narrow banking could
allocate capital efficiently.
Here there are two opposing
risks. The first is that the sup-
ply of funds to riskier, long-term
activities would be greatly
reduced if we did adopt narrow
banking. Against this, one
might argue that, with public
sector debt used to back the lia-
bilities of narrow banks, inves-
tors would be forced to find
other such assets.
The opposite (and greater)
risk is that the fragility of bank-
ing would be re-invented, via
“quasi-banks”. This is what has
just happened, after all, with
“shadow banking”. In the end,
those entities, too, have been
rescued. The big point is that a
financial structure character-
ised by short-term and rela-
tively risk-free liabilities and
longer-term and riskier assets is
highly profitable, until it col-
lapses, as it is likely to do.
The answer to the second
dilemma is to make banking
illegal. That is to say, financial
intermediaries, other than nar-
row banks, would have the
value 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-term
borrowing, used to purchase
longer-term and risky assets, on
wafer-thin equity, would be
ruled out. The equity risk would
be borne by the funds’ inves-
tors. Trading entities would
exist. But they would need
equity funding.
Christophe Chamley of Boston
University and the Paris School
of Economics, and Laurence
Kotlikoff of Boston University,
proposed such radical ideas in
the FT’s Economists’ Forum on
January 27, 2009. It is the sim-
plest way I can see of avoiding
the danger that narrow banking
would shift the risks inherent in
such activities elsewhere.
The most important point is
that where we are now is intol-
erable. Today’s concentrations
of state-insured private wealth
and power must surely go. The
official sector believes that
tighter regulation, particularly
higher capital requirements, can
contain these risks. But this is
likely to fail.
If it does, we will need to be
radical. Yet narrow banking
would still not be enough. We
would need to rule out quasi-
banking. Otherwise, we would
soon return to the world of fra-
gility and bail-outs. Funds that
replace banks would have to
pass the risks directly on to the
outside investors.
The authorities will not enter-
tain such radical ideas right
now. But the financial system is
so inherently fragile that radical
reform cannot be pronounced
dead. It is only dormant.
* Narrow Banking: The reform
of banking regulation, www.
csfi.org.uk.
This article was first published
on September 29, 2009.

Goldman Sachs ‘Too big to fail’ is

should be too dumb to keep
allowed to fail FINANCIAL SECTOR

Trying to prevent
and bad ones do not. There
is a sense in which the
bankruptcy of Lehman was
to ensure essential financial
services to individuals and
businesses are regulated

with its own hedge and private

BANKING
The Fed­regulated
investment bank’s status
is untenable, writes
John Gapper
A decade ago, when Goldman Sachs
was a private partnership, it had
$6.5bn in equity and its 220 part-
ners, most of whose money was
tied up in the firm until they
retired, took good care of their pot
of gold.
The bank’s trading and principal
investing division – the part that
took the most risks with partners’
capital – was balanced with its fee-
based investment banking and
asset management divisions. Trad-
ing contributed about a third of its
revenues in the two years leading
up to its 1999 initial public offering.
After it sold shares in the IPO to
outside investors – pension and
mutual funds hold about 80 per
cent of its equity – it steadily
increased its appetite for risk. Its
fixed-income and currency division
has become dominant, bringing in
two-thirds of Goldman’s revenues
in 2006 and 2007 (and 78 per cent in
the first nine months of this year).
In last year’s crisis, the US gov-
ernment made clear that it stands
behind Goldman and other big
investment banks. Goldman
received a $10bn capital injection
from the Treasury (since returned)
and $21bn of its debt is backed by
the Federal Deposit Insurance Cor-
poration. It is now a financial hold-
ing company whose regulator and
lender of last resort is the Federal
Reserve.
So, if Goldman Sachs took on
more risk when its equity was held
by outsiders than with its partners’
own money, what can we expect
now that the government implicitly
accepts that it is “too big to fail”?
Goldman has an even bigger incen-
tive to risk other people’s money.
It is a problem if the most power-
ful broker-dealer on Wall Street has
the same privileges as the most
mundane commercial bank. Not
only does the fact that it may pay
$23bn in bonuses this year upset
people, but also its incentives are
skewed.
Solving this requires two things
to be addressed. First, Goldman’s
intention to operate as a institu-
tional Wall Street firm – complete
equity funds – while having govern-
ment and Fed support. Second, its
tradition of setting aside half its
revenues each year for employees.
On the first point, Goldman’s sta-
tus strikes me as untenable. It may
be better regulated by the Fed than
the Securities and Exchange Com-
mission but counting it as just
another bank, with the same privi-
leges and obligations as retail
banks and credit card companies,
makes little sense.
This is not to accuse it of being
reckless, or insouciant about how it
operates. It navigated the crisis
best of all the investment banks
and does not run itself as if it is
bound to get bailed out. It is well
capitalised and holds $170bn of
cash and liquid assets to hand, just
in case.
Nor is it merely a giant hedge
fund. Its pure proprietary activities
make up about 10 per cent of its
revenues. Market-making in bonds
and 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 from
the banks for which the discount
window – the Fed facility that
allows its regulated banks to bor-
row cash in exchange for securities
in extremis – was invented. Until
recently, no one would have sug-
gested that Goldman deserved a
place with them.
Mervyn King, governor of the
Bank of England, put it well. The
“utility aspects of banking where
‘Utility aspects of
banking are quite
different from some of
the riskier activities that
banks undertake’
we all have a common interest in
ensuring continuity of service, are
quite different in nature from some
of the riskier activities that banks
undertake, such as proprietary
trading”.
One possibility is for Goldman to
spin off its activities that come
under the latter heading: the hedge
funds 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-
Distorted: lumping Goldman with commercial banks is a stretch
cial utility. Even then, it should not
be treated by the Fed like a retail
bank which has its deposits guaran-
teed and is, as Mr King phrases it,
“too important to fail”. Goldman
must be structured and regulated
in such a way that it could safely
be allowed to fail in any future
financial crisis.
This would address some of the
justifiable public anger about Wall
Street firms having been bailed out
by taxpayers, but what about the
second point: Wall Street’s lavish
rewards to its senior employees?
The bonus problem in investment
banking is not the absolute size of
the rewards (although shareholders
ought to ask themselves if the
employees really are worth it) but
the incentives they create.
Goldman probably has one of the
most partner-like pay structures for
its managing directors. About two-
thirds of bonuses are in restricted
stock that vests over four years and
its most senior partners have to
Bloomberg
hold 75 or even 90 per cent of the
stock until after they retire.
That is one reason Goldman has
navigated the financial crisis better
than others, but it could still learn
from its past. By returning to the
system of locking up all (or 90 per
cent) of its managing directors’
bonuses until they retire, it would
make them even more careful.
If taxpayers could see not only
that Goldman’s bonuses were a
form of equity partnership, but also
that the bank would be allowed to
founder in a future crisis, it might
sap some simmering resentment.
Alternatively, Goldman could
keep its old riches and newfound
official status, keep on taking more
financial risk, and try to square the
circle by convincing people that it
is a utility that operates in the pub-
lic interest. That might be a strug-
gle.
This article was first published on
October 21, 2009.
failures is itself
doomed to failure,
says John Kay
In the 2007-08 crisis, many
different kinds of financial
institution failed or were
saved only by state inter-
vention. Large financial
conglomerates – Citigroup
and Royal Bank of Scot-
land. Investment banks –
Bear Stearns and Lehman
Brothers. Smaller retail
banks without investment
banking arms (but with
active treasuries) – North-
ern Rock and Sachsen
Landesbank. Diversified
banks, such as Fortis, and
specialist lenders, such as
Hypo RE. Public agencies,
such as Fannie Mae and
Freddie Mac. America’s
largest insurer, AIG. Tax-
payers will be footing the
bills for a generation.
All these businesses
exemplified management
hubris and, in almost all,
the failure was the result of
losses in activities that
were peripheral to their
core business. Otherwise
they had little in common.
The variety of institutions
is matched by the variety of
regulators. The list of agen-
cies supervising failed busi-
nesses is much longer than
the list of institutions.
There are people who
believe that, in future, bet-
ter regulation, co-ordinated
both domestically and inter-
nationally, will prevent
such failures. The interests
of consumers and the needs
of the financial economy
will be protected by such
co-ordinated intervention,
and there will never again
be major calls on the public
purse.
There are also people who
believe that pigs might fly.
Mervyn King, governor of
the Bank of England has
made enemies by pointing
out that they will not.
It is impossible for regula-
tors to prevent business
failure, and undesirable to
pursue that objective. The
essential dynamic of the
market economy is that
good businesses succeed
a triumph of capitalism, not
a failure. It was badly run,
it employed greedy and
overpaid individuals, and
the services it provided
were of marginal social
value at best. It took risks
that did not come off and
went bust. That is how the
market economy works.
The problem now is how
to have greater stability
while extricating ourselves
from the “too big to fail”
commitment and taking a
realistic view of the limits
of regulation. “Too big to
fail” exposes taxpayers to
unlimited, uncontrolled lia-
bilities. The moral hazard is
not just that risk-taking
within institutions that are
too big to fail is encouraged
but that private risk-moni-
toring of those institutions
is discouraged.
Interconnected systems
too complex and dangerous
to fail are not unique to
The crisis was
caused by greedy
and inept bank
executives
financial services. Failure
could also have cata-
strophic consequences in
electricity networks and
nuclear power stations.
Interconnectedness is han-
dled by building robust sys-
tems. If the failure of indi-
vidual components might
destroy the whole, systems
are redesigned to eliminate
the problem.
The paradox is that every
financial institution has
elaborate procedures to deal
with a technological failure,
but neither they nor the
financial system as a whole
have measures for organisa-
tional failure. We need to
achieve that – by setting up
firewalls between activities,
within companies and
across sectors, and by
breaking down large insti-
tutions into parts so prob-
lems of individual elements
do not risk the whole.
The best way to safeguard
the real economy while pro-
tecting the public purse is
but to refuse to underwrite
risk-taking. Some – includ-
ing Martin Wolf – argue
this result could be
achieved by higher capital
requirements and “living
wills”. If these require-
ments were sufficiently
demanding, they would
achieve the same outcomes
as the separation involved
in narrow banking –
because they would amount
to much the same thing.
The capital requirements
would have to be not just
higher, but much higher,
while an effective living
will would need to
ringfence retail operations
and assets to enable an
administrator to take them
over seamlessly in a crisis.
Their activities under-
written by implicit and
explicit government guar-
antee, it is increasingly
business as usual for con-
glomerate banks. The politi-
cians they lobby sound
increasingly like their
mouthpieces, espousing the
revisionist view that the
crisis was caused by bad
regulation. It was not: the
crisis was caused by greedy
and inept bank executives
who failed to control activi-
ties they did not under-
stand. While regulators
may be at fault in not hav-
ing acted sufficiently vigor-
ously, the claim that they
caused the crisis is as ludi-
crous as the claim that
crime is caused by the indo-
lence of the police.
The governor of the Bank
of England is one of the few
public officials to have
grasped that the primary
purpose of regulation is to
protect the public, and not
to promote the interests of
the financial services indus-
try. When the next crisis
hits, and it will, that frus-
trated public is likely to
turn, not just on politicians
who have been negligently
lavish with public funds, or
on bankers, but on the mar-
ket system. What is at stake
now may not just be the
future of finance, but the
future of capitalism.
This article was first pub-
lished on October 28, 2009.
FINANCIAL TIMES TUESDAY DECEMBER 15 2009 ★ 7

The FT’s Year in Finance

A Lehman deal would not have saved us

THE LESSONS out to a manifestly misman-
aged institution. There
Niall Ferguson might very well have been
explores alternative no Tarp. That surely would
have been a death sentence
outcomes for Citigroup, an institution
three times larger than Leh-
man.

I
f only. Lawrence
McDonald begins his
insider’s account of
the fall of Lehman
Brothers with seven “what
if” scenarios, speculating on
how different decisions
might have saved his
former employer. If only
Dick Fuld, Lehman’s chief
executive, had listened to
those who warned of
impending losses on the
bank’s property portfolio. If
only Mr Fuld had not antag-
onised Hank Paulson, the
then Treasury secretary.
And so on.*
Mr McDonald is far from
the only person who
believes that the Lehman
bankruptcy could have
been avoided. Alan Blinder,
the former Federal Reserve
vice-chairman, has called
the decision to let the bank
fail “a colossal error”.
Christine Lagarde, the
French finance minister,
denounced it as a “horren-
dous” mistake. When an
event is followed by such
upheaval – the biggest
financial panic since 1931,
the worst recession since
the war – it is only human
to imagine how the milk
might not have been spilt.
When, at January’s World
Economic Forum in Davos,
I argued that this was wish-
ful non-thinking, I found
few supporters.
If only. If only Lehman
had been saved, there
would have been no credit
crunch. No near-Depres-
sion. The S&P 500 would
not have sunk to 682 (its
nadir last March). We
would probably be back to
1,500 by now.
If only Lehman had been
saved, Republicans might
muse, there would have
been no Democratic land-
slide in November’s US
elections. Instead of Presi-
dent Barack Obama, we
would have John McCain in
the White House. After all,
the presidential race was
still pretty close in the sum-
mer of last year. It was the
severity of the economic cri-
sis after September 15 that
really doomed Mr McCain –
not least because he himself
had earlier confessed his
ignorance of economics.
A McCain presidency, of
course, would have had
very different priorities: no
Keynesian stimulus bill, no
“public option” in any
healthcare reform. If only
Lehman had been saved,
there would be no threat of
Obamacare and no town
hall hysteria about socialist
“death panels”.
Why stop there? If only
Lehman had been saved
No other way: the reason no buyer could be found for Lehman was that it was in its death throes
and Mr McCain had won,
the Green Revolution in
Iran would have had Ameri-
can support and Mahmoud
Ahmadi-Nejad would no
longer be president.
If only Lehman had been
saved and the stock market
had not tanked, Michael
Jackson would not have
needed to commit to those
50 comeback gigs in Lon-
don. He would not have felt
so stressed and would not
have taken all those seda-
tives. If only Lehman had
been saved, Jacko would
still be alive.
If only.
Actually, no. All would
not have been for the best
in the best of all possible
worlds if only Lehman had
been saved. On the con-
trary, a decision to bail out
Mr Fuld would almost cer-
tainly have had worse con-
sequences than letting him
and his company go under.
In a parallel universe, no
doubt, another Mr Fuld
might have made a serious
effort to sell Lehman. Hav-
ing seen the fate that befell
Bear Stearns, he had six
months to find a buyer.
There were at least three
potential suitors: the
Korean Development Bank,
Bank of America and Bar-
clays.
But in this universe, Leh-
man’s chief executive per-
sistently overplayed his
hand, overvaluing the prop-
erty assets on the bank’s
balance sheet by as much
as $25bn-$30bn. Mr Fuld
was adamant: “As long as I
am alive this firm will
never be sold. And if it is
sold after I die, I will reach
back from the grave and
prevent it.”
In another parallel uni-
verse, another Treasury sec-
In one respect
Hank Paulson did
the right thing –
albeit unwittingly
retary and Fed chairman
might have come up with
the money to incentivise a
buyer of Lehman (as they
had when JPMorgan Chase
bought Bear Stearns with
the help of a $30bn loan).
But there was a reason
why no buyer could be
found in this universe. Leh-
man was a firm in its death
throes. It had lost $6.7bn in
the space of six months. It
had debts in excess of
$600bn. Its assets were col-
lapsing in value. Even
when a deal with Barclays
seemed within reach, the
British Financial Services
Authority vetoed it. Alistair
Darling, the chancellor of
the exchequer, made it
clear: “We are not going to
import your cancer.”
So, in a third and final
parallel universe, an alter-
nate Mr Paulson and an
alternate Ben Bernanke
could have nationalised
Lehman outright – as they
had already nationalised
Fannie Mae and Freddie
Mac on September 7, and
would nationalise AIG the
day after Lehman filed for
bankruptcy. These surely
were the kind of “unusual
and exigent” circumstances
that permit the Fed to take
emergency action.
In this universe, however,
Mr Paulson had resolved to
stop being “Mr Bail-out”.
More than once, he stated
bluntly that there would be
“no taxpayer money on the
line” for Lehman. When Mr
Fuld’s lieutenants warned
that their bank’s failure
would unleash a financial
tsunami, Mr Paulson
accused them of “talking
their own book”.
It is clear that he under-
estimated the consequences
of letting Lehman fail.
Maybe, as a former Gold-
man Sachs chief executive,
he did let his prejudice
against Mr Fuld get the bet-
ter of him. In one respect,
however, Mr Paulson did
the right thing – albeit
unwittingly. By showing
Americans – and particu-
larly their legislators in
Congress – just what could
happen if even the fourth-
largest investment bank
failed, he created what had
hitherto been lacking: the
political will for a wholesale
bail-out of the US financial
system.
The critical point is that,
like Bear Stearns, Lehman
was just an extreme case of
a general phenomenon. A
relatively small number of
very large financial institu-
tions had become danger-
ously leveraged and were
on a fast track to insol-
vency as their property
investments imploded. Reli-
ant on misleading risk-man-
agement models, and count-
ing on the vastly over-ex-
tended insurer AIG to pay
out if their counterparties
defaulted, they were like
lemmings in a line, going
over the cliff one by one –
or rather being pushed off
by short-sellers.
What was needed was not
a succession of ad hoc gov-
ernment-backed takeovers.
As Ken Lewis, Bank of
America’s chief executive,
came to realise when he
looked more closely at Mer-
rill Lynch, today’s buyer
risked being for sale tomor-
row, since no one’s balance
sheet was safe. Bob Dia-
mond must thank his
maker every day that the
FSA did not approve a deal
Brendan McDermid/Reuters
that might have destroyed
Barclays; instead, he got
what he wanted – Lehman’s
core investment banking
business – dirt cheap from
the bankruptcy court.
What was needed was a
huge bail-out across the
board. And that was what
the $700bn troubled asset
relief programme (Tarp)
ended up being.
Recall that even after
Lehman’s failure it still
took two attempts to get
Tarp passed. If Mr Paulson
and Mr Bernanke had taken
over Lehman on their own
initiative, there would have
been an outcry in Congress
against yet another hand-
Like the executed admiral
in Voltaire’s famous phrase,
Lehman had to die pour
encourager les autres – to
convince the other banks
that they needed injections
of public capital, and to
convince the legislature to
approve them.
Not everything in history
is inevitable; contingencies
abound. Sometimes it is
therefore right to say “if
only”. But an imagined res-
cue of Lehman Brothers is
the wrong counterfactual.
The right one goes like this.
If only Lehman’s failure
and the passage of Tarp had
been followed – not immedi-
ately, but after six months –
by a clear statement to the
surviving banks that none
of them was henceforth too
big to fail, then we might
actually have learnt some-
thing from this crisis.
The real tragedy is that
the failure of Lehman has
left Wall Street’s survivors
both bigger in relative
terms and more secure
politically. As long as the
big banks feel confident
that they can count on the
government to bail them
out – for who would now
risk “another Lehman”? –
they can more or less
ignore calls for lower lever-
age and saner compensa-
tion.
If only we had learnt from
Lehman that no bank
should be “too big to fail”,
we might still have a real
capitalist system, instead of
the state-guaranteed mon-
strosity that is the real leg-
acy of last year’s crisis. If
only.
* Lawrence G. McDonald
and Patrick Robinson, A
Colossal Failure of Common
Sense: The Inside Story of
the Collapse of Lehman.
This article was first pub-
lished on September 14, 2009.

The dangers of silo thinking

THE LESSONS
Cultural translators are
needed if we are to avoid
missing important clues,
says Gillian Tett
When Larry McDonald, a former bond
trader at Lehman Brothers, wrote an
exposé of that broker’s collapse, it
seems that his main intention was to
reveal the extraordinary folly and
ineptitude of the former Lehman
bosses.
In practice, though, his colourful
tale also highlights – almost inadver-
tantly – another crucial problem that
haunts the modern financial world:
the curse of silos.
For, as McDonald narrates, several
years before the Lehman collapse in
the autumn of 2008, its own fixed-
income department was already so
alarmed by the American real estate
market that they were hunting for
ways to go “short”.
However, while one department of
Lehman was exceedingly bearish,
other departments, such as the mort-
gage securitisation team, were so
aggressively bullish that they were
increasing their exposure – and the
different departments were in such
rivalry that they barely knew what
the other was doing, with disastrous
consequences.
It is a saga that raises a wider
moral, not just for bankers, but for
investors too.
Vats of ink have been spilt to
explain all the macro-economic and
regulatory reasons for the financial
crash.
But one issue that has received less
attention is the trend towards frag-
mentation in the financial industry,
not just in a structural sense (ie
departments that do not talk), but a
mental 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 the
cracks” because there were numerous
competing regulatory bodies in the
US. Look too at how British policy-
makers tried to separate out the con-
duct of monetary policy (managed by
the Bank of England) from financial
regulation (handled by the Financial
Services 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 bank
marked by internal tribalism. Institu-
tions such as UBS, Merrill Lynch and
Citi demonstrated similar problems.
And this sense of fragmentation has
not just hampered information flows
around banks, but has also prevented
information flowing across the market
too. That, in turn, has fuelled a sense
Vats of ink have been spilt
to explain all the
macro­economic and
regulatory reasons for the
financial crash
of tunnel vision among some inves-
tors, with equally dismal results.
Back in the years of the credit
boom, for example, many equity
investors were only dimly aware of
what was happening in the credit
default swap world. Similarly, those
corporate treasurers who were pour-
ing cash into money market funds
often had only a hazy idea about
events 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 in
that field.
But the financial crisis has high-
lighted with painful clarity just how
dangerous such tunnel vision can be.
And the good news is that some finan-
ciers, investors and policymakers are
belatedly trying to combat it.
The hot new fad among regulators,
for example, is macro-prudential sur-
veillance (a posh phrase for proactive
regulation that tries to join up all the
dots). Investment banks are scurrying
to beef up their risk management
functions, 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 is
happening in seemingly disconnected
silos – be that in the Chinese auto
industry, carbon trading markets or
credit default swaps.
The bad news is that the curse of
silos will not be easy to beat. For one
bizarre paradox of the modern age is
that while techology is integrating the
world in some senses (say, via the
internet), it is simultaneously creat-
ing fragmentation too (with people in
one mental silo tending to only talk to
each other, even on the internet.) And
as innovation speeds up, this is creat-
ing a plethora of activities that are
only understood by “experts” in a silo
– be that in finance or in numerous
other fields.
That pattern implies there is now a
big need for “cultural translators”,
who can explain what is happening in
those silos to everyone else. But the
cadre of cultural translators in today’s
world is pitifully small (and may even
be shrinking, as institutions such as
media organisations and rating agen-
cies find their business models under
threat).
Therein lies one of the essential
challenges for investors today: namely
how to understand the micro-details
of the silos, and see how all the mac-
ro-pieces add up. The challenge is
likely to intensify, not diminish, in
the coming years – precisely because
we now live in an era where both
interconnections and tribalism hold
sway.
This article was first published on
October 8, 2009.