UK: How the Market Made Us Stupid

Four trillion dollars is a lot of money. It is the entire annual output of
Britain and France put together. It is also the amount American investors
in high-tech shares have lost over the past 12 months -- and that's before
their losses in the rest of the stock market. The entire rickety American
economic success story has rested on a crazy stock market boom so that even
taxi drivers were trading in dot.com stocks and running up unparalleled
levels of debt because they felt so wealthy. Now they are left, like the
rest of America, with the debts and worthless stocks.

And the crisis in the American financial system is matched by one in Japan. Japan's massive financial bubble burst 10 years ago and it has yet to clear up the financial detritus. The banking system is racked by up to $350
billion of bad debts, but the banks' capacity to ride the financial hit is
undermined by the downward plunge of the Japanese stock market because
their own capital is invested in the shares of other banks -- a double
whammy which already means many are technically bankrupt. And if we take
seriously the hint from Japanese finance minister Kiichi Miyazawa that
Japan might be the first major state since the war to unilaterally write
down the value of its national debt, its financial system has to be
regarded as on the brink. For the world to have one calamity would be bad
enough; to have two simultaneously is more than careless.

It is eerily reminiscent not of the kind of recessions of the post-war
period -- which have been painful enough -- but of the recessions up until
1930, as Larry Summers, the outgoing US Treasury Secretary, has said. Japan
and the US have in their different ways made the cardinal error; they
allowed their stock markets to become too intertwined with their overall
financial system, reinventing the impulses that made nineteenth and early
twentieth century recessions so vicious. What made those recessions last
twice as long as post-war recessions was that they were accompanied and
reinforced by bank and stock market collapses.

In Britain there is no longer any folk memory of what it means for a bank
to go bankrupt, but as recently as the 1880s major banks could go bust,
sending local economies into tailspin; firms lost their credit lines and
workers and consumers their savings. In the US the experience was no less
raw. The New York stock market began to have national importance as early
as the mid-nineteenth century, and its ups and downs rippled out across the
national economy. Banks were no more stable than the strength of the city
or town in which they traded, and if one went down others followed like
nine-pins. As the pace of industrialisation and urbanisation quickened in
Europe and the US, workers could be suddenly thrown out of work by equally
sudden contractions of credit lines and investment funds. The 1930s slump
was the last of the great stock market and bank-induced economic collapses.

The great success story of the 50 years that followed, led by liberal and
social democratic politicians, was to tame these wild forces. A mixture of
regulation, credit control and state intervention in the banking system
stabilised the financial system while welfare states helped underwrite the
risk to ordinary workers and give them buying power that contributed to
stabilising demand.

But as the consequences of the irrationalities of stock market gyrations
and wild bank-lending -- the consequence of applying free market economic
principles to finance -- were forgotten, so the reasons for the regulations
were forgotten too. Know-nothing politicians of the Right, their
intellectual acolytes and financier paymasters lobbied increasingly for
'deregulation' and 'liberalisation'. Bit by bit the controls came off. In
the US, Rooseveltian financial reforms of the New Deal were scrapped over
the 1980s and 1990s as hindering the competitiveness of US banking.
American finance now has all the 'freedoms' it had in the nineteenth
century, taking us back to the same wild capitalism.

My hunch is that the world is about to learn an awesome lesson; the
conservative theorists were wrong and the liberal Keynesians right. The
information technology revolution may have constructed a new economy, but
it is one that has ancient parallels. IT could never have got off the
ground so quickly without stock market finance, but it had the impact of
making an already febrile and irrational investment community even more
stupid, speculative and herd-like than usual as it chased what it imagined
were new pots of IT gold.

Moreover, IT has been one of the reasons it has been so hard to regulate
finance, with the borders between banks and the stock market becoming so
much more porous; banks may be bigger but their disastrous nineteenth
century-type exposures to stock market losses have been reinvented. To be
effective regulation had to become smarter, faster and more international,
but in the current environment building the essentially left-of-centre
coalitions that might effect such regulation has been difficult.

So we are where we are. In the US, rather like the 1920s, the stock market
boom spawned a massive misallocation of savings as Americans abandoned
caution and played the markets. They have been duped into running up a
scale of personal debt rarely witnessed. Worse, the prospect of easy profit
has created a new populism in which stock ownership and speculation are
portrayed as democratically enfranchising -- while progressive politics,
with its instinct to contain and regulate finance, is cast as against the
best interests of the people.

Unravelling stock market bubbles is always painful when the linkages have
been allowed to infect the entire financial system; the ordinary credit
lines that lubricate the wider economy become polluted by what has happened
in the stock market. In this respect Japan presents a warning. The losses
go so deep that policy interventions such as lowering interest rates and
reducing taxes are much less effective than they were in the immediate
post-war period. The US has a market structure that means it will get the
adjustment over more quickly and radically than Japan -- but that means any
recession will be compensatingly more intense.

Europe will not escape the fall-out -- but it is in a much stronger position
precisely because its stock markets (except in Britain) have a much less
central role in its financial system. And despite some wobble under fire
from ignorant American critics and their British poodles, Europe has
maintained a regulatory structure that retains that insulation. As that
realisation grows, the European Union will be seen as a safe haven. And
Britain will be glad to be a member of a club in which economic activity is
not seen as the by-product of a casino.

• 186 Financial Services, Insurance and Banking