HSBC Private Bank (UK) Limited

But what would the great man have made of today's mess?

As the managerial heads of banks start to roll, I am reminded of Keynes’s sardonic comment. ‘The sound banker, alas, is not one who sees danger and avoids it, but one who when he is ruined, is ruined in a conventional and orthodox way along with his fellows so that no one can really blame him.’ This gets much closer to the heart of our present financial crisis than the populist clamour against greedy bankers. Keynes’s observation also improves on Alan Greenspan’s attribution of the banking crisis to the ‘under-pricing of risk world wide’. Greenspan gives the game away when he goes on to say that ‘both risk models and economic models – as complex as they have become – are still too simple to capture the full array of critical variables that govern global economic reality’.

But what value can one assign to risks if they cannot be ‘captured’? The under-pricing of risk only became obvious in retrospect. Before banks started to collapse, the conventional wisdom was that the risks were ‘safe’, i.e., that one could accurately calculate what they were. In thrall to ‘risk management’ models that they barely understood, bank chiefs acted conventionally, and by their lights, correctly. Indeed, had they acted otherwise, they might have been held culpable for failing to ‘maximise shareholder value’. Greenspan is right, though, to mention economic models. It is the economic models – the models of economists – that begat the risk models. The forecasting models used by banks are applications of the economic theory their creators learnt in their economics or MBA courses. The de-regulation of financial markets was the fruit of the same theory. If one is searching for blame, it lies with current economic theory. But this is beyond the understanding of the general public who have to be satisfied with more visible scapegoats.

Since the 1980s the dominant paradigm in economics has been rational expectations theory. This assumes that people make efficient use of all the information available to them: everyone is an economic forecaster. Of course, forecasting errors are possible – it is costly to get hold of all the information ‘out there’ – but since the errors are expected to be random, expectations are, on average, ‘correct’. Micro-forecasting models are based on rational expectations theory. Most of them are proprietary products sold to customers on the basis of their ability to predict the future. Their method is to establish a range of probabilities within which future events can occur – a normal distribution of risk. Furthermore, when stocks are combined into portfolios, the risk decreases in proportion to the number of stocks held. The key assumption behind diversification is that the returns on different stocks are uncorrelated, so that when we hold many stocks, the risks which are unique to each tend to cancel each other out. Correct prices on average are assured by the force of equal, but opposed, errors. Any vestigial risk of loss can be hedged by credit default swaps.

The trouble with these models is that any unforeseen event may have such a large impact as to make them meaningless. It was one such event, the rouble default of 1998, which caused the collapse of the hedge fund Long Term Capital Management. A much greater unforeseen event, the downturn in American house prices in 2006, devastated the world’s banking system, with consequences which are still unfolding.

For Keynes a much greater proportion of economic life than would be accepted by today’s ‘rational expectations’ theorists and their micro-modelling disciples fell into the category of uncertain rather than merely risky. He claimed that our knowledge of future returns on investment was ‘fluctuating, vague, and uncertain’. How do we, under such circumstances, save our faces as rational actors? His answer was that we adopt certain ‘conventions’ or ‘rules of thumb’: we assume that existing opinion, as expressed in current prices, correctly sums up future prospects, and by copying what everyone else is doing. ‘Knowing that our own judgment is worthless…we endeavour to conform with the behaviour of the majority or the average. The psychology of a society of individuals each of whom is endeavouring to copy the other leads to what we may strictly term a conventional judgment’.

These conventions are capable of giving financial markets a great deal of stability for long periods, with bulls and bears cancelling each other out. But any view of the future based on ‘so flimsy a foundation’ is liable to ‘sudden and violent changes when the news changes’, since there are no ‘strong roots of conviction to hold it steady’. When ‘the practice of calmness and immobility, of certainty and security suddenly breaks down… new fears and hopes will without warning take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled board room and nicely regulated markets are liable to collapse…The market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning, yet in a sense legitimate, where no solid basis exists for a reasonable calculation’.

Keynes knew what he was talking about, having made and lost three fortunes playing the markets. (He ended up with about $30m in today’s money.)

Keynes’s chapter 12 of his General Theory of Employment, Interest and Money may be read as a superb account of the paradox of financial innovation. The stock exchange reduces the riskiness of investment by making ‘liquid’ for the individual investments which are ‘fixed’ for the community. This reduces the proportion of their resources that people will want to hold in cash, but by the same token it enlarges the scope for speculation and thus makes investment more volatile, and magnifies the scope of collapse. When the news changes, everyone suddenly wants to become ‘liquid’, but, as Keynes reminds us, ‘there is no such thing as liquidity for the community as a whole’. The same paradox of innovation can be seen in the ‘securitization’ movement of the recent past. A huge gain in liquidity for individuals has turned into a massive credit freeze for the world.

So now we are where we are, what are governments to do? The same economists who devised the theory of efficient markets are now saying that anything governments do will only make things worse. Here, for example, is Eugene Fama, Professor of Finance at Chicago University: ‘The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs saving that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.’

It is absurd to say that if resources are ‘idle’, extra spending simply moves resources from one use to another. It brings idle resources into use. That economists can go on repeating that ‘idle resources’ are ‘in use’ testifies to the fact that, for many of them, hatred of any form of government intervention is stronger than their reason or humanity. Paul Krugman has commented mordantly that ‘economists who have spent their entire careers on equilibrium business cycle theory are now discovering, in effect, that they invested their savings with Bernie Madoff’.

Professor Fama is right in one respect. If government issues long-dated bonds to fund its spending plans, there is a danger of ‘psychological crowding out’. The government will have to pay more for its debt if markets believe it is heading for bankruptcy. It is for this reason, but only for this reason, that extra borrowing may absorb saving that would otherwise go into private investment. However, this can be avoided by printing money.

To ask what Keynes would be recommending today is, in a sense, idle. For him, diagnosis was fundamental: the cure was ‘necessarily subject to the particular conditions of the times’. At least we know what he recommended during the Great Depression.

Keynes did not believe that a really serious recession could be reversed by interest rate policy alone. The reason is that any big increase in pessimistic expectations causes banks and companies to add to their cash balances. This raises lenders’ price for parting with cash (or at least prevents it from falling) just at the moment when borrowers are clamouring for cheaper money. At the bottom of the Great Depression he wrote: ’It still may be the case that the lender, with his confidence shattered by his experience, may continue to ask for new enterprise rates of interest which the borrower cannot expect to earn…If this proves to be the case there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidise new investment’.

At present the government appears to be embarked on a twin-track strategy of pumping money into the banking system and subsidising private sector investment. The finance required for this to make any impact on the recession is now so vast that a substantial ‘quantitative easing’ is inevitable. In his Treatise on Money Keynes suggested open-market operations ‘a outrance’. but doubted whether a central bank would be ruthless enough to persist in it for long enough for it to be successful. He also gave modest approval to Silvio Gesell’s idea of distributing vouchers, cashable within a month, directly to stimulate consumer spending. And, of course, there was his tongue-in cheek suggestion for burying banknotes in bottles and getting people to dig them up.

How does one prevent something like this from happening again? Keynes’s main preventive idea was counter-cyclical budgeting. This is no longer adequate, at least in its old form. It would be foolish to jettison all we have learnt about the failures of ‘Keynesian’ policy in the 1960s and 1970s. Today we would need to pay much more attention to creating better institutions. We must seriously ask the question: what do we want of our banks? How do they fit into the fabric of a ‘good’ society? The bail-outs have also exposed a huge problem of moral hazard. Institutions have been rescued because they are ‘too big too fail. This gives a blank cheque for management to take unjustified risks. One way of guarding against moral hazard is to ensure that no bank or company in the private sector is ‘too big to fail’. We must find a way of making financial innovation safer without drying up its springs. Some bank chiefs must also recognize that the criticism they now face has been partly fuelled by the fact that, in their search for maximum returns, they have become desperately unfriendly to all but their wealthiest customers.

But above all, Keynes’s message is that economists must get to work on their models again. He insisted on the importance of starting from realistic assumptions, not Platonic ideal types like ‘economic man’, or perfect competition, or complete information, as the only way of making economics practically useful to society. It is a lesson economists will have to learn all over again.