Banking and Orthodox Economics: An Ugly Brew

Nothing that has emerged about the JP Morgan losses announced last week has altered my original conclusion. This was a basic failure of governance, of regulatory oversight, and of control. Oh, and of orthodox economics. Again.

Yes there were rules in place to prevent such losses. They were ignored. Vanity, hubris, call it what you will, stopped the bank from exercising self-restraint. What appeared to be highly risky, complex, and very large transactions were allowed to take place despite the fact that they were risky, complex, and very large.

The bank thought it was more clever and sophisticated than it was. It turns out to have been dumb. Very dumb.

The oddity here is that these kinds of dumb plays are what brought the banks to their knees back in the crisis. Obviously no one at JP Morgan learned the lesson.

The other oddity is that these kinds of transaction look so smart when they are first planned and thought through. They usually start off well. The initial profits confirm the management’s view that it was correct in overriding the control and risk mitigating policies, the ultimate losses overwhelm those initial profits and make the management look like asses. Which they are.

Bravado is commonplace in banking. Especially in trading. Traders always think they can outsmart the market. None of them can. At least over the longer haul. What happens is that temporary successes – such as those JP Morgan saw – are remembered and rewarded, while the longer haul mediocrity is forgotten since it would deflate all those precious egos strutting about on the executive floor.

Banking is a long term rewards business. It deals in averages. Those averages are hugely influenced by the market. There is a massive actuarial element to the way in which banks profit or loss accumulates.

And, to beat the old Keynesian drum, endemic uncertainty undermines any of the risk calculations that underpin decision making.

Banks have specific reserves against known – potential – losses. For instance, when a customer stops making payments on a loan a bank will prepare to lose its money and will write-off as a loss at least, if not all, the cash at stake. Over and above these specific losses banks also hold large unallocated or general reserves. They know there will be losses ahead. They just don’t know the where, the how, or the what that will define those losses or their impact. This general reserve is a way of dealing with such uncertainty.

I have dealt with banking for a long time. It is a cyclical business. Losses are inevitable. It comes with the territory of being an intermediary. It is why banks ought to be cautious and boring.

The problem is not just that of Minsky style booms and busts – where a strong economy encourages lending of ever more marginal quality and ends up creating its own demise as the banks get overconfident – but has been exacerbated by the stupidity imported from economics.

As you all know by now I have a very low opinion of orthodox economics. This is because such economists don’t have much of a clue about how an economy works. They live in an alternative universe of infinitely flexible price movements, rational actions, and instantaneous adjustments. In such a place – Platonic in the extreme – it is possible to convince yourself that market forces take care of everything including sorting out banking. In this never land regulation is a burden and a source of inefficiency – how can you improve on perfection after all? But ever since the collapse of the Walrasian project in the mid 1970’s we have all known that perfect worlds like that of orthodox economists cannot exist. Moreover we also know that we have no clue as to whether markets actually work to achieve the results that ardent free market supporters like to argue they do. Worse still for the orthodox: all the evidence points exactly the opposite way. Markets are prone to instability, irregularity, chaos, and great cycles. They need a lot of institutional structure to stop them veering over a cliff.

Which is what regulation is supposed to do for banking.

One explanatory note. The Walrasian project was a hundred year long research and theory development project within economics to prove that, under certain conditions, free markets will arrive at what is called a general equilibrium. That is a point at which supply exactly matches demand, everyone is happy with the resource allocation, and no further beneficial exchange can occur. It’s nirvana. It’s also impossible to arrive at. The project collapsed because the definitive solution – purporting to prove the existence of a general equilibrium – was so absurd, patently ridiculous, and laughably divorced from any real world existence that it became an embarrassment to all but a hardy few orthodox economists. In a true science the collapse would have signaled a radical change in theoretical discussion. In economics it lingers on.

And it lingers on in the most pernicious way.

Because economics is ideological at its core, orthodox economists – people who hate government intervention in the economy – still make policy pronouncements as if markets performed the way the defunct Walrasian project wanted them to. Their continued advocacy of the free market proposition is not supported by theory, but it suits their politics. So they support and peddle policies designed to strip the economy of its institutional structure and to reveal the enchanted world of market magic that better conforms to their libertarian longings.

They refer to government as a burden. Or as a dead weight. They regard regulation as a gross interference. They believe, fervently and despite the evidence, that markets will allocate resources with stunning and unerring effectiveness.

Back to JP Morgan.

The losses announced last week are evidence that banks are hopeless at allocating resources effectively. There are too many variables in an economy for even the most brilliant analyst, trader, and manager to have sufficient foresight, let alone cognitive and calculating capacity to trade without risk. Losses will happen. Shareholders will get hurt. Since those losses could leak over and require taxpayer bail-outs, they are not something we can just ignore and leave to the shareholders to fix. Banking is central to our economy. It is a utility. We cannot tolerate it blowing up every so often.

Yet it does.

So, in order to minimize the social cost of banking’s inherent instability we used to regulate it severely. Tight regulation worked well between the Great Depression and the late 1980’s. Unfortunately that’s when orthodox economists unleashed their Platonic vision on us all – without admitting its inner lunacy and it failure – and advocated deregulation.

This was a bi-partisan movement. Such was the hegemony of orthodox economics that all mainstream economists, in both parties, supported deregulation. Indeed the decisive legislation freeing up the banks came during the Clinton administration, with Larry Summers leading the charge.

The inevitable result has been a succession of bubbles and crises that culminated in the great recession.

JP Morgan has been on the front lines trying to press back against re-regulation. It has argued forcefully that banks can monitor themselves and require a light regulatory touch at most.

Yet here we are.

My own view is that we need to return to the old Depression era style of regulation. That, and we need to break up the bigger banks to make them both more humble and more easily digested by those market forces they all laud so much. That’s not where we are headed though. Which is why I argue that we will be facing more crises in the future.

And, as JP Morgan has demonstrated, that future crisis may not be that far away.

Bankers cannot help themselves. They think they are smart, when in fact they are simply, and occasionally, lucky. At best.

We should not gamble the economy on being lucky.

Nor should we gamble it on a defunct and discredited economic theory.

I consider in profoundly unethical for the economics profession not to be transparent about the failure of the Walrasian project. More to the point it is doubly unethical to continue to pronounce policies as if it had been a success. Advocating the deregulation of banking being an example of this lack of ethics. Continued advocacy of free market economics is an ideological, not a theoretical economics, position. I have no problem – although I disagree – when it is couched as such.

Then again, economics lags way behind other disciplines and professions in it ethical behavior. Wrecking the economy periodically just because they don’t went to admit theoretical failure, is par for the course for orthodox economists. They’ll do it again.

So will JP Morgan.