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Nobody Is Innocent

On December 14th Howard Davies, Director of the London School of Economics and Political Science (LSE), gave a public lecture on ‘The Financial Crisis. Who is to blame?’at the HSE . Video of the event added.

This is the seventh visit to Russia for Mr. Davies. And this time before starting to talk about economics, he spoke about... football. Being aware of the recent ‘achievements'of the Russian national squad, he recalled his first visit to Moscow in 1966, when England won the World Cup, and expressed his regret that the English team would not have a chance to play against the Russian side in the 2010 World Cup. ‘As far as I understand, you are not planning to go to South Africa'- he sympathized with the audience.

Having won over the audience with this joke, Howard Davies attempted to get serious, but that was not easy to do:since the crisis started, many answers have been given to the lecture's title question. Howard Davies listed the most popular and witty versions.

Firstly the LSE Director reminded the audience of the pamphlet by Matt Taibbi from Rolling Stone, who accused Goldman Sachs of constructing all the big frauds on the financial market since the Great Depression and warned that ‘they are going to do it again'. In Taibbi's words, Goldman Sachs is a ‘great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money'.

According to other commentators, other guilty parties in the crisis include:

  • Economists who have become lazy (accuser:Dani Rodrik, professor at Harvard);
  • Business-schools which do not teach anything useful (accuser:The Guardian newspaper);
  • Testosterone, which forces top managers and brokers to gamble and take risks (accusers:various physiologists and biochemists);
  • Videogames, which cultivate aggressiveness and a need for adventure in people (accuser:Susan Greenfield, professor at Oxford);
  • Human greed (accuser:Rowan Williams, Archbishop of Canterbury);
  • Jews (accusers are numerous, and in particular, according to surveys, there are a lot of them among US Democrat voters).

According to Howard Davies, such a plethora of opinion proves that people are confused and are looking for someone to blame, which can be very dangerous. And this lack of understanding exists not only among ordinary people, but at the level of officials responsible for market regulation as well as high level managers.

But not everybody is panicking. For some reason, Russians are remaining optimistic. Howard Davies decribed as a ‘mystery'the fact that despite the ongoing decrease in the standard of living, the decrease in GDP and rising unemployment, Russian citizens are still confident in their government and the banks as well. The level of confidence in those institutions in Russia during the crisis period is far above the average world level.

As for the changes to banks and the credit market as a whole, Mr. Davies compared the events to a ‘five act Shakespearean tragedy'. Everything started with the subprime mortgage crisis in the US, where for a long time, credit had been given to those who could never repay it. That led to a liquidity deficit:banks could no longer trust not only private and corporate clients, but each other as well. In such circumstances companies were uncovered who were overly reliant on derivatives, and the scale of credit catastrophe became obvious. The crash of financial and hence product markets became inevitable. And in trying to reanimate their economies, governments all over the world have had to pump unprecedented amounts of money into their financial systems.

It seems that we have managed to avoid the worst, but the potential for rebuilding the economy is still shaky, and this process will be long and painful. And without analyzing the reasons there is a risk of falling into the same trap twice.

So, in Howard Davies's authoritative opinion, what has led the world to such a deep crisis?

He sees the key reason in the global economy imbalance which has been increasing since the late 1990s - early 2000s. Put simply, countries and population just forgot what it meant to live within their means. While some of them were increasing export and creating huge reserves, the others turned a blind eye to increasing national debt, their budget deficit and negative trade balance. Attracted by cheap credit, households also fell into this trap, not thinking of how they would repay their debts when the mortgage bubble burst. Despite popular opinion, the fall was painful not only for Americans, but also for the Irish, where over years of seeming prosperity, real estate prices have almost doubled. As a result, Ireland (together with Greece which is standing on the verge of bankruptcy) has been the most affected of all European countries.

The fast growth of issue of securitized bonds helped to inflate the credit market even more. Hedge funds also supported the rush. ‘Everywhere you look you could see credit and asset price bubbles'- Howard Davies summarized.

All those things took place with total collusion from national governments and institutions responsible for financial market regulation. According to Howard Davies, former Deputy Governor of the Bank of England, monetary policies, which have been ignored over the last few years, should now focus more on credit growth, financial intermediation and asset prices. Another challenge for developed countries'central banks will be the rise of inflation, provoked by massive state investment into the economy.

Weak regulation of the financial sector was not a determining factor, but did also influence the development of the crisis. ‘You trust these people who are looking after your money much less than you trust normal people you meet in the street. Which is a rather depressing thing, certainly for financial institutions'- said Mr. Davies, who was the Executive Chairman of the UK Financial Services Authority (FSA) in 1997-2003.

Today's architecture of financial regulation has several fundamental problems. It is ‘extremely complicated'on the global level. It lacks a central authority able to make quick decisions on both global and local levels. Financial regulators in the US are poorly coordinated and sometimes even compete with each other. In Continental Europe there is a mixing of national and supernational regulators, and as for Great Britain, the Bank of England is ‘too distant from the financial markets'. In the US, key markets like derivatives or insurance are almost free of regulation.

All these things demonstrate that the whole system of financial regulation needs a radical reform, i.e. creation of a ‘macro prudential mechanism'which would limit risks without creating obstacles to economic activities. The creation of such a mechanism is an ‘intellectual challenge'for contemporary economists. It is not clear whether they are able to rise to this challenge, since, according to Prof. Paul Krugman from Princeton University, much of the past 30 years of macroeconomics was ‘spectacularly useless at best, and positively harmful at worst'.

So, on this evidence, what can we say about bankers who turned out to be bad risk managers:they made risk-taking deals and encouraged their clients to do this, and often even shifted the whole responsibility to top managers?

‘So, as you see, this failure had many parents, and each of them contributed to it'- Howard Davies summarized.

The LSE Director's words on the necessity of strengthening regulation his warning that in the new financial system that will arise, today's knowledge may become useless, obviously scared some of the students. Olga Kuzina, Associate Professor of the HSE Department of Economics Sociology, who was also among the audience, asked Mr. Davies whether he thought that reactions to the crisis might be excessive and if it would be better to start with not overregulating systems, but with more financial education for the man in the street.

Howard Davies agreed that there was a danger of ‘making banks so safe that they will be unable to do anything'. But shifting the responsibility for financial risks to consumers seems unjustifiable to him:events proved that even lawmakers cannot be trusted as market regulators. As for assessing the actions of Russian financial authorities, the English economist refused to do this, and merely said that in Russia, unlike in the West, they have managed to keep their citizens optimistic, and this has real benefits in times of crisis.

Having answered all the questions, Howard Davies again met the students at the reception for graduates of the HSE and LSE International College for Economics and Finance (ICEF). At the meeting he said that he was pleased with the collaboration between the two universities and hoped it would expand, and also gave hope to young financiers by saying that the current round of redundancies in the financial sector was coming to an end and banks and corporations would soon need new qualified personnel, so new graduates definitely wouldn't remain unemployed for long.

As part of his visit to the Higher School of Economics, H. Davies also met the ICEF administration, held a seminar for students of the ICEF programme in Financial Economics, met HSE President Alexander Shokhin, HSE Academic Supervisor Evgeny Yasin, First Vice Rector Vadim Radayev, members of ICEF Board of Trustees Sergey Dubinin, Member of VTB Capital Board of Directors, and Mikhail Zadornov, VTB-24 Bank President - Chairman of the Board.

Howard Davies's visit to the HSE in November 2008.

Video of Howard Davies's lecture on ‘The Financial Crisis. Who is to blame?'




Oleg Seregin, HSE News Service

Photos by Polina Frolova