They bet the house on black and it came up red. In this exclusive extract from his new users’ guide to finance and investment, economist John Kay explains how greed and academic mumbo jumbo turned the City into a monstrous hybrid of public utility and self-enriching casino, and why the house rules will have to change.
NOBODY SHOULD doubt that a vibrant and professional financial services industry is essential to a prosperous economy. Only market economies can provide citizens with the standards of living that the West has come to expect. A market economy needs to direct investment to the most productive uses and needs to monitor the performance of large businesses. A market economy finances the operations of governments and enables borrowers and lenders to operate on different time-scales.
A market economy must allow citizens to save and to borrow to meet changing financial needs across their lifetimes. A market economy should protect citizens, or enable them to protect themselves, against day-to-day risks.
The liberal capital markets of Britain and the United States achieve all these things. They do not achieve them particularly well, but they achieve them better than any other system.
But the scale of activities needed to allocate capital efficiently to industries and companies is a small fraction of the resources that the financial services sector employs today.
We have created a monster that is out of control. The resources the sector demands, the size of the financial rewards it offers, and the political influence that institutions wield are all excessive. The wealth of the individuals employed in financial services affects every aspect of economic and political life, sucks in talent that would be better employed elsewhere, and distorts the values of whole societies.
The modern financial services industry is a casino attached to a utility. The utility is the payments system, which enables individuals and non-financial companies to manage their daily affairs. The utility allows them to borrow and lend for routine activities, and allocates finance in line with the fundamental value of business activities.
In the casino, traders make profits from arbitrage and short-term price movements. The users of the utility look to fundamental values. The occupants of the casino are preoccupied with the mind of the market.
Modest levels of speculative activity may improve the operation of the utility. By exploiting arbitrage opportunities, they can bring the mind of the market back in line with fundamental values. But as trading levels increase, the mind of the market, determined by the power of conventional thinking, is itself the main influence on prices.
The activities of the casino have come to dominate the utility.
In the summer of 2007, the handsomely paid leaders of the financial services industry announced that if the governments of the world did not provide emergency funds to keep casino players at the tables they would bring the utility to a halt. The US Federal Reserve and European Central Bank came quickly to the rescue. The Bank of England arrived somewhat more slowly, arguing that the players must learn a lesson. Britain's regulators allowed Northern Rock to fail.
As gamblers everywhere were forced to acknowledge the scale of their losses, they became increasingly mistrustful and reluctant to play with each other. They pleaded that governments should take the role of "the house" and ensure all debts were settled. In the US government intervention of October 2008, the US government acknowledged that role. European governments followed suit. The British government provided the most extensive funding, but on the most demanding terms.
There is universal agreement that "more effective regulation" must be the price of the bail-out. There is less agreement about what that "more effective regulation" might mean. The professionalisation of financial services has changed regulation as it has changed markets. The focus of regulation is now on principles and rules, not character.
Central bankers and financial regulators were once City or Wall Street grandees, weighty figures distinguished by experience and connections. Alan Greenspan, who acquired near saintly status as America's central banker for almost two decades, was different.
The well-connected Greenspan was also a professional economist, if not a particularly distinguished one. His ascendency meant that the financial economists had taken over. When Greenspan retired in 2007, both the chairman of the US Federal Reserve board and the governor of the Bank of England were respected academics and authors of scholarly articles. Instead of an agreed code of behaviour, the financial economics of "subjective expected utility" (SEU) - based on a mathematical probability formula - became the major influence on market regulation.
But the application of economic theory to financial markets is often naïve, and often politically charged. Efficient market theorists asserted that the New Economy bubble was a distillation of the wisdom of thousands of market participants. Devotees of SEU claimed that the credit bubble was a new and more sophisticated system of allocating risk where it would be most effectively managed. Market professionals, and the politicians who represented their interests, stood ready to applaud these supposed insights and flatter those who delivered them.
The models bore little relation to tawdry reality. No-one who lived through the 1998-2000 New Economy or dotcom boom and the 2003-07 credit bubble can still believe that market prices are well-considered valuations of securities.
When consumers find product quality difficult to assess, they tend to overpay. Goods and services are bought by those who overestimate their value, not by those who underestimate them.
When investment banks hire traders, when small savers purchase funds, when corporate executives select advisers, when treasurers invest in structured credit, the winner's curse comes into play. The difficulties of distinguishing skill from luck, of penetrating complexity, of determining fundamental value, all work towards encouraging people to pay too much.
And that gives a clue to the question which most people outside the City of London - and some inside it - often ask: "Why are people in the financial services industry paid so much?" The simple arithmetic of compounding gives a basic insight into the answer. Small percentages of large amounts, levied on many occasions and accumulated over time, add up to very large sums.
But why, an economist will ask, are these returns not competed away? To some extent, they are. Much of the revenue of the City goes into the pockets of employees, and into lavish offices and expenditures, as well as into the profits of City firms.
That is why there are so many investment funds vying for your attention. But the profitability of the City is mainly the result of information asymmetry. Where information is imperfect, markets and market outcomes are imperfect. The financial services industry exists - and is needed - because of imperfections of information.
Arbitrage, the mainstay of the financial services industry, is absurdly rewarding. Seeing something is worth £2 when it is priced at £1 is as profitable as making something priced at £1 into something that is worth £2, although the social value of correctly assessing wealth is very much less than the social value of creating that wealth.
The New Economy bubble was the product of the self-serving puffery of corrupt analysts. The credit bubble was a game of "pass the parcel" whose participants vied to dump risks on players less well informed. Both bubbles were based on systematic misrepresentations no less venal because they contained an element of self-deception.
The academic cheerleaders were, in the main, innocent dupes. Not especially well paid, generally centre-left in political orientation, they provided philosophical justification for greed and for rightist ideology, through a Panglossian message of markets efficient in both a broad and a narrow sense.
The most public involvement of distinguished economists in cutting-edge financial practice would end in the fiasco of long-term capital management. They believed their own models.
But financial economics offers illuminating insights rather than truth. A more nuanced view acknowledges the ways in which the financial services industry has failed taxpayers and retail customers. It recognises the economic importance of the financial services industry but does not equate the interests of businesses within it, or their employees, with the public good.
In the last decade we have seen the abuse of retail customers during the New Economy bubble, systematic overcharging for investment management services, followed by reliance on taxpayers for support when the credit bubble jeopardised the survival of financial institutions. These events should be more than sufficient to dispel any sense that there any relationship between the profits of financial services businesses, the earnings of their employees, and the value of services rendered to society at large.
What next? Where there has been abuse, there will be regulation. The primary objective of the regulation of financial services is that the casino should never again jeopardise the utility. Many people seem to think that the best method of achieving this is close supervision of the casino.
They are wrong. Junior officials do not have the capability, or the authority, to advise bankers paid multi-million pound salaries and bonuses against what, with hindsight, appear to be strategic business errors. How could they succeed where the boards of these institutions could not? Nor is it realistic to suppose that, if they did have such power, they could challenge the most powerful political lobby in the country.
The practical result of the inevitable clamour for "more effective" regulation will be more meetings, more regulators and more compliance officers. Their additional rules will be as irrelevant to the next bubble as the endlessly debated Basle I and II capital requirements were to this one.
The better response is to separate the utility from the casino. Because conglomerates are riddled with conflicts of interest, they are bad for their shareholders and a bad idea for taxpayers, who have to pick up the bills incurred by incompetent traders.
Yet the collapse of the credit bubble has actually strengthened the role of conglomerates, because only retail banks have resources large enough to meet the capital requirements of players in the casino.
The primary object of regulation should not be to ensure good practice in financial services businesses, but to protect retail customers. There is a stark contrast between the size and general profitability of the financial services industry and the poor service it delivers to its customers. The best advice on selecting products is, in most cases, to buy cheap and to do as much as you can yourself.
Neither regulation nor markets will ever ensure that ordinary retail investors receive good financial advice. The economics of the business makes such provision impossible. We select clothes and food, furniture and cars, for ourselves from the shelf or the showroom floor because the services of skilled, knowledgeable, impartial intermediaries cost more than we are willing to pay.
The cost of high-quality professional services is much greater. Bespoke legal advice is priced out of reach and medical advice accessible only because it is made free. The most that can be expected - more than is available at the moment - is the confidence of large supermarkets, where the store's concern for reputation encourages good value products.
Many people in the City have genuine interest in ideas, and genuine concern for the public good, but these activities are, in the main, conducted outside formal business hours. There are also in the City some of the most selfish people outside prisons, who believe that - beyond the cash they generate - no justification for their activities is required.
The City of London is an important British export industry and deserves substantial credit for that. A process of change and reform will take the City less seriously than it takes itself, and less seriously than politicians have taken it. Neither the intelligent investor, nor the concerned citizen should be intimidated by the City, or unduly impressed by its increased but exaggerated expertise and professionalism.
You cannot be an intelligent investor if you believe that markets are always efficient or deny that they are mostly efficient. Aside from that, the most useful realisation for the intelligent investor is that the most trustworthy hands are your own.
THE SCOT WHO SAW IT COMING
Born in Edinburgh, John Kay is one of the UK's leading economists. A fellow of St John's College Oxford and a visiting professor at the London School of Economics, he is also a columnist for the Financial Times and a member of the Scottish government's council of economic advisers. The Long And The Short Of It is published by the Erasmus Press on January 20.
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