An interview with Financial Times columnist John Kay
by Max Rashbrooke
When John Kay was at school in Edinburgh in the 1960s, his less able classmates – the ones who, he says, “weren’t going to get as good maths grades as I was” – were destined for a career in banking. In those days finance was a gentle profession, with plenty of time for long lunches and a round of golf or two.
It was a stuffy, exclusive world, and perhaps few would regret its passing. But it was a world where relationships mattered and bank workers hadn’t forgotten their core reason for existence: the basic tasks of processing payments, managing wealth, minimising risk, and getting capital to the people who need it.
How much has changed in forty years! Now, even after they should have been chastened by the catastrophe that was the global financial crisis (GFC), the Masters of the Universe are still riding high, dominating the real economy and indulging in a swathe of activities far removed from those economically – and socially – important purposes.
Kay, a professor of economics at the LSE and columnist for the Financial Times, knows this better than most. One of the world’s most influential explainers of economics, he has the distinction of being gifted in both his subject area and its description for a lay audience. Unlike some of his contemporaries at high school, he got good maths grades and studied the subject until university – for a while, at least. “At the time the maths got difficult, it was time to bail out and do economics instead,” he says, wryly.
Kay was in Wellington last week giving a talk to the Government Economics Network, among other engagements. He has just published, to enthusiastic reviews, a book called Other People’s Money, which identifies the roots of the GFC in a long process he calls financialisation – the growing dominance of finance in the world economy.
Kay is quick to point out the problems created by an over-mighty finance sector and over-confidence in its power. Take bank failure rates. They have steadily increased since the 1980s, the point at which many of the brakes were taken off banks’ activities. Some people were fooled by the supposed Great Moderation, a brief period between 2002 and 2007 when there were virtually no crises – but the GFC put paid to that.
Financial crises, Kay points out, are not “facts of nature” but “the product of human behaviour and institutions” – and can be averted, or at least minimised, if those two things are better shaped.
This is not to say that finance is all bad. “You do need a finance sector. There are no examples of well-developed modern economies that have no finance sector.” But societies have to ask themselves two questions, he says: what is the point of finance, and why is it so profitable?
Finance traditionally has four key roles, the first being to simply manage payments. Humdrum tasks of this nature occupy many bank staff. As Kay points out: “Most people who work in finance system aren’t masters of the universe being paid telephone-number salaries.” In Barclays, for instance, the top 1% of earners get 40% of the firm’s total remuneration, while most staff are paid less than £25,000 a year – below the median wage.
The other traditional roles of banks are wealth management (“smoothing out consumption”, as economists call it), capital allocation and risk mitigation. In recent years banks have convinced themselves they are managing risk supremely well – an illusory confidence best illustrated by the story of the 2005 Federal Reserve conference held at a place called Jackson Hole, in Wyoming. Organised in honour of the Federal Reserve chairman Alan Greenspan, it was a celebration of the supposed Great Moderation.
As Kay tells it, the Indian economist Raghuram Rajan tried to spoil the party by warning of the risks to global stability, in particular the ‘long tail’ of events that were unlikely to happen but would have devastating consequences if they did. However, his paper “wasn’t very well received at that particular conference”. Instead Rajan was told that the new financial system was spreading and diversifying risk.
This episode demonstrated “the unimportance of being right”, Kay says, dryly; it also recalled John Maynard Keynes’s aphorism, “It is better to be conventionally wrong than to be unconventionally right.”
The wider problem, Kay argues, is that the business of managing risk – also known as insurance – has two quite different roots, one in Swiss cantons where villagers would gather together and share the costs of things like replacing dead cows, and the other in Lloyd’s coffee house in London, where gentlemen would gamble “on anything”, including the health of the King and the outcomes of battles. The problem for the people assembled at Jackson Hole “is that they thought they were in a Swiss village, but in fact they were in Lloyd’s.”
During his Government Economics Network talk, Kay at one point turned financier, offering, with British charm, to sell his audience a product consisting of “a credit default swap based on a synthetic collateralised debt obligation based on a sub-senior tranche of sub-prime mortgage debt”. To much laughter, he asked a woman in the front row: “Madam, would you like to take this offer?” (Sensibly, she didn’t.)
It was a nice demonstration of just how far finance has lost its bearings – and, in its ever-increasing complexity, has heightened risks, not managed them. If, today, we went out on the streets of Wellington and asked people, ‘Do you think finance is something that has made your life more secure than it was 20 years ago?’, then, Kay says, “The people you asked that question of would think you’ve had taken leave of your senses.”
So much for risk mitigation – and banks aren’t really doing much capital allocation either. These days, large companies – the likes of Google, Apple and Facebook – don’t generally raise funds from the capital markets. Overwhelmingly they are self-financing, generating more than enough cash for their needs from day-to-day operations.
The result, Kay says, is that the financial system “has largely lost sight of its core purposes … and principally deals with itself. What we need to do then … is to move back to, or move towards, a system in which finance is based on the genuine, underlying needs of the real economy.”
At this point in the argument, most people would mount a case for more regulation. But not Kay. One senses that, like Rajan, he enjoys holding contrary views – and on this subject he mounts a convincing case.
Look at the number, and length, of new banking acts, he says. Despite claims that the finance sector was deregulated, the figures show a spiralling volume of laws in the last two decades. “If that is deregulation,” he says, “it doesn’t look like it to me.” It’s worth remembering that things like credit default swaps started in an attempt to avoid regulation. “Along this path [of more regulation], only madness lies.”
The answer, in Kay’s world, is to focus not on writing more complex rules but on reforming the structure of institutions and the incentives of people working in them. He is particularly hot on the idea sometimes crudely described as ‘breaking up the banks’: moving back to a world with smaller, more specialised institutions, a world in which retail banking, the business of taking deposits from ordinary folk, is separated from high-risk investment banking. Banks should focus on one of their four core purposes and be rewarded “in reference to” that purpose.
The size of banks is such a great problem, Kay argues, that it has allowed many CEOs to escape punishment by pleading ignorance of what was happening in their firms. “If it is impossible for the CEOs and the directors of banks to know what employees are doing, then we need to simplify their structures until we get to the point where they can.”
The principle should be this one, he says: “If you take the bonus, you take the rap.” Or, to put it a slightly wittier way, “If you are in charge of a den of thieves, that in itself is a criminal offence. It is not a defence to say that you are so distant from the den of thieves that you thought it was a monastery. Which has largely been [a] successful [excuse] and is the main reason why … they [senior banking staff] haven’t been prosecuted.”
Kay is not optimistic about the chances of reform, however. Little has been done since the GFC, and if anything the problems of scale have only been made worse by the mergers that happened in its immediate aftermath. The problem is that, especially in the United States, the finance sector has a disproportionate hold over politicians.
“I think we’re going to find it very difficult to enact meaningful reform until we tackle the political power of the financial sector,” Kay says, all wryness gone. Its donations to political parties are one aspect of the problem, as is “the revolving door” between government and business. “Politicians realise that, in life after politics, being on good terms with the financial sector won’t do them any harm.” And there are other forms of cosiness, such as the intellectual and cognitive capture that comes from spending too much time around bankers.
The result, in Kay’s view, is that the dominance of the finance sector – which has lain behind most recent crises, including the 1990s meltdown in Asia, the new economy bubble, the global financial crisis and the ongoing Eurozone fracturing – remains just as much a threat as it ever has been. And, he says gloomily, “We’ll continue to face [that threat], until we face that mother and father of all crises.”
No-one knows exactly how it will strike, and we are all at risk. Kay notes “a slight undercurrent of complacency” in New Zealand, even if the relatively good performance of our Australian-owned banks justifies some sense of pride. But wherever the crisis hits, underneath it will probably be a financial sector divorced from its roots and a little in love with its own cleverness.
Thinking back to his school days, Kay notes once more the disappearance of the old world of banking and its replacement with computer-based trading driven by complex algorithms. The new bankers aren’t necessarily better people than they were back then, but what has wrought the change, Kay reflects, is that the profession stopped taking the less able students – and began attracting the ones whose maths grades were better than his.