Barack Obama's falling ratings
The summer of waning love
Of polls and presidents
ONCE upon a time—ie, a few months ago—Barack Obama was the hip new president with the cool manner, who made no mistakes and enjoyed the approval of a majority of voters. Today the president is still cool: his big speech on health reform this week was delivered with his signature mix of passion and intelligence. But he has come close to losing that majority. His job-approval rating has fallen to 51% after eight months in office. If he dips below 50% before November, says Gallup, Mr Obama will have reached that point in near-record time, falling faster in public opinion than any post-war presidents bar Gerald Ford and Bill Clinton.
What has Mr Obama done to deserve this summer of waning love? Democrats wail that a right-wing fringe is determined to delegitimise the president and that the media has amplified its voice. How else could panic about fictitious “death panels” drown out rational debate about health reform? News that Mr Obama was to give a talk to the nation’s children generated cries of “indoctrination”—until the speech, on September 8th, turned out to be a schoolmasterly homily in favour of hard work.
And yet the polls suggest that Mr Obama’s trouble is not only with the right. Writing in the National Journal, Charlie Cook, a respected analyst, has observed that independent voters are deserting Mr Obama fastest. In recent weeks this segment of the population has been giving Mr Obama an approval rating in the mid- to high 40s, down from the 60-70% that prevailed from mid-April to early June. The loss of these weathervane voters, said Mr Cook, should “terrify” the Democrats as they look ahead to the mid-term elections in only 14 months’ time.
This may be too alarmist. Frank Newport, the editor-in-chief of the Gallup Poll, notes that most presidents lose popularity after their election. Mr Obama’s rating among all voters has fallen (see chart) but remains close to the historical average of 55%. As for independents wavering most, unattached voters are naturally more fickle than loyalists. And the number of true independents is smaller than it seems. About a third of voters say they support neither main party, but the proportion falls to about 10-12% after subtracting those who admit to “leaning” towards one party or the other.
The first year is anyway a lousy guide to presidential fortunes. Ronald Reagan and Mr Clinton also faced big economic difficulties early in their terms. Unlike Mr Obama’s (so far), their ratings fell through the 40s, yet both were re-elected to second terms. George Bush senior was highly popular through his first year and became more so after the Gulf war of 1991. But voters slung him out after a single term.
All that said, the wavering of independents is bound to worry Democrats facing mid-term elections next year. An abrupt change in the opinion of 10-12% of the electorate can in principle have big consequences, says William Galston, a senior fellow at the Brookings Institution in Washington. But he, for one, is struck by a similarity between Mr Obama’s troubles and those of Reagan in 1981.
Reagan, too, inherited an economic crisis that did not respond rapidly to corrective action. In 1982 the Republicans went into the mid-terms with unemployment above 10% and a president whose approval rating languished in the 40s. Yet the expected electoral calamity failed fully to materialise: the Republicans held their own in the Senate while losing 26 seats in the House, less than had been feared.
Might a similar pattern help the Democrats next year? Perhaps: but few Democrats now in office hark back to the Reagan precedent. More are fixated on their own party’s fate in the mid-terms of 1994, when the Republicans stormed back and recaptured the House. A lot are sure that the cause of that debacle was the failure of Bill and Hillary Clinton to pass health reform, and that coming up empty again could prove calamitous this time, too.
But it is also arguable that the Democrats’ big problem 15 years ago was not the failure on health care but the perception that the party had moved too far left. And that could happen again. On September 5th Van Jones, a White House adviser on green jobs, was forced to resign after it emerged that he had once signed a petition accusing the Bush administration of knowing in advance about September 11th 2001 but doing nothing in order to furnish a pretext for a war. Just a lapse in vetting, said the White House. But grist to the mill of all those telling voters that the cool Mr Obama presides over a government of big-spending wild-eyed radicals bent on nationalising health care.
Fiscal policy
The other exit strategy
Independent budget offices would help politicians’ promises to be prudent tomorrow
ECONOMIC policymakers across the rich world face two delicate balancing acts over the new few years. The first, involving monetary policy, is being widely discussed and carefully planned by teams of technocrats. Central bankers must keep their balance-sheets big and interest rates low for long enough to prevent deflation setting in, but they also have to be prepared to change things quickly to prevent inflation taking off. The second balancing act, involving fiscal policy, depends on politicians rather than specialists—and has, so far, been shamefully ill-planned.
In the short term public largesse is a necessary response to the slump in private demand. Budget deficits have ballooned—to an average of almost 10% of GDP across the big, rich countries—for good reasons, as governments have bolstered their banks and provided fiscal stimulus, and as sagging economies have sapped tax revenues. Withdrawing that support too fast would be foolish. Particularly after a banking bust, premature fiscal tightening can push weak economies back into decline, as Japan’s ill-timed consumption-tax increase in 1997 showed. The same risk holds today, particularly if the fiscal squeeze involves incentive-dulling tax increases.
But public profligacy cannot last for ever. Even if the nascent recovery takes hold, the IMF reckons the gross government debt of the rich world’s big economies will reach an average of 115% of GDP by 2014 and continue to rise thereafter in some places, notably America. The weight of this debt will eventually push up interest rates, crowd out private investment and sap economic growth. Far nastier outcomes, from out-of-control inflation to outright default, are conceivable.
To be fair to the politicians, this fiscal balancing act is far harder than the central bankers’ task, for two reasons. First, politicians must not only get the timing of fiscal tightening right, but must also decide on the best ways to cut spending and increase taxes, and the right mix between the two. These decisions involve more goals, more tools and more politics than stabilising prices. Second, politicians lack the credibility that central bankers have built up after two decades of low inflation. The first of these differences is inevitable: decisions about the size of government and its priorities are profoundly political and politicians must answer to voters for their choices. But politicians could go a long way towards building credibility for their fiscal decisions by copying more of the tricks of modern monetary policy.
Over the past 20 years central banking has been revolutionised. A powerful consensus has emerged that economies perform better if monetary policy is left to an independent group of experts with a clear mandate (usually an inflation target) and that transparency around central bankers’ assumptions and actions helps anchor people’s expectations of future inflation. Some of this focus on rules and transparency has already rubbed off on fiscal policy. Countries from Sweden to Chile have rules to limit deficits and enforce transparent budgeting, and independent bodies to assess politicians’ budget decisions. America has the Congressional Budget Office (CBO) and the euro zone has the Stability and Growth Pact (see article). By and large, though, these tools for fiscal credibility have been less well developed, less widely adopted and generally less effective than their monetary equivalents. That must change.
Transparency’s clear benefits
One route emphasises fiscal rules. Germany, for instance, recently passed a constitutional amendment to limit the build-up of debt. Rules have worked well in some places, notably Chile. But often such rules have been discredited by manipulation—think of Britain’s Golden Rule, which permitted borrowing only to invest over the economic cycle. If too strict, they could force premature tightening. Just as an inflation target is important, but does not by itself make central bankers credible, so a fiscal rule is a start, not a cure-all.
Hence the importance of the other approach: appointing independent budget monitors. Politicians will not (and should not) outsource tax and spending decisions to unelected technocrats, but all countries should have independent bean-counters to pass judgment on their fiscal plans. Even without statutory power, such bodies have an impact. New cost estimates from the CBO, for instance, recently changed the terms of America’s health-care debate. These bodies should not just assess politicians’ plans, but offer simulations of different fiscal paths. Britain’s Tories want to copy the CBO model.
They are right. No politician likes being second guessed, but the greater fiscal credibility that such rules and institutions provide actually increases a finance minister’s room for manoeuvre. It also helps central bankers, by assuaging investors’ fear that bankrupt governments will resort to printing money. Credibility will not magically remove the difficult budget choices that lie ahead. But it is an important place to start.
Speculators and the oil price
Data drilling
A little more light is shone on the oil markets
BASHING “speculators” is a popular pastime for American politicians trying to explain high and volatile oil prices. But whether speculation has really been responsible for spiking prices is a controversial issue. In 2008 the Commodity Futures Trading Commission (CFTC) issued a report dismissing the role of speculators in last year’s startling run-up in prices. But banks, hedge funds and others who bet on oil (without a use for the stuff itself) still face limits on the positions they can take, if Gary Gensler, the new CFTC head, can show that their influence in markets does harm.
On September 4th the CFTC added more evidence to the debate by releasing what it said were more transparent data on market positions. Before this month, the CFTC simply classified traders as “commercial” or “non-commercial” in its weekly report on the overall long and short positions in the market. Now it has started to disaggregate them further, into producers and buyers, swap dealers and “managed money”. The third category includes hedge funds.
What do the new data show? On the New York Mercantile Exchange (NYMEX) swap dealers and managed money were both long on oil in the week to September 1st—the former by more than a 2-to-1 ratio. Producers and users, by contrast, are net short on oil by similar margins. And the swap dealers and managed-money players are bigger in the market, both in terms of the contracts they hold and their own sheer numbers.
But analysts at Barclays Capital note that long swaps accounted for just 6.4% of total futures and options contracts, not enough to drive prices up on their own. Physical traders held more of the outstanding long positions (10.3%) and held even more short positions. This one set of numbers, in other words, does little to prove that speculators are overriding market fundamentals to drive prices. New quarterly data also released by the CFTC show that money flows to exchange-traded funds (ETFs) in commodities failed to correlate strongly with last year’s price surge.
There are more disclosures to come. The CFTC says it will soon release the newly disaggregated data going back three years. If those numbers, like the quarterly ETF data, are equally unconvincing on the role of speculation, the case for limiting positions will be weakened. And a strong counter-argument remains: that speculators provide crucial liquidity. Even if they also have some effect on prices, taking them out of the game could well do more harm than good. It is tempting to look for scapegoats when high prices hurt consumers. But the real culprits for oil-price volatility may be much more familiar: supply, demand and global instability.
Health-care reform in America
Fired up and ready to go
The president weighs in, successfully, on health-care reform
“THE time for bickering is over. Now is the time for action.” With those fiery words, delivered to a special joint session of Congress on September 9th, Barack Obama made his case for reforming America’s troubled health system. Coming after a legislative recess in which his efforts were demonised at town hall meetings across the country, this speech was widely seen as his best, and perhaps last, chance to rescue his most important domestic policy initiative from failure.
The speech was a success on several measures. It was passionate, which is essential if he is to win over a sceptical American public and energise his liberal base. Mr Obama has seemed professorial, even pedantic, during recent town hall meetings on health reform. This week, though, he seemed to have fire in his belly. For weeks, right-wing critics have made nonsensical but alarming claims that his reforms will lead to “death panels” and other travesties. Mr Obama’s efforts to deflect such attacks by taking the high road have left many on the left cold, and confused the general public. In his speech, he denounced the right’s “bogus claims” bluntly, insisting that such talk was “laughable if it weren’t so cynical and irresponsible. It is a lie, plain andsimple.”
The most powerful part of his speech was his invocation of Senator Edward Kennedy, the liberal giant who had championed health reform for decades before he died last month. Reading from a letter he had received from him posthumously, as his widow listened from the gallery, Mr Obama made the moral case for change: “At stake are not just the details of policy, but fundamental principles of social justice and the character of our country.”
During this passage, he cleverly reminded Americans that leading Republicans currently hostile to Democratic efforts at health reform—including Senators Orrin Hatch and John McCain—had worked hand-in-hand with Mr Kennedy on earlier, smaller efforts at health reform. That points to the second reason to think that Mr Obama’s speech may yet succeed in kick-starting reform this autumn: it managed to position the president as a reasonable and moderate adult in a room full of petty and partisan ideologues.
The Republicans did not help their cause with their behaviour during his speech. Some, including their whip in the House, were caught fiddling with their BlackBerrys. Others rudely waved hand made signs or copies of Republican health bills. And one, from South Carolina, even shouted out “You lie!” when Mr Obama insisted that his reforms would not cover illegal immigrants. (He later apologised.)
The speech positioned Mr Obama as a moderate in style and substance. He pointed out that while some on the left are demanding a single-payer system and some on the right want to abolish the system of employer-provided insurance, he considers both options too radical. He also announced a surprising idea to use executive authority to encourage state-level experiments in curbing malpractice abuses.
Mr Obama also unveiled the main elements of his own centrist reform plan for the first time. He wants to expand coverage to some 30m Americans without insurance, principally by introducing an individual mandate for cover, insurance exchanges, subsidies for the less well-off and heavy regulation of insurers. He also accepted an important proposal to tax the most lavish of insurance plans.
Crucially, he made it plain that he would not accept a health-reform bill from Congress that raises the deficit—not now, not ever. He also vowed that most of the $900 billion his plan will cost—again, the first time he has given a firm figure for his initiative—will come not from taxes on the rich, as the current bills in the House envision, but from internal savings to be realised within the health system.
He offers two reasons to suppose that this claim is not complete bunk. The first is the White House’s support for empowering an independent panel of experts to cut costs in Medicare and other government health schemes. This matters, because Congress has shown it is incapable of making such difficult cuts. More impressive is his vow this week that any final bill must include provisions for mandatory spending cuts that would kick in if budgeted cost savings do not materialise.
Will this speech be enough to get the president’s reform agenda back on track? It just might be. One reason to think so is the deft way Mr Obama signalled a willingness to compromise on the “public option” this week. The left has insisted on a government-run insurance scheme, but this ill-founded idea is strongly opposed by the health-care industry and by Republicans. It also has no hope of passing the Senate, as Max Baucus, the head of its Finance Committee, confirmed this week. Mr Obama voiced theoretical support for the idea, but by also supporting other options—including, crucially, the idea that such a plan could be triggered only if necessary later—he has, in effect, dealt it a death blow.
Several committees in the House have already passed versions of health bills, but all contain the public option and are seen as too far to the left of the Senate—and now, it is clear, of where Mr Obama stands. So all eyes are now on the Senate Finance Committee, where a “Gang of Six” led by Mr Baucus has been working to forge a moderate bill that could provide the backbone for any final health law this year. Mr Baucus this week unveiled his own $900 billion proposal (also a moderate approach without the public option), and announced plans to finalise a bill next week.
Earlier this week that effort seemed to be flagging, as two of the Republicans in the gang, Charles Grassley and Mike Enzi, appeared to be undermining its efforts. That leaves Olympia Snowe, the free-spirited Republican from Maine, as the most courted legislator in recent memory. Mr Obama’s speech and sensible proposals, which are similar to those drafted by Mr Baucus, and his openness to the trigger option favoured by Ms Snowe, can only boost efforts at compromise.
Whether it is enough to keep Ms Snowe and perhaps one or two other Republicans firmly on board remains to be seen. But even if it does not, the next few weeks could yet produce a bill that is better than anything seen thus far and which would be worth passing. He was not the first president, Mr Obama said, to take up health-care reform; but he was determined to be the last.
GM and Opel
Magna force
Canadian and Russian companies win the battle for GM’s European arm
THE collapse of General Motors into bankruptcy and government control was a startling reminder of how a once-mighty company could fall. But amid the gloom came hope that, after a short period of financial restructuring in Chapter 11 protection which ended in July, GM would be reborn able to survive in the tough business of carmaking. An announcement by Germany’s chancellor, Angela Merkel, on Thursday September 10th gives an indication of how lean GM might turn out to be. GM has decided to sell its European arm, Opel/Vauxhall, to a consortium headed by Magna, a Canadian car-parts firm. The new model is starting to look rather different from the old one.
GM was at its lowest ebb when it decided to offload Opel/Vauxhall. The failing giant needed to shed debts and workers and its European unit was losing over $1 billion a year. Potential bidders emerged with a variety of schemes for Opel/Vauxhall, but these needed to satisfy both GM and the German government, which had propped up Opel/Vauxhall with loans. Germany is prepared to give another big slug of state aid to Magna, its favoured bidder, because Opel is based in Germany and employs around half of its 50,000 workers at four plants there.
The decision by GM followed four months of wrangling and unseemly arguments over a rival bid from RHJ International, a Belgian finance firm, after potential offers from Fiat and a Chinese carmaker fell away. But Magna, in league with Sberbank, a Russian bank, and Gaz, a Russian carmaker, always seemed a firm favourite. Its pledge to keep job losses to a minimum encouraged the German government to promise another €4.5 billion ($6.6 billion) in state aid that it was not prepared to give to a rival bidder. RHJ had planned more fundamental restructuring that would have seen many more jobs lost. Germany had no truck with that, as Mrs Merkel’s government feared the political consequences with elections looming.
GM was exasperated by the demands of Germany’s government and unions, which threatened “spectacular actions” if Magna were not victorious. The Americans first favoured RHJ and then even pondered trying to raise funds to keep Opel/Vauxhall. But cash-strapped GM would have had to repay a €1.5 billion bridging loan to the German government. America’s government now owns 61% of GM and is reluctant to provide more aid for the sake of saving European jobs.
The Magna deal will give Gaz access to Opel/Vauxhall’s intellectual property. This might help to put the Russian carmaker into pole position in Russia, which is likely soon to become the biggest car market in Europe. RHJ was only interested in turning around the carmaker and offered GM the right to buy back its shares when the process was completed. A dispute over GM’s unwillingness to let go of its technology has apparently been resolved.
GM seems to have come to the conclusion that it had no option but to do a deal with Magna. It will retain a 35% stake in Opel/Vauxhall. This will give the American carmaker a grasp on the small-car technology that seems vital for continued success in an American market battered by the credit crisis and pricey oil. But it remains to be seen whether Magna, in a European car market suffering from overcapacity, can make good on promises to preserve jobs by using Opel/Vauxhall’s plants to make cars for other manufacturers.
GM’s brief hopes that it might hang on to Opel/Vauxhall and cling to the idea that it is still a global car company have gone. As Americans trade down to smaller vehicles it may serve GM well to prepare for a lowlier role too.
Mergers and acquisitions make a comeback
The return of the deal
A new merger wave may be forming, with lots of companies’ shares still at relatively cheap prices
THERE is nothing like a good bidding war to lift capitalism’s spirits. And that may be exactly what is about to happen after Kraft made a $17 billion bid for Cadbury on September 7th. The venerable British confectioner rejected out of hand the American food giant’s offer, saying it “fundamentally undervalues” the company, which could continue to thrive on its own. Kraft’s management said it would be disciplined, but intended to pursue a hostile bid. This triggered speculation that other big food companies, such as Nestlé, Hershey and Mars, might enter the fray, perhaps as a “white knight” that would help Cadbury maintain its independence—or, at least, give it up on more advantageous terms.
Kraft’s move is one of several in recent days that have raised hopes of a new wave of mergers and acquisitions just as it seemed, after a summer of inactivity, that 2009 would be a moribund year for M&A. On September 8th Deutsche Telekom and France Telecom said they would merge their British mobile-phone operations, respectively T-Mobile and Orange, to create a new market leader. The same day Vivendi of France said it was buying GVT, a Brazilian mobile-phone firm, for €2 billion ($2.9 billion). On August 31st Disney bought superhero factory Marvel Entertainment for $4 billion, and Baker Hughes offered $5.5 billion for its fellow Houston-based energy-services firm, BJ Services. The next day eBay sold a 65% stake in its internet-phone unit, Skype, for $1.9 billion, to a group of private-equity investors.
Perhaps this will prove to be nothing more than a dead-cat bounce, a brief flurry of long-overdue deals that were held back until senior executives and investment bankers returned from the beach. After all, dealmaking had fallen to unnaturally low levels in the aftermath of last year’s financial panic and subsequent economic slump, so a burst of post-summer action was always a possibility without it necessarily implying a turn in the cycle. Until the Disney and Baker Hughes deals, August was shaping up to be the worst month for M&A since 1995, according to Dealogic. (It was still the worst month since 2003.) To the end of August, the total value of deals worldwide was just short of $1.5 trillion, 36% lower than at the same stage last year, and 56% below what it was at the end of August 2007, the record year.
Yet hopes are rising that the recent spate of deals might indicate a genuine turning point in the merger market. “While it is not yet evident in the statistics, the level of corporate dialogue has picked up recently,” says Christopher Ventresca, co-head of North American M&A for JPMorgan. One reason is that many firms now think systemic risk in the financial system has fallen to a low level. Another, he says, is that they have done the defensive work needed to shore up balance-sheets after last year’s panic: refinancing debt where necessary and making sure that they have plenty of what the crisis revealed as the possible difference between corporate life and death—financial liquidity.
With that sorted out—thanks, not least, to a dramatic reopening of the debt markets, at least for more creditworthy companies—managers are trying to figure out how to expand their businesses in what forecasts suggest will remain a lacklustre economy for years, at least in rich countries. Buying growth from outside, rather than generating it organically, may be the easiest option. There is also a momentum effect in M&A, especially as the cycle turns. “Seeing some well-known firms start to do deals will create more confidence in others,” says Mr Ventresca.
Share prices are also now in a sweet spot for a revival of deals, says David Bianco, an equity strategist at Bank of America Merrill Lynch. They have rallied decisively enough to inspire confidence that the worst is over, yet valuations are still depressed by historic standards and when compared with past recoveries from financial crises. In other words, there are bargains to be had.
Big is back
Health care and technology, the two industries that have seen the most merger activity during the recent downturn, are likely to remain strong, says Mr Bianco. Nowadays, if a hardware, software or services firm is not one of the ten or so industry giants, it faces a difficult future—which is why the likes of Oracle and IBM are finding increasingly willing sellers among small and medium-sized technology firms.
Consolidation in financial services, which has been growing because of bankruptcy and rescue acquisitions, will henceforth increasingly be the result of choice, not necessity. Regional banks, smaller trust banks and asset managers will realise that their best strategy is to be bought by one of the 15 largest finance conglomerates, with a market capitalisation of over $20 billion. Mr Bianco, who has clearly been spending too much time in Starbucks, calls these “venti financials”.
Cyclical industries such as retailing and food manufacturing may also see lots of mergers and takeovers. Having cut costs drastically, many firms in these industries can look forward to decent cashflow; as their confidence returns they may invest this cash in acquisitions to boost growth.
If there is a new merger wave, a much larger proportion of the deals will be strategic than in the wave that ended in 2007. In other words, the deals will combine firms in the same industry, such as the putative Kraft-Cadbury marriage, or allow a firm to take advantage of its existing strengths, such as a presence in a particular region or a distribution network, by adding new products—as with Disney’s purchase of Marvel, which will add its archive of 5,000 characters to Disney’s own.
One reason strategic deals are likely to be more common is that managers may be less resistant to selling in the current, more risk-averse environment: it may be better to bank a merger premium now than to hold out in the hope of a better offer later. A second reason is the decline of private-equity firms, which in the carefree credit-bubble era that ended in 2007 were outbidding even strategic buyers who were able to generate instant cost-savings or revenue growth. The Skype deal is unlikely to signal a resurgence of private equity. Two of the main buyers, Silver Lake Partners and a new venture-capital firm recently launched by Netscape’s co-founder, Mark Andreessen, are technology specialists that make little use of debt—in sharp contrast to classic private-equity buy-out firms such as Kohlberg Kravis Roberts.
Although the credit markets have reopened, they are not yet ready to finance high-yielding leveraged buy-outs, by private equity or anyone else. This is likely to be the main brake on more merger activity. The debt that is available is no longer “covenant lite”, and is likely to be forthcoming only for buyers who are willing to pay a large chunk of the purchase price with their own equity. Even those companies that could raise large amounts of debt are unlikely to do so. Some lessons, at least, have been learnt from the recent crisis.
The financial industry
Unnatural selection
Wall Street and the City of London survived thanks to state support. Now they need to be weaned off it
“WE HAVE a long track record of pulling together when times are tough…We’re on the right track.” Thus spoke the boss of Lehman Brothers on September 10th 2008. Within five days Lehman had gone bust and it quickly became clear that the world’s financial system had problems far beyond a single badly run investment bank and temporarily frozen credit markets. After two decades of expansion and deregulation, and the greatest bull market finance has ever known, many of the world’s banks were dangerously undercapitalised. Governments were forced to step in, providing capital, loans and guarantees to banks. In America, the euro zone and Britain the sums involved so far amount to about one sixth of GDP.
A year on from Lehman that still looks like the right call. After the crash in 1929 America’s economy shrank by a quarter and the unemployment rate hit 25%. This time round, with the banks wrapped in cotton wool, extremely low interest rates and big public-spending packages, the economic distress has been massively smaller. Yet the recession has still been extremely painful, prompting a sense of outrage at the financial industry and in particular the big wholesale banks that execute transactions for clients and trade on their own account. This reflects not just their past sins, but also the perception that nothing has really changed.
In a league of its own
That is not entirely true. Many bankers have lost their jobs. Some skyscrapers in Manhattan and London’s Canary Wharf have new signs on them. Famous firms like Merrill Lynch have been swallowed up; the reputations of others such as UBS and Citigroup have been mauled. Plenty of hedge funds have folded. There have been relative winners, too. Many commercial banks have done well (particularly in Spain, Canada and Australia) and JPMorgan Chase, Bank of America and Barclays have expanded their investment banks (see article).
But the dramatic changes in the pecking order mask a lack of more profound change in the system of finance itself. Lehman aside, no big firms have been allowed to fail (as they would have done, unaided). Thanks to state aid, the law for big firms today is what Gordon Gekko, the red-blooded villain of the film “Wall Street”, dubbed “survival of the unfittest”.
Indeed, taken together, financial firms have not even really got smaller. Exclude “useful” loans to the real economy, and over the past year the remaining underlying risk-adjusted assets of the nine biggest investment banks worldwide have been broadly flat. Statistical measures of the maximum trading losses these firms could face on those positions suggest that, in aggregate, they are taking more risk. Their combined balance-sheet is 40% bigger today than in mid-2005. And all this has been amplified into public outrage by the foolish decision to pay out bumper bonuses again.
The fury at “business as usual” in the Temples of Mammon is understandable, but it is a rotten basis for trying to regulate finance. For one thing, the recent return of profits and bonuses has occurred in unusual circumstances: it is easier for healthier banks to make profits when their weaker rivals are cowed. Once competitors are back on their feet and tighter regulations introduced, things will look very different. Far from being the return of the big bonuses, this could be their last hurrah.
And bonuses are, for the most part, the symptom not the disease. They certainly have done damage, persuading traders to load the system with toxic securities and sucking away capital: in the year before its demise, Lehman paid out at least $5.1 billion in cash compensation, equivalent to a third of the core capital left just before it failed. More recently Morgan Stanley promised so much pay in its latest quarter that it almost made an underlying loss. In any other business that would be a risk for shareholders. But finance’s risks are everyone’s because banks rely both directly and indirectly on taxpayers’ support.
The scale of that help is huge. Loans from central banks and debt guarantees alone amount to $2.7 trillion. As with any private industry in receipt of almost unlimited cheap public funds, finance now has every incentive to be as big as possible—beyond the point of usefulness. Change the assumptions behind this weird system, and everything else, including pay and the heads-I-win, tails-you-lose culture, will move too.
Removing the explicit side of the state’s commitment is relatively simple. Some guarantees are still plainly needed now, but a firm deadline of, say, five years for the final expiry of the governments’ various crisis-induced pledges should be set globally. With the world economy in better shape, this looks more realistic than it did six months ago. But even then the implicit assumption will linger that banks will always be bailed out. This is the core problem. There are two possible responses to it: regulate banks to try to make them safer, and attempt to limit the implicit guarantee. Both approaches are now needed.
Taming the beast
On regulation there have been some wacky ideas. Britain’s top financial policeman has endorsed a tax on transactions to cut the industry down to size, an idea that is Utopian and misguided. Similarly, the idea that regulators know the optimal size of the financial sector, or are good at running banks, is a fantasy. Trying to prevent blow-ups in the first place is more sensible with economy-wide “macro-prudential” regulators working to counter bubbles such as the recent housing mania.
Booms and bust will not disappear; hence the crucial importance of bolstering capital, the buffer that banks depend on to absorb losses. At the top of the last cycle, capital levels would have needed to be about double the current permitted floor for America’s banks to have got through the crisis without raising more funds. The Basel club of regulators is working to raise the level and improve the quality of banks’ capital. It may also be possible to vary capital charges to prod banks to shrink, improve liquidity and, yes, curb pay. But capital, a fairly blunt tool, could be asked to do too much.
The same is true of regulators themselves. Last time round they were meant to stop banks from self-harm and make sure they had enough capital. Just because they are trying harder now does not mean they will succeed. Focus only on more rules and the medium-term risk is of a colossal, semi-socialised banking system crawling with outgunned, possibly captive regulators. Hence the importance of the second response: a concerted effort to reduce the implicit state guarantees.
That is easier said than done, especially since the recent bail-outs have reaffirmed the state as a backstop. There are, however, other options. “Living wills” can force banks to plan for their own collapse, which should make it easier to protect depositors while forcing creditors, not taxpayers, to bear the pain. There is also a case for forcing banks to finance themselves with a slice of junior “hybrid” debt (which has never been state-guaranteed). Its cost, and thus banks’ profits, may at least for a while be more sensitive to the risks being taken.
No one should pretend that banking is an industry where pure natural selection takes place. But as guarantees, both explicit and implicit, are withdrawn, the hope is that self-discipline will be imposed on banks, not just swathes of new regulation. There are signs that riskier banks are already paying more to finance themselves. This differentiation must be promoted, so the weak and reckless are gradually forced to shrink and live within their means—and not off taxpayers’ largesse.
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