Merv the Swerve skids

In propping up Northern Rock, the governor of the Bank of England is tacitly condoning casino capitalism - with public money as the stake.

by Richard Reeves
Last Updated: 31 Aug 2010

A decade ago, I wrote a column calling for the installation of the Bank of England's chief economist as the governor. The piece was so positive - highlighting the candidate's intellectual rigour, financial experience and impregnable reputation in the City - that it embarrassed my editor. Now I'm the one blushing: his name was Mervyn King.

King has been badly - perhaps fatally - wounded by September's Northern Rock debacle. The damage resulted from a stunning, 180-degree about-turn. When the market for three-month debt seized up - a market on which Northern Rock's directors had been reliant - he at first insisted that it was not the job of the Bank of England to help. Northern Rock had taken some big risks, and risk, by definition, has a downside as well as an upside.

King was admired for his toughness. But then, as the queues of terrified depositors curled around the branches of Northern Rock, the Bank changed tack and pumped cheap money into the market and bailed out the flailing bank. At last count, Northern Rock had borrowed £8bn from Threadneedle Street.

To say King has egg on his face would be an understatement: he is entombed in omelette. Either he publicly changed his mind on an issue of strategic significance in a matter of days, or he bowed to public and/or political pressure and used public funds in a manner that he considers irresponsible. Neither explanation reflects well on a central banker, and it seems unlikely King will serve a second term.

The whole spectacle throws some light on our peculiar, hypocritical approach to risk and reward. Initially, King had invoked the danger of 'moral hazard' - a term well known to the insurance industry that means people who are insured against a particular risk are much more likely to take it. If your car is covered against theft, you might not bother locking it. Since the Northern Rock incident, banks know that they can borrow recklessly on the international money markets, or build huge debt portfolios on small asset bases, and that the Bank of England will step in to save them if things go pear-shaped. So where is the incentive to be cautious? King invoked moral hazard, then created it.

If he'd stuck to his guns, Northern Rock would have gone under. And rightly so, according to economic theory: the firm took the risks and must pay the price. The problem, of course, is that the real losers would not have been the bank's directors but its customers: the pensioner who would have seen her whole life savings wiped out because Northern Rock's board fancied themselves as latter-day Gordon Geckos. In King's world of 'rational economic men', this would have been the right outcome. But socially, politically and morally, it is hard to argue for.

In theory, Mrs Pensioner should have been exercising her power and discretion as a consumer to move out of Northern Rock. Having looked closely at the bank's accounts, studied the long-term trends in the London Interbank Offered Rate, read the analysts' reports and concluded that the bank was unacceptably vulnerable to a tightening in the short-term debt markets - which might indeed occur if American banks became concerned about the volume of sub-prime borrowers in their portfolios - she should have moved her money.

But for us punters, such exercises are a flight of fantasy. To most of us, 'securitisation' sounds like a safe thing, conjuring up images of locks and guarantees - rather than selling on debt in the unstable three-month money market. Given that neither the Bank nor the Financial Services Authority saw it coming for Northern Rock, what chance were customers supposed to have? Consumer sovereignty is simply a myth in a world of such financial complexity.

What this means, though, is that the taxpayer ends up as insurer of last resort. Already the Government is moving to increase the amount of savings that will be guaranteed by the state to £35,000. At the heart of this is a debate about the balance between the free market and the state's role.

Free-market capitalism, financial regulation and globalisation have created the conditions for phenomenal levels of innovation in the money markets: theoretical mathematicians can now make a fortune devising products that only they (and maybe two others) fully understand. Much of this innovation has been beneficial, allowing more sophisticated management of risk and giving institutions opportunities to grow quickly: how else could Northern Rock have gone from regional bank to global player?

When things are going well, we welcome these changes and the boost they often give to share prices and therefore our pension funds. But when things go wrong, we cling to the apron strings of the state. Capitalism thrives on risk - but it seems that although we all want the upside, we'd rather not have the downside. We want the gain without the pain.

The hard truth is that most of us have no idea what financial institutions are up to, and little prospect of finding out, and simply believe that banks are safe places for our money. But ambitious directors can now play the global financial field, as Northern Rock did, and reap huge commercial rewards if it goes well. At its most extreme, this is a kind of 'casino capitalism': the trouble is, it's our money they're playing with.

Richard Reeves is director of Intelligence Agency, an ideas consultancy; e-mail: richard@intelligenceagency.co.uk.

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