Wednesday, 6 August 2014

The financial crash: rotten apples or rotten barrels?

I have just been reading Ha-Joon Chang's very interesting "Economics: The User's Guide". It was written for people just like me, who are conscious of the role economics plays in our lives but don' t really understand what it is. So it provides an explanation of key concepts and issues, relating them to the current economic difficulties in the world.

One chapter which particularly resonated with me as a systems person was Chapter 8, where he looks at the changing world of banking. What happened in 2008 was something of a mystery to me, as a crisis in the US housing market led to the collapse of the western economic system. Chang explains the phenomenon of 'asset-backed securities', and traces this back to the deregulation of the financial sector in the United Kingdom and United States back in the 1980s. Freed from the traditional role of taking savers' money and investing it, banks were increasingly able to create financial products that did not really exist and sell them on, over and over again.

What Chang describes is a classic feedback loop: deregulation made it possible for banks to create highly profitable financial products, the profit stimulated the creation of ever-more complex products which generated more profit and the merry-go-round just kept on turning. The risk protection that people thought was built into these products made it seem invincible, until, of course, the people at the bottom of the financial heap ran out of money. At which point it all came tumbling down.

At that time the British and American financial regulators said that this could not happen again, as the 'rotten apples in the barrel' lost their jobs (e.g. Sir Brian Pittman in 2009, or Of course, no systems thinker would have believed that.

Apart from the dubious nature of this business, what also interested me were the emergent properties that Chang sees as coming out of this change.

Firstly, the magic of asset-backed securities encouraged even non-financial organisations to start playing in this new casino. In the short-term things were very profitable, much more so than tedious activities such as making things or research and development, and this made the shareholders very happy. Who cares what the future of the company is in the long-term if you can make big money in just a couple of years? So another feedback loop starts up.

Secondly, the banking industry suddenly became very attractive to young, clever people; people who in previous generations might have gone into manufacturing industry now became attracted to the big rewards and glamour of the banking world. So industry is deprived of talented people while the banking industry continues to grow. We can see here the start of another feedback loop where manufacturing in the UK and the United States becomes increasingly unfashionable and  irrelevant.

If these feedback loops continue, the outlook, in my mind, is not very bright. The Chinese manufacturing economy will continue to grow and Britain and America will just become places to recycle money. That may be good for the tiny minority working in the financial industry, but it does not bode well for the great majority in the rest of these countries.

As Peter Senge pointed out, the system always wins. This is not a system that looks very healthy for most people in the world.

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