Cambridge Economics Cambridge Faculty of Economics econ.cam.ac.uk Alumni Newsletter of more than £65 billion of taxpayers’ Adair Turner: money to prop up the merged Lloyds- Welcome After the Deluge HBOS and RBS in order to support the FROM PROFESSOR WILLY BROWN financial system. Our sixth Alumni newsletter once This experience, and that of the again places the current work of following four and a half years as the the Faculty in the perspective of its FSA worked to stabilise and reform past achievements and our subject’s financial services, has shaped Turner’s future challenges. Some feel for critical yet constructive views on the what is going on now is given by strengths and weaknesses of the pieces about Esther Duflo, who gave market mechanism; on the nature the Marshall Lecture, a conference on religion and economics, and and role of policy making and of the research of some prominent regulation; and on the current state Faculty members. Looking back, of economic theory and analysis. At we celebrate the very different Cambridge (Caius, 1974-78), he read intellectual contributions of the first History and then Economics, after lives of Frank Hahn, Robin Marris which his career included McKinsey, the and Dorothy Wedderburn. But international management consultancy; economics as a subject has always the Confederation of British Industry, been most effective when it has as Director-General; and Merrill Lynch, not been at ease with itself, and Paul Seabright castigates its current the investment bank, before leading the introversion. In the same spirit, FSA. we lead with Adair Turner’s robust reflections on where his experience Theory and practice of the financial crisis leaves At the FSA, Turner inherited an economic theory. n September 20th 2008, in organisation whose policies were the midst of the whirlwind founded on ‘light touch’ regulation of We are keen to keep in touch with our released by the onset of banks and other financial institutions alumni and welcome your feedback on O the global financial crisis, Adair in a system where monetary policy, Turner(1) became Chairman of the banking supervision, macro-prudential [email protected] UK’s Financial Services Authority responsibility, and fiscal policy were – until recently the statutory body split between different bodies. The responsible for the monitoring and FSA’s approach to achieving competitive regulation of the financial services and efficient financial markets by industry. Five days before, Lehman forbidding or removing obstacles to Brothers had filed for bankruptcy self-generating adjustment drew on the after the US Treasury had declined general equilibrium models of modern to bail it out. And at home, just two neo-classical microeconomics. In these days earlier Lloyds TSB bank had been models, complete and competitive persuaded to come to the rescue of markets for factors, products and HBOS, a mortgage and corporate capital balance simultaneously within lender, which was on the brink of a framework of sustainable economic collapse. Two weeks later, Royal growth and low and stable inflation. Bank of Scotland, at the time the For the many adherents of the ‘efficient world’s largest bank by assets, failed. markets hypothesis’, the ‘Great Government had to provide a total Moderation’ period of faster growth Issue number 6 Autumn 2013 and low inflation that lasted from many other sectors, are far less valid often overlooked. He reflects on what the mid-1990s until the Crash was in finance. He notes that financial he labels “the strange amnesia of seen as proof of the essential truth markets cannot only create endogenous modern macroeconomics” which he of this analysis. In the face of this, instability, but also generate large suggests has ignored insights about the Turner drew quickly and deeply on his opportunities for rent extraction. He importance of the financial system and knowledge of History and Economics highlights the danger that in many of credit and money creation processes and on his professional experience. He financial markets the pursuit of these which were central to the work of both recognised that the financial sector is opportunities is not moderated by social John Maynard Keynes and Friedrich not the passive and compliant creature interaction or by pride in physical end Hayek even though they drew different of competitive markets’ theory. Rather products, which contain the unbridled conclusions from their analysis. it is prone inherently to fluctuations and pursuit of self-interest in many other to instability. sectors of the economy. The digits on In Turner’s view, it is baying for the the screen are so remote from reality moon to hope for a ‘scientific’ paradigm He explores three reasons for that money becomes the measure of all for Economics, where experiments can turbulence in financial markets. One things. The people involved are not evil, be replicated and fundamental and is that all financial markets, including but we need a culture under which they enduring principles can be established. those for equities, debt securities or are made aware of the consequences of Economic analysis will always involve foreign exchange, can be subject to their actions. discourse, debate and dissent – indeed, herd and momentum effects, and that is its fascination. But theory now thus to periods in which valuations Turner is trenchant on the failure of needs to move forward - on two fronts are fundamentally irrational. This economic theory to relate to, anticipate in particular. First, it must take into contradicts the efficient market and explain turbulence in markets. account the broad range of evidence hypothesis, which he sees as based on During his time in Cambridge as a and theories that research in Economics a failure to understand the distinction student, the Keynesian consensus, and other disciplines makes available, between risk and uncertainty and on which had been dominant throughout including those from paradigms and the erroneous assumption that human the post-second world war period, was analyses that are currently out of beings are wholly rational. breaking apart in the face of falling fashion with mainstream thinking. output and employment accompanied Such work is complex and difficult but Second, Turner stresses the particular by rising prices (‘stagflation’). This is very important. Following directly features of debt contracts, which in the paradigm came to be replaced from this, his interest in History comes economic upswing can be created in by versions of the ‘Washington into play when he urges awareness and excessive quantities because investors Consensus’, promoted in large part by understanding of both economic history ignore “tail risks”, and which in the the IMF, in which active fiscal policy and the history of economic thought: downswing create economic disruption was discouraged in favour of targeting the latter, he points out with a hint of because of the rigidities inherent in inflation and economic growth through criticism, has not been taught explicitly default and bankruptcy processes. the use of monetary policy instruments, in the Economics Tripos for some years. Referencing the work of Harvard in particular interest rates. Flexible and economist Andrei Shleifer he suggests competitive markets, it was claimed, Looking forward that many of the debt securities created would then ensure equilibrium. Although having come to the end of in the years before the crisis “owed his term as FSA Chairman, Turner is their very existence to neglected risk”. Washington retrospective still vitally engaged in the debate on The Washington Consensus and economic policy. In the light of the Minsky moment its aftermath are now under heavy extended recession in the UK and Third, Turner recalls the work of the attack from both inside and outside elsewhere since the Crash, and of the American economist Hyman Minsky, Economics. Turner joins in the criticism strident debate about austerity, he has who illustrated how credit creation on three main grounds. First, the put forward the case for Overt Money by banks can fuel asset price rises, in reliance of the analysis on rational Finance (OMF) to reduce fiscal deficits. particular in real estate, generating self- expectations, which assumes that This calls for central banks permanently reinforcing cycles which end in crisis agents work in pursuit of their own self- to monetise additional budget followed by deleveraging and recession. interest with complete or near-complete deficits so as to boost consumption He stresses in particular the point that, information, is inadequate and and investment in both the private contrary to many simplistic descriptions, potentially misleading, given evidence and public sectors without raising banks do not merely intermediate pre- on individual and group behaviours expectations that policy would be existing savings, but create credit and from branches of knowledge reversed at some future date, perhaps money de novo. This fact he believes is that include biology, psychology sharply, which would negate the central to understanding why market and sociology. Second, analytical incentive to spend. He recognises that economics can suffer extreme and frameworks are frequently presented if the taboo against money finance is harmful instability. as internally consistent and complete broken there is a danger that politicians in themselves, whereas reality is might use this tool to excess and in the Overall Turner is convinced that complex and sometimes contradictory. many circumstances where it would financial markets are quite different Lastly, the distinctive characteristics be harmful as well as the few where from most product and service markets, of the financial sector – in particular it is required. But he argues that it is and that the propositions in favour its significance in the economy and possible to locate decisions on the use of market liberalisation, strong in its tendency towards instability – are of money finance within independent 2 central banks pursuing appropriate the development of a technique for stocks.