Financial Times, 4 August 2015
LESSONS I LEARNED TACKLING FINANCIAL,CRISIS THAT NEVER WAS
By Ed Balls
One of the stranger experiences you can have as a Treasury minister is engaging in a tense discussion with the Governor of the Bank of England about a problem that does not exist.
My contretemps with the Governor came, during a 3-hour meeting in early 2007, as we decided what action to take to tackle a purely theoretical banking crisis at the end of a 10-day simulation exercise.
As the UK’s financial services minister, I had decided that we should conduct that exercise to test our systems. Little did any of us know that the real thing was just around the corner.
Were today's policy-makers to simulate a financial crisis today - and I hope they are - they won’t struggle for plausible scenarios.
There have been enough sharp equity and commodity market scares in the past year, triggered by the feared tightening of US monetary policy, to warrant the simulation of a full-blown trans-Atlantic stock market correction.
Even setting Greece aside, they could also wrestle with the impact on investors of a sharp slowdown in China or Brazil, or a further escalation of hostilities in Eastern Europe or the Middle East.
They would be spoilt for choice if simulating the collapse of one of the many country-specific bubbles fuelled by cheap borrowing, from the London housing market to sub-prime US auto loans.
And if looking for a repeat of the 2007 crisis, but given the much tougher rules now in place in the formal banking sector, they could focus on the frothier end of activity in the world of asset management and shadow banking - quite rightly high on the list of concerns for the Financial Stability Board, chaired by Bank of England Governor Mark Carney.
In retrospect, the current economic situation – apparently healthy growth but with plenty of downside risks – contains some concerning echoes of the situation in 2006, a year before the global financial crisis began.
Back then, with inflation and interest rates historically low, the consensus was that economies were still 'recovering' from the global oil and dot-com shocks earlier in the decade.
Economists debated whether continued loose monetary policy was necessary to maintain that recovery, or whether it was simply serving to fuel the next, bigger crisis. But in both the US and UK, central banks were inclined to believe the 'great moderation’ was delivering a ‘new normal' - a more benign cycle with lower household savings the result.
At the same time, I remember spending hours in the European Council listening to the German finance minister lecturing Britain about irresponsible 'hedge funds', even while German banks were falling over themselves to buy US sub-prime mortgages and Greek debt.
It was in that uncertain environment that I decided to initiate our 2007 crisis simulation. It envisaged a lending institution collapsing after an unexpected legal ruling, and a large UK-wide clearing bank being exposed to huge liabilities as a result, turning a local difficulty into a systemic event.
After a lengthy series of phone calls, exchanges of memos, and fresh ‘events’ being added to the simulation, that tough meeting between myself, Bank Governor Mervyn King, and Chair of the Financial Services Authority Callum McCarthy resulted in a decision to put concerns about moral hazard aside and step in to arrange a takeover of the clearing bank.
In the short-term, it did help that all three institutions had been through that simulation when the real crisis struck later in the year, although I know many of the same arguments resurfaced in the far tougher and lengthier meetings that ensued then.
However, there are also three long-term lessons I learned from that exercise which are of relevance to today's policy-makers, as they prepare responses to current risks.
First, if weaknesses are exposed in the system, they must be fixed quickly. Back in 2007, we identified from the simulation that our deposit-insurance system was old and creaking, and that EU state aid rules could obstruct decisive action to find an acquiring bank. The Treasury commissioned the work and agreed with the Bank of England a plan to sort out those problems. But only on an 18-month timetable. Fortunately, the structural reforms recommended by the Financial Stability Board, are happening much more urgently, particularly in the UK.
Second, decision-making procedures really matter. Even in a simulation exercise, our three hour meeting was arduous. It helped greatly that there were three institutions in the room, able to debate the issues and hammer out an agreement.
Of course, the tripartite system did not spot the real crisis coming. Almost nobody did. But I am concerned that, under the new arrangements which replaced that system, the equivalent discussion would now take place exclusively within the Bank of England, with just one principal at the top.
In my view, the head of the Prudential Regulatory Authority must also have a direct line to the Chancellor, underpinned by proper structures for crisis decision-making which currently don't exist.
My third lesson is that sometimes the biggest potential crises are staring you in the face. In our simulation, the lending institution that collapsed was, in fact, a northern building society. And when a buyer was needed for the large clearing bank, who did the FSA propose? ABN-Amro.
Just a few months later, it was still unexpected when Northern Rock collapsed for real; while the misplaced confidence in ABN-Amro’s stability was doubtless one of the reasons RBS was allowed to go ahead with its disastrous takeover.
It’s clearly hugely important, as they make the difficult and delicate judgement about whether and when to tighten monetary policy, that policy-makers are alive to all the distant threats to stability, from emerging market slowdowns to new financial activities beyond their regulatory reach. But, while continuing to scan the horizon, they must always keep one careful eye on what's going on at the end of their nose. Ed Balls is Senior Fellow at Harvard Kennedy School and a former Shadow Chancellor and Cabinet Minister
When a decision is important enough to warrant a national referendum, it is always a momentous event, and usually carries monumental risks.To hold one such referendum in a generation is bold enough. To hold two in three years is reckless in the extreme. Yet this is Britain's course. The vote on Scotland's future was destabilising enough, and the issue remains far from resolved. But now - in 2017 - the UK must make the equally seismic choice on whether to stay in the European Union. I was taken aback last summer by quite how much concern the Scottish referendum caused the UK and international business community, and the paralysing impact on investment. It highlighted a deeper truth about the interaction of politics and economics. Because referendums inevitably risk pitting political short-termism and emotion against long-term economic logic. And that is never an attractive prospect for rational investors or business leaders. Contrast that with the UK remaining outside the Euro in 2003, a Cabinet decision made exclusively on a Treasury assessment of Britain's long-term national economic interest. While the famous 'Five Tests' guiding that assessment were indeed first revealed to the Financial Times from the back of a New York taxi, they were not, as popular myth would have it, drawn up there. Instead, they were carefully worked out during visits to Bonn, Paris and Brussels in the year before the 1997 election.
And while Gordon Brown undoubtedly had an open mind as to whether the Tests could be met, I suspected from the outset that they would not. Twelve years on, with the Euro locked in a never-ending and ever more costly crisis, that judgement seems sounder by the day. Now ask yourself: if we were to base the judgement on whether Britain should stay in the EU on a similar long-term economic assessment, what would the decision be? First, any pro-Europeans who say the economic case is unambiguous do their cause a disservice. To deny the serious economic problems involved in continued EU membership is factually absurd and politically unwise. In economic terms, last September's Scottish vote was about whether to maintain an effective, centuries-old currency union with strong fiscal, regulatory and political underpinning. No-one could say the same of the current Euro arrangements, where the focus on Greece's gaping wound is distracting attention from a whole series of maladies facing more influential Euro zone economies. Any feasible future for the Euro is going to require a much closer union in fiscal, banking and monetary policy. While the UK will thankfully stand outside those arrangements, that undoubtedly makes it harder to maintain our influence and prevent decisions made at Euro zone level damaging British interests.
On top of that, increasing labour mobility is becoming ever more necessary as a means of adjustment for under-developed EU countries, just when open migration is becoming increasingly unsustainable - politically and economically - in the UK and elsewhere. Given all those concerns, I understand the viewpoint of pessimists who cannot see an acceptable future for Britain within Europe. I also agree with Prime Minister David Cameron's insistence on the need for reforms of the single market, labour mobility and benefits, as difficult as they will be to deliver. But while appreciating all the challenges of continued EU membership, they do not outweigh the economic advantages and potential opportunities. Europe is our biggest trading partner. We gain hugely from the single market's liberal trade policies and regulatory harmonisation. Much UK Foreign Direct Investment depends on our continuing membership. And our voice in economic negotiations with America and Asia is stronger as part of the European trading bloc than shouting on our own. That is why in every conversation I have ever had in America, from the White House to the wider business world, the view has been unanimous: don't leave, stay in and fight for reform and open markets. That is why, given that we have to go through a referendum, I will argue that long-term, economic logic dictates a 'Yes' vote. But the Government’s strategy to win that vote currently has two problems. The first is the 2017 timetable. Europe's future will be determined over the next five to ten years, not the next 24 months. There is simply no chance of securing meaningful treaty change on that timetable. Our EU partners neither have the time or inclination to make Britain’s needs their urgent priority.
As with the Five Tests, the Government would have been better placed offering a referendum once they could show the conditions of continued membership had been met, not just on the promise of future change.
The second, and more serious, problem is the Government’s reluctance even to engage with the referendum debate until they can show progress on their reform agenda.
This is leaving a vacuum gleefully filled by the Euro sceptics, while putting the pro-EU campaign in a negative stance from the outset, pointing out the risks inherent in withdrawal but hampered from making the positive case for staying in.
If there is one important lesson from the Scottish referendum, it is that campaigning on a negative may be enough to clinch the battle but risks losing the war.
The SNP's subsequent general election landslide showed how much they won the battle for hearts and minds during the referendum, co-opting the appeals to youth, patriotism and optimism about the future.
The pro-EU campaign must not make the same mistake. It cannot just say Britain will lose jobs and influence if we leave. We have to win the argument that - despite Europe's problems - Britain can be stronger, wealthier and more influential in the world if we stay in and fight our corner. The Government needs to make this positive case now, rather than wait for the current 'renegotiation' to deliver what can only ever be a work-in-progress. Unionists allowed the agenda to be dictated by the separatists in one referendum. Twice would be truly reckless.
Ed Balls is Senior Fellow at the Harvard Kennedy School and a former UK Shadow Chancellor, Cabinet Minister and Chief Economic Adviser