The death of Eddie George (Edward George, or Baron George of St. Tudy in the County of Cornwall, former Governor of the Bank of England) on April 19 came as a shock. I knew he had been ill with cancer for a long time, but one is never prepared for the finality of death. This post is not an attempt to assess his place in history, but just a recording of some tales I will remember him for.

(1) The autodafé of the unsecured creditors is coming to a US bank near you

A binding budget constraint sure concentrates the mind, even for the US Treasury. There is just one way to make the US government’s policy towards the banks work.  That is for the Congress to vote another $1.5 trillion worth of additional TARP money for the banks – $1 trillion to buy the remaining toxic assets off their balance sheets, and $0.5 trillion worth of additional capital.   The likelihood of the US Congress voting even a nickel in additional financial support for the banks is zero.

There is no real money left in the original $700 bn TARP facility – somewhere between $ 100 bn and 150 bn – to do more than stabilise a couple of pawn shops.  The Treasury has been playing for time by raiding the resources of the FDIC (which, apart from the meagre insurance premiums it collects, has no resources other than what the Treasury grants it) and of the Fed.  The Fed has taken an open position in private credit risk to the tune of many hundreds of billions of dollars.  Before this crisis is over, its exposure to private sector default risk could be counted in trillions of dollars.

The president of Brasil, Lula da Silva, at a joint press conference on the 27th of March 2009 with Gordon Brown, the UK prime minister, made the following statement: “This crisis was caused by the irrational behaviour of white people with blue eyes, who before the crisis appeared to know everything and now demonstrate that they know nothing.”

That statement is not merely ignorant and stupid.  That statement is racist.  As a white person with blue eyes, I am offended by it.  I am waiting for Mr. Lula da Silva’s apology to the entire population of white people with blue eyes.

Having a white skin and blue eyes is clearly not necessary for causing the crisis.  I am sure Citi CEO Vikram Pandit wants to claim at least some of the credit for the crisis.  His predecessor, Chuck Prince is white but does not have blue eyes.  He was named by Fortune Magazine In 2008 as one of eight economic leaders “who didn’t [see] the crisis coming”, and identified in January 2009 by Guardian City editor Julia Finch as one of twenty five people who were at the heart of the financial meltdown.  He also made the famous statement in July 2007 that : “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.  E. Stanley O’Neal, the former chairman, president and chief executive officer of Merrill Lynch, is an African American (I don’t know his eye colour).

Having a white skin and blue eyes is clearly not sufficient for causing the crisis or contributing to it.  I will spare the readers of this blog the list of names of white people with blue eyes who did not cause this crisis.

President Lula da Silva may want to defend his racist remark by noting that white people with blue eyes were disproportionately represented among those who caused the crisis or contributed to it.  He would no doubt be right.  He also would be advised to take an introductory course on the distinction between statistical correlation/association and causation. Concepts like spurious correlation, omitted variables (wealth, class, education, gender to name but four of the most obvious ones), and common third factors driving a statistical association between two variables, would represent a welcome addition to the intellectual capital of the Brazilian president.

President Lula da Silva’s statement is an example of inappropriate racial profiling.  Wikipedia defines racial profiling as “the inclusion of racial or ethnic characteristics in determining whether a person is considered likely to commit a particular type of crime or an illegal act or to behave in a “predictable” manner.”

For the would-be defenders of president Lula da Silva, let me be clear about what I mean by racism.  I again use a definition drawn from Wikipedia: Racism, by its simplest definition is the belief that race is the primary determinant of human traits and capacities and that racial differences produce an inherent superiority of a particular race. People with racist beliefs exhibit stereotype-based prejudices towards individuals and groups of people according to their race.”

Note that I am condemning the sin, not the sinner.  I am not saying the president Lula da Silva is a racist.  All I am asserting is that the statement he made – that white people with blue eyes are responsible for the crisis – is a racist  statement.

To those who believe that a statement that is racist according to the definition quoted from Wikipedia is not really racist unless it is directed at a racial or ethnic group that is weak, oppressed or at the bottom of the social totem pole, I recommend a regular washing of the mind with soap and water.

The weak and the poor, and billions of others who are quite innocent of the mistakes, excesses and crimes that brought us the crisis are not helped by facile racist remarks attributing blame for the crisis coming from the leader of one of the key emerging markets.  Racial divisions and stigmatization according to eye colour will not help humanity crawl out of the hole it is in.  We have to pull together.  President Lula da Silva’s statement threatens to pull us apart.

I have always been a believer in the screw-up theory of history (and particularly of disasters) rather than of the conspiracy theory of history (disasters).  The financial crisis that has engulfed the world certainly offers massive evidence for the importance of screw-ups – errors, mistakes, misunderstandings, singular stupidity verging on idiocy, misjudgements and missed opportunities.  I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance – of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours.

Introduction: central banks need fiscal back-up

Even operationally independent central banks are agents of the state.  And like every natural or legal entity operating in a market economy, the central bank is subject to a(nintertemporal ) budget constraint.  Some central banks are owned by the ministry of finance.  The Bank of England, for instance, is owned 100 percent by the UK Treasury. The ECB is owned by the national central banks (NCBs) of the 27 EU member states. These 27 NCBs have a range of different ownership structures.

The Federal Reserve System is not owned by anyone (conspiracy freaks need not bother writing comments to deny this and to attribute ownership of the Fed to the Queen of England, the Vatican, the Rockefeller family or the Elders of Zion). Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company.  Ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, fixed at 6 percent per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks).

Even though central banks can ‘print money’ or create money electronically by fiat, they are constrained in their financial operations by two factors.

Insurable risk

When insurance began to develop as an industry, it was soon felt necessary by those trying to enhance the reputation and respectability of the industry to distinguish it from gambling. The outcome of this process is that today, for a financial activity to classify as insurance and to be regulated as insurance, it has to offer products or contracts that protect against loss; gambling seeks or creates opportunities for speculative gain.  More precisely, insurance hedges an open position in order to reduce exposure to risk; gambling creates or increases open positions to boost exposure to risk.  There are a host of deep issues here, such as ‘what is the right metric for risk’ or  ‘the risk to what: financial wealth, consumption, utility’?  I will acknowledge these deep issues, ignore them and proceed.

For the insurance industry, the insurance vs gambling distinction was operationalised using the concept of insurable interest.  An insurable interest is what economists would call an open position that is reduced in size by the insurance contract.  In life insurance, this means that a person or a legal entity can insure the life of a third party only if the value of the life to the party wishing to purchase the insurance is greater than the value of the payout under the life insurance policy.

In property insurance, people have an insurable interest in property they own up to the value of the property, but not beyond that.

Nobody home in Washington DC

Since the Obama administration took over on January 20, the US Treasury has effectively been out to lunch.  As widely reported (see e.g. this account in the Financial Times),  Sir Gus O’Donnell (as cabinet secretary the top UK civil servant) has attacked the “absolute madness’ of the US spoils system, where a new Federal administration replaces the entire top stratum of the civil service with new officials possessing the right political connections and leanings.  Quite a few of these top officials need to be confirmed before they can start working.  This can take months.  Many of the new officials have no political, government or administrative experience and spend most of their first months in office trying to figure out where the washroom is instead of designing and implementing policy.

It is a system designed to produce protracted policy paralysis.  Often this does not matter much.  It may even be helpful to the greater good at times – “That government is best which governs least.” – but in times of war and deep economic crisis, when the world we thought we knew may be falling apart, it is not a bad idea to have a government that can both think and act.  The current US administration neither thinks nor acts much, judging from the results.

The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member of during the years 1997-2000 contained, like its successor vintages of external and executive members, quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity.  Indeed, the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding.  It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.  Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes  rather than by a powerful desire to understand how the economy works – let alone how the economy works during times of stress and financial instability.  So the economics profession was caught unprepared when the crisis struck.

This post contains the comments I made at the 6th Annual Conference: Emerging from the Financial Crisis, held at the Center on Capitalism and Society at Columbia University, on February 20.  It contains 22 points, two for each of the 12 disciples, minus Judas Iskariot, who is otherwise engaged, buying silver futures.

1.      It is necessary, for political economy reasons, to rush new comprehensive regulation of the financial sector.  While it would be better, holding constant the likelihood of the measures being adopted and implemented, not to act in haste, there is now a unique window of opportunity – a period of extraordinary politics, in the words of Balcerowicz – to actually get the thorough regulatory reform we need.  The reason is that the private financial sector is on its uppers – down and out – and will not be able to put together much of a fight, let alone its usual boom-time massive lobbying effort to veto radical measures.  It is better to over-regulate now and subsequently to correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions.

I had been planning to blog today on US Treasury Secretary Timothy Geithner’s proposals for saving/reviving financial intermediation in the USA.  However, picking through the entrails of this multi-faceted, surprisingly incomplete, seriously underfunded, occasionally well-designed but mostly inadequate, counterproductive and unnecessarily moral-hazard-creating set of proposals was just too depressing.  I will wait till I am at my parents’ home this weekend, mollified and mellowed by my father’s good claret, before I review the Geithnerbharata.  But as a four-finger exercise before the main concert, I shall discuss here the second Dutch government bail-out of ING.  Many of the issues involved in and principles raised by this deeply unfortunate exercise also are central to the Geithnerbharata.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website