How to Avoid Another Financial Crash

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The Keynes Society welcomes a large number of schools and colleges to tonight’s event. Among our guests are students and teachers from:

The Keynes Society Presents...

Biddenham International SchoolsBishop Ramsey CE SchoolBurgress Hill SchoolCharters SchoolDean Close SchoolDowne House SchoolDownside SchoolDr Challoner’s Grammar SchoolGuildford High SchoolHeathfield SchoolHolt SchoolHoly Family Catholic SchoolKing’s School WorcesterLongdean School

Lord Wandsworth CollegeMagdalen College SchoolMary Hare School for the DeafMerchant Taylors’ SchoolRoyal Grammar School GuildfordSacred Heart RC SchoolSir William PerkinsSurbiton High SchoolSwanlea SchoolThe John Warner SchoolThe Marist SchoolTonbridge SchoolWatford Girls’ Grammar SchoolWoodbridge School

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A word from the organiser Speaker profiles

Ha-Joon ChangInternational Bestselling author Ha Joon Chang is a specialist in development economicsand Reader in Political Economy of Development at the University of Cambridge. In 2005,Chang was awarded the Wassily Leontief Prize for Advancing the Frontiers of EconomicThought. He is author of Kicking Away the Ladder: Development Strategy in Historical Perspective (2002), which won the 2003 Gunnar Myrdal Prize and Bad Samaritans: RichNations, Poor Policies and the Threat to the Developing World (2007). Since the beginningof the 2008 economic crisis, he has been a regular contributor to the Guardian, and avocal critic of the failures of our economic system. In 2010, Chang released his bestsellingbook: 23 Things They Don't Tell You About Capitalism.

Ann PettiforAnn Pettifor is a widely published author and analyst of the global financial system. Sheco-authored the Green New Deal, which was published by the New Economics Foundationin July 2008. She predicted an Anglo-American debt-deflationary crisis back in 2003, and is known for her work on the sovereign debts of low income countries and for leadingJubilee 2000. She is currently a fellow of the New Economics Foundation, Director of Advocacy International Ltd and PRIME (Policy Research in Macroeconomics).

Paul OrmerodPaul Ormerod is the author of The Death of Economics, Butterfly Economics and WhyMost Things Fail. He studied Economics at Cambridge and his career has spanned theacademic and practical business worlds, including working at the Economist newspapergroup and as a director of the Henley Centre for Forecasting. He is the founder of VolterraPartners. He is a fellow of the British Academy for the Social Sciences and in the 2007/2008 academic year was a Distinguished Fellow at the Institute of Advanced Study at theUniversity of Durham. In July 2009 he was awarded an honourary Doctor of Science degree by the University of Durham for the ‘distinction of his contributions to the disciplineof economics’. He presents regularly at a wide range of business and academic events.

Crispin OdeyCrispin Odey is a London-based hedge fund manager and the founding partner of OdeyAsset Management. He founded Odey Asset Management in 1991, George Soros beingone of the original investors, seeding Odey $150 million. Odey came to wide attention in2008 when he successfully anticipated the credit crunch. Odey Asset Management's OdeyEuropean Inc. fund was ranked No. 5 on Bloomberg's 2012 list of the 100 Top-Performing Large Hedge Funds.

Welcome everyone to Eton College and to the Keynes Society. Thank you all for attending this evening, we have a spectacular discussion in store! When I firststarted organising this event way back in May, little did I know the grand scale itwould reach. We are very fortunate to have four panel members of the highest quality tonight, all of whom are prepared to challenge the prevailing consensus. Thevenue, School Hall, is Eton’s largest lecture hall and will provide a fitting backdropto tonight’s proceedings.

The title of this event is of course, ‘No More Business As Usual: How to AvoidAnother Financial Crash.’ The 2008 crisis marked a sea-change point. In myeyes, it was a failure on three counts: 1. A failure of oversight from Governmentsand Central Banks alike, 2. A failure of modeling in not being able to predict thecrash and 3. A failure of ideology. Underpinning the crisis was the fundamentallyflawed neoliberal ideologue which has dominated main-stream economic thinking.

The event will, on one level, analyse the causes of the 2008 crash, the worldwide response, what lessons have been learnt and how future crashes can be avoided. Yeton a deeper level, the aim of this evening is to challenge existing world views anddiscuss the exciting new developments in economic theory. Foremost amongst theseis a redefinition of human ‘rationality’ in a way that takes into account advances inbehavioural economics, particularly advances in network theory. We hope to shakeoff the shackles of the textbooks and syllabi in order to encourage innovative andbold new economic thought.

When planning this event, I wanted it to being as interactive as possible, engagingas many knowledge-thirsty students from a wide range of schools. I am delightedthat 27 schools (bringing 375 students) will be attending this evening, a staggeringnumber and far exceeding any Society meeting Eton has ever had. Furthermore,half of the evening will be devoted to questions from the floor. My hope is that theevening will be one of collaboration, thought-provocation and engagement.

It has been an honour and a joy to organise this event; I hope that everyone has a fantastic time!

Yours Sincerely,Anthony Beaumont, Event Organiser and Chair

Weapon of financial mass destruction

According to a calculation based on IMF databy Gabriel Palma, my colleague at Cambridgeand a leading authority on financial crises, theratio of the stock of financial assets to worldoutput rose from 1.2 to 4.4 between 1980 and2007. The relative size of the financial sectorwas even greater in many rich countries. According to his calculation, the ratio of financialassets to GDP in the UK reached 700 per centin 2007.

...In the old days, when someone borrowedmoney from a bank and bought a house, thelending bank used to own the resulting financialproduct (mortgage) and that was that. Howeverfinancial innovations created mortgage-backedsecurities (MBSs), which bundle together up toseveral thousand mortgages. In turn, theseMBSs, sometimes as many as 150 of them,were packed into a collateralized debt obligation(CDO). Then CDOs-squared were created byusing other CDOs as collateral. And thenCDOs-cubed were created by combining CDOsand CDOs-squared. Even higher-poweredCDOs were created. Credit default swaps(CDSs) were created to protect you from thedefault on the CDOs. And there were manymore financial derivatives that make up the alphabet soup that is modern finance.

The result was an increasingly tall structure offinancial assets teetering on the same foundationof real assets (of course, the base itself wasgrowing, in part fueled by this activity, but let usabstract from that for the moment, since whatmatters here is that the size of the superstructurerelative to the base was growing). If you makean existing building taller, without widening thebase, you increase the chance of it topplingover. It is actually a lot worse than that. As thedegree of ‘derivation’ - or the distance from theunderlying assets- increases, it becomes harderand harder to price the asset accurately. So,you are not only adding floors to an existingbuilding without broadening its base, but youare using materials of increasingly uncertainquality for the higher floors. No wonder Warren Buffet, the American financier known for his down-to-earth approach to investment, called financial derivatives‘weapons of ‘financial mass destruction’ - well before the 2008 crisis proved their destructiveness.

...Thus, exactly because finance is efficient atresponding to changing profit opportunities, itcan become harmful for the rest of the economy.And this is why James Tobin, the 1981 Nobellaureate in economics, talked of the need to‘throw some sand in the wheels of our excessively efficient international monetary markets.’ For this purpose, Tobin proposed a financial transaction tax, deliberately intendedto slow down financial flows...Other means include making hostile takeovers difficult(thereby reducing the gains from speculative investment in stocks), banning short-selling (the practice of selling shares that you do notown today), increasing margin requirements(that is the proportion of the money that has tobe paid upfront when buying shares) or puttingrestrictions on cross-border capital movements,especially for developing countries.

All this is not to say that the speed gap betweenfinance and the real economy should be reduced to zero. A financial system perfectlysynchronized with the real economy would beuseless. The whole point of finance is that itcan move faster than the real economy. However, if the financial sector moves too fast,it can derail the real economy. In the presentcircumstances, we need to rewire our financialsystem so that it allows firms to make thoselong-term investments in physical capital,human skills and organisations that are ultimately the source of economic development, while supplying them with the necessary liquidity.

Ha-Joon Chang

What they tell youThe rapid development of the financial markets has enabled us to allocate and reallocate resourcesswiftly. This is why the US, the UK, Ireland and some other capitalist economies that have liberalizedand opened up their financial markets have done so well in the last three decades. Liberal financialmarkets give an economy the ability to respond quickly to changing opportunities, thereby allowingit to grow faster. True, some of the excesses of the recent period have given finance a bad name,not least in the above-mentioned countries. However, we should not rush into restraining financialmarkets simply because of this once-in-a-century financial crisis that no one could have predicted,however big it may be, as the efficiency of its financial market is the key to a nation’s prosperity.

What they don’t tell youThe problem with financial markets is that they are too efficient. With recent financial ‘innovations’that have produced so many new financial instruments, the financial sector has become more efficient in generating profits for itself in the short run. However, as seen in the 2008 global crisis,these new financial assets have made the overall economy as well as the financial system itself,much more unstable. Moreover, given the liquidity of their assets, the holders of financial assets are too quick to respond to change, which makes it difficult for real sector companies to secure the ‘patient capital’ that they need for long term development. The speed gap between the financialsector and the real sector needs to be reduced, which means that the financial market needs to bedeliberately made less efficient.

...Now, the real trouble is that what countries like Iceland and Ireland were implementing were onlymore extreme forms of the economic strategy being pursued by many countries- a growth strategybased on financial deregulation, first adopted by the US and the UK in the early 1980s. The UK putits financial deregulation programme into a higher gear in the late 1980s, with the so-called ‘BigBang’ deregulation and since then has prided itself on ‘light-touch’ regulation. The US matched itby abolishing the 1933 Glass Steagal Act in 1999, thereby tearing down the wall between investmentbanking and commercial banking which had defined the US financial industry since the Great Depression. Many other countries followed suit...

Weapons of financial mass destruction?The result of all this was an extraordinary growth in the financial sector across the world, especiallyin the rich countries. The growth was not simply in absolute terms. The more significant point is thatthe financial sector has grown much faster - no much, much faster - than the underlying economy.

Selected extracts from 23 Things They Don’t Tell You About Capitalism

Thing 22:Financial Markets need to become less, not more efficient.

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global rationality of economic man with akind of rational behaviour which is compatiblewith the access to information and computational capacities that are actuallypossessed by organisms, including man, inthe kinds of environments in which such organisms exist.’ In the complex situationswhich characterise much of our lives, copyingis a powerful way of solving this problem, ofscaling down the vast dimension of choice andits subsequent consequences into a manageablerule of behaviour. We might copy different agentsfor different reasons, but we copy nonetheless.

The rational paradigm has spectacularly failedto explain and predict not just how the presentcrisis emerged, but how it spread and burgeoned, initially starting with a relativelysmall US mortgage crisis, quickly developinginto a credit and banking crisis, leading to aworld-wide financial crisis, a global debt crisisfor small and then big countries such as Italy,and finally, at the time of writing, into a generalpolitical crisis threatening the economic stabilityof the entire planet and the welfare of everyoneon it.”

The conduct of business and policy decisions of all kinds must take account of the fact that the fundamental features of our social and economic worlds have been qualitatively transformed over the course of the past century. The word ‘must’ is usedhere with its full imperative force. Network effects are the driving force of behaviour.

Paul Ormerod

Extracts from Positive Linking:

Are we in fact rational?

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The description of the world of the 21st centuryis the background against which we have assessed the validity of the model of how a ‘rational’ agent behaves. According to this theory, agents gather available information aboutan issue, process it to arrive at the best possibledecision given their fixed tastes and preferences,and do so in isolation from other agents. Inother words, their preferences are not affectedin any way by what other agents do. Neither dothey change in any way over time.

Clearly this is not the world works. To be fair,the theory may have been a reasonable approximation to reality in the late nineteenthcentury, when it was first being formalised. Butin general it does not fit with the world in whichwe live now. There are many reasons for this,but the principal one is the fact that our individualtastes and preferences are not at all fixed andindependent of the preferences of others. Theyevolve over time. And a key factor in their evolution is that we often copy the opinions,actions and choices of others.

The word ‘copy,’ is a shorthand way of describinga range of motivations for an agent changing

behaviour as a direct result of the influence ofother agents. The fashion motive is one. Peerpressure is another, as is the related but subtlydifferent concept of peer acceptance. For example, the more people who are obese inyour social circles, your networks, the more acceptable it is for you to be obese also. Peopledo not decide to copy others deliberately andbecome obese themselves, but the social pressures and influences on them not to become obese are relaxed when other peoplein their networks are already obese.

Even in the 1930s, as we have seen, Keynesbelieved that the world was sufficiently complex, sufficiently difficult to interpret, that ‘we have as a rule, only the vaguest idea of any but themost direct consequences of our acts.’ Keynesargued that the very concept of rationalityneeded to be redefined in such a world. Copying other agents often makes sense because they might be- it does not mean thatthey necessarily are- better informed than weare as individuals. In the 1950s, (Herbert)Simon again raised the need to reassess thedefinition of what constitutes rationality of economy man: ‘The task is to replace the

Three Key Ideas:Networks: How people, firms, things areconnected to each other, and how differentways in which they are connected have different implications.

Complex Systems: How the properties of systems as a whole emerge from theinteractions of their component parts.These are systems in which the whole ismore than the sum of the parts.

‘Rule of thumb’: Decision makers in economics. How we can understand manysocial and economic questions better if we relax the traditional assumption that decision makers attempt to find the ‘best’decision. Instead, they appear to use simple rules of thumb to arrive at ‘fairlygood’ decisions.”

The Global Financial Crises is the result of ignoring, denying and even concealing lessons known toour predecessors. The most important lesson is that the interests of the private financial sector are ultimately opposed to the interests of entrepreneurs, innovators, creatives and society. In the 1930sour predecessors insisted that democracy be placed in a position superior to the power of money,that finance should be servant and not master to the economy and society. In between 1931 and1970 finance was wrested from the private sector and placed in the hands of the transparent and accountable state, under a mandate (the 1944 Bretton Woods Agreement) to maintain stability andbalance in trade and finance.

The instigator behind this radical re-ordering of society was John Maynard Keynes. Keynes is oftenderided as a 'tax and spender' or as an 'inflationist'. He is most often defined by the fiscal policies heput in place to help economies recover from the crisis of 1920s financial liberalism. Yet Keynes wasprimarily a Monetary Reformer. He rejected the liberal financial order of the pre-Depression years andsought to provide the world with a soundly managed monetary system. Keynes argued that that thelevel of employment and activity in an economy depended critically on the rate of interest. Pre-requisiteto a prosperous and just society was a low rate of interest. A low rate of interest permits private industryto thrive. For capital investment projects to expand, activity depends on affordable and cheap finance.Ecologically sustainable finance must also be cheap finance. Because, if the cost of finance is halvedthen a great deal more investment projects become viable, including renewable energy projects, public transport, sustainable construction and the like. Equally, government expenditure can be freelyextended if the interest burden is low. During World War II when Britain borrowed more than it hadever done before, interest rates never rose above 3 per cent.

Keynes's policies permitted recovery from the Great Depression, underpinned the allied war effort andfostered the golden age of economic activity that prevailed until the 1970s. It is a commonplace to regard the golden age as the result of state expenditure, but that is only one side of the story. The lowunemployment, high activity and prosperity across the globe was also the result of private activity,when nations produced what they consumed, industry thrived and invested heartily. State budgetsexpanded, but were under control and rarely substantially in deficit. International trade, too, flourished,but was complementary, not pre-requisite to domestic achievement.

There is often a tendency today - especially in Europe - to see trade as the only route to prosperity forweaker economies. But Keynes saw things differently.

“If nations can learn to provide themselves with full employment by their domesticpolicy," he argued, "there need be no important economic forces calculated to setthe interest of one country against that of its neighbours. International trade wouldcease to be what it is, namely, a desperate expedient to maintain employment athome by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle, but a willing and unimpeded exchange of goods andservices in conditions of mutual advantage.”

A New Economic Unit of Measurement:The Key to the Democratisation of FinanceA buzz word for the solution to the Financial Crisis that occurred in 2007 seems to bethe democratisation of finance - extending the sound financial principles to a biggersegment of our society. The main focus so far has been to utilise our informationtechnology capabilities in order to better inform the public about the murky world offinance. However, I believe that the key to improving public awareness should bemore simple, yet drastic. It is the adoption of an inflation-indexed unit of account.In 1967, the Chilean government introduced the ‘unidad de fomento’, which is the daily price of abasket of goods and services, just like an interpolated version of the consumer price index. It hasbeen used extensively by the government, and increasingly so as a unit of account for commerce -essentially, it is replacing money. People nowadays tend to quote prices in UFs, and use a UF-Pesoexchange rate when paying with the local currency. This system clearly works: Chile is the most inflation-aware country in the world.

The recent housing boom and the financial crisis that ensued could’ve been avoided if the governmentshad adopted this idea. One of the most significant errors that has infected the housing market is thepoor understanding of inflation by the general public. In the early 1980s, rapid inflation in the UnitedStates meant that the stock market was very low in value. This reflected the very high nominal interest rates, even though real interest rates were not - an outcome called the ‘Modigliani-Cohnhypothesis’. Subsequent disinflation caused the stock market to go up, excessively. This so-called money illusion could have been avoided if the accounting had been done in this new unit of measurement.

The housing bubble in the 2000s was, in part, caused by the public’s difficulty with understandinginflation. As the National Association of Realtors advertised, nominal house prices have, on average,doubled every decade. However, in real terms, prices haven’t budged for over a century (since theearly 1890s). If we had measured home prices in these new proposed units, people would generallyhave known this fact, and would not have gotten the idea - as they did in the early 2000s - thathome prices always went up.

I have barely scratched the surface of the numerous benefitsthat this new economic unit of measurement for inflation canbring to our economy. Chile has already paved the road for reform, and we shouldn’t hesitate to apply it. The unfortunate lack of understanding that the public has for inflation is the achilles heel of our economy. After all, even the Great Depression could’ve been avoided had the workers understoodthat real prices were falling and thusallowed employers to cut nominal wages. The new economic unit is the way forward- it is a promising solution to the ignorant public and a shield to any future crises.

Ann Pettifor[ ] Jae Hyung Kim[ ]

How did we get here when we have been here before?

have risen consistently. As the crash has proven,this is a thoroughly unhealthy condition for aneconomy.

What was unhealthy in the economy as a wholeproved wholly pathogenic in the financial sector.Free from the restrictions of post-Depressionregulation and reassured by the safety net provided by Glass-Steagall’s deposit insurance,the banking system grew progressively morehighly leveraged and began to dabble in increasingly risky areas (such as US sub-primemortgages). The rise of a shadow-banking sector, free from the eyes of both the accountantand the law, was instrumental in the constructionof a fundamentally unstable financial structure –so much so that it was felled by a relativelysmall number mortgage defaults.

And this ideological shift was not just an American condition. One need look only to the behaviour of Iceland’s Landsbanki or Glitnir,and the subsequent financial cataclysm, oreven the UK’s Northern Rock, to see evidenceof a wider pattern of recklessness. The recklesstendency of the financial system was by nomeans the change that precipitated such chaos;it was the ideology-driven dismantling of the restraints on base human instinct. I think that inthis sense the problem is a political one, in which

government has failed to protect humanityfrom itself. The Dodd-Frank Act will

go someway to re-regulating theAmerican financial sector, but

only time will tell if capitalismhas learnt its lesson.

It is difficult to read any newspaper without stumbling upon some kind of journalismthat commiserates the Financial Crash of 2008. This is rightly so, for we still live in aworld afflicted by the consequences of the event. Unemployment still hangs at around7%, whilst in the years before the crisis it averaged around 4.5%. Even today, thisequates to around 4 million more people who are without jobs. I need not go into moredetail. The 2008 crash, though, is arguably the tip of the iceberg (so to speak). It wasthe manifestation of a long period of ideological upheaval in capitalism and politics -one that has proven harmful in a wider sphere of economic life.

The original causes of the crash are well known. In 2005, house prices in major cities in California,Florida and Arizona (amongst others) were 150% greater than in 2000. The housing bubble beganto deflate in 2006, though the construction slump was offset by strong export growth due to theweakness of the dollar. This became problematic, however, when lower home prices bore fruit inwidespread mortgage defaults, bringing down with them an immensely complicated web of financialinstruments. Collateralised debt obligations, along with various other heavily jargonised financial assets, rapidly unwound. For the highly leveraged banking system, insolvency became a majorthreat. With inter-bank lending now looking unpleasantly risky, the American financial system beganto slide into a credit crunch.

Any possibility of recovery was eliminated by the failure of Lehman Brothers, a mid-sized investmentbank that collapsed in September 2008. Lending to the shadow banking system, comprised of manynow infamous names such as Bear Stearns and Merrill Lynch, evaporated. The yield on junk bondsrose from 8% before Lehman’s fall to 23% in the aftermath. The maelstrom of the US banking systeminevitably dragged down both the US and foreign economies, as consumption and investment collapsed in the face of financial turmoil.

The wider causes of this can be traced back deeper into history. Indeed, it is important in studyingboth the crisis and its aftermath to consider the wider trends in economics in which it occurred. The2008 crisis can be seen as the belated result of the proliferation of free market capitalism: the rejectionof intervention in the belief that markets are best left alone. This is particularly attributable to MiltonFriedman, whose liberalist approach was a profound influence upon contemporary policy makerssuch as Ronald Reagan or our own Thatcher. The effects of this ideological shift have been felt in the

Andrew Hayley

The 2008 Financial Crash:

A WiderContext

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US economy since the Reagan and Carter eras,during which the elaborate regulatory system ofthe post-Depression years was systematicallydismantled. Carter’s deregulation of the airlineand natural gas industries (to name but a couple)was symbolic of a sea change in economic policy. Reagan continued of this reform in the financial sector, perhaps most notably in the1982 Garn-St. Germain Act which relaxed loantype restrictions. The repeal of the de jure separation of commercial and investment activities as espoused in the Glass-Steagall Bill,which had also provided insurance for depositors,signalled the comprehensive demolition of thepost-Depression regulatory system.

The period following this was one of rising debt,inequality and instability. Between 1979 and2007, the USA’s bottom 20% of householdssaw their incomes rise by 18%. For the top 1%,the increase was 277%. This elite band saw itsafter tax share of GDP rise from 7.7% to 17%over the same period. Paul Krugman in particulardescribes a process of ‘contagion’, as higherwages in the deregulated financial industrystimulate wider increases in executive pay. Reagan’s tax cuts also contributed to thisworsening inequality. At the same time, the increase in consumption that had fuelled theliberal era’s growth was a result of hugecredit expansion, with householddebt rising from 47% of GDP in1980 to 94% at its peak in2009. Indeed, much of theprosperity of the period was a credit-driven illusion;wage rates have remainedlargely stagnant whilst average working hours