Yes, the banks are to blame

Daniel Davies’s effort to become the most popular man in Britain has, apparently, not developed to his advantage, to quote the Emperor Hirohito. It struck me that there are two opposed explanations for the unusual toxicity of the comments thread that ensued, and they tell us quite a lot about the Great Bubble and the Great Recession that followed.

The first would be Daniel’s explanation. Look at them! It took only six comments for someone to analogise him to a soldier whose commander pays him in whiskey and delta 8 vapes to cut the ears off prisoners, and sixty-five for someone to compare him to one of the anonymous organisers of the Holocaust. We got to Josef Stalin by comment 115 and to Megan McArdle by 108. Surely, this is evidence that there is an unreasoning and unproductive rage around at anything that smacks of banks, bankers, or banking.

The second would be mine. Fans of Daniel Davies’s work since the distant era of will appreciate that he is a practised and expert troll, and distinguished among the guild of ancient Norwegian bridge-guardians by the fact he can turn it on and off as desired. Knowing that bankers are unpopular (were they ever popular?), and that Crooked Timber is a website full of left-wing people, he crafted a post that would cause them all to freak out amusingly.

You will of course notice that the basic distinction here is that one explanation is demand-driven and one supply-driven. The first assigns agency to the buyer, the second to the seller. The distinction is important in economics – one of the most standard assumptions is that consumer sovereignty holds and that firms are generally price-takers. Another key assumption is that industry fundamentally responds to demand. Electrical engineers would say that it is load-following, like a power plant whose output can be throttled up or down to respond to the needs of the grid.

In itself, this isn’t controversial. Industries produce what they can sell. There are lags in the supply-chain, and it’s possible to have temporary shortages or surpluses, but basically, the rate of production is both constrained and driven by demand. But the stronger form of this argument, and the one that is baked into essentially all economic models, is that not just the quantity of goods, but also their quality and kind, is demand driven. The distinction between drivers and constraints is important here. It is obvious, and trivial, to say that things nobody will buy won’t be produced for very long. But that is only half the argument.

How did we decide to try making fireguards out of chocolate, or self-certifying mortgages with negative-amortising interest rates, in the first place? Obviously, there are cases where new products do respond to an identifiable demand. At the level of the whole economy, though, this implies that every conceivable product or service already exists in latent form in the minds of customers, as if there was a statue in every block of stone waiting to get out. This is…somehow implausible and unsatisfying. Among other things, it has the curious consequence that being really true to the core assumptions of economics implies eliminating the role of the entrepreneur, at least as an inventor or product designer rather than as an operational manager.

If entrepreneurs are a thing, on the other hand, we have to accept the possibility that firms have agency in structuring the markets they sell into, that even if aggregate supply doesn’t create its own aggregate demand, it is possible for specific supply to create its own specific demand. It’s Milan fashion week, after all – an institution exquisitely dedicated to the proposition that producers can at least try to define what consumers will want.

Now, back to the mortgage market. Mortgage brokers are a fine example of a business that really is demand-driven. People come to them and say how much house they are trying to buy, and the broker tries to find someone who will lend them the money. As they were both in competition as firms, and usually rewarded on commission as individual workers, their structural incentives were to follow the housing market wherever it went. In that sense, property buyers had real agency and hence culpability. The broker/originator sector was also meant to evaluate their creditworthiness, but as it didn’t take the risk on the loans itself, it didn’t have any incentive to turn people down. It had agency, and therefore also blame.

But what about the banks? Just treating them as a normal business is illuminating. Businesses invent new products all the time – sometimes following demand, sometimes reaching ahead of it. Sometimes, what they invent is dangerous to the public and they have to be restrained. Nobody would argue, for example, that in inventing the RBMK nuclear reactor, the Soviet nuclear industry wasn’t berserkly irresponsible and directly to blame when one blew up.

And one product the banks surely did invent was outsourced mortgage-servicing. This practice may yet prove to be one of the most pernicious of the Great Bubble, not because it led to illegality as such (although there’s plenty of that), but because it is a major obstacle to recovery, and it is the more profitable the longer it stays that way. When lenders were responsible for collecting payments and dealing with borrowers themselves, they were much more likely to be reasonable with borrowers who struggled to keep up the payments. They had good economic reasons for this; typically, they would recover much more of their money in a negotiated settlement than in a foreclosure, an expensive process in itself that usually ends with the property going for auction at a fire-sale price.

But once the servicing function is outsourced, the incentives are actually reversed. Not only does the servicer, the party who has direct contact with the borrower, have no incentive to agree a modification of the original loan, they have every reason to insist on foreclosure. They get paid based on the tasks they carry out, and foreclosure generates a lot of lawyering and letters, all of them chargeable to the lender.

Now, there are three ways out of a balance-sheet recession. One is economic growth itself. As, I recall, Daniel Davies once said, if you are in debt as an individual, the best solution of all is to increase your income if it is at all possible. And the Kulmhof-Ranciere study argues that increasing real wages is the best way out of the crisis at the macro-level. Another is inflation. And the point has been made, by one Daniel Davies among others, that inflation is a rather simple mechanism to adjust all sorts of contracts that were set at nominal prices that have become unpayable, one which avoids all the complex machinery of courts and loan officers.

And a third is bankruptcy, in which we recognise by law the fact that both the lender and the borrower agreed on a contract that has become impossible to honour, and both of them share in the cost of cramming it down to a realistic level. Here is a case in which a major new product invented by the financial sector, in advance of demand, is directly blocking one of the three roads to economic recovery. To what extent the banks are responsible for the lack of progress on the other two is left as a topic for discussion.

In my next post, I’m going to look at some more people who are to blame. They are not Greek schoolteachers.

15 thoughts on “Yes, the banks are to blame

  1. “[…] increasing real wages is the best way out of the crisis at the macro-level. Another is inflation.”

    Aren’t they one and the same ?…

  2. No, they’re not. One is a general oversupply of money combined with no corresponding general increase of goods to buy, the other is an increased rate of transfer of money from the employing few to the employed many, with no general increase in money supply. Wage “inflation” is an invention of employers trying to make a phenomenon that’s inconvenient to them alone, look like a phenomenon that inconveniences everyone.

  3. Thanks, Derek. I would also point out that inflation without wage inflation is no solution at all, as in that case, even though you inflate away part of the debt, everyone’s personal budget is squeezed and therefore aggregate demand is squeezed. If you try this hard enough, you’ll manage to inflate prices while shrinking GDP and therefore keeping the debt/GDP ratio from falling.

    This is roughly what is happening in the UK.

    I suspect that the central banks’ war on “core inflation” may have destroyed the economy in order to save it.

  4., huh? I remember a brilliant 9/11 screed to the effect that it just went to show that whatever else we had learned, it was obvious that I had been right all along, and the policies I had previously advocated clearly were more essential than ever.

    The bit on Crooked Timber filled me with a wholly abnormal desire to flame until I remembered the rule of the land – that someone being wrong on the internet is no reason to get all red faced and start yelling.

    I suppose this comment makes me a supply-sider. I suppose the shoe is fitting today at least….

  5. But what about the inexhaustible demand of the USA and especially UK (but also Irish and Spanish) middle aged middle and upper classes for tax-free capital gains and lower wages for the working and under classes?

    I think that makes for a case that politicians, bankers and the public (at least the middle aged middle/upper classes) all righteously agreed to massively redistribute income from the exploitative lower and less propertied parasites to the deserving middle/upper and more properties producers.

    That is policy in the past few decades was neither driven by the impulse of the supply or demand sides,
    but by moral crusade to improve the morality of the distribution of wealth and income on both the demand and the supply side, punishing scrounger and rewarding the deserving.

    As to who belongs to the two categories there may have been some interesting misunderstandings. I was particularly amused by an article in a recent edition of the Times (2011-09-17, Janice Turner, “Women are taking a hit and they are angry”) which said:

    �The C2 women who voted Conservative last time did so because they, in low to middling-paid roles such as nurses, secretaries and carers, believed welfare had grown too generous, that benefits rewarded the do-nothings while they toiled. They hoped the Tories would crack down.
    Now, they are shocked to discover the Government regards them as part of the problem. They work in the “bloated public sector”, their meagre pensions are grotesquely lavish, their often tough vocational jobs are regarded as worthless and dispensable. Labour celebrated “hard-working families”; the Tories tell them it was their salaries – not the bankers’ excesses – that broke the economy.�

    An interesting argument that I found in an (unmentionable in “polite” society) blog is that the firce demand for more and more and more tax-free capital gains came from or at least benefited mostly middle class middle aged and older women voters: because of divorces being very common, and women outliving men, most residential estate property (by value in particular) in the UK belongs exclusively to middle ages middle or upper class females.

  6. “The bit on Crooked Timber filled me with a wholly abnormal desire to flame until I remembered the rule of the land – that someone being wrong on the internet is no reason to get all red faced and start yelling.”

    That kind of attitude is exactly why we don’t get any comments around here.

  7. It strikes me that outsourcing mortgage servicing, if it’s a bad idea, is naturally limiting. The lenders lose out as they loan money to people who can’t repay it, and then get charged a lot of transaction costs. It might take them years to figure this out, but eventually they’ll get there.

    It’s like chocolate fireguards, at some point all but the dimmest buyers are going to notice that their “fireguard” keeps leaving a soggy mess of chocolate in front of the fireplace. (Or they eat the fireguard first, and are happy, but in the case of purchasing mortgages issued by other people on houses owned by total strangers, presumably this is done purely out of the desire for money.)

    Markets are driven by the intersection of supply and demand, not by any one side. Entrepreneurs introduce new products all the time, sometimes they take off, sometimes they don’t. To take the electricity sector, yes, power plants are load-following in the short-term, but if power companies can’t cover their fixed costs then they shut the power plants, and the electricity consumer gets blackouts (see India).

  8. Alex: Do “these recessions” keep happening? Recessions keep happening, but that doesn’t mean that each recession has the same cause. After all, there’s quite a large number of ways of stuffing things up.
    (Though I am willing to believe that there are some hard lessons that every generation has to learn the hard way. “The only thing we learn from history is that we learn nothing from history.”: Hegel. I’ll just add that this quote applies to all humans, regulators as well as market participants.)

  9. We have certainly had a lot of nasty accidents with directly financial causes over the last couple of decades. I personally feel that the financial liberalisers are currently in a position from where a period of silence might be welcome.

  10. How about the advocates of the Basel Accords? Would you prefer a period of silence from them as well, given recent events?

    Anyway, I think that J.S. Mills’ arguments for freedom of speech, in chapter 2 of On Liberty, are very convincing when he argues that even when we are right, we benefit from testing our arguments against the best those who are wrong can come up with. That’s because it improves our understanding of our own arguments. (see

    After all, you’re not going to argue, surely, that it’s impossibly for a badly-thought-through regulation to actually increase financial risk?

  11. How about the advocates of the Basel Accords? Would you prefer a period of silence from them as well, given recent events?

    I don’t think this is actually a choice. Pretty much everyone in any position of authority with regard to banking or finance could well do with shutting up at the moment.

    [note – combination of strawman and patronising tone. this is not a yellow card yet, but you are at liberty to upgrade to one]

  12. I’m very sorry about the strawman, I certainly did not mean to misrepresent your argument. I must have misread what you were saying, can you please tell me in what way I misrepresented you (thus unintentionally creating said strawman)?

    And my apologies for the patronising tone, it was as unintentional on my part as my creation of strawmen. I am kicking myself, in my past experience, generally when I try to patronise someone it leads to me metaphorically getting egg on my face (eg by trying to patronise someone who turns out to be a university professor in the subject area 🙁 ), so I consciously try to avoid patronising to avoid embarrassing myself. If you could tell me what I said that came across as patronising, and how I could rephrase that to make my point in a non-patronising way, I would also appreciate that, so I can further reduce my risk exposure in the future.
    (Please, really I am trying to avoid patronising and strawmen, I would really like to engage with your arguments seriously, and I have re-written and re-written this trying to figure out both a way to say what I am thinking and also avoid any hint of patronising, but I don’t know if I have succeeded at all. Perhaps I am adding in more patronisation, aarrgh…)

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