The so-called 'credit crunch' which began in the summer of 2007 has now evolved into something altogether more significant and disturbing. A climax of sorts was reached on 7 September 2008, when Hank Paulson, Secretary to the US Treasury, announced that the Federal government would be guaranteeing the debts of Fannie Mae and Freddie Mac, two institutions which provided the financial backing for some 80% of recent US mortgages. A right-wing Republican administration, champion of the free market, had in effect nationalised the largest financial institution in the country; there could be no clearer indication that this is the biggest financial crisis since the 1930s. There swiftly followed the collapse of Lehman Brothers, the greatest corporate bankruptcy in history, the forced take-over of Merrill Lynch and the emergency rescue of the world's largest insurance company, AIG. Therewith three of the top five US investment banks went under (Bear Stearns, a third, having already sunk in March). Meanwhile, the UK's largest mortgage lender, Halifax Bank of Scotland, was taken over by Lloyds TSP to prevent its collapse.
Stock markets have plunged. In the USA and UK, and in other European countries, banks and building societies have accumulated unknown amounts of 'toxic debt', deriving from subprime mortgage deals. So far they have written off some $500 billion of debt, and they are still counting. As a result they are reluctant to lend money to one another or to potential house-buyers, since they can no longer be sure who can pay back whom and when. They even find it difficult to realise the assets in their portfolios, since selling them drives down the price and degrades those assets. House prices decline, and with them owners' confidence in their own wealth, and their ability to raise loans quoting their homes as collateral. Builders, retailers and manufacturers are all facing tighter markets and laying off some of their employees.
Much of this was foreseen in a book published six months before 'black September'. In The New Paradigm for Financial Markets George Soros asserted that what has happened is the bursting of a 'super-bubble', climax of the successive booms and busts that have disrupted financial markets at various junctures in the last quarter of a century: Latin American debt after 1982, the Savings and Loan Association crash in 1986, the Asian and Russian crises of 1997-8 and the dotcom bubble of 2000. In each case except the last the IMF and/or national central banks have had to step in to restore a stability that the market was incapable of recreating unaided. Soros argued that under the influence of market fundamentalism - the misguided belief that markets should be given free rein because they are self-correcting and tend towards equilibrium - credit had expanded to the point where it was dangerously unsustainable. He believed the time had come for the super-bubble to burst, provoking a crash which would be as serious as the slump of the early 1930s, though it would take different forms and would be tackled in different ways.
Soros explained the fallibility of the market through what he called 'reflexivity'. Participants in any activity, including finance, cannot simply stand back and study their situation with entire rationality and with full information at their disposal; they are bound up in the process, and they have to use what information they have before them - inevitably always inadequate and imperfect - to take decisions. They are therefore bound to make mistakes, and in finance those mistakes will tend towards self-reinforcing over-optimism about what credit can achieve. Furthermore, their actions change the reality they are assessing. Selling the shares of a poorly-performing company is not only a rational response to reality; it also changes that reality by helping to drive the price yet further down. Self-reinforcement thus works in both directions.
I believe Soros is right, but has not fully identified the force driving financial markets, which is trust. Trust is one of the most pervasive, but also least noticed, features of social life. We all exercise it unthinkingly every day. For forty-one years I have been trustingly paying substantial sums each month into a pension scheme, without getting a penny in return. Fortunately my trust was justified: when I retired a few months ago, I started to see the benefit.
Life is full of these more or less routine exercises of trust. As Soros remarked, seldom if ever can we obtain all the information we would need in order to take decisions in a fully rational manner. Even when we ponder decisions carefully, at a certain point we have to stop seeking further information, say 'enough is enough' and take a decision based on what we know and how we feel. The way in which we do this is strongly influenced by the society in which we live, its customs and its culture. Furthermore, trust has its own dynamic: it is usually self-reinforcing. We go on trusting beyond the point at which evidence suggests distrust would be more appropriate. Trust is not infinitely elastic, though: eventually counter-evidence has its effect and we turn to distrust, which is equally cumulative and self-reinforcing. This is exactly what has been happening in financial markets.
The paramount symbol of trust in modern society is money. It enables us in normal times to obtain goods and services from people we do not know, have no other grounds for trusting, and are never likely to meet again. Anyone who lived through German hyperinflation in the 1920s or Russian hyperinflation in the 1990s can tell you what absurd and cumbersome devices people have to adopt, if money cannot be trusted, to obtain daily requirements that we take for granted.
But money is complex and many-layered. Much of the money most of us possess takes the form of an entry in electronic account records. Behind that is paper money, which many people think of as 'real money', even though no bank keeps enough of it to satisfy its customers, should they all turn up together to withdraw their funds. But that money is not really 'real' either. Each note bears a statement that the Bank of England 'Promises to pay on demand the sum of' - ten pounds, let us say. That promise refers to reserves of gold that the Bank of England holds - except that the Bank does not hold anything like enough of it to cover all the banknotes in circulation, and anyway it long ago cancelled its obligation to offer gold in return for notes. Even if it still did, what can you do with gold? You can't eat it, or wear it, or warm yourself with it. So money is not a real 'good' or benefit, just a symbol of entitlement to a benefit, a symbol which society trusts, even though it is at least one stage removed from that benefit. The current voracious demand for gold shows that in uncertain times we feel safer descending several storeys in what begins to look like a rickety structure.
Modern financial systems, especially the launching of substantial public debt, originated in the late medieval cities of Italy, Germany and the Netherlands, where the timely payment of obligations could be guaranteed by the solidarity of municipal elites. The first time a major monarchy adopted such techniques came with the late-seventeenth-century revolution in England. After the overthrow of the Stuarts, through the Bill of Rights of 1689 the great landowners and London merchants bound the new monarch, William III, to constitutional rule: he had to share with parliament his power over the state budget and over the army and navy, and also his right to declare a state of emergency. He could not raise taxes or float loans without the consent of parliament. In return the landowners and merchants consented to being seriously taxed: this was their down-payment for gaining new powers. Both components of this 'constitutional-financial' revolution were crucial. They laid the foundations for both modern capitalism and the nation-state, which for long went inseparably together.
The revolution took place as war with France was getting under way, a war which turned out to be extremely expensive, and which demanded effective mobilisation of the nation's resources. To cope with those expenses, the monarchy had to borrow huge sums of money. It floated new loans, and these were guaranteed by parliament in the form of the national debt. Those who bought Treasury bonds would receive guaranteed annuities for life, or for a stipulated period. Since parliament was elected, had decisive powers and represented the real wealth of the country, those bonds were as trustworthy as any investment can be. Moreover, they were transferable, that is, they could be bought and sold. So, if one needed one's original money back in a hurry, that was possible too. The bonds became very popular and the national debt became an effective engine for raising revenue.
It was crucial also that this settlement was guaranteed by a national bank. In 1694 the Bank of England was set up with two main functions: (i) it managed the government's debt; (ii) it guaranteed the value of the pound sterling. It was able to issue paper money, backed by the authority of the English monarchy and parliament and hence by the trust people placed in them. Again, this greatly expanded the potentiality of the economy. Wealthy people gained far more confidence in investing their money, not only in the Bank itself or in treasury bonds, but in the economy generally. It became much easier to establish insurance companies, which not only augment people's confidence in the future, but also generate funds that can be used for investment. Joint-stock companies became more acceptable, and a stock exchange gradually took shape, facilitating collective economic enterprise and giving wealthy people confidence in investing their money. Taken together, these were powerful motors for wealth-creation, based on trust.
What was this wealth used for? At first, it was mostly used for war. The result was what the historian John Brewer has called the 'military-fiscal state', far more efficient than Britain's great rival France at raising both taxes and loans, so that with more modest resources it was able to mobilise much greater economic power for war-making purposes. Later on this formidable money-making machine would be deployed for investment in the world's first 'industrial revolution.'
In a sense this was a great success story. But there were two serious problems. The first was that the new financial instruments added an extra layer to the trust already embodied in money. In modern parlance, the whole system was 'leveraged'. That meant that in a crisis it was liable to more abrupt and cumulative seizures of distrust than money itself. The first example of this ailment was the 'South Sea Bubble'. The South Sea Company was essentially a 'pyramid scheme', of the kind we saw in Russia and Albania in the 1990s, no longer paying dividends out of real profits, but using recent investments to pay off obligations to somewhat older investors. Eventually it became clear what was happening, and in September 1720 the 'bubble' burst. Dividends ceased, South Sea shares became almost worthless, and many investors faced ruin.
The South Sea Bubble suggests what has been repeatedly confirmed since: that the capitalist economy, based on ever more complex layers of trust, is liable to panics and crashes. When trust breaks down, it does so abruptly and cumulatively, as we learned in September 2007, when anxious depositors queued up outside branches of Northern Rock to withdraw their money, and again on a much larger scale in September 2008.
The other major drawback of the new financial system was that it was very hard on the poor. Issuing treasury bonds was never sufficient: interest on the huge national debt was paid partly out of the highest tax rates in Europe, most of which were indirect and so inflicted the greatest hardship on the poorest people. Besides, to obtain secure collateral for raising loans, landowners would clear tenants with undocumented or short-term tenure off their lands, to become agricultural wage-labourers, to go into the towns to seek employment, and not infrequently to end in the workhouse. It took a political struggle lasting more than two centuries for some of the wealth of the rich and of the exchequer to be channeled into providing social security, health and education for the great mass of the British people. Once that happened, though, the nation-state became the most effective instrument yet devised for spreading risk and redistributing benefits, and it thus became a very powerful repository of trust, not least for the poor.
In the end, then, the nation-state created effective new ways of enabling ordinary people to provide against risk and misfortune in their own lives. Where in traditional societies people looked to family, friends, local community or religious institutions to help them face life's risks, nowadays most of us put our faith in savings banks, insurance policies and pension funds, with state welfare as a back-up for those least able to make provision for themselves - and note that these institutions all depend on economic growth. As Robert Samuelson has remarked, 'The triumphant religion of the twentieth century was not Christianity or Islam but economic growth.' Investment in economic growth became a panacea for all ills. In recent decades this has worked pretty reliably, but it has also erected a new storey - in fact several new storeys - on to the already highly leveraged edifice of trust on which we base our lives.
During the twentieth century many people in advanced countries also guaranteed their future by investing in urban real estate, taking out large mortgages not only in order to have a secure roof over their heads, but also because houses and flats offered a better and safer return than most other forms of investment. Placing trust in bricks and mortar has worked well for those who have been able to afford it, but, as Financial Times commentator Martin Wolf has pointed out, it also turned most of us into 'highly leveraged speculators in a fixed asset that dominates most portfolios and impairs personal mobility' (Financial Times, 10 September 2008). Mass investment in real estate has also created a new underclass, the first-time buyers and those on low-pay, who have little hope of ever owning their own homes. It is no accident that the current crisis was sparked off by subprime mortgages, which were originally designed to bring some of them into the housing market.
Since the massive deregulation of financial systems of the 1980s, a new layer or two have been added to the sprawling ziggurats of trust that already loomed over the landscape. Banks and building societies have been advancing their customers more and more credit (the financial term for trust) on easy terms to buy homes, cars and consumer durables. They have been able to do this partly because prevailing interest rates were low, but partly because thanks to deregulation banks no longer had to keep the accruing liabilities on their books: they split them up, repackaged them and offered them as securities for other banks to buy. Since these 'securitised' packages were apparently too complex for most dealers to understand, the resulting deals were based largely on trust. House prices rose steeply, so houseowners had greater assets to offer as collateral to raise further loans. At the same time, though, new extremes of inequality were created: non-houseowners, unless they could acquire subprime mortgages, saw the possibility of buying a house recede further and further into the distance. Nearly everyone took on more and more debt, supported or unsupported. In this way a world of socially divisive make-believe - or, if you prefer, weakly based trust - was created.
Meanwhile, the funds in which we place our trust have been investing their resources all over the world to bring in a better return on our behalf. Lending money to friends and family, which used to be more or less routine, has become much less common. Instead most of us place our trust, directly or indirectly, in investments. Today we have to all intents and purposes one single global financial system. Over the last thirty years most of us have - in many cases without even realising it - been investing in countries we have never visited and know nothing about. As Jeffry Frieden has pointed out, 'Mutual funds, investment trusts, and banks in the rich countries have brought small investors, retirees, union pension funds - anyone with even modest savings - into direct contact with stocks and bonds from Bangkok to Budapest to Buenos Aires, from Seoul to St Petersburg to Sao Paulo.' Insurance companies have done the same. Between 1980 and 1995 investments from mutual funds, insurance funds, pension funds and such like grew tenfold, and much of this was foreign investment, which often offered better returns. Such investments have enabled us to feel confidence in our own future, to rest assured that in case of disaster - fire, storm damage, a serious illness - we would be able to cope, and that when we get too old to work we shall be able still to lead a decent existence.
All this is right and proper, but it too has a downside. We have ensured that most of the benefits of worldwide trade accrue not to the people who need them most, but to the citizens of the relatively wealthy countries. It is not just governments and multi-national companies that are to blame. We are all responsible, since we use the proceeds to insure against risk and provide for our own futures in the ways I have indicated above.
Even when it functions well, then, the present international financial system creates huge and ultimately unsustainable distortions, which are especially damaging to the poor. At the moment, moreover, it is not even functioning well, and many of the rich can no longer feel secure. So the system needs repairing, and while doing so we should endeavour to eliminate its underlying defects. I have been working on the history of structures of trust in various past societies. My findings suggest that, when there is a real crisis of trust, the best way to tackle it is to both broaden and democratise trust.
After the Second World War, for example, it was obvious that placing one's trust in the nation-state alone generated huge and destructive wars. The nation-state was too small a unit to cope with the economic and social problems of the mid-twentieth-century world. So political leaders in Europe and the USA set about creating international institutions like the World Bank, the International Monetary Fund, the General Agreement on Tariffs and Trade, and the European Economic Community, which could spread risk, alleviate poverty, deal with crises collectively and prevent an economic downturn provoking beggar-my-neighbour national policies. Similarly, the Marshall Plan aimed to stimulate growth in post-war European countries, not least so as to draw their peoples out of poverty, and reduce their temptation to turn to Communist economic policies.
However, the international financial institutions set up after 1945, which once promoted stability and reduced poverty, are no longer doing so. If the globalisation of the nineteenth century was dominated by Britain and reflected British interests, today's globalisation, as Joseph Stiglitz has shown, is dominated by the USA and reflects that country's interests as well as its culture and institutions - its trust structures, in fact. The USA and other developed countries protect their own agriculture and ailing industries in a way that impedes the access of poorer countries to their markets. Developed countries ensure that capital flows are liberalised, since they make money from them, but that labour flows are not, though they would help poorer countries to earn money in their own way. Intellectual property rights obstruct the delivery of lifesaving generic medicines to those in poorer countries who need them and cannot pay first-world prices. And so on. We are repeating the mistakes of eighteenth and nineteenth century, and metaphorically consigning the world's 'bottom billion' to the workhouse.
The current so-called globalised economy is also pretty hard on poorer people in the advanced countries. Workers with long-established skills are made unemployed or reduced to very low wages. When the wealthy 'non-doms' buy spacious properties in London and the south-east, and second homes in Cornwall and Norfolk they drag up house prices and make it difficult for first-time buyers to secure any kind of permanent home. In the USA, moreover, the big companies have been gradually shifting the potentially crippling risk of health insurance on to the shoulders of their employees.
All these defects intensify inequality, threaten the stability of the whole international economy, and generate powerful resentment and distrust. Contemporary Islamist terrorism has many roots, but one of them is certainly extreme distrust of the West, directed against the way western economies have exploited non-western peoples, compelling them to observe the disciplines of the market without gaining its benefits and to adopt aspects of a secular, materialist life-style that affronts their beliefs. Many Muslims, not only the terrorists, are rejecting Samuelson's 'triumphant religion of the twentieth century'.
September 2008 has been a decisive turning point, whose scale can be understood only by those who know some financial history. We have reached the end of the almost unregulated credit markets we have become used to in the last thirty years. Thatcher-Reaganomics and the 'Washington consensus', the notion that markets could be relied on to regulate themselves, have brought to their knees the entire US mortgage market, together with the world's largest insurance company and three of the top five US investment banks. Banks and building societies have been able to lend money recklessly, rewarding themselves generously for so doing, while the public sector bears the risk. That is both morally and financially unacceptable. It is clear that serious regulation of the financial sector, at least in the USA and UK, will have to become the norm.
There are, however, two serious problems about tighter regulation. One is that it may stifle credit and hamper economic growth of any kind; that would undermine the structures of trust we have all become accustomed to. The other is that, in the absence of strong international governance, it will be carried out mainly by national governments, who in the process may restore protectionism and rebuild the 'fortress nation-states' which gave us the 1930s depression and the second world war.
The situation is especially serious in the USA and the UK, since both have heavy governmental and personal debts. In the UK personal debt is currently 177% of disposable income, in the USA 141% (Financial Times, 10 September 2008). Both countries also have an overpriced housing market, and both, especially the UK, are heavily dependent on financial services for their national incomes. Yet in neither country has any politician started to think seriously about what should follow the collapse of the 'Washington consensus'. This issue should figure urgently on the agenda of all political parties. Any leader who can produce a convincing and effective programme will dominate the agenda for the next two or three decades.
The present financial crisis is still unfolding, and we cannot tell how serious it will be. Comparisons with the 1930s are now certainly justified. Like all crises, though, this one gives us the opportunity to undertake a fundamental rethink and to reconfigure our international economic institutions so that they are both more equitable and more open to the input of the poorer countries. Doing so should make it easier to generate other forms of trust - which are desperately needed if we are to make a start on solving such intractable problems as nuclear proliferation and global warming.
Not all the problems of globalisation can be solved overnight. The plight of those in the developed world priced out of a job by cheaper overseas competition will remain unenviable; but the chances of their retraining and finding other more productive work will improve if the overall financial framework is more inclusive and more equitable. The key is to broaden and, as far as possible, to equalise the foundations of trust in the world as a whole, so that the generally beneficial effects of money in its modern guises can be restored, and perhaps extended to other fields of international cooperation too.
I am very grateful to the Institute for Advanced Study, Princeton, where an Elizabeth and J. Richardson Dilworth Fellowship in 2006-7 enabled me to study and present preliminary findings on the history of trust. This article is an expanded and updated version of one which appeared in the 'British Academy Review', issue 11 (July 2008).
John Brewer, The Sinews of Power: war, money and the English state, 1688-1783, London: Unwin Hyman, 1989.
Paul Collier, The Bottom Billion: why the poorest countries are failing and what can be done about it, Oxford University Press, 2007.
Jeffry A. Frieden, Global Capitalism: its fall and rise in the twentieth century, New York: Norton, 2006.
Robert Gilpin, The Challenge of Global Capitalism: the world economy in the 21st century, Princeton University Press, 2000.
Geoffrey Hosking, 'Trust and distrust: a suitable theme for historians?' Transactions of the Royal Historical Society (6th series), vol 16 (2006), 95-116.
George Soros, The New Paradigm for Financial Markets: the credit crisis of 2008 and what it means, New York: Public Affairs, 2008.
Joseph E. Stiglitz, Making Globalization Work, New York: Norton, 2006.
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