Ewald Engelen Et Al. - Misrule of Experts? The Financial Crisis As Elite Debacle

Economy and Society Volume 41 Number 3 August 2012: 360 382
Misrule of experts? The nancial crisis as elite debacle

Ewald Engelen, Ismail Ertu rk, Julie Froud, Sukhdev Johal, Adam Leaver, Michael Moran and Karel Williams
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Abstract
This paper is about knowledge limits and the financial crisis. It begins by examining various existing accounts of crisis which disagree about the causes, but share the belief that the crisis represents a problem of socio-technical malfunction which requires some kind of technocratic fix: the three variants on this explanation are the crisis as accident, conspiracy or calculative failure. This paper proposes an alternative explanation which frames the crisis differently as an elite political debacle. Political and technocratic elites were hubristically detached from the process of financial innovation as it took the form of bricolage, which put finance beyond technical control or management. The paper raises fundamental questions about the politicized role of technocrats after the 1980s and emphasizes the need to bring private finance and its public regulators under democratic political control whose technical precondition is a dramatic simplification of finance. Keywords: knowledge; experts; elites; nancial crisis; nancialization; bricolage.
The financial crisis that began in August 2007 bankrupted the idea that selfregulation and a light touch regulatory regime could check risky behaviour and prevent systemic crisis in financial markets. The period since August 2007 has been one of critical reflection by policy-makers and academics over what went wrong and what might be done to prevent future crisis. Here, marked differences have emerged. Some read the crisis as a structural phenomenon
Adam Leaver, 6.04 Harold Hankins, Manchester Business School, University of Manchester, Booth St West, Manchester, M15 6PB, UK. E-mail: adam.leaver@mbs.ac.uk Copyright # 2012 Taylor & Francis ISSN 0308-5147 print/1469-5766 online http://dx.doi.org/10.1080/03085147.2012.661634
Ewald Engelen et al.: Misrule of experts?
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with little blame attached to individuals, and greater emphasis on the unanticipated and accidental consequences of system complexity. For others, the crisis was caused by the avarice of bankers and other actors who apparently knew what they were doing, and were aided and abetted by self-interested regulators and politicians. A third set of authors emphasize institutionally and/ or culturally produced calculative failures, where un-knowing but active subjects created runaway risks that they neither understood nor controlled. In many cases, the analysis of crisis centres on socio-technical failures which would be solved by new restorative interventions, supervised and administered by technocratic experts. This paper deals with two problems that emerge from this narrow framing of the crisis as a serious, but momentary, malfunction in financial markets, where that malfunctioning part or feature can be fixed, and thus stability restored, with new and inventive technical tools. First, it seeks to make the case that the quest to restore control to financial markets is quixotic because innovation takes the form of bricolage, with instability written into its DNA. For this reason transformative rather than restorative reform is required, where the fundamental principle of action must be to downsize and simplify finance. Allied to this is a second point: that the crisis was not just the result of technical failure in financial markets, but also the outcome of a political and regulatory debacle, where the hubristic detachment of elites created the space for finance to grow and become more complex. This paper therefore explores the cultural and institutional dimensions of this elite hubris, and is designed to sound a note of caution to those who blithely recommend new tools with which to fix finance and neglect the ordinary politics of UK financial regulation and oversight. Our contention is that if technical reforms of financial markets are to work, they must, first, be transformative and, second, be coupled to greater democratic control and accountability at regulatory and political levels. Our paper develops this argument in four sections. The first reviews current explanations of crisis, where differences are classified according to whether the causes are located in structure or agency, or in neither as part of a kind of third way explanation. In this section we argue that these explanations of the crisis (as accident, conspiracy or calculative failure) share common assumptions about how crisis is generated within socio-technical systems amenable to technical, and mainly technocratic, fixes. The second section explains the process of financial innovation as bricolage where restorative reform became an input to strategic calculation rather than a powerful external constraint. The third section describes how bricolage produced a fragile latticework of connections that evade technical control across four dimensions: volume, complexity, opacity and interconnectedness, thus making the activity inherently ungovernable. The fourth section then outlines the political dimension of the crisis. Within this frame, the section focuses on the massive failure of regulation before the crisis and argues that the crisis was then permitted by the inaction of political and technocratic elites whose hubristic detachment was such that they made no serious attempt to control the finance
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sector. A brief conclusion draws out some implications and makes some recommendations. The final verdict is that this financial crisis is different from earlier credit crises because it now requires a political solution.
The financial crisis in a socio-technical frame The causes of the August 2007 financial crisis have been understood in a variety of ways. Typically, authors fall into one of two camps: for some it was an accident the unanticipated product of system malfunction; for others it was unbridled individual greed. Yet, despite the differences that exist within and between these perspectives, both groups generally assert or assume that stability within financial markets can be restored through technical interventions which hand great responsibility to technocratic overseers. This section reviews these two perspectives, before briefly summarizing other accounts, which engage with our two key observations: that knowledge limits render finance practically unmanageable in its present incarnation; and that reform is not just a question of selecting the correct socio-technical fix, but rather is a broader problem of accountability in politico-regulatory structures. The idea that the 2007 crisis was the result of a socio-technical malfunction, and could be fixed by technocrats with new tools, is the basis for most official reports on the subject. This is no surprise given that their usual remit is to identify problems and recommend solutions, but what is notable is the distinct lack of any discussion on either the limits of technocratic control in a sector like finance or the institutional failings which led to the crisis. Instead, reports like those by De Larosie ` re, Turner and Walker, all published in 2009, offer detailed analysis of multiple and compounding system failures but then assume that this can be rectified with the right kind of technical interventions which return financial markets to a state of stability by restoring the defective part(s). The system malfunction analysis and list and fix format also appears in a number of academic publications on the crisis where an emphasis is placed on the need for better regulation of mortgage originators and improved transparency in securitization markets (for example, De La Dehesa, 2007; Unterman, 2009). In a more theoretical development, system malfunction arguments appear in recent academic accounts inspired by Perrows (1984) classic work on normal accidents. Guille n and Sua rez (2009), for example, use Perrows frame to argue that financial markets became more complex as banks diversified and products became more opaque. Similarly, the system became more tightly coupled as leverage levels and bespoke derivatives tied in the fortunes of major banks, eroding the safety buffers which might prevent cascading losses across notionally separate financial institutions and markets (see also Schneiberg & Bartley, 2009, p. 7). From this perspective the crisis was not caused by human venality or fraud, but by anonymous interactions within a closed system (Palmer & Maher, 2010, p. 84). Restoring stability to financial
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markets is, therefore, a technical matter of reducing system complexity and introducing redundancies that improve robustness. If these authors view the crisis as a product of malfunction in a closed system, a second group of authors take the opposite position: that the crisis was not caused by impersonal systemic interactions, but by knowing actors. Yet, despite this fundamental disagreement, the idea that errors can be reversed, and stability can be restored, through technical interventions alone is retained. This idea is at the heart of most moral hazard analyses, which explain the crisis as rational responses by knowing subjects to distorted incentives. Bebchuk et al. (2009) argue that the boards of large banks understood the risks they were taking, but calculated that other actors (shareholders and taxpayers) would take on the costs if the gambles failed (see also Becker, 2008; Dowd, 2009; Ho, 2009). Elite actors therefore responded rationally to institutionally set remuneration incentives, which encouraged short termism and increased the probability of corporate failure (Dowd, 2009, p. 144). Moral hazard, we are told, is easily solved with a basic technical reform of remuneration structures so that a greater portion of pay is remitted in longdated share options with claw-back provisions. Other authors recommend more radical cures for moral hazard, such as the separation of retail and wholesale banking activities in a bid to end too-big-to-fail incentives created by state bailout guarantees (see, for example, King quoted in Halligan, 2011). It is at this point that we would emphasize the importance of a different set of authors who continue the knowing actors theme, but recognize that problems have a political and regulatory context primarily strong economic and/or ideological connections between financial and political elites which may frustrate attempts to impose new technical reforms. Ironically, this is the position of Charles Perrow, the progenitor of normal accident theory, who, like Bebchuk et al. (2010), argues that the financial crisis was neither above agency nor inevitable, but rather caused by self-interested agents, conscious of the effects of their actions. But, it is crucial to note that Perrow (2009) argues that malfeasance was aided and abetted by political and regulatory elites who, seduced by donations and the offer of revolving door jobs, deliberately turned a blind eye to the manifest dangers building up within financial services (see also Blackburn 2008, pp. 81 4). These claims are taken further by Simon Johnson, ex-chief economist at the IMF, and James Kwak (2010, pp. 6 7, ch. 7), and by those on the radical left like Gowan (2009) who in different ways argue that the power of the major banks is systemic, and that the (Anglo-American) state has simply become an expression of prevailing class relations where finance capital is in the ascendance (see also Wade, 2008, pp. 13 14). Perrow (2009), Johnson and Kwak (2010) and Gowan (2009) argue that financial market problems are both technical and political, insofar as it would be foolhardy to expect radical reform from a political and regulatory coterie. The political dimension of the crisis is important, and these authors are right to emphasize this neglected part of the story. Yet their understanding of the political dimension does, however, border on the conspiratorial, where politicians cut
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shadowy deals with senior bankers with self-serving intent. Such ideas presume shared private knowledges and interests, and ignore the possibility that elite politicians and bankers might have had agency without really understanding what they were doing and the likely outcomes of their actions. From this point of view, we would emphasize the importance of a third set of authors, who propose more sophisticated institutional and cultural explanations about knowledge limits. Most notable here is the work of Financial Times commentator, Gillian Tett, who identifies the problems created by institutional silences and silos within banks, and between banks and regulators, which meant that the arcane, technical innovations within credit markets were not well understood by bank CEOs or politicians (Tett, 2010). The limits of knowledge or practice are constructed differently by MacKenzie (2010a) whose argument is that different clusters of evaluation around asset-backed securities (ABSs) and collateralized debt obligations (CDOs) created arbitrage opportunities that resulted in financial catastrophe. The Gaussian copula assumptions used by CDO engineers assumed low default correlations in mortgage-backed ABSs, which boosted demand for riskier ABS tranches, which in turn allowed new mortgages to be written to riskier households. The cultural and calculative explanations of Tett and MacKenzie emphasize the importance of human agency in the current financial crisis without reducing everything to a conspiracy on the part of knowing actors. But, in contrast to Perrow and others, their reform recommendations are surprisingly modest. Tett (2010) proposes an anthropologists variant on the socio-technical fix for finance and argues the case for a more active role for outsiders or cultural translators who could develop a more holistic view. MacKenzie offers different socio-technical solutions, such as the need for better models which build from the bottom up (MacKenzie, 2010b), as well as for banks to pay more attention to the gaps in evaluation cultures (MacKenzie, 2009). Nevertheless the insights of Tett on institutional blockages to knowledge sharing, and MacKenzie on the unanticipated consequences of various actors transposing specific knowledges into different settings, are crucial and raise the central question about the limits of manageability. Our analysis now explains in more detail precisely why finance in its current form is unmanageable and requires transformative rather than restorative intervention. The third section then follows by developing a stronger political dimension to the analysis. Here we emphasize the hubristic detachment of political and technocratic elites from events in financial markets, which ultimately proved fatal. The challenge for transformative regulation is therefore not just selecting the right technical tools, but securing greater accountability and oversight of politicians and technocrats.
Bricolage and ungovernability Some of the authors discussed in the first part of the previous section retain the idea that the crisis is an error or aberration in a system that is normally
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stable, and hence stability can be restored with the right socio-technical tools to fix the defective parts. The elephant in the room is whether finance in its current form is simply beyond this kind of palliative reform, and whether finance is a system which generates order and disorder simultaneously. Our first claim is that finance is now technically ungovernable, so that any attempt to restore finance to some kind of equilibrium or balance is futile because instability is written into its DNA. We make this case by arguing that financial innovation takes the form of bricolage which has had four key consequences the growth of volume, complexity, opacity and interconnectedness. With bricolage, restorative regulation ceases to be an external constraint and becomes an input for future financial improvisation by creative bricoleurs. The fundamental problem from a technocratic perspective is that financial innovation does not progress in a predictable and rule-bound fashion; it does not take the form of scientific experiment or grand plan, but rather takes the form of what Le vi-Strauss (1966) termed bricolage (Engelen et al., 2010). Our definition of financial innovation as bricolage differs from orthodox understandings. For mainstream finance, innovation and financial market practice are driven by rationalities. Financial innovation is viewed as the application of scientific formulas inducted from experiments and applied in markets by financial engineers. Bricolage on the other hand, rather than producing events from structures of formal knowledge, involves the creation of structures out of events; it is innately improvisatory and the structures built are without a central, guiding, scientific rationality. For Levi-Strauss, the bricoleur, builds up structures by fitting together events, or rather the remains of events, while science, in operation simply by virtue of coming into being, creates its means and results in the form of events, thanks to the structures which it is constantly elaborating and which are its hypotheses and theories (1966, p. 22). On the surface, the idea that financial innovation is bricolage may appear incongruous and implausible when there is widespread use of economic models which draw on scientific theory, for example in pricing options (Black Scholes), measuring risk exposure (value at risk) or producing structured derivative products (Gaussian copula models). To this we would make two responses. First, the models used are diverse and involve improvisation by reflexive market actors (Beunza & Stark, 2010; Haug & Taleb, 2009; MacKenzie, 2003). Haug (2006) lists 60 models for pricing options alone, while Merton (1995) lists 11 strategies for taking the same basic leveraged long position. This all suggests that the models are not plans or blueprints which format behaviour, but more a suite of adaptable resources that can be drawn upon selectively to meet market opportunities that present. Second, if financial models are a resource not a plan, then it is important to remember that they are just one element of a broader company (or even divisional) trading strategy. It is possible that two companies integrate identical formulas into entirely different trading strategies. To take a simple example: MacKenzie (2010a) convincingly demonstrates how the low default correlation
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assumptions that underpinned ABS CDOs created a fatal arbitrage opportunity, as CDOs bought risky ABS tranches from which they produced reams of AAA-rated paper. But banks responded differently to this event. Some, like Merrill Lynch, Citi, Bear Stearns and UBS, took the correlation assumptions at face value and bought/retained this AAA paper funded by cheap repo loans, booking a profit on the spread between the lower, short-term borrowing rates on the repos and the higher yield on the securities (Gorton, 2010; Milne, 2009). Others, like Goldman Sachs were more concerned with exploiting the information asymmetries created by these correlation assumptions. In their $1bn sub-prime backed Timberwolf CDO, Goldman allegedly went short on the securities sold to investors, which infamously included one of Bear Stearns now defunct hedge funds (Reuters, 24 April 2010); and on their Abacus CDO, Goldman allowed a client hedge fund to select the underlying collateral for the deal, but this fund subsequently shorted the securitized structure. In both cases the same models are used for different ends, with different economic outcomes, because they are integrated into a variety of strategies with a range of goals. The tangible result is morphing meso-configurations of instruments, practices and market relations constructed from events, which in turn become the start point for improvisation in the next phase of bricolage (see Engelen et al., 2011, for extended discussion). To this general point about bricolage we can add a more specific point that technical interventions which respond to immediate problems are unlikely to prevent future crisis because they become simply another event from which financial institutions improvise in the next phase. This is a crucial destabilizing condition. In the standard case of industry regulation, the characteristics of the activity are fixed or slow to change so that regulation can be conceived of as an external constraint on the activity. But, in the case of financial regulation, innovation ensures that activity characteristics can morph through and around events including regulation, which itself becomes a primary input. This was the case with credit derivatives, where Basel I and II capital adequacy accords became intrinsic to the developments of the CDO industry. In this case a credit default swap became a legitimate instrument to remove the credit risk from the balance sheet and thereby reduce the amount of capital that a bank needs to hold to offset that risk. This regulation became an event from which new structures like partially funded synthetic CDO were built, driven by regulatory capital arbitrage which swelled bank revenues and enlarged the bonus pool.
The challenge of volume, complexity, opacity and interconnectedness The improvisatory nature of financial innovation as bricolage, and the subsequent ease with which restorative regulation is incorporated into banking strategies, created unprecedented problems for regulators by the 2000s. Bricolage has then created four new challenges in the form of volume,
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complexity, opacity and interconnectedness which makes it ungovernable and now requires transformative rather than restorative interventions. In terms of volume, many recent innovations, particularly in swaps markets, are designed to manufacture risk and leverage, rather than hedge risk. If risk is tradable and leverage magnifies returns, then derivatives are a key way through which the financial sector generates its own feedstock synthetically, and provides new opportunities for volume and return. This, rather than risk management, was often the principal reason for banks and other financial actors interest in options and futures, where premium and margin were used to speculate on price movements in financial markets. For example, total return swaps or credit default swaps make it possible for financial actors to gain (levered) exposure to the return profiles (and risks) of particular securities or indexes, without necessarily dedicating the resources to buy them outright. The purchase of $100 million of ABSs would normally require the commitment of $100 million of cash. But the same result can be achieved via a credit default swap, where a trader could sell insurance on the security and charge a premium aligned with the interest payments on the underlying securities. The CDS requires no funding other than any collateral required by the buyer, which is substantially less than the $100 million required to buy the securities outright. Thus the CDS seller has a synthetic levered position, without ever buying the underlying securities. For this reason, as Das (2010) points out, it was possible for CDS volumes to exceed four times the value of the underlying bonds and loans by the end of the boom, with multiples in currency and interest rate swaps much higher. Those volumes are now so large as to be fundamentally destabilizing. The notional value of contracts outstanding on over-the-counter (OTC) derivative markets increased 950 per cent from $72,134 billion in June 1998 to a peak of $683,814 billion by June 2008, before falling back to $614,673 billion by the end of 2009. Measured comparatively, OTC contracts outstanding grew from around 2.4 times global GDP in 1998 to roughly 10 times by the end of 2009, according to the Bank for International Settlements. At the peak in 2008, the value of OTC derivatives outstanding was equivalent to the value of all goods and services produced globally in the previous twenty years (Duncan, 2009). When exposures exceed multiples of global GDP, as we will demonstrate later in the argument, the sheer weight of finance becomes difficult to control at national level where regulation is primarily located. If these levels of exposure make governing finance difficult, then governability is further reduced by complexity. Complexity takes two forms: at the level of the product and at the level of the market relations around the product though there is some difficulty in distinguishing the two. At the level of the product, CDOs moved from relatively simple cash or true sale, balance sheetoriented structures in the late 1990s to actively managed, synthetic, arbitrageoriented structures by the mid-2000s. As the models became more complex, so too did the market relations around them. Figure 1 shows a fourth-generation hybrid CDO that combines both cash and synthetic securitization. It is actively
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Figure 1
Partially funded synthetic CDO structure
Source: UK Balance of Payments, The Pink Book.
managed throughout its life by two special purpose vehicles (SPVs): SPV3 creates and manages a portfolio of reference assets that are not totally derived from the originating banks balance sheet, while SPV1 and possibly SPV2 buy and sell credit default swaps to try to boost the overall arbitrage profits. Total return swaps and credit default swaps both provide protection and augment (or preserve) returns from the reference portfolio of assets, in theory diversifying the sources of protection purchase. Reference assets managed by SPV3 can include mortgage-backed and other ABSs, but may also involve both long positions in derivatives like credit default swaps. Portfolio creation and management also necessitate a need for access to a liquidity fund via a bank counterparty and a fund manager. As early as 2001 The Economist reported that [t]he chairman of American Express, Kenneth Chenault, was man enough to admit . . . that his outfit did not fully comprehend the risk underlying a portfolio of whizz-bang investments known as CDOs (26 July 2001). If senior market actors privy to the marketing literature of early-stage CDOs struggled to comprehend what was going on with relatively simple CDO structures, it is not hard to see why regulators looking in from the outside might struggle in 2007 to understand the points of vulnerability and possible risks. If these CDOs are difficult to understand in retrospect, they would be virtually impossible for regulators to understand ex ante. The related opacity of finance is therefore a third challenge to regulators. The opacity of finance is
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not just the inevitable consequence of complexity, because opacity owes much to fair value accounting and the widespread use of off-balance sheet special purpose vehicles domiciled in tax havens. Because most derivatives are traded over the counter and as such are effectively bespoke, there is no large, central secondary market from which mark to market valuations might be inferred. For this reason, paradoxically, there is an over-reliance on the valuation models of the institutions that generate the securities to price those securities (ICAEW, 2009). Perversely, this mark to model privilege is used to avoid taking writedowns in the absence of market liquidity. This was the case in early 2007 when sub-prime defaults rose and banks initially refused to write-down the value of their mortgage-backed securities because their models apparently indicated there was no problem, much to the frustration of hedge funds who had shorted those structures (Lewis, 2010). Valuations then went to zero very quickly as the artifice of valuation disintegrated in the crunch of August 2007 (Smith, 2010). If prices provide no signal to regulators of emerging risks and problems until it is too late to make ameliorative interventions, then this opacity is a major control problem. This control problem is also exacerbated by the growth of the shadow banking system, as off-balance-sheet entities domiciled in the Cayman Islands and elsewhere mean exposures are increasingly sheltered from the scrutiny of regulators who can follow the obligations only until they vanish from sight. Readers up to this point might acknowledge that these developments pose significant tests to technocrats, but do not necessarily undermine the case for restorative reform provided it is ambitious enough. Our response is that the fourth challenge, interconnectedness, makes technocratic responses to financial crisis increasingly futile. Interconnectedness takes two forms: the concentration of relations and exposures between core financial institutions, and the exposure of national governments to their own domestic financial industry or, as we are now discovering, to the financial sector of foreign sovereigns. In terms of the interconnectedness of financial institutions, the combination of higher volumes with growing industry concentration (see Crotty, 2007) has resulted in the creation of a fragile, complex latticework of exposures and obligations between systemically important banks. By 2009, J. P. Morgan had derivatives exposure of $78,545 billion in a total market valued at $614,673 billion. According to the Office of the Comptroller of the Currency (2009) bank trading and derivatives report, the notional value of derivatives held by US commercial banks was $212.8 trillion (2009, p. 1). Of the 1,030 US commercial banks that submitted their derivatives exposure, the top five claimed 97 per cent of this notional value. Such concentration is quite staggering. An important qualification is that many industry observers argue that the size and risks associated with such exposures are reduced by netting: a bank may have a long default risk in one market, and hedge by going short if industry conditions change. But post-netting exposures are still very large; moreover, the distressed conditions under which netting might take place are precisely those under which it would be impossible to enforce regulation.
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Domino-like effects are the logical result if one counterparty does not or cannot fulfil a sizeable contractual obligation because this would create suspicion and fear, and disrupt a sequence of payments from bank to bank as many financial institutions found out to their cost when the monoline insurers faced massive losses and credit downgrades in early 2008. The combination of the four challenges volume, complexity, opacity and interconnectedness ties large, systemically important banks together in a compact which assures mutual self-destruction in the event that one collapses. This is now all the more serious: as post-2008 events demonstrate, given bricolage, a national banking system in a small, open country can have liabilities much larger than the mobilizable assets or revenue-raising powers of their national governments. This was the case in small economies like Iceland and Ireland where banking assets to GDP ratios rose to over 800 per cent and both are now effectively unable to meet banking bailout costs. But, as Table 1 shows, several medium-sized countries like the UK and France were not far behind, with banking assets to GDP ratios of 400 500 per cent in 2007. Here, the costs of backstopping the banks increased public indebtedness leading to expenditure cuts and tax rises which will, most likely, move such economies away from the growth path necessary to pay down public debt. Growing internal distributive conflict is paralleled by international disagreements about who bears the cost of bailouts because international cross holdings of sovereign and bank debt complicate the solution of default which confuses the identity of creditor and debtor. All of this suggests that national governments should reject restorative technical interventions and begin to think radically about more transformative solutions that seek to restrain financial bricolage and limit the size of the financial sector. Finance generates relatively few jobs and modest taxation income for the Treasury (CRESC, 2009). But this kind of shift in the Table 1 Top six bank assets to GDP (%) and bank assets per capita (US$), 2007, selected countries
Aggregate bank Aggregate Aggregate assets per bank bank assets of capita Population top six banks assets to (US$) GDP (US$000s) (000s) 61,707 82,247 60,975 301,621 301,621 8,805,886,701 6,286,500,638 10,995,443,626 7,151,775,000 4,271,680,000 415.1% 214.9% 503.9% 51.0% 30.5% 142,705 76,434 180,327 23,711 14,162
GDP (US$000s) France 2,121,475,000 Germany 2,925,667,000 UK 2,181,900,000 USA (commercial 14,010,800,000 banks) US (investment 14,010,800,000 banks, top five) Source: Bankscope database.
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Figure 2 UK current account, nance, goods and service trade balance (nominal m). principles of financial reform remains politically unattractive for national governments like that in the UK, which takes the finance sectors public relations story at its own estimation and is hostile to a more hands-on approach to industrial policy, despite the rhetoric about rebalancing the economy. There is something to be said for finances contribution to the balance of trade when financial services trade surplus grew from 11,769 million to 32,919 million between 1999 and 2009. This growth did offset the poorly performing trade balance in goods which fell from -29,051 million to -81,875 million over the same period, as Figure 2 shows. For this reason any attempt to shrink finance should be balanced with growth from other exporting sectors which would require the invigoration of a social democratic project that seeks to encourage specific kinds of production across activities and the regions (CRESC, 2011). The transformative project of shrinking finance is of fundamental necessity because the volume of financial liabilities held by core financial institutions, and their interconnectedness, now tethers the fortunes of national governments to the performance of their banks, and their respective counterparties. The paradoxical combination of scale and fragility has handed great economic and political power to a small group of financial institutions, whose threatened collapse constrains policy-makers in terms of options and implementation. For this reason financial reform is not just a technical challenge about creating more transparency or solving imagined incentive problems. It is also a
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democratic challenge of reducing the size of financial markets and institutions so that their activities are not so damaging to the national economies and, by dint of their linked exposures, they are less able to exert their will against that of the electorate. On this basis, the 2007 crisis should be understood as an elite debacle, driven by improvising bankers and allowed by permissive regulators; thus reform should focus on improving the democratic accountability of political and technocratic elites.
The financial crisis as elite debacle If the 2007 crisis was an elite debacle, we can turn to the politics literatures on policy disasters which provide us with various general perspectives of limited relevance to the specific case of finance. Hence we present a different kind of argument about how elite debacle in finance is rooted in a distinctive and detached post-1980s mode of governance after deregulation. In the UK case, the rhetoric of neoliberalism and the long history of trust between finance and its public regulators were reinvented as politically sponsored light touch regulation. Hubristic detachment was then encouraged by new modes of governance driven by organizational developments. The resulting financial crisis was then a debacle of policy elites who failed to understand finance as ramshackle bricolage which was bound to go wrong (in unpredictable ways). The politics literature on disasters divides into three broad streams which take different epistemological and ontological positions. The first may be called fatalistic insofar as the dominant theme is simply that accidents will happen. This account often unites some high theorists of catastrophe with commonsense accounts, and, of course, echoes Perrows classic 1984 position on normal accidents which, under some technological and social conditions, must be expected. Practitioners faced with the problem of making sense of fiascos post hoc commonly stress the complexity of the world and the inevitability of things going wrong (for examples ranging from BSE to financial failure, see Moran, 2001). A second may be referred to as constructivist, where the emphasis is on the absence of a stable objective understanding of a fiasco or disaster. Shifting value criteria, or even the passage of time, can change our understandings of a particular fiasco, and its extent. A commonly cited example is the Sydney Opera House, which began as a disaster and ended as a triumphant icon. The most extended statement of this account is Bovens and tHart (1996; see also Bovens et al., 2001) where the dominant message is that fiasco cannot be explained objectively and so the aim is to explore the different meanings assigned to specific fiascos. A third stream is the modernist stream, epitomized in the sub-title of Scotts (1998) classic study, How certain schemes to improve the human condition have failed. Here disasters are the result of a particular historical conjuncture in the modern world; a toxic combination of modern state power
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and the Enlightenment legacy of an obsession with legibility, simplification and measurement. The result is high modernist disasters in arenas as diverse as the modern city, economic planning and the management of nature. Thin simplification knowledge derived from standardized measurement systems overrides metis the practical knowledge derived from everyday experience and the result is disaster. The argument uncannily echoes Oakeshotts (1962) case for the primacy of tacit knowledge over expertise and data in the practice of government. The specific debacle which led to the events of August 2007 differed in a number of respects from these general accounts. Interestingly, the fatalistic view has been forcefully attacked by Perrow (2009), and is untenable if we wish to locate causes and avoid teleology. Indeed the fatalistic accidents will happen account is probably most useful to policy-makers attempting blame avoidance in the inquests that follow fiasco (this excuse was tried, for example, in earlier fiascos, like the Baring collapse of the mid-1990s and the UK banking crisis of the mid-1970s: see Moran, 1986, 2001). A constructivist understanding of the debacle is equally inappropriate because, while there may be competing explanations of the crisis, its scale and negative consequences are inescapable as sovereign defaults beckon. What culminated in the 2007 8 crisis is not, like the Sydney Opera House, a blessing in disguise. Equally, it is hard to argue that the crisis is caused by an obsessive modernist concern with control, monitoring and surveillance at the expense of metis. While this trend is observable in a number of public- and private-sector examples, often with contradictory results (see Dunleavy, 1995; Power, 1994), it would be hard to picture what happened in financial regulation in the run up to the crisis as exhibiting a modernist mania for control. On the contrary, the main thrust of policy was in the opposite direction with the dismantling of monitoring and control under regimes that placed excessive faith in market operators and too heavy a reliance on the tacit, practical knowledge of those with expertise in markets. In this sense it was deference to metis, not its extinction, that gave us the crisis. This observation provides us with a starting point: why was there such deference to the practical knowledge within financial markets and the supposed capacity of market actors and institutions to recognize, package and manage risk? In the UK case we can begin by recognizing that deference to the markets went with the grain of long-established habits of British financial regulation and with the rhetorics of the current neoliberal project. The pattern of financial regulation and oversight in the UK was characterized by high levels of trust between regulators and those regulated within an enclosed, interconnected policy-making community around finance that has resisted the audit and evaluation imperatives so well described by Power (1994). This resulted in a particular form of regulation that relies heavily on shared, interpersonal knowledges, with evaluation and decision making often informal, i.e. driven by the imponderables of personal judgement (Moran, 2001, p. 421) rather than the strict, routinized,
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indicator-driven regimes of oversight and control that characterize other sectors. Financial regulation was initially reinvented after the 1986 Big Bang of deregulation and then again when New Labour in office re-regulated finance with the merger of banking supervision and investment services regulation under the auspices of the Financial Services Authority (FSA). But finance was never subject to the more adversarial forms of regulation typical under new public management regimes in the public sector or the more proactive, handson approach of regulators in the privatized utilities sector like telecoms, where reducing costs to the consumer was the fundamental principle of action. The peculiar regulatory privilege of finance reflects the endurance of what other authors have termed club government (Marquand, 1988). In numerous areas of public policy the Thatcher revolution, consolidated under New Labour, destroyed the club system, replacing it with more transparent, centralized and low trust systems of control (Moran, 2003). It seemed, superficially, that the centralization of regulatory authority in the FSA in 1997 had accomplished something similar. But the FSA was an imposing Potemkin village: behind its impressive fac ade, it deferred club fashion to the elites in the market. This system has persisted in part because of the close reciprocal ties between financial elites and high public office, which provide ample opportunities for financial reward to senior politicians and bureaucrats who leave public service via the revolving door to enter into lucrative directorship or advisory roles in industry (see Gonzalez-Bailon et al., 2010; Hood & Lodge, 2006). Tony Blair, for example, currently makes 3.5 million per year as a senior advisor to J.P. Morgan on top of the 500,000 per year as an advisor to Zurich Financial, another six figure sum as advisor to private equity firm Khosla Ventures and 1 million per year as a governance advisor to Kuwait (McSmith, 2010). But ideas were also important in Britain and the United States as part of a rhetorical commitment to a neoliberal project of social and economic reconstruction in the image of a deregulated system of free market capitalism. This rhetoric was not always faithfully implemented (see Konings, 2008), and could not be implemented in finance where state withdrawal was not an option. But is it too much to assert that this rhetoric was fundamentally ideological in its orthodox Marxist sense, articulated by knowing political elites to empower finance capital? It is more prudent to view neoliberal thought as the ideational centre of gravity which influenced and encouraged light touch regulation as the most likely model of achieving sustainable economic growth. Light touch, for example, was personally championed by New Labours Chancellor Brown for whom it was governments positive contribution to the success of London as an international financial centre:
And just as two years ago we promoted the action plan for liberalising financial services across Europe, I can tell you that the Treasury is now working . . . to ensure that the forthcoming European financial services white paper signals a new wave of liberalisation. . . . In 2003, just at the time of a previous
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Mansion House speech, the Worldcom accounting scandal broke. And I will be honest with you, many who advised me including not a few newspapers, favoured a regulatory crackdown. I believe that we were right not to go down that road which in the United States led to Sarbanes-Oxley, and we were right to build upon our light touch system . . . fair, proportionate, predictable and increasingly risk based. (Brown, 2006)
The policy of light touch was empowered by the short-term success of the debt-fuelled boom of the mid-2000s, which reinforced the neoliberal consensus and encouraged optimism about an emergent new epoch. For technocrats like Mervyn King, this was the Great Moderation, the NICE decade, the Goldilocks economy; for Chancellor Brown the growth rates confirmed his conviction that policy-makers had effectively abolished boom and bust. In retrospect, these claims and assumptions are deeply hubristic in the more or less exact meaning of that word: an overbearing self-confidence that led to ruin. And with hubris comes post hoc denial, as events and ones personal role within them are rewritten to accommodate emerging realities, as was the case with Gordon Brown:
As I said in Harvard ten years ago, we need an early warning system so that international financial flows are properly monitored. . . . We must create a framework for the international governance that we currently lack. We must consider at a global level the regulatory deficit. For a decade I have said that the current patchwork arrangement is inadequate. (Brown, quoted in Booth, 2009)
The role of hubris in modern politics is closely documented in studies of foreign policy disasters such as the Afghanistan and Iraq conflicts (see Beinart, 2010; Owen, 2007, 2008; Scheuer, 2007). The public case for intervention in Iraq involved the hurried manipulation of intelligence evidence to defend a decision previously agreed with President Bush, that the UK would support the US in their quest to remove Saddam, depriving the cabinet and parliament of key information in the meantime (Sands, 2011). The Butler inquirys verdict on New Labours style of sofa government is understated but nevertheless devastating: we are concerned that the informality and circumscribed character of the Governments procedures which we saw in the context of policy-making towards Iraq risks reducing the scope for informed collective political judgement (Butler, 2004, para. 611). The decision processes which led to the Iraq war, as detailed by Lord Butlers inquiry, show a pattern of casualness and bravado characteristic of what Owen (2008) calls hubristic incompetence: a situation where elite political leaders have the self-perception that they are missionaries or heroes, endowed with powers to do good and take the correct decision without necessarily engaging with the intricacies of policy detail. Policy on financial market oversight, by way of contrast, was marked by
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hubristic detachment a cavalier lack of interest in the detail of financial market operations and a faith that everything was probably all right. This may have been due to a perception that the right kind of people were in charge of key banking institutions, and so it is important not to forget the lessons of Milibands (1969) classic study of the UK capitalist state which emphasized the importance of social ties. But perhaps more pertinent is the growth of a broader culture of government in an organizational and institutional setting which weakened political control and democratic accountability. It is possible to identify two key institutional developments which empowered hubristic modes of leadership after the 1980s at a political and regulatory level, and which contributed significantly to the crisis in the late 2000s. First, senior politicians became increasingly detached from events in financial markets due to the dual process of centralization and devolution that allowed political leaders to concentrate on big picture strategy, leaving tedious evidence and detail to subordinate technicians. The delegation of economic policy decisions such as interest rate setting, financial regulation and trade policy to a newly empowered technocratic elite had the effect (superficially, at least) of depoliticizing economic decision-making by moving it beyond the reach of democratic control (Peck & Tickell, 2002). The result was a political elite na ve to the developments in financial markets but happy to ride the bubble, while technocrats pondered the detail but lacked the will and initiative to intervene without any political steer. Second, the emphasis on controlling inflation, as the principal concern of economic management, removed checks and balances and encouraged hubristic detachment at the top of key regulatory institutions. Gordon Browns 1997 decision to devolve interest rate setting to the Bank of England with a remit to keep inflation below 2 per cent empowered the Banks Monetary Policy division at the expense of the Financial Stability division, who also ceded banking and securities oversight duties to the newly created FSA. This unbalanced the Bank of England by recalibrating internal status hierarchies around monetary concerns and expertise within the institution (see also Pomerleano, 2010), and also encouraged stronger divisions between what, following Dunleavy (1980), we might term organizational elites and professional experts. The new monetary policy remits drew the Governor, Mervyn King, and other senior Bank employees into elite policy-making circles in Whitehall, producing a new cadre of senior organizational operators connected to key opinion formers, politicians and their advisors. This led to increasing hubris as Kings speeches adopted the trite, reassuring language and bland generalities that are normally the preserve of a front bench politician:
Securitisation is transforming banking from the traditional model in which banks originate and retain credit risk on their balance sheets into a new model in which credit risk is distributed around a much wider range of investors. As a result, risks are no longer so concentrated in a small number of regulated
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institutions but are spread across the financial system. That is a positive development because it has reduced the market failure associated with traditional banking the mismatch between illiquid assets and liquid liabilities that led Henry Thornton and, later, Walter Bagehot to promote the role of the Bank of England as the lender of last resort in a financial crisis. (King, 2007)
If hubris dominated Bank of England decision-making, examples of ineptitude, casualness and a more general lack of professional scepticism are reported about the operations at the FSA (e.g. Financial Times, 11 October 2007, 12 November 2008; and see also FSA, 2008). Such ineptitude is conservatively understood as the result of the low levels of remuneration and poor recruitment at the FSA, but the lack of rigorous oversight cannot be entirely divorced from the general political pressures that emanated from the practice of light touch regulation and the confidence of key operators like King about the benefits of market self-regulation. In many ways the assertive connection in elite policy circles between non-inflationary growth and laissez faire financial markets meant the Bank and the FSA, while often organizationally divorced, were ideologically united in deferring to the metis of the markets. The paradox is that hubristic detachment is in part the result of a division of labour between politicians and technocrats which empowered a new style of organizational expert like Mervyn King, who failed to engage with the detail of financial innovation. But this is not to imply that re-engagement would have prevented crisis, though arguably it may have made us more prepared as credit markets faltered. The more fundamental problem is not knowledge gaps which can be solved through reorganization or socio-technical interventions, but knowledge limits which are written into the DNA of financial innovation when it takes the form of bricolage. The nature of financial innovation sets practical limits on the capacity of outside experts to understand and manage finance, even with new data or different conceptual approaches. The aim of reform should be to render finance amenable to technical controls, but that in turn requires a fundamentally new compact between civil society and its politicians and regulators, and a transformative technical agenda which seeks to shrink finance and bring it back under democratic control.
Conclusion Our argument is that we are not living through a financial crisis caused by some isolated socio-technical malfunction which experts can identify and fix. We are living through compounding political disasters, the product of an elite debacle, that come after a massive misjudgement about the character and consequences of financial innovation. Technocratic elites and their political sponsors have failed in their first duty as public servants, to protect the citizenry from predatory capitalist business which privatizes its gains and
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socializes its losses. The interim result is public expenditure cuts that are beginning to bite in countries like the UK, and bailouts of Greece and Ireland that have failed to stabilize the Eurozone. The future may be one of intensifying intra-national and international distributive conflict, with unpredictable political consequences. But if such grand harm was permitted by detached politicians and regulators, it is too much to suppose that they can now make things better by improving their technical capacity to monitor, understand and steer financial activity. Their earlier hubristic misjudgements have had semipermanent, hard to reverse consequences. The political belief in the social value of growth in financial services will not disappear overnight, nor will the blind faith in free markets, because they are deeply engrained culturally and ideologically. Institutionally, the triangular relation between finance, technocracy and elected politicians is one where the ostensibly independent technocrats and politicians are hostages of a financial sector that produces valuable exports but also dangerous liabilities. Under such conditions the issue is not a technical one about preventing future crises, but a democratic issue about public control of our economic and social futures. Against this background the analysis in this paper should be read more as an attempt to clarify the problem and open out debate. That debate must begin by asking a different question from the one that currently dominates current academic and policy documents: how do we fix finance and prevent future crisis? Instead we should begin by debating how to bring finance under democratic control. This would require at least three levels of intervention. At a basic level it would involve greater public accountability of politicians and regulators, and new structures put in place for more effective checks and balances. Certainly this might include the use of cultural translators working within the banks as Tett (2010) proposes, but more importantly it would mean greater public engagement and representation on those bodies with oversight responsibilities. For example, if trades union members working within the retail banks had been asked about the kinds of mortgages they were offering to clients and their possible downsides, alarm bells might have sounded earlier. Second, the principle of shrinking finance would require some sociotechnical interventions. The logic of our analysis of financial innovation as bricolage and of the problems associated with volume, opacity and interconnectedness suggests policies that limit the volume of financial transactions which bind bank exposures together in unpredictable ways. To do this we would like to see a greater proportion of all financial transactions brought onto an exchange with onerous regulations about margin requirement and also for a Tobin-style tax to be applied to each transaction. This would not only render many of the speculative transactions unprofitable and thus reduce volume, but would also build up a fund from which more productive investments could be used. This has advantages over the often-mooted partition or separation of retail and wholesale activities which rests on the double misconception that wholesale markets can be allowed to seize or blow up and that wholesale traders
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know what they are doing. Knowledge failure in densely interconnected wholesale markets caused the last crisis, not moral hazard. An appropriate response to the crisis must, therefore, be radical, both in developing knowledges that can challenge orthodoxies and embedded elite groups and in facilitating control of finance in ways that reduce the possible impact of future crises, as well as their likelihood. These ambitions underline that this is, above all, a democratic issue.
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Ewald Engelen is Professor of Financial Geography at the University of Amsterdam. His interests range from migration and the welfare state to
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shareholder value and corporate governance. He is currently directing a research project on the decline of the Amsterdam nancial centre after nancialization. Ismail Ertu rk is Senior Lecturer in Banking at Manchester Business School and a member of the Centre for Research in Socio-Cultural Change (CRESC) at the University of Manchester. His current research interests include corporate governance, emerging markets and the reinvention of banking. Recent books include Financialization at Work (2008) and CRESCs Alternative Banking Report (2009). Julie Froud is Professor of Financial Innovation at Manchester Business School and a member of the Centre for Research in Socio-Cultural Change (CRESC) at the University of Manchester. Her current research interests include elites and nancialization. Recent books include Financialization at Work (2008) with Ismail Ertu rk et al. and Financialization and Strategy (2006) with Adam Leaver et al. Sukhdev Johal is a Reader in the Management School at Royal Holloway. His expertise is in social and economic statistics. He is currently working on British manufacturing and the national business model and was responsible for argument and exhibits in CRESCs Alternative Banking Report and Working Paper 75 on the national business model. Adam Leaver is Senior Lecturer at Manchester Business School and a member of the Centre for Research in Socio-Cultural Change (CRESC) at the University of Manchester. His research interests in nancialization include new actors such as hedge funds as well as analysis of the lm and music industries. Recent books include Financialization at Work (2008) with Ismail Ertu rk et al. and Financialization and Strategy (2006) with Julie Froud et al. Michael Moran is Mackenzie Professor in the Politics Department at the University of Manchester. His current research focuses on the politics of the nancial crisis from 2007. Recent publications include The British Regulatory State (2007) and articles on the politics of nancial regulation and reform, including a contribution to the 2011 Socialist Register. Karel Williams is Convening Director of the Centre for Research in SocioCultural Change (CRESC) at the University of Manchester and Professor at Manchester Business School. His current research interests include nancial elites and the politics of nancial crisis. Recent books include Remembering Elites (2008) with Mike Savage and Financialization at Work (2008) with Ismail Ertu rk et al.

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Economy and Society Volume 41 Number 3 August 2012: 360 382

Misrule of experts? The nancial crisis as elite debacle

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