2 . The Darwinian Economy

The Deregulation Illusion

What is the biggest problem facing the world economy today? To listen to some people, you might think the correct answer is insufficient financial regulation. According to a number of influential commentators, the origins of the financial crisis that began in 2007 – and still does not seem to be over – lie in decisions dating back to the early 1980 s that led to a substantial deregulation of financial markets. In the good old days, we are told, banking was ‘boring’. In the United States, the Glass–Steagall Act of 1933 separated the activities of commercial and investment banks until its supposedly fateful repeal in 1999 .

‘Reaganera legislative changes essentially ended New Deal restrictions on mortgage lending,’ the Princeton economist Paul Krugman has written. ‘It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life …’ It was ‘also mainly thanks to Reaganera deregulation’ that the financial system ‘took on too much risk with too little capital’.1 In another of his newspaper columns, Krugman looked back fondly to a ‘long period of stability after World War II’. This was ‘based on a combination of deposit insurance, which eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both limits on risky lending and limits on leverage, the extent to which banks were allowed to finance investments with borrowed funds’.2 It was indeed a golden age: the ‘era of boring banking was also an era of spectacular economic progress’.3 ‘Overall business productivity in America grew faster in the postwar generation, an era in which banks were tightly regulated and private equity barely existed, than it has since our political system decided that greed was good.’4

Krugman is by no means a lone voice. Simon Johnson has written a devastating account of financial recklessness in his book Thirteen Bankers.5 Even Chicago’s Richard Posner has joined the chorus calling for a restoration of Glass – Steagall.6 To cap it all, the architect of the behemoth Citigroup, Sandy Weill himself, has now recanted.7 The wirst draft of the history of the financial crisis is in, and here is what it says: deregulation was to blame. Unfettered after 1980, financial markets ran amok, banks blew up and then had to be bailed out. Now they must be fettered once again.

As will become clear, it is not my purpose to whitewash the bankers. But I do believe this story is mostly wrong. For one thing, it is hard to think of a major event in the US crisis – beginning with the failures of Bear Stearns and.Lehman Brothers – that could not equally well have happened with Glass – Steagall still in force. Both were pure investment banks that could equally well have been mismanaged to death before 1999 . The same goes for Countrywide, Washington Mutual and Wachovia, commercial lenders that blew up without dabbling in investment banking. For another, the claim that the economic performance of the US economy before Ronald Reagan was superior to what followed because of the tighter controls on banks before 1980 is simply laughable. Productivity certainly grew faster between 1950 and 1979 than between 1980 and 2009 . But it grew faster in the 1980s and 1990s than in the 1970s. And it consistently grew faster than in Canada after 1979 . Unlike Paul Krugman, I think there were probably a few other factors at work in the changing productivity growth of the past seventy years: changes in technology, education and globalization are among those that spring to mind. But if I wanted to make his kind of facile argument I could triumphantly point out that Canada retained a far more tightly regulated banking system than the US – and as a result lagged behind in terms of productivity.

To a British listener, if not to an American, there is something especially implausible about the story that regulated financial markets were responsible for rapid growth, while deregulation caused crisis. British banking was also tightly regulated prior to the 1980s. The old City of London was constrained by an elaborate web of traditionalguildlike restrictions. The merchant banks – members of the august Accepting Houses Committee – concerned themselves, at least notionally, with accepting commercial bills and issuing bonds and shares. Commercial or retail banking was controlled by a cartel of big ‘high street’ banks, which set deposit and lending rates. Within the Stock Exchange autonomous brokers sold, while jobbers bought. Over all these gentlemanly capitalists, the Governor of the Bank of England watched with a benign but sometimes stern headmasterly eye, checking ungentlemanly conduct with a mere movement of his celebrated eyebrows.8 On top of these conventions, a bewildering range of statutory regulations had been imposed before, during and after the Second World War. The 1947 Exchange Control Act strictly limited transactions in currencies other than sterling, controls that remained in place until 1979 . Even after the breakdown of the system of fixed exchange rates established at Bretton Woods, the Bank of England routinely intervened to influence the sterling exchange rate. Banks were regulated under the 1948 Companies Act, the 1958 Prevention of Fraud (Investments) Act and the 1967 Companies Act. The 1963 Protection of Depositors Act created an additional tier of regulation for deposittaking institutions that were not classified as banks under the arcane rules known as ‘Schedule 8’ and ‘Section 127’.9 Following the report of the 1959 Radcliff e Committee, which argued that the traditional tools of monetary policy were insufficient, a fresh layer of controls was added in the form of ceilings on bank lending.10 Consumer credit (which mainly took the form of ‘hire purchase’ or instalment plans) was also tightly regulated. Banks recognized as such by the Old Lady of Threadneedle Street were required to maintain a 28 per cent liquidity ratio, which in practice meant holding large amounts of British government bonds.

Yet there was anything but ‘spectacular economic progress’ in this era of financial regulation. On the contrary, the 1970s were arguably Britain’s most financially disastrous decade since the 1820s, witnessing not only a major banking crisis, but also a stock market crash, a real estate bubble and bust and doubledigit inflation, all rounded off by the arrival of the International Monetary Fund in 1976 . That era also had its Bernie Madoff, its Bear Stearns and its.Lehman Brothers – though who now remembers Gerald Caplan of London and County Securities, or Cedar Holdings, or Triumph Investment Trust? Admittedly, the secondary banking crisis was partly due to a botched change to banking regulation by the government of Edward Heath. But it would be quite wrong to characterize this as deregulation; if anything, the new system – named, significantly, ‘Competition and Credit Control’ – was more elaborate than the one it replaced. Moreover, egregious errors of monetary and fiscal policy were just as important in the crisis that followed. In my view, the lesson of the 1970s is not that deregulation is bad, but that bad regulation is bad, especially in the context of bad monetary and fiscal policy.11 And I believe the very same can be said of our crisis, too.

A Regulated Crisis

The financial crisis that began in 2007 had its origins precisely in overcomplex regulation. A serious history of the crisis would need to have at least five chapters on its perverse consequences:

First, the executives of large publicly owned banks were strongly incentivized to ‘maximize shareholder value’since their own wealth and income came to consist in large measure of shares and share options in their own institutions. The easiest way they could do this was to maximize the size of their banks’ activities relative to their capital. All over the Western world, balance sheets grew to dizzying sizes relative to bank equity. How was this possible? The answer is that it was expressly permitted by regulation. To be precise, the Basel Committee on Banking Supervision’s 1988 Accord allowed very large quantities of assets to be held by banks relative to their capital, provided these assets were classified as low risk – for example, government bonds.

Secondly, from 1996 the Basel rules were modified to allow firms effectively to set their own capital requirements on the basis of their internal risk estimates. In practice, risk weightings came to be based on the ratings given to securities – and, later, to structured financial products – by the private rating agencies.

Thirdly, central banks – led by the Federal Reserve – evolved a peculiarly lopsided doctrine of monetary policy, which taught that they should intervene by cutting interest rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not aff ect public expectations of something called ‘core’ inflation (which excludes changes in the prices of food and energy and wholly failed to capture the bubble in house prices). The colloquial term for this approach is the ‘Greenspan (later Bernanke) put’, which implied that the Fed would intervene to prop up the US equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumerprice inflation, and for some obscure reason not about houseprice inflation.

Fourthly, the US Congress passed legislation designed to increase the percentage of lowerincome families – especially minority families – that owned their own homes. The mortgage market was highly distorted by the ‘governmentsponsored entities’ Fannie Mae and Freddie Mac. Both parties viewed this as desirable for social and political reasons. Neither considered that, from a financial viewpoint, they were encouraging lowincome households to place large, leveraged, unhedged and unidirectional bets on the US housing market.

A final layer of market distortion was provided by the Chinese government, which spent literally trillions of dollars’ worth of its own currency to prevent it from appreciating relative to the dollar. The primary objective of this policy was to keep Chinese manufacturing exports ultracompetitive in Western markets. Nor were the Chinese the only ones who chose to plough their current account surpluses into dollars. The secondary and unintended consequence was to provide the United States with a vast credit line. Because much of what the surplus countries bought was US government or government agency debt, the yields on these securities were artificially held low. Because mortgage rates are closely linked to Treasury yields, ‘Chimerica’ – as I christened this strange economic partnership between China and America – thus helped further to inflate an already bubbling property market.

The only chapter in this history that really fits the ‘blame deregulation’ thesis is the nonregulation of the market in derivatives such as credit default swaps. The insurance giant AIG came to grief because its London office sold vast quantities of mispriced insurance against outcomes that properly belonged in the realm of uninsurable un -certainty. However, I do not believe this can be seen as a primary cause of the crisis. Banks were the key to the crisis, and banks were regulated.^c

This last point is important because figures as respected as Paul Volcker and Adair Turner have cast doubt on the economic and social utility of most, if not all, recent theoretical and technical advances in finance, including the advent of the derivatives market.12 I am rather less hostile than they are to financial innovation. I agree that modern techniques of risk management were in many ways defective – especially when misused by people who forgot (or never knew) the simplifying assumptions underlying measures like Value at Risk. But modern finance cannot somehow be wished away, any more than Amazon and Google can be abolished to protect the livelihoods of booksellers and librarians.

The issue is whether or not additional regulation of the sort that is currently being devised and implemented can improve matters by reducing the frequency or magnitude of future financial crises. I think it is highly unlikely. Indeed, I would go further. I think the new regulations may have precisely the opposite effect.

The problem we are dealing with here is not inherent in financial innovation. It is inherent in financial regulation. Private sector models of risk management were undoubtedly imperfect, as the financial crisis made clear. But public sector models of risk management were next to nonexistent. Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.13

The question for me is not ‘Should financial markets be regulated?’ There is in fact no such thing as an unregulated financial market, as any student of ancient Mesopotamia knows. The Scotland of Adam Smith had a lively debate about the kind of regulation appropriate to a papermoney system. Indeed, the founder of freemarket economics himself proposed a number of quite strict bank regulations in the wake of the 1772 Ayr Banking Crisis.14 Without rules to enforce the payment of debts and punish fraud, there can be no finance. Without restraint on the management of banks, some are very likely to fail in a downturn because of the mismatch between the durations of assets and liabilities that has been inherent in nearly all banking since the advent of the fractional reserve system. So the right question to ask is: ‘What kind of financial regulation works best?’

Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work. It puts me in mind of the great Viennese satirist Karl Kraus’s famous quip about psychoanalysis: that it was the disease of which it pretended to be the cure. I believe excessively complex regulation is the disease of which it pretends to be the cure.

Who Regulates the Regulators?

‘We cannot control ourselves. You have to step in and control [Wall] Street.’15 Those were the words of John Mack, former chief executive of the investment bank Morgan Stanley, speaking in New York in November 2009 . The legislators of the US Congress obliged Mr.Mack by producing the Wall Street Reform and Consumer Protection Act of July 2010 (henceforth the Dodd – Frank Act, after the names of its two principal sponsors in the Senate and House, respectively).

The rule of law has many enemies. One of them is bad law. Formally intended to ‘promote the financial stability of the United States by improving accountability and transparency in the financial system, to end“too big to fail” [institutions], to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes’, Dodd – Frank is a nearperfect example of excessive complexity in regulation. The Act requires that regulators create 243 rules, conduct 67 studies and issue 22 periodic reports. It eliminates one regulator and creates two new ones. It sets out detailed provisions for the ‘orderly liquidation’ of a Systemically Important Financial Institution (SIFI). It implements a soft version of the socalled Volcker rule, which bans SIFI s from engaging in ‘proprietary trading’, or sponsoring or owning interests in private equity funds and hedge funds. But that is not all.

Section 232 stipulates that each regulatory agency must establish ‘an Office of Minority and Women Inclusion’ to ensure, among other things, ‘increased participation of minorityowned and womenowned businesses in the programs and contracts of the agency’. Unless you believe, with the head of the International Monetary Fund, Christine Lagarde, that there would have been no crisis if the bestknown bank to fail had been called ‘Lehman Sisters’ rather than Lehman Brothers, you may well wonder what exactly this particular section of Dodd – Frank will do to ‘promote the financial stability of the United States’. The same goes for Section 750, which creates a new Interagency Working Group, to ‘conduct a study on the oversight of existing and prospective carbon markets to ensure an efficient, secure, and transparent carbon market’, and Section 1502, which stipulates that products can be labelled as ‘DRC conflict free’ if they do not contain ‘conflict minerals that directly or indirectly finance or benefit armed groups in the Democratic Republic of the Congo or an adjoining country’. Conflict diamonds are bad, of course, as are race and sex discrimination, not forgetting climate change. But was this really the appropriate place to deal with such things?

Title II of Dodd – Frank spends nearly eighty pages setting out in minute detail how a SIFI could be wound up with less disruption than the bankruptcy of Lehman Brothers caused. But in the final analysis what this legislation does is to transfer ultimate responsibility to the Treasury Secretary, the Federal Deposit Insurance Corporation, the District of Columbia district court and the DC court of appeals. If the Treasury Secretary and the Federal Deposit Insurance Corporation agree that a financial firm’s failure could cause general instability, they can seize control of it. If the firm objects, the courts in Washington have one day to decide if the decision was correct. It is a criminal off ence to disclose that such a case is being heard. How this ex -traordinary procedure is an improvement on a regular bankruptcy is beyond me.16 Perhaps, on refiection, SIFI should be pronounced ‘sci-fi’.

As I have suggested, it was the mostregulated institutions in the financial system that were in fact the most disasterprone: big banks on both sides of the Atlantic, not hedge funds. It is more than a little convenient for America’s political class to have the crisis blamed on deregulation and the resulting excesses of bankers. Not only does that neatly pass the buck. It also creates a justification for more regulation. But the old Latin question is apposite here: quis custodiet ipsos custodes? Who regulates the regulators?

Now consider another set of regulations. Under the Basel III Framework for bank capital standards, which is due to come into force between 2013 and the end of 2018, the world’s twentynine largest global banks will need to raise an additional $ 566 billion in new capital or shed around $ 5.5 trillion in assets. According to the rating agency Fitch, this implies a 23 per cent increase relative to the capital the banks had at the end of 2011.17 It is quite true that big banks became undercapitalized – or excessively leveraged, if you prefer that term – after 1980 . But it is far from clear how forcing banks to hold more capital or make fewer loans can be compatible with the goal of sustained economic recovery, without which financial stability is very unlikely to return to the US, much less in Europe.

Lurking inside every such regulation is the universal law of unintended consequences. What if the net effect of all this regulation is to make the SIFI s more rather than less systemically risky? One of many new features of Basel III is a requirement for banks to build up capital in good times, so as to have a buffer in bad times. This innovation was widely hailed some years ago when it was introduced by Spanish bank regulators. Enough said.

Unintelligent Design

In the preceding chapter, I tried to show the value of Mandeville’s Fable of the Bees as an allegory of the way good

political institutions work. Now let me introduce a diff er-

ent biological metaphor. In his autobiography, Charles Darwin himself explicitly acknowledged his debt to the economists of his day, notably Thomas Malthus, whose Essay on the Principle of Population he read ‘for amusement’ in 1838. ‘Being well prepared’, Darwin recalled, ‘to appreciate the struggle for existence which everywhere goes on[,] from longcontinued observation of the habits of animals and plants, it at once struck me that under these circumstances favourable variations would tend to be preserved, and unfavourable ones to be destroyed. Here, then, I had at last got a theory by which to work.’ 18 The editor of the Economist Walter Bagehot was only one of many Victorian contemporaries who drew the parallel back from Darwin’s theory of evolution to the economy. As he once observed: ‘The rough and vulgar structure of English commerce is the secret of its life; for it contains the“propensity to variation”, which, in the social as in the animal kingdom, is the principle of progress.’ 19 We shall hear more from Bagehot below.

There are indeed more than merely superficial resemblances between a financial market and the natural world as Darwin came to understood it. Like the wild animals of the Serengeti, individuals and firms are in a constant struggle for existence, a contest over finite resources. Natural selection operates, in that any innovation (or mutation, in nature’s terms) will flourish or will die depending on how well it suits its environment. What are the common features shared by the financial world and a true evolutionary system? As I have argued elsewhere,20 there are at least six:

•‘genes’, in the sense that certain features of corporate culture perform the same role as genes in biology, allowing information to be stored in the ‘organizational memory’ and passed on from individual to individual or from firm to firm when a new firm is created;

•the potential for spontaneous ‘mutation’, usually referred to in the economic world as innovation and primarily, though by no means always, technological;

•competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist;

•a mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of underperformance – that is, ‘diff erential survival’ ;

•scope for speciation, sustaining biodiversity through the creation of wholly new ‘species’ of financial institutions;

•scope for extinction, with certain species dying out altogether.

Sometimes, as in the natural world, the financial evolutionary process has been subject to big disruptions in the form of geopolitical shocks and financial crises. The difference is, of course, that whereas giant asteroids come from outer space, financial crises originate within the system. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with ‘mass extinctions’such as the bank panics of the 1930s and the Savings and Loans failures of the 1980s. A comparably large disruption has clearly happened in our time. But where are the mass extinctions? The dinosaurs still roam the financial world.

The answer is that, whereas evolution in biology takes place in a pitiless natural environment, evolution in finance occurs within a regulatory framework where – to adapt a phrase from antiDarwinian creationists.–‘intelligent design’ plays a part. But just how intelligent is this design? The answer is: not intelligent enough to secondguess the evolutionary process. In fact, stupid enough to make a fragile system even more fragile.

Think of it this way. The regulatory frameworks of the post1980 period encouraged many banks to increase their balance sheets relative to their capital. This happened in all kinds of different countries, in Germany and Spain as much as in the United States. (We really cannot blame Ronald Reagan for what happened in Berlin and Madrid.) When propertybacked assets fell in price, banks were threatened with insolvency. When shortterm funding dried up, they were threatened with illiquidity. The authorities found that they had to choose between a Great Depression scenario of massive bank failures or bailing the banks out. They bailed them out. Chastened by ungrateful voters (who still do not appreciate how much worse things could have got if the ‘too big’ had actually failed), the legislators now draw up statutes designed to avoid future bailouts.

Dodd – Frank states clearly that taxpayers will not pay a penny the next time a SIFI goes bust. It is rather less clear about who will pay. Section 214 is (mercifully) unambiguous: ‘All funds expended in the liquidation of a financial company under this title shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through as -sessments.’ So what about secured creditors, the bank bondholders whom so much was done to protect from loss in 2008~9 ? Prudently, Dodd–Frank commissions a study on that one. After all, if the net effect of the legislation really is to rule out any public funding for a seriously bankrupt SIFI, it is hard to see how those bondholders can avoid a sizeable loss. But if that is the case, then the cost of capital for big banks must rise, even as their return on equity is going down. You wanted to reduce instability, but all you did was increase fragility.

Another and related way of thinking about the financial system is as a highly complex system, made up of a very large number of interacting components that are asymmetrically organized in a network.21 This network operates somewhere between order and disorder – on ‘the edge of chaos’. Such complex systems can appear to operate quite smoothly for some time, apparently in equilibrium, in reality constantly adapting as positive feedback loops operate. But there comes a moment when they ‘go critical’. A slight perturbation can set off a ‘phase transition’ from a benign equilibrium to a crisis. This is especially common where the network nodes are ‘tightly coupled’. When the interrelatedness of a network increases, conflicting constraints can quickly produce a ‘complexity catastrophe’.

All complex systems in the natural world – from termite hills to large forests to the human nervous system – share certain characteristics. A small input to such a system can produce huge, unanticipated changes. Causal relationships are often nonlinear. Indeed, some theorists would go so far as to say that certain complex systems are wholly nondeterministic, meaning that it is next to impossible to make predictions about their future behaviour based on past data. Will the next forest fire be tiny or huge, a bonfire or a conflagration? We can’ t be sure. The same ‘power law’ relationship seems to be apply to earthquakes and epidemics.22

It turns out that financial crises are much the same. And this shouldn’ t surprise us. As heterodox economists like W. Brian Arthur have been arguing for years, a complex economy is characterized by the interaction of dispersed agents, a lack of any central control, multiple levels of organization, continual adaptation, incessant creation of new market niches and no general equilibrium. Viewed in this light, as Andrew Haldane of the Bank of England has argued, Wall Street and the City of London are parts of one of the most complex systems that human beings have ever made (see Figure 2.1).23 And the combination of concentration, interbank lending, financial innovation and technological acceleration makes it a system especially prone to crash. Once again, however, the diff erence between the natural world and the financial world is the role of regulation. Regulation is supposed to reduce the number and size of financial forest fires. And yet, as we have seen, it can quite easily have the opposite effect. This is because the political process is itself somewhat complex. Regulatory bodies can be captured by those whom they are supposed to be regulating, not least by the prospect of wellpaid jobs should the gamekeeper turn poacher.

Figure 2.1 Network connectivity balloons for the international financial system

Source: Andrew Haldane, Bank of England (see note 23 for full reference).

They can also be captured in other ways – for example, by their reliance on the entities they regulate for the very data they need to do their work.

In his book Antifragile, the statistician and options trader turned philosopher Nassim Taleb asks a wonderful question: what is the opposite of fragile? The answer is not ‘robust’ or ‘strong’, because those words simply mean less fragile. The true opposite of fragile is ‘antifragile’. A system that becomes stronger when subjected to perturbation is anti-fragile.24 The point is that regulation should be designed to heighten antifragility. But the regulation we are contemplating today does the opposite: because of its very complexity – and often selfcontradictory objectives – it is profragile.

Lessons from Lombard Street

Overcomplicated regulation can indeed be the disease of which it purports to be the cure. Just as the planners of the old Soviet system could never hope to direct a modern economy in all its complexity, for reasons long ago explained by Friedrich Hayek and Janos Kornai,25 so the regulators of the postcrisis world are doomed to fail in their eff orts to make the global financial system crisisfree. They can never know enough to manage such a complex system.

They will only ever learn from the last crisis how to make the next one.

Is there an alternative? I believe there is. But I believe we need to go back to the time of Darwin to find it. In Lombard Street, published in 1873, Walter Bagehot described with great skill the way in which the City of London had evolved in his time. Bagehot understood that, for all its Darwinian vigour, the British financial system was complex and fragile. ‘In exact proportion to the power of this system’, he observed, ‘is its delicacy.– I should hardly say too much if I said its danger..fieven at the last instant of prosperity, the whole structure is delicate. The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.’ 26

No one has ever given a better description of how a bank run happens than Bagehot; those unfamiliar with Lombard Street had to find out for themselves in 2007, at the time of the runs on Northern Rock and Countrywide, and again in 2012, when it was the turn of the Spanish Bankia to lose the confidence of its depositors. One of the great beauties of Lombard Street is the way it surveys all the key institutions of the London money market – the ascendant jointstock banks, the waning private banks, the bill brokers, the new savings banks – and exposes the weakness in the position of each. In theory, Bagehot would have preferred a system in which each institution had to look to itself by maintaining a reserve against contingencies. But in practice the London market had evolved in such a way that there was only one ultimate reserve for the entire City and that was the Bank of England’s: ‘the sole considerable unoccupied mass of cash in the country’.27 As in our time, in other words, the central bank (and, behind it, the government that called it into being) constituted the last line of resistance in time of panic.

By reviewing half a century of financial crises, Bagehot brilliantly showed how the Bank of England’s role as custodian of the nation’s cash reserve was quite different from its role as defined by statute or, indeed, as understood by the men running it. In the 1825 panic the Bank had done the right thing, but much too late in the day, and without knowing quite why it was the right thing. In each of the three panics that followed the passage of the Bank Charter Act of 1844 – a piece of legislation which was largely concerned with the Bank’s noteissuing function – the Act had been suspended. There was, as in our time, uncertainty about which securities it would accept as collateral in a crisis. The Bank’s governance structure was opaque. Its governor and directors were themselves not bankers. (In those days they chose merchants; nowadays we prefer academics – which not everyone would regard as an improvement.) They barely coped when a SIFI called Overend Gurney blew up in 1866.

Bagehot’s remedies were clearcut, though I believe they are very often misinterpreted. The famous recommendation was that in a crisis the central bank should lend freely at a penalty rate: ‘Very large loans at very high rates are the best remedy …’ 28 Nowadays we follow only the first half of his advice, in the belief that our system is so leveraged that high rates would kill it. Bagehot’s rationale was to ‘prevent the greatest number of applications by persons who do not require it’.29 Watching all banks, strong and weak alike, gorge themselves on today’s seemingly limitless supply of loans at nearzero rates, I see what he meant.

We also neglect the rest of what Bagehot said, and in particular the emphasis he laid on discretion as opposed to set rules. In the first place, he stressed the importance of having Bank directors with considerable market ex -perience. ‘Steady merchants’, he wrote, ‘always know the questionable standing of dangerous persons; they are quick to note the smallest signs of corrupt transactions.’ Executive power should be conferred on a new, fulltime deputy governor acting as a kind of permanent undersecretary. And the advisory Court should be selected so as ‘to introduce … a wise apprehensiveness’.30

Secondly, Bagehot repeatedly stressed, as he put it, ‘the cardinal importance of [the Bank of England’s] always retaining a great banking reserve’. But he was emphatic that the size of the reserve should not be specified by some automatic rule, the way the banknote circulation was under the 1844 Bank Charter Act: ‘No certain or fixed proportion of its liabilities can in the present times be laid down as that which the Bank ought to keep in reserve.’ The ideal central bank would target nothing more precise than an ‘apprehension minimum’, which ‘no abstract argument, and no mathematical computation will teach to us’ :

And we cannot expect that they should [he went on]. Credit is an opinion generated by circumstances and varying with those circumstances. The state of credit … can only be known by trial and inquiry. And in the same way, nothing can tell us what amount of ‘reserve’ will create a diff used confidence; on such a subject there is no way of arriving at a just conclusion except by incessantly watching the public mind, and seeing at each juncture how it is affected.31

Nor should there be predictability in the Bank’s discount rate, the rate at which it lent against goodquality commercial paper. The rule ‘that the Bank of England should look to the market rate and make its own rate conform to that … was … always erroneous’, according to Bagehot. The ‘first duty’ of the Bank was to use the discount rate to ‘protect the ultimate cash of the country’.32 This too of course implied a discretionary power, since the desirable size of the reserve was not specified by any rule.

There are some today, like Larry Kotlikoff and John Kay, who see the only salvation in a rootandbranch structural reform of our financial system: ‘narrow banking’ of some sort, if not the replacement of banks altogether.33 I can see the intellectual appeal of such arguments. In theory, perhaps it would be much better if big banks were chopped up, leverage ratios were drastically reduced and the interconnections between deposittakers and risktakers were reduced.34 But, like Bagehot, I take the world as I find it, and I do not expect to see in my lifetime a wholesale abandonment of the current model of ‘too big to fail’ institutions backstopped by the central bank and, if necessary, by the public purse. Our task, like Bagehot’s, is ‘to make the best of our banking system, and to work it in the best way that it is capable of. We can only use palliatives, and the point is to get the best palliative we can.’ 35

How to Encourage Bankers

‘The problem is delicate,’ as Bagehot candidly concluded his great work, and ‘the solution is varying and difficult.’ 36 It remains so today. But I believe a return to Bagehot’s first principles would not be a bad starting point. First, strengthen the central bank as the ultimate authority in both the monetary and supervisory systems. Second, ensure that those in charge at the central bank are ‘apprehensive’ as well as experienced, so that they will act when they see excessive credit growth and assetprice inflation. Third, give them considerable latitude in their use of the principal central banking tools of reserve requirements, interest rate changes and openmarket securities purchases and sales. Fourth, teach them some financial history, as Bagehot taught his readers.

Finally – a point Bagehot did not need to make because in his time it was a matter of course – we must ensure that those who fall foul of the regulatory authority pay dearly for their transgressions. Those who believe this crisis was caused by deregulation have misunderstood the problem in more than one way. Not only was misconceived re -gulation a large part of the cause. There was also the feeling of impunity that came not from deregulation but from nonpunishment.

There will always be greedy people in and around banks. After all, they are where the money is – or is supposed to be. But greedy people will only commit fraud or negligence if they feel that their misdemeanour is unlikely to be noticed or severely punished. The failure to apply regulation – to apply the law – is one of the most troubling aspects of the years since 2007. In the United States, the list of those who have been sent to jail for their part in the housing bubble, and all that followed from it, is risibly short. In the United Kingdom, the harshest punishment meted out to a banker was the ‘cancellation and annulment’ of the former Royal Bank of Scotland CEO Fred Goodwin’s knighthood.

Bagehot never got the powerful deputy governor that he proposed; instead the governor became the kind of permanent and powerful official Bagehot had envisaged. However, since being deprived of his regulatory role, which was handed to the Financial Services Authority by Gordon Brown, the governor has been in the unenviable position of running a monetary policy research department (combined recently with an emergency moneyprinting works). The Federal Reserve System, too, has no real teeth. The agencies supposed to prosecute fraud have performed miserably. The result is that very few malefactors have been brought to justice in a meaningful way.

I will cite just one of many possible examples. In October 2010 Angelo Mozilo reached a settlement with the Securities and Exchange Commission in which he agreed to pay $ 67.5 million in penalties and ‘disgorgements’ to settle civil fraud and insidertrading charges relating to his time as CEO of Countrywide, the failed mortgage lender. At least part of this fine was paid not by Mozilo himself but by Bank of America, which acquired Countrywide in the depths of the financial crisis, and by insurers. Between 2000 and 2008 Mozilo received nearly $ 522 million in total compensation, including sales of Countrywide stock: nearly ten times more than the fine.37 If there was nothing criminal in his conduct, it is surely only because the criminal law is defective in this area.

Voltaire famously said that the British periodically executed an admiral pour encourager les autres. All the detailed regulation in the world will do less to avert a future financial crisis than the clear and present danger in the minds of today’s bankers that, if they transgress in the eyes of the authority on whom their business ultimately depends, then they could go to prison. Instead of exhausting ourselves drawing up hopelessly complex codes of ‘macroprudential’ or ‘countercyclical’ regulation, let us go back to Bagehot’s world, where individual prudence – rather than mere compliance – was the advisable course, precisely because the authorities were powerful and the crucial rules unwritten.

I began this chapter by contradicting the proponents of stricter regulation, only to end it by advocating the exemplary incarceration of bad bankers. I hope it is now clear why these positions are not contradictory but complementary. A complex financial world will be made less fragile only by simplicity of regulation and strength of enforcement.

To repeat: among the most deadly enemies of the rule of law is bad law. The next chapter will consider at a more general level the ways in which the rule of law itself, broadly defined, has degenerated in Western societies – and especially in the United States – in our time. In the realm of regulation, as I have said, we ought to be going back to Bagehot. But has the rule of law in the Englishspeaking world inadvertently gone back to Dickens? Has the rule of law degenerated into the rule of lawyers?

c In the United States by (among other measures) the International Lending Supervision Act of 1983, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991.