Tuesday, 28 July 2009

Answering a Royal question

It seemed a simple enough question at the time, back in last November at the opening of a new building at the London School of Economics: “Why”, Her Majesty Queen Elizabeth II asked the distinguished economists about the world financial crisis, “did nobody notice it?” Professor Luis Garicano, director of research at the London School of Economics’ management department, did his best.

The London Daily Telegraph reported at the time that Prof Garicano told the Queen: “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing.” It was hardly a startling explanation and the Monarch, whose private wealth is estimated at £320million by Forbes magazine, including a personal investment portfolio valued at £100million, appeared unimpressed. Normally not one to express a public opinion about a controversial matter she was heard to describe the turbulence on the markets as “awful”. Portfolio losses tend to affect investors with a churlishness like that.

With the honour of their profession so clearly challenged, the economists of the LSE called in reinforcements to attempt a more definitive response. The content of a suitable reply was discussed at a special seminar conducted at the British Academy in June that was attended by economic heavyweights including Treasury permanent secretary Nick MacPherson, Goldman Sachs chief economist Jim O’Neill, Observer economics columnist William Keegan, Paul Tucker, deputy governor of the Bank of England, Vernon Bogdanor, the constitutional expert from Oxford University, and HSBC’s chief economist, Stephen King. LSE professor Tim Besley, a member of theBank of England monetary policy committee, and the eminent historian of government Peter Hennessy were given the drafting role to explain the “psychology of denial” that gripped the financial and political world in the run-up to the crisis.

With all the benefits that hindsight can bring, the three-page missive from the group of eminent economists explains to Her Majesty that there was “a failure of the collective imagination of many bright people”. As explained in the letter, extracts from which werepublished in the Observer on Sunday, that as as low interest rates made borrowing cheap, the “feel good factor” masked how out-of-kilter the world economy had become beneath the surface, with some countries, such as the US, running up enormous debts by borrowing from others, including China and the oil-rich Middle Eastern states, that were sitting on vast piles of cash.

Despite these yawning imbalances, they say, “financial wizards” managed to convince themselves and the world’s politicians that they had found clever ways to spread risk throughout financial markets — whereas “it is difficult to recall a greater example of wishful thinking combined with hubris”.

Everyone seemed to be doing their own job properly on its own merit. And according to standard measures of success, they were often doing it well,” they say. “The failure was to see how collectively this added up to a series of interconnected imbalances over which no single authority had jurisdiction.”

That meant when the reckoning came it was extreme, starting in summer 2007 and culminating in the near-collapse of the entire world financial system after the bankruptcy of Lehman Brothers last autumn.

In summary, Your Majesty,” they conclude, “the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole.”

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