I'm a bit of a fan of the medical TV series House. The brilliant main doctor, Gregory House, himself disabled as a result of a misdiagnosis, is typically very keen on the idea that the complicated disorders he investigates cannot be treated successfully unless they are diagnosed accurately. Other characters often urge that the situation is desperate and Something Must be Tried, but House backs himself to diagnose accurately, except as an absolute last resort when time runs out. Often in the show, the need to try something dominates and many treatments are tried based on misdiagnosis. Such treatments often make things worse - either by actively harming the patient or by preventing accurate diagnosis.
I raise this because at the moment I believe there are two very important misdiagnoses going on in respect of the financial sector crisis. These misdiagnoses are leading to actions liable to temporarily cover up the true nature of problems or actively to make things worse. Here are the two I mean:
- The view that the financial sector's key problem is that it has become undercapitalised (or in some cases insolvent) as a result of losses from past bad loans.
- The view that regulation failed to prevent this crisis because it was implemented poorly.
Let me take these in turn. I do not doubt for a moment that there have been bad loans made in the past that have to large losses, rendering many financial institutions undercapitalised or insolvent. But the error is to think that this is a matter of history, that if only we could get banks to not be silly in their lending practices now they would all be fine except for the burden of these past losses, so that capital injections can save them. I have argued many times before that I consider this a serious error of diagnosis. In my view the correct diagnosis is that much of the financial sector will not generate sufficient profits in the future to pay off loans taken out in the past (it isn't just that they made bad loans, it is that they themselves are poor risks qua borrowers) and that other parts will not generate profits at all. If I am correct, then unless there is significant restructuring of the sector (some is going on, but not nearly enough yet) then future losses will wipe out the governments' capital injections. Institutions with future profitability crises cannot be saved by capital injections except insofar as these are used to buy time for restructuring.
I know I have said this before many times, but I do not believe that many opinion formers have understood the point up to now. I certainly believe that governments should face much more challenge on this issue - on what basis does our government believe that the UK's government-dependent financial institutions will, without significant restructuring, be in a position to honour their debts? If they won't ever be able to honour their debts without significant restructuring, why are we giving them vast sums of money so that they can lose it all in ongoing unviable businesses? Indeed, worse than that, why is our government urging these institutions to engage in ever more unprofitable business at the expense of potentially-profitable competitors? (For remember, when you subsidize a loss-making company in a competitive environment, you don't simply lose money - you also risk bankrupting rivals that ought to be taking over the business of the failed firm and thereby increasing their profits.)
Second misdiagnosis: regulation. We see this diagnosis all around. There are lots of personal criticisms of the FSA or of Mervyn King or Alan Greenspan, as if somehow all the world's financial regulators and central banks, quite by chance, happened to be incompetent at the same time. I see criticisms of the boards of banks, as if they were all morally culpable or personally incompetent. One thinks: "Isn't that an amazing coincidence, that we get all these negligent on incompetent people turning up at the same time in such senior positions?" This is so self-evidently silly, it's astonishing that the angle gets any airtime at all. A marginally less silly, but still badly flawed angle is the claim that financial regulation was too light touch (some say that "light touch became soft touch"). But this remains a claim about implementation, not strategy. The contention is that the regulatory approach was broadly correct; it just wasn't done very well in practice.
No. A crisis on this scale, as widespread as this, is not to be diagnosed in terms of a bit of an error here, not quite tough enough there, rather incompetent at this, somewhat negligent at that. Surely it must be manifest to any disinterested observer that there was something wrong with the strategy, not the implementation of that strategy. As I have urged before, my view is that the whole regulatory approach of the past twenty years has been badly flawed. It is clear now (some of us complained earlier, but I think none of us thought matters would turn out this badly) how foolishly hubristic regulation has been. The strategy has been to try to replace, almost throughout the system, personal responsibility for assessing the risks we take on when we buy financial products and the value that they have to us - to replace this personal responsibility (caveat emptor!) with regulatory badging, particularly through financial regulators but also through ratings agencies.
We have taken the view that appointed "experts" were the people to understand how sound companies were or what were the pros and cons of new products we hadn't seen before. But that strategy was flawed. Much political and journalistic comment is along the lines that it just wasn't done well enough - that, somehow, if we'd only paid FSA staff rather more or had more of them or got them to think about this or that issue more then all would have been well. Do we really believe that? Of course, with the benefit of hindsight we can always see detailed mistakes made in the past. But was it merely a matter of detail? Surely it must be obvious that this is to look at the surface - it's chasing the symptoms, not properly diagnosing the disorder! If we misdiagnose here - if we set up grander, more invasive, more "tough love" regulators and regulations in the future - that will make the next such crisis worse. For no regulator can hope to understand the value of every new financial innovation, or anticipate the unanticipatable implications of new and complex processes. Redoubling our efforts to make regulatory badging work as a strategy - driving caveat emptor out even more - will be the piling of hubris upon nemesis.
Misdiagnosis could well harm the patient more, not make her better. Accurate diagnosis permits a cure of that disease. Of course one day we will become sick with something else, and we all die in the end. sic transit gloria mundi. But let's diagnose today's disorder correctly and deal with tomorrow's problem tomorrow.