Regulation was major cause of financial crisis, says David Davis

In a speech to the London-based Legatum Institute, on Thursday of last week, David Davis MP set out “thoughts about the causes of the economic crisis, our responses, and the future threats.” Key extracts are republished below.

The first simple fact is that the policy of the USA and UK allowed too much money into the economy, too cheaply, for too long.

“You are probably all familiar with Minsky, but as a reminder, he said that the longer the growth period, the more you stretch the economic cycle, the more successful the most high-risk and aggressive financial companies will be. Companies that borrow more, invest in riskier or lower quality assets, will do disproportionately well. This encourages an increase in the level of debt that is considered acceptable by all companies and by the financial marketplace in general. The increase in debt finance fuels an increase in asset prices. The longer the growth phase goes on, the more debt-ridden and riskier companies get, and the more overvalued and lower quality their asset base becomes. More and more money will flow to the apparently successful high-risk companies. In a strange, reverse-Darwinian process, the most fragile will flourish. Portfolios of debt financing poor quality investments will grow geometrically. As a result of this process, the longer the boom, the bigger will be the crash.  Quite why people needed Minsky to tell them this, I do not know. Charles Mackay was saying similar things in 1841 when he wrote his book, on the South Sea Bubble and the great tulip mania. It was called “Extraordinary Popular Delusions and the Madness of Crowds”. Keynes alluded to something similar… The point here is simple. Capitalism requires economic downturns to correct the risk profile of the economy and the accuracy of its asset pricing. Without that, the mechanism runs away, and we have an inevitable crash.   It is better that these corrections are frequent and small, rather than infrequent and disastrously large. Politicians must understand this and their economic strategy should accept the economic cycle as a way of balancing the finances of the economy. If central banks are given this task, they must manage asset price inflation and economy wide debt levels as part of their job.”

Second. The macro economic strategy was bad enough, but the well-intended actions of government made an already unstable financial sector even more fragile.

"We all know about the attempts at social engineering the housing market that was at the core of the subprime crisis.  Just as dangerous, however, the regulatory structure of banking actively encouraged the practises that we all now recognise as disastrous. The Basel  Accord was created in 1988, and was the backdrop for all the major national regulatory frameworks. It was modified a number of times up until it was replaced in 2008. It essentially defined and set the capital requirements for banks, how much capital you need, and how much debt you are allowed. We hear the phrase, “financial innovation”, a lot. From 1998 to 2008 a significant part of that so-called financial innovation was designed to game the system, to allow the banks to make the maximum amount of risky investment on the back of the minimum amount of capital. Each of the most famous and most dangerous innovations was a response to this pressure.

• Securitised mortgages and collateralised debt obligations - “CDOs” in the jargon - explicitly made risky assets look low risk, and reduced the bank capital that had to be used. This particularly applied after Basel I was modified early in this decade.
• Credit default swaps essentially “borrowed” the triple-A rating of companies like AIG to make loans look lower risk, by insuring against default.   This was to meet triple-A requirements under Basel.
• Putting risky investments off balance sheet into so-called structured investment vehicles, or SIVs, removed some risky investments from the calculation all together.

“…We need to simplify: build firewalls where possible within the financial network to prevent the spread of crises. We need to render the accounts of the financial system transparent and comprehensible. We probably need a structural solution. But most of all, we need to understand and act on the fact that if we incentivise people to misbehave, misbehave they will. And that is precisely what the regulatory system has done these past 20 years.”

Third. The next problem we will inherit from this crisis is the sheer size and burden of the state.

“Gordon Brown was massively increasing the size of the state before the credit crunch. Massive increases in the costs of welfare, health, education, and local government were the order of the day for the decade before the crunch. The Coalition is right to make cutting the deficit its top priority. Labour's Rake's Progress to national bankruptcy had to be brought to an end. We could not go on spending money we did not have. As former Treasury Chief Secretary Liam Byrne so concisely put it: “I am afraid there is no money.” Actually Mr Byrne rather understated the problem.  As he wrote his parting shot, the world's bailiffs were preparing to beat a path to our door.  Let me make it quite clear. It would have been immoral for the Government to load yet more debt on future generations to repay. And it would have been economically illiterate. David Cameron and George Osborne should be congratulated for having the courage to grasp this nettle so decisively and so immediately.”

“An even bigger challenge faces this Government. We cannot be defined by a purely cuts agenda. If the only message the public takes away from the events of the next few months and years is one of retrenchment and loss of services, politically, at least, we will have failed. We need a more positive narrative than only simply of endless and painful retrenchment. We need to rediscover the case for growth _ and make it loud and clear across the land. Higher spending, higher borrowing, a bigger and more intrusive state has been tested to destruction… One of the most pernicious things about the Brown binge is that it was designed to create a dependency state, both politically and economically. In political terms he created handouts that he explicitly challenged the Tories to say that they would withdraw, from Christmas bonuses to child endowment funds. Even worse, he created welfare systems that discouraged work, and as a result were designed to ratchet up and progressively create a bigger and bigger load on fewer and fewer [overburdened] taxpayers.  This has explicit implications for George Osborne in his round of cuts. There will be occasions when he has to choose between easy, immediate cuts in spending, or transforming the system to ensure that the political and economic pressures lead to long term lower spending. The obvious area where this is contentious is in Iain Duncan Smith's welfare budget. Optimal state arguments on this are clear. We should always favour the long term reduction over the short term.”

We need to take a long term view of the structure of our economy and its potential for growth.

“We need to create a million jobs all over again _ but not by expanding the state_s bloated payroll. We need to create more entrepreneurs _ people who will risk their money and their reputation on a wealth creating idea. Most of our future expansion will start at least in niche markets.  So we need to help small and medium sized firms expand. We have about one million small firms in Britain. If only half of them took on two more workers in the next year, that_s an extra one million jobs. But help is not some box-ticker from Whitehall or the Town Hall. Help means lower business taxes, less red tape, less wealth-destroying interference from officialdom. And we need to teach our young people the economic facts of life. Fewer and fewer can expect to work for big firms employing thousands of people. More and more should expect to set up their own companies and join the wealth-creating classes. We need an active agenda for growth. We need to believe in markets again. Free enterprise. Low taxation. Only that way can we turn the tide.”