Gordon Schücker

MK: So we’ve talked about how the financial system worked before the days of government intervention.

JG: Ah, then yes.

MK: Lender of last resort. And I think I came to the conclusion in the crisis that admirable though much of that might have been, we live in a world now where if there is a crisis, the government will step in as the insurer of last resort. If that is going to be the case, then it is very important that we diminish the moral hazard implied by that by making sure that the potential recipients pay an insurance premium before we get to that point in order to minimize the scale of the support that taxpayers have to provide.

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JG: Quote, “Can’t you do something or say something to relieve people’s minds? They have made up their minds that something awful is up, and they are talking of the very highest names, the very highest.” This is beseeching the bank– governor of the Bank of England. And here is what the governor of the Bank of England thought to himself. If I– maybe this is the– yeah. If I do nothing, and the crash comes, I shall never be forgiven. If I act and disaster never occurs, Parliament would never forgive me for having pledged the National Credit to a private firm. So is that what happened in 2007? Those your night thoughts in 2007?

MK: Well, certainly all of those issues came to the fore. I don’t think we faced a situation in which an institution in 2007 as significant as Barings was in the late 19th century was at risk. We had the Northern Rock episode. And Northern Rock was a very good example of an institution that had done nothing out of the ordinary in terms of the nature of its operations. But the scale of what it did was such as to mean that its business model basically came to an end when the mortgage-backed security market closed.

And to my mind, one of the most disturbing things about the Northern Rock episode was that the new internationally agreed capital standards, Basel II, which had just been introduced at the beginning of 2007, made it possible for Northern Rock to say, we’re the best capitalized bank in the UK. And it true, according to those standards. And it’s quite difficult, if you have a regulatory regime where everyone is supposed to follow these standards, to blame a bank for saying, we’ve– according to these standards, which you’ve told us we should use– we are well capitalized.

In fact, their leverage ratio was outrageously high. It’s something like 80 to 1. So the standards were clearly wrong and absurd. And that to my mind suggests that it makes no sense to pretend that ex ante, looking forward, that any of us are going to be able easily to work out an appropriate international regulatory standard which will see us through a crisis.

JG: In the day, it was up to the individual bankers and the stockholders, who of course had mostly, for the 19th century, had personal responsibility for the outcome of– certainly for the debt of the firm.

MK: Yes. And we’ve removed that, do you see? By putting in place– as long as banks take risks, which are similar to those being taken by other banks– so they know they’ll all be in the same boat– then basically banks will say, well, look, if the whole system gets into trouble, they’ll be forced to cover that.

JG: Well, Mervyn, when the music is playing, you have to get up and dance.

MK: Well, that’s the argument. And I think these are issues we still haven’t really really thought through.

JG: They’re still front and center, no?

MK: Yeah. And what we’ve done instead is to put in place something that’s absurdly complex and detailed.

JG: And arrogant to the extent that somebody in Basel or elsewhere is deciding that a certain kind of security ought to get a certain weight of risk. They’re not bearing the cost. I mean, these people are intelligent, well- educated, well-trained. They mean well, except isn’t it yet again the nth demonstration of the futility of top-down direction of people acting in markets?

MK: And trying to pretend that there is a scientific basis for forecasting–

JG: The pretense of knowledge.

MK: Yes, it is. And you know, the belief that we can somehow decide what assets really are risky and which are not. And even today, I find if you go back, everyone is not only too ready to say, but it was obvious that these things were too risky, or that things were done that were crazy, because you’re blaming people at the time.

But we wouldn’t have made that mistake, is the presumption behind that comment. But that’s always shown to be false with history. The real danger here lies in those people who say, we can decide today what the risk weights are for different kinds of assets. And that will, therefore, prevent us from having another crisis in future. It won’t.

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JG: But we have skipped over altogether a piece of early predictive machinery that is now, even today, I guess, situated in the boardroom of the Bank of England, which is a weather vane. Can you tell us– in conclusion, let us go back to things that work, Mervyn. Tell us about the weather vane.

MK: So this was installed in the 18th century, and it’s linked to–

JG: Can you describe it?

MK: Yeah, well, there’s a wind dial inside the courtroom of the bank, where the directors met, which shows the direction of the wind. And it’s linked to a weather vane on the roof of the Bank of England. So why did they want this? They wanted it because the direction of the wind determined when the ships could come up the Thames. If the wind was from the east, it would blow the sailing ships up the River Thames.

The cargo would be unloaded, and they needed then to ensure that there was sufficient money and credit to enable the merchants of the city of London to buy the cargoes from the ships. And when the weather– when the wind changed round to the west, from the westerly direction, the ships could then go back out again, and they could reduce the supply of money and credit. So the key indicator for determining the supply of money and credit was the direction of the wind.