G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj The Political Quarterly, Vol. 85, No. 4, October–December 2014 DOI: 10.1111/j.1467-923X.2014.00000.x Crises and Paradigm Shift STUART P. M. MACKINTOSH Abstract Crises can force leaders and technocrats together, highlight failures and, more rarely, precipitate changes in ideological worldview and the prevailing consensus. In 2007–8, the worst financial and economic crises since the Great Depression of 1929 caused a paradigm shift in financial and regulatory ideology. G20 leaders and central bankers reasserted collective power and authority over financial markets and global banks to an extent and in a manner not seen since the collapse of the Bretton Woods system in 1971. The retreat of state authority reversed direction. The spell of the ‘mystical Anglo-Saxon model of liberalisation and deregulation’ was broken. In 2014 the paradigm shift is still underway and still under attack by recalcitrant bank CEOs and their lobbyists, but the shift may be durable—signalling a major change in international regulation of the world’s largest financial markets and firms. Keywords: financial crisis, paradigm shift, international re-regulation, state power In 1543 an obscure Polish canon lay dying in his bed. As he slipped from the world he was concerned about the imminent publication of a book on which he had laboured for decades. This work, the ramifications of which had so disturbed him that he had for a long time refused to publish it, despite the urging of his small circle of friends and admirers, had just been printed and first copy lay by his bedside. Shortly after his death, the book—On the Revolutions of Heavenly Spheres,1 by Nicolaus Copernicus—would lead to the replacement of a geocentric view of the universe, with the earth static at the centre and the planets revolving around the globe, with a heliocentric view, in which the earth and planets revolved around the sun. Copernican theory, confirmed by observations by Brahe, Kepler and Galileo, was what Thomas Kuhn2 identified as a paradigm shift in worldview. But the full significance of the new theory was not immediately apparent. The true magnitude of Copernicus’s observations only gradually became clear with the passage of time, when ultimately there was a total rejection of the prior, erroneous Aristotelian view. Just as in science, economic, ideological and regulatory paradigm shifts are comparatively rare events, with long periods of small incremental adjustments to the status quo interrupted by gradually increasing numbers of unexplainable anomalies, and ultimately a sudden crisis 406 and disruptive jump in the consensus as a new theory and practices takes hold. Today, six years after the worst financial and economic crises since the Great Depression of 1929, I detect that a paradigm shift in financial and regulatory ideology is underway. States are reasserting their collective power and authority over financial markets and global firms to an extent and in a manner not seen since the collapse of the Bretton Woods system in 1971 and the closure of the gold window by President Nixon. The retreat of the state authority that Susan Strange3 described in the 1990s has reversed direction. The spell of the ‘mystical Anglo-Saxon model of liberalization and deregulation’ 4 has been broken. As the late Tommaso Padoa-Schioppa observed: ‘If the years before the crisis were years of over-reliance on markets and mistrust in government—or, more simply put, too much market and too little government— what we have seen in 2008 and 2009 has been a spectacular comeback of government.’ 5 Changing paradigms is never easy In 2014 a shift in worldview and policies is underway—is being constructed, strengthened, and defended. As such, the shift is not necessarily equally strong in all aspects, or equally visible to every observer of the financial crisis and its aftermath. That is to be # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 Published by John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj expected, for paradigm shifts take time to become solid, durable, and widely recognized as such. What is underway is a major change in the balance of power between states and financial markets, and this process has parallels to Margaret Thatcher’s victory and the ideological and policy response begun in 1979. Margaret Thatcher came to power during an economic crisis of stagflation, which coincided with a fracturing within the Labour party. The economic crisis and failures of the Labour party government helped precipitate regime change in the Conservative party and in the House of Commons. But at the outset, and indeed even some years later, relatively few observers suggested that Thatcher’s ideology and approach would fundamentally change the politics, economics and civic culture of Britain—yet, with the benefit of greater temporal distance, the Thatcherite revolution is now widely recognised and is seen a key lasting shift in the politics and governance of Britain. Just such a process is becoming visible in the reforms in response to the financial crisis, with major policy changes underway—but perhaps, at least upon a first cursory glance, they do not appear as dramatic as is the case when viewed from a greater distance and taken as a whole. As in other previous ideological and economic cycles, the existing worldview blotted out economic historical memory amongst leaders and technocrats prior to 2008. The Thatcherite (and Blairite) mantra of deregulation and self-regulation was the norm, and the supposed benefits of these (for the City of London and Britain more generally) were lauded and stressed. During the decades from the 1970s onwards, the frequency of national boom and bust cycles grew and the number and severity of national banking crises rose, but few paid attention. The Anglo-Saxon deregulatory market fundamentalist narrative worshipped by Keith Joseph, Tony Blair and even Gordon Brown precluded actors from seeing the ‘black swan’, the extreme exogenous event or economic crisis coming. Instead a great moderation was said to be underway. In this manner, deregulatory tropes provided ideological justification for the boom of the 1990s and 2000s. These beliefs allowed the withering of state power, creation of massive interconnected unregulated markets, huge, global, but unmanageable firms and complex, difficult-to-understand instruments that would in 2007 rapidly transmit price declines in houses and condos in Nevada and Florida sold to poor, credit-challenged Americans to banks in the UK and Germany, and then around the globe. As the credit crunch and economic contagion spread, tens of millions of workers lost their jobs and savings, and trade and commerce risked grinding to a halt. The panic grew, and leaders faced the most significant economic and financial crises since 1929. Crises and opportunity Confronted by an economic catastrophe of historic proportions, old solutions proved insufficient. A break point occurred. But the US could not fashion the solution alone or solely with its G7 colleagues and allies, as it had in the past. Instead, pushed by events, in November 2008 President George W Bush turned the G20 into a new leaders’ forum; this would be mirrored in 2009 by a technical forum, the Financial Stability Board, to secure advanced and emerging states’ solutions and reforms. World leaders present at these key early summits use the same language. They talk of being on a cliff, of looking into the abyss, of having no alternative and needing to step back. The leaders knew they had to act, even though they differed on the rhetoric, with a lame-duck US president eschewing attacks on the market system while Gordon Brown, Nicolas Sarkozy and Angela Merkel painted a much broader picture of the reforms required. Central bankers present at this pivotal juncture talk about seizing a new consensus, of a convergence, of a new regime, using language evocative of the ideological jump they would all collectively make together. These were the same central bankers who were bailing out the system, taking over firms, acting in concert with governments to arrest the crisis. In a real sense, these actors at this point of maximal crisis had the same experience and, as a result, a common new consensus view of what was needed to halt it and to ensure it did not happen again. What the leaders and their technocrats agreed to in 2008–9 amounted to a massive Crises and Paradigm Shift # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 407 The Political Quarterly, Vol. 85, No. 4 G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj commitment to the reassertion of state power over financial markets, firms, actors and investors. State authority would be extended collectively by the G20 and their central bankers. Reregulation was in and deregulation was banished from the lexicon. Leaving the markets to reach equilibrium by themselves alone was recognised as foolish. Irrational actors and the mania of market panic had to be replaced by the strong steadying hand of the state and re-regulation. Going forward, these leading states would take back authority over markets and firms and responsibility for financial stability. To do this, leaders adopted an aggressive interventionist regulatory approach—one that, without a crisis, could not have been agreed upon. The new ideological accord was not to be a wholesale rejection of market economics, but it was a repudiation of the worst elements of economic neoliberalism and undue deference to markets. State authority was back in vogue. If a paradigm shift is to be made real, to have solidity and permanence, ideological jumps in beliefs and narratives are insufficient: what also matters is action. What made Thatcher formidable, after all, was not just her ideological sharpness and rigour; it was her strength and determination to change policy, often radically and suddenly. Thus she challenged and crushed the miners and unions. She sold off council housing for a pittance and stopped building public housing. She clashed repeatedly and publically with her allies in the European Economic Community, unwilling to bend or turn away. G20 leaders and their proxies acted similarly decisively in the immediate period after the crisis erupted in 2008 and 2009, with real and potentially lasting policy shifts via G20 summitry. In 2008 at the Washington summit, and in 2009 at the London summit in particular (Gordon Brown’s finest diplomatic performance) and, to a lesser degree, at the Pittsburgh summit, a political and policy agenda was laid out which signalled that a paradigm shift in the global regulation of financial markets and firms would occur. In making that leap, political leaders looked to their technocrats and experts to specify the reforms required. The central banking community led by Mario Draghi, now president of the European Central Bank, and Mark Carney, now governor of the Bank of England and chairman of the Financial Stability Board, offered up a series of detailed architectural plans for the future regulation of global markets, the scope of which had not previously been ever seriously contemplated. Without the dynamic of the crisis, vested national interests would have blocked action. The elements of the new consensus The plans laid out in 2008 and 2009 are still being used today in the collective application of state power over markets and the world’s biggest banks. The crisis created room for manoeuvre, negotiating space and a broader consensus for reform. When you are in a crisis all together—advanced and emerging, east and west, north and south—matters are clarified and difficult solutions are easier to reach. So what are the tangible facets of the new policy framework? Institutions are created First, the G20 leaders’ forum permanently supplanted the G7 grouping as the top negotiating forum for world leaders advanced and emerging, signalling that the old days of North Americans and Europeans telling the rest of the world what to do is now at an end; the leaders needed the buy-in, political and fiscal, of China, India and other rising powers, and henceforth these players would always be at the top table. This is a major change in international summitry—a recognition of the change in the balance of power, the rise of China, Brazil and, to a lesser extent, India and Russia. These emerging country leaders are much less leery of asserting state prerogatives over markets; they stood behind the G20 move to take back authority over major financial markets. Second, the G20 backed the creation of a new body, the Financial Stability Board (FSB), and gave Mario Draghi and Mark Carney leadership roles. From 2009 this international institution provided a top-down overview of global risks to financial stability, and today it acts as the coordinating body for the financial reforms which its own, hardline leadership demands and oversees. The forum lacks formal power but is strongly backed by leading European and North American central bank- 408 Stuart P. M. Mackintosh The Political Quarterly, Vol. 85, No. 4 # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj ers, and is also financed by them. It is this community and this forum that is the principal agent in the concrete shift in the way in which global markets would be regulated by states from 2009 onwards. Taxing banking and risk-taking Third, the same central bankers leading the FSB thrashed out a new deal on the oversight of the world’s biggest banks. The G20 goal was to constrain the excesses of the largest banks in the world and help ensure future individual institutional and broader financial stability. Going forward, governments and regulators would focus on ensuring the stability of the economy as a whole and more closely overseeing the world’s largest international banks, which pose the largest risk in economic crises when they confront possible failure. To achieve this dual goal the G20 and FSB agreed higher bank capital and other international rules (called Basel III) in the space of twelve months in 2009–10. This is incredibly fast for such a complex negotiation; the central bankers seized the space created by the crisis to speed the reforms, well aware that opponents of reform would be quiescent for only a short while. The accord required that the biggest banks hold risk-adjusted capital of at least 10 per cent, an order-of-magnitude increase over the previous woefully inadequate levels (one major bank in Europe, for instance, was found by regulators in 2008 to be leveraged by over 400 times). Risk-taking major banks are required to hold even higher levels of capital. The world’s largest banks also face additional requirements designed to lean against excess risk-taking and the economic cycle, with banks building up buffers in the good times that can be drawn down when economic troubles stress firms and undermine their stability. These rules—on capital, on leverage, on liquidity of bank capital—are all designed to make the cost or tax associated with being a large and systemically important bank much higher, to restrict and punish risk-taking and (a not unimportant aspect) to cut banks’ return on equity, from 20-plus per cent precrisis to high single digits post-crisis. Banks have rushed to prove they will comply, with most banks already exceeding the Basel III minimums well before the 2019 implementation deadline. This is the reason why readers see almost daily accounts of major banks raising capital, retaining earnings, and lowering profit forecasts; there is a rush to prove each bank’s institutional fortitude, because if they wait for the market or the European Central Bank to find otherwise, the consequences for their business will be dire. In the post-crisis climate the pressure on big banks is not just international; it is also national. National bank regulators are buttressing and strengthening domestic regimes by further tightening national laws, regulations and costs for bankers taking risk that could fall on the public purse. Thus, rather than a race to the bottom, I see a race to add further strength to the international Basel III minimums. In America, in the UK, in Switzerland, in China, the central bank defenders of the new consensus are demanding yet more capital, yet more barriers against failure of the largest, most risk-taking firms, on top of Basel III. A race to the top is underway, making it more costly to take badly judged risks as bankers, not less. Some policies are strong, others less so Individually, each policy adjustment may be more or less strong. Basel III is substantial and significant, if we are to believe not only the regulators but the wails of anguish from the bankers themselves. But other areas of reform have different impacts. In the financial derivatives space, concerning the products which transmitted mortgage risk from US home owners to investors around the globe while obscuring and multiplying the interconnected risk, the G20 and national regulators have created an entirely new regulatory system to standardise a majority of these products, to lower costs, to allow comparison and price discovery and, where necessary, to also increase prices in line with actual risk. New laws are going on the statute books in all major markets and will apply to global markets worth trillions of US dollars per day. Entire markets that were completely unregulated before 2008 are now being overseen by the FSB and national regulators. Once again, without a crisis, this breakthrough would not have occurred. Past efforts by Timothy Geithner (when he was a Crises and Paradigm Shift # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 409 The Political Quarterly, Vol. 85, No. 4 G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj central banker) came to naught; post-crisis, these products are being regulated. On bankers’ bonuses the news is less consistent, more mixed. The US administration has steadfastly refused to regulate bankers’ bonuses, agreeing to weak codes of conduct and then not applying them properly. In the European Union, in contrast, the regulation of bankers’ pay is on the table and being changed. The FSB too has go in on the act, creating a new dispute settlement system for banks that believe their competitors are not applying agreed standards. Finally, on the most difficult issue of all, ‘too big to fail’, there has been least progress. The biggest banks have been forced to plan their own funerals, with so-called living wills, and efforts have been underway to work out how to dismantle a banking giant were it to fail (called resolution). But the truth of the matter is that in 2014, if a major international bank once again teeters on the brink of collapse, no one in finance believes they would be allowed to fail. States would have to step in yet again. Hence the biggest banks still have a valuable (in terms of cost to borrow) implicit guarantee worth many tens of billions of US dollars. Thus the policy adjustments that make the ideological shift real and possibly long-lasting vary from strong to weak. But this is the nature of major ideological and policy shifts: not every individual facet is equally robust. However, if these changes are taking place within a new paradigm—and I maintain they are—the totality of the regulatory reforms can be seen as more significant. This is because once policy-makers, and in this case the central bankers at the core of the regulatory system, make a jump in their consensus worldview, they are more resistant to attacks from outsiders (such as global banks and their myriad of lobbyists). Once again there are parallels with Margaret Thatcher’s government. She had many neoliberal successes (against the unions, for example). But in some areas she achieved much less (failing in her attempts to radically reduce spending on the welfare state, for instance). But weakness in one area over another does not deny the nature of the overall shift, even though in the mid-1980s it was not fully visible to all observers. Underlying the policy shifts in the 1980s were cultural currents that began to support the shift. I detect these in this financial regulatory case as well. Banking in the new normal Evidence of the new reality can be seen in the actions of the banks themselves. State assertiveness is affecting bank business models— as it should if the shift is becoming real. The smarter bank CEOs see the regulatory writing on the wall, and are making major adjustments; they can see this is no temporary, ephemeral movement. It is notable that those banks which performed worst have new CEOs most willing and most able to make the conceptual and business model jumps. So RBS is abandoning investment banking, drawing back to its retail roots and shrinking its American footprint. UBS has slashed its investment bank activities, as has Credit Suisse. Proprietary trading is off-limits in the US (thanks to former Federal Reserve Chairman Paul Volcker). In this way the more forward-looking CEOs are recognising a world in which banking may become a little more boring and less lucrative. Thank goodness for all of us. Finance in disrepute Broader cultural shifts have also begun. The Occupy Wall Street movement, although now past, played an important role, for it helped spark the debate on the growth of inequality and wealth represented by the excesses of international finance in London and New York. As Andy Haldane of the Bank of England noted, Occupy was a transformative movement. It helped change and impact the wider debate, even as the protests’ anarchic and disorganised nature blunted their broader effectiveness. The research in Thomas Piketty’s On Capital builds on and in a sense relies on (by being released at just the right cultural moment) the critical foundation that Occupy laid.6 Post-crisis, among the public, bankers are looked at very unfavourably indeed. A 2012 Mori poll found only 24 per cent of the public trusted bankers to tell the truth, third from the bottom, only just above real estate agents and politicians. Gone is the time is when the giants of finance could deliver their sometimes dubious pearls of wisdom without derision 410 Stuart P. M. Mackintosh The Political Quarterly, Vol. 85, No. 4 # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj or criticism. This reputation damage is significant and lasting and feeds into the wider public view of the finance profession and sector. This cultural change to one more critical of finance and of banks is reflected in a falling desire to work in the financial markets. For example, in 2014 only 16 per cent of MIT MBAs went into finance—a drop from 27 per cent the year before. In the US graduates are opting for technology firms over finance; at Stanford 32 per cent of the class of 2014 accepted tech jobs and just 26 per cent headed into finance, while two years ago those figures were 13 per cent and 36 per cent, respectively. Central bankers have the advantage With this apparent cultural shift underway, G20 and the FSB, state authorities and central bankers retain the upper hand. At present there are few signs key players, such as Mark Carney of the Bank of England, or Janet Yellen, or Stan Fischer—the latter two chair and vice-chair, respectively, of the Federal Reserve System (America’s central bank)— are backing off from defence of the new reality they have helped lead and construct. Expectations to the contrary are wrong. Mark Carney came to the Old Lady of Threadneedle Street lauded by a city establishment fooled by their own dreams and fantasies, in which they projected their desires and wishes onto the new governor. They hoped Mr Carney would be softer on the City than Mervyn King, who had, post-crisis, taken a highly critical view of bankers and banking. The UK financial sector’s view of the new governor was wrongheaded. Instead, Mr Carney (who was in fact quite tough as governor of the central bank of Canada) is defending his construction, the FSB, as the new normal, with its emphasis on the aggressive re-regulation of the world’s largest banks, of higher capital, of lower leverage, of taxation of excessive risk-taking by banks. Recent comments by Carney on inclusive capitalism in London only serve notice that he will continue a tough line. Governor Carney asked: ‘Who does finance serve? Itself? The real economy? Society? And to whom is the financier responsible? Herself? His business? Their system? The answers start from recog- nising that financial capitalism is not an end in itself, but a means to promote investment, innovation, growth and prosperity.’7 These rhetorical questions demonstrate the governor is well aware of societal demand for finance and banks which are socially responsible rather than ‘socially worthless’ (in Adair Turner’s memorable phrase). Indeed, a continued assertion of state authority by regulators over markets and firms is being seen. Banks have been punished and some CEOs removed (such as Bob Diamond of Barclays or Vikram Pandit of Citigroup). As of June 2014, the world’s largest banks have paid fines totalling more than $115bn, with JPMorgan Chase paying in excess of $20bn. Still others, such as RBS and UBS (in Japan) and BNP Paribas and Credit Suisse (in America), are for the first time in decades admitting to serious criminal acts. While critics complain that too few bankers have been made to spend time in the custody of HM Prisons (and they are probably correct in that complaint), it is also true that the scale of the fines, admissions of criminal guilt and ongoing enforcement actions would never have been conceivable absent the financial crisis and the galvanising effect it has had among the G20 and central bankers acting as the states’ regulatory guardians. So the shift toward greater state power and authority over markets and firms and away from the fetishised financial markets of the 1970s– 2000s continues. With the LIBOR, FOREX and commodity scandals (and who knows what else) still unfolding, the probability of further criminal charges and revelations is high. If that happens, those banks with rotten cultures at their core will face further infamy, reputational damage and worse, and the cultural shift will grow stronger, not weaker. Conclusion In 2008–9 the financial and economic crises forced political leaders and their central bankers to abandon the old worldview and jump to a new ideological and policy consensus: a reassertion of state power and authority over global financial markets, the world’s largest banks and financial firms. Today we are living through the creation of a new normal. It is still being built, and it is still a work in progress. Scientific, ideological and, indeed, economic Crises and Paradigm Shift # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014 411 The Political Quarterly, Vol. 85, No. 4 G:/WORK/Blackwell Journals/PolQ/PolQ85-4/02_POQU12115.3d ^ 22/12/14 ^ 15:6 ^ bp/amj paradigm shifts are rare events, and are not instantaneous but take years to become fully visible and durable. Copernican theory only became accepted very gradually. Margaret Thatcher’s full impact took time to be recognised. Similarly, observers will have to wait and watch to see if this new paradigm is longlasting, but the initial indicators appear positive and suggestive of a meaningful, durable, international ideological and financial regulatory policy shift. Notes 1 N. Copernicus, On Revolutions of Heavenly Spheres, New York, Prometheus, 1995. 2 T. Kuhn, The Structure of Scientific Revolutions, Chicago, University of Chicago, 1996. 3 S. Strange, The Retreat of the State: The Diffusion of Power in the World Economy, Cambridge, Cambridge University Press, 1996. 4 M. El-Erian, ‘Market fatigue: The Anglo-Saxon model has taken a knock’, The Economist, 1 October 2009. 5 T. Padoa-Schioppa, ‘Markets and government before, during and after the 2007-20xx Crisis’, Per Jacobsen Lecture, Basel, Switzerland, 27 June 2010. 6 T. Piketty, Capital in the Twenty-First Century, Cambridge, Harvard University Press, 2014. 7 M. Carney, ‘Inclusive capitalism: Creating a sense of the systemic’, Bank of England, 27 May 2014. 412 Stuart P. M. Mackintosh The Political Quarterly, Vol. 85, No. 4 # The Author 2014. The Political Quarterly # The Political Quarterly Publishing Co. Ltd. 2014