Book-A-Day 2010 # 84 (4/28) -- I.O.U. by John Lanchester

Nobody saw the real estate crash of 2007 coming -- except for a large number of investors who bet against the bubble and made a fortune. Except for a huge number of homeowners nationwide who saw the paper values of their homes skyrocket, and knew that it wasn't sustainable. Except for plenty of people in the financial industry and the financial press, who had seen bubbles before.

Well, maybe then everybody saw it coming -- or everyone that mattered, anyway. Everyone certainly knew that there would be a correction in the market -- except for the poor deluded few that believed Alan Greenspan's managed-growth-forever Kool-Aid -- but, since most of them were still making bets on the markets continuing to rise (journalists needing ad buys for their publications, homeowners needing those price increases to make their interest-only loans look mildly plausible, and all those brokers and traders making money on every transaction), they all just kept hoping that the correction wouldn't happen until tomorrow. But we all know that tomorrow eventually comes.

I.O.U. is one of the slew of books that started in late 2007 and will continue for another two years (at least), explaining and explicating and making clear as many aspects of our financial mess as they can. This one is by a novelist, John Lanchester, who found himself working on a novel set in the finance industry in mid-2007, when everything started to go to hell. He shifted gears at some point, as he kept keeping track of what was happening and he tried to work out why it was all happening, to writing this book instead of the novel -- a short book about what happened and why, as the not-entirely-accurate subtitle says (I sense the hand of some fellow marketer behind it, and salute that faceless personage) "Why Everyone Owes Everyone and No One Can Pay."

Lanchester keeps his eye on the big picture, making sweeping statements when he needs to, and avoids getting caught up in the minutia of which bank did what -- and which of the players are "banks" and which are "nonbank financial institutions," for that matter. He does clarify categories when he has to, to keep the chain of blame clear, but he mostly lumps these entities together as "banks," which is entirely reasonable. (After all, the most obvious Too Big To Fail "bank" was AIG, which was primarily an insurance company but which had proliferating arms with their fingers in every financial pie imaginable.)

Along the way, he uncovers the real reasons for the boom that ended with this crash, and it's not a pretty one: the financial industry created an unregulated market for bets against anything they could devise, ran up the value of the pool of those bets until it was many times the actual value of the assets (those being the entire world economy) underlying the bets, and then kept building higher and higher, assuming that gravity and cyclical market downturns could be dealt with as easily as starry-eyed government regulators.

The resulting book is amazingly quotable, as it explains the highs and lows of the recent market:

The credit crunch was based on a climate (the post-Cold War victory party of free-market capitalism), a problem (the subprime mortgages), a mistake (the mathematical models of risk), and a failure (that of the regulators). It was the regulators' job to prevent both the collapse of individual companies and the systemic risks which ensued; they failed. But that failure wasn't due so much to the absence of attention to individual details as it was to an entire culture of the primacy of business, of money, of deregulation, of putting the interests of the financial sector first. This brought us to a point in which a belief in the free market became a kind of secular religion., The tenets of that religion are familiar, and they have been a central part of the story so far: the primacy of laissez-faire capitalism, the magically self-regulating nature of the market, the superiority of the free market to all other forms of human organization. These are all debatable, contestable positions -- but in the Anglo-Saxon world, we forgot to contest them. This should be an enduring lesson of the crisis -- an understanding that the rules governing the operating of markets were not handed down on stone tablets but made by human beings and are in constant need of revision, supervision, and active, imaginative enforcement. We can't afford to forget this point: humans make markets. (pp.201-202)

I find myself wanting to type out Lanchester's entire last chapter -- where he synthesizes the issues covered by the previous chapters, and adds them up to form a damning picture of financiers drunk with debt and leverage, scornful of anyone who does anything else and utterly sure of their own righteousness:

One of the peculiar things about the world of finance is that it freely offers the sensation of being proved right to its participants. Every transaction in the markets has a buyer and a seller, and in most cases one of them is right and the other wrong, because the price goes either up or down. The cumulative weight of this rightness-or-wrongness is one of the things that make financial types psychologically distinctive. Artists, sportsmen, surgeons, plumbers, and the rest of us have secret voices of doubt, inner reservations about ourselves, but if you go to work with money and make money, you can be proved right in the most inhumanly pure way. This is why people who have succeeded in the world of money tend to have such a high opinion of themselves. And this is why they seem to regard themselves as paragons of rationality, while others regard them as slightly nuts. Outsiders don't often get a good look at this mind-set in its full pomp, but when we do, it makes an unforgettable impression. (pp.203-204)

He's not one of the many who wants to assign blame to just one convenient scapegoat -- the rating services, the regulatory agencies, the investment banks, the derivative traders, the homeowners who signed mortgages that they wouldn't be able to afford, Bush or Clinton or Chris Dodd or Hank Paulson or the secret ruling Goldman Sachs cabal -- since he's sure that this boom and bust were precisely what the derivative market was destined to become; like all immense crashes, it's obvious in retrospect, but no one listened to the voices of reason ahead of time since there was money to be made: huge, dog-choking piles of money, which all went to the bankers.

The regulators failed; but they failed because the bankers made them fail. All the rules which existed, about bank capital and reserve requirements, about risk, and about cross-border regulatory supervision, were energetically, systematically, and determinedly circumvented by some of the banks. They treated the rules as things designed by thick people to slow them down and hamper their rightful profitability. It was self-evident to them that they had a better understanding of the risks they were taking than did anyone else. They behaved like drivers who regard speed limits as things to be obeyed only by muppets. It's as if they saw the thirty-miles-an-hour sign but then realized that the speed cameras wouldn't work if you were doing more than seventy -- and took that as their cure to roar through built-up areas at the highest speed possible. The proliferation of nonbank banks, the pervasive use of derivatives to increase rather than to hedge risk, the overwhelming preference for over-the-counter derivatives -- all of these things were critical contributors to the disaster, and all of them had, not just as some marginal benefit but as their central purpose, the determination to get around the banking rules. (pp.204-205)

Lanchester probably put this book to bed eight or ten months ago, but I found this passage near the very end (it's the last quote, I promise) particularly pointed, as my local government here in New Jersey is fighting over exactly these issues. (As probably is your local government in wherever you are.)

As the bill is paid, and especially as taxes go up while services and jobs go away, people are going to get steadily and inexorably more furious. I'm not sure at whom; I hope it's at the responsible bodies, but I wouldn't bet on it. Public rage is like lightning, and tends to discharge its energies at anyone who has the bad luck to be prominent in the wrong way at the wrong time. (p.223)

I.O.U. probably isn't the definitive book on the crash; books like that tend to come late in the cycle, to synthesize the prior art and turn it into an integrated argument about what came before, during, and after. It's still too soon to get that kind of distance, since we don't yet know yet what the shape of the post-crash economy will be. (Though I personally hope that things aren't as doom-laded as Lanchester puts it in that last chapter; it clearly was written in mid-2009, when everything was lousy through and through.) But it's one of the very best books on the current economy available now: clear-eyed and thoughtful, engagingly written and layman-friendly. I know a little bit about the economy and the world of finance from my day-job, but Lanchester has studied this world intently and sees it with the clarity only a real outsider, and a great writer, has. If he can write this well and entertainingly about a market crash, I probably need to check out his other books.
Book-A-Day 2010: The Epic Index
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