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Inaction stations - In times of crisis, policymakers rarely have the option of doing nothing

04/10/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

“All of humanity's problems stem from man's inability to sit quietly in a room alone.”
Blaise Pascal, Pensées

The recent anniversary of the collapse of Lehman Brothers five years ago provoked a flood of commentary and analysis. One angle that particularly caught the eye of The Value Perspective was Berenberg analysts characterising the decision by US policymakers to allow the stricken investment bank to fall into disorderly bankruptcy as “one of the most expensive mistakes in financial history”.

 “The consequences were catastrophic,” commented the note’s authors. “On Monday 15 September 2008, the global wholesale financial market started to implode. As a result, an ongoing modest economic correction in the US morphed into the worst recession in the developed world since the Great Depression of 1929-1932.”

Now, one might question how much of that analysis benefits from hindsight – at the time, it certainly did not feel like we were experiencing a “modest economic correction” – but what we do know is that nobody can say for sure what would have happened if policymakers had acted differently by propping up Lehman Brothers or, later on, allowing other, larger banks also to fall into bankruptcy.

The argument for allowing failing banks to collapse rather than restructuring them is that this enables their debts to be written off and economies, unencumbered by excessive debts, to grow much faster from that base. Thus, for example, Iceland was able to benefit from the debt of its collapsed banks being written off while the likes of Ireland, Portugal and Span could not – and their economies have struggled ever since.

The one riposte the policymakers have to any criticism of their actions, both in and after September 2008, is reasonably straightforward – laissez-faire economists may be correct in arguing it would be better to allow more banks to fail but what if they were wrong? The world economy would be severely impacted and regulators would appear to be doing nothing.

So, yes, most people would probably agree that not helping Lehman Brothers to survive was a mistake but what about, for example, the fate of Royal Bank of Scotland? Plenty of commentators were arguing five or so years ago that it should have been allowed to fail because that is how capitalism works, how debt is written off and how economies recover.

But who knows what would have happened if policymakers had followed that course of action? Or should that be ‘inaction’? In times of crisis, doing nothing is not an option for policymakers and, this time five years ago, both public and press may well have taken allowing yet more banks to fall into bankruptcy as something akin to negligence.

All of which brings us to the thorny issue of quantitative easing (QE), which plenty of people oppose on the grounds it could generate inflation at some point in the future and so they argue that policymakers would be better advised to do nothing.

If the economy is in a bad place, the argument continues, then economics should just be allowed to run its natural course – while some people and businesses will go bankrupt, the surviving businesses become stronger and debts are written off for the weak, allowing a stronger rebound when the downturn passes.

Once again, however, the point is not whether or not QE could generate inflation – which of course policymakers refute – but that doing nothing is simply not an option. The anti-QE lobby may be right but what if they are wrong? Policymakers have to do something and, seeing as interest rates are at all-time lows, the only tool left in the box to bolster confidence in central banks – and central bankers – is QE.

In The Little book of behavioural investing – how not to be your own worst enemy, James Montier highlights a study of football goalkeepers facing penalties. In it, the goalkeepers chose only to dive to their left or their right – roughly half the time for each. However the penalty-takers chose to kick the ball to the goalkeepers’ left, right – or straight down the centre – about a third of the time each.

Statistically speaking, simply by standing still the goalkeepers would have saved more penalties than they did by diving left and right – and Montier’s investment angle on all this is that, while investors may feel they ought constantly to be buying and selling stocks to take advantage of rising and falling prices, they would actually be better off keeping their portfolio turnover low. Inaction can work for investors and (at least until the penalty takers get wise) for goalkeepers but, as Blaise Pascal, may have sensed, it is a luxury rarely afforded to policymakers.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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