Who pulled the switch?

One of the interesting features of financial and economic crises is their suddenness. It's as if the world is happily strolling along a well-trodden path on which someone has built a man-trap. We don't see the crash coming and we walk straight into it. Yet when we look back on what happened, we see all too clearly that the signs were obvious - we just didn't notice them.

Economists have made numerous attempts to explain this apparent blindness without a great deal of success. The fact is that financial crises do not come out of the blue, and some people do see them coming. The world is warned about its folly, but chooses to ignore. Those who shout "WATCH OUT - THERE IS DANGER AHEAD" and try to suggest alternative courses of action are dismissed as Cassandras and their thinking is excluded from mainstream academia and the corridors of power. This suggests that the cause is more psychological than economic - it is rooted in people's behaviour. Like a Greek tragedy, the end is inevitable because of the nature of the players.

In this post I shall attempt a psychological explanation of the behaviour that leads to financial crises. I am not a psychologist, but I do have some training and experience in Transactional Analysis (TA) and it is that theory that I shall use in this post.

Economists are familiar with "Game Theory", but perhaps less so with the TA idea of psychological games. Yet the pattern of behaviour that leads to a financial crash looks to me very much like the sort of thing that goes on when people play psychological games - as we all do, all the time.

The creator of the concept of psychological games, Eric Berne, defined them thus:
"A game is an ongoing series of complementary ulterior transactions progressing to a well-defined, predictable outcome. Descriptively, it is a recurring set of transactions... with a concealed motivation... or gimmick."
Games have a characteristic pattern: all players participate willingly in what appears to be a mutually satisfying serious of exchanges until someone breaks the rules ("pulls the switch") and the game comes to an abrupt end, accompanied by confusion, panic and anger as all participants are forced to face the truth they have been avoiding.  In TA, games have one purpose only, and that is to avoid what Berne calls "intimacy" and we might call "reality". And they are anything but fun. Psychological games range from mildly upsetting to downright vicious and even murderous. Someone always gets hurt.

Despite their painful nature, psychological games tend to be repeated. Rather like a rugby player who gets injured every time he plays and yet continues to play, people have preferred games that they play again and again, even though they get hurt every time. Getting hurt in a psychological game is preferable to facing reality.

So if the 2007/8 financial crisis was caused by someone pulling the switch in a massive psychological game, what was that switch and who pulled it? I am indebted to Liam Byrne for unwittingly defining it, though he personally did not pull it. After he lost his job as Treasury Secretary in the UK General Election, Byrne famously left a note for the next incumbent which said "There's no money left". And that, in a nutshell, defines the belief switch that caused the financial crisis.

In the run-up to the financial crisis, the prevailing belief was "We will never run out of money", and more and more of it was created to satisfy demand. I'm not going to get into arguments about whether credit money created by financial institutions is "real" - as far as the participants in this particular game were concerned it was real, because they could use it to buy stuff and have a good time. But in 2007, someone highly influential indicated that the supply of money was running out. I don't know exactly who this was, though I'd regard the Fed's decision to raise interest rates as a fairly strong signal - raising interest rates does restrict the supply of money. Anyway, investors started to withdraw their funds. This caught out the Bear Sterns hedge funds, which collapsed in August 2007, at which point banks scared of losing their money stopped lending it to smaller banks. Smaller lending institutions such as the UK's Northern Rock suddenly found themselves unable to borrow money from the interbank market to fund their lending: American lenders were bailed out by the Federal Housing Association, but Northern Rock was forced to seek emergency funding from the Bank of England. The tragedy for Northern Rock was not that the Bank of England was operationally unprepared to provide emergency liquidity - the Treasury gave permission for the funds to be provided - but that someone at the Bank of England told the press that Northern Rock had run out of money. Suddenly the game was up and there was a very public run on Northern Rock as scared depositors queued up to withdraw their money. And the rest is history: unable to recover from the loss of both wholesale funding and deposits, Northern Rock was eventually nationalised. But the run on shadow banks continued for another year, ending with the collapse of Lehman Brothers and bailout of banks all over the world as the prevailing belief changed from "We will never run out of money" to "There's no money left".

It is wrong to assume that the first statement - what Berne calls the "gimmick" - is false and the second - the "switch" - is true. Actually neither is true. The switch is as false as the gimmick: the entire game is illusion. And notice what happened next. Instead of confronting the reality of global economics (to which I will return shortly), the world embarked on a new game, called "Austerity".

What is depressing is that the world has played this sequence of games before: "Profligacy" ("we will never run out of money") followed by "Austerity" ("there's no money left"). The last time this sequence was played in earnest, it caused enormous suffering across the developed world and ended in world war. We played a milder version in the 1970s and 80s, which ended with the collapse of the Soviet Union and wars in Eastern Europe. Perhaps the "switch" in the Austerity game is popular uprising and replacement of political regimes - but as Orwell described in "Animal Farm", one political regime looks much like another.....

But it is unnecessary. The Austerity game is as much an avoidance of reality as the preceding Profligacy game. We do not have to cut support to the poor and vulnerable. We do not have to increase people's tax burden. We do not have to pour money into banks in the hopes that they will lend to people who already have too much debt. We do not have to suppress interest rates to extract money from savers. We do not have to bail out foreign creditors at the expense of domestic production (are you listening, Greece?). And above all, we do not have to accept that money is scarce. If it is scarce, it is because we have made it so. And in the developed world, where goods are anything but scarce and can be produced at very little cost, it is a disgrace that people are increasingly poverty-stricken because of shortage of money. I am reminded of Steinbeck's description of fruit, fallen from the trees and left to rot because consumer prices had fallen so low it was not worth farmers' while to pick it, being ruined with petrol to prevent the starving migrants from the drought-stricken American Mid-West from taking it. Nowadays, of course, we wouldn't use petrol - it's too expensive - but there are other ways of preventing people from getting the necessities of life for nothing.

What is needed is for economists and politicians to put their various ideologies to one side and take a hard look at how the economy ACTUALLY works, and what is really going on. Shortage of money is not the problem: allocation of money is the issue. Money is being created, but it is not going where it is needed, and this leads to unnecessary shortages of goods that actually are in abundant supply. That is the defining characteristic of both games - Profligacy as much as Austerity. The underlying reality is gross inequality and misallocation of resources. Until the world recognises this, we are doomed forever to play out the same sequence of games.

UPDATE December 16th 2012: I think we've discovered who pulled the switch in 2007 (thanks to @Hatti_Fattener on Twitter). This NYTimes report from August 9th, 2007 discloses that BNP Paribas suspended three of its funds because it was unable to value subprime MBS used as collateral. The press report of BNP's decision alone would have been sufficient to trigger the repo collateral margin calls that according to Gary Gorton forced banks to sell assets at fire sale prices, triggering a general collapse of asset prices. Further digging reveals that, according to the NY Fed, this was actually a run on ABCP, which started when the sponsor of a single-seller mortgage conduit, American Home, declared bankruptcy and three mortgage programs extended the maturity of their paper; in response to this BNP Paribas halted redemptions at two of its mortgage-affiliated programs due to being unable to value ABCP paper. DTCC data shows that this triggered a run on over 100 investor programs, not all of them directly connected with subprime. This was a third of the entire ABCP market, and caused the closure of the MBS market. So it seems the switch-puller was a Fed primary dealer. 


  1. Excellent post hitting the nail on the head,All that really needs correcting is those who gained to be brought back into line whilst those who was lost out gain,Carthage use to wipe the slate clean every 7 years to stop their economy running out of control,those who have the power see it has a illusion,whilst those who believe they have the power are delusional about it
    The best we could hope for is a bubble when areas in the bubble pushes out the surface area controls bring it back into line
    ie the "great" computer revolution only dragged some
    important parts of the economy into the apple falling syndrome you portrayed

  2. 1908 mass production of cars 1929 crash no Breton woods,1950/60's white goods with Breton woods,1990 computer no breton woods
    20 years approx between both,also colloration between rich 10% owning 90% of wealth or more

  3. Steve Keen also links it to the BNP Parisbas decision.

  4. Another excellent post...

    Or to continue with Orwell's Animal Farm (w.r.t "switch" back in 2007)

    “Mr Jones, of Manor Farm, had locked the hen-houses for the night, but was too drunk to remember to SHUT the POP-HOLES”

  5. What makes you think that central banks are excluded from the shadow banking system?

    1. As shadow banks are by definition unlicensed and (in theory) unsupported by government, it is nonsensical to include central banks in "shadow banking". However, central banks can be forced to support shadow banks in a financial crisis: we saw this with the Fed's support for shadow banks in 2008 after the fall of Lehman, but it's also worth remembering the Bank of England's bailout of about 60 unlicensed savings & loan banks in the Secondary Banking Crisis of 1973-4.

    2. So what happens when a group of banks decide to withdraw license from a particular central bank because their contract was broken?

    3. Banks do not license central banks. Governments do.

    4. Not "in theory". In fact and in practice. Central bank is simply an arm of government. In most countries the central bank is wholly owned by the state. In the US it is not, but it is still controlled and supported by the state.

  6. In the run-up to the financial crisis, the prevailing belief was "We will never run out of money", and more and more of it was created to satisfy demand.

    Or was it? Bonds are not money, but aren't they mostly what was created to satisfy demand?

    Perhaps what ran out in 2007 was not so much money, but people willing to hand their money back and wait for a little more later?

    But where does it come from later?

    1. No, it wasn't just bonds. Broad money (M3 in the US, M4 in the UK) rocketed in the run-up to the financial crisis.

      However, I did say that this is a BELIEF. And I also said that it is not true.

    2. OK, so we instead agree upon "credit" then? Or perhaps "loans"?

      Still money wasn't created. More and more of it, however, was owed.

      I agree people seem to believe loans are the same thing as money, despite the plain fact they are not. Even the Bank of England would have us all believe "loans" = "(broad) money". Do they really believe it, or are they just laughing?

      A loan is a loan is a loan. If I loan you my pen, it doesn't suddenly grow a sibling and call that a "broad pen"? Even if you did choose to call it (the one pen that actually exists) a broad pen while you have the use of it, you will still need to return a "narrow pen" to me later. Which is fine, as long as you retained my pen so you have it to give back. But people don't tend to borrow money so they can write something down real quick with it and then give it straight back?

      Maybe I just keep telling you to keep the pen on loan for a bit longer every time it is due back to me. And we agree among ourselves that we won't call it a gift. After all, some day I might surprise you by saying where's my pen man? Maybe I just decide on a whim it's nice to be the one with a pen for a change, I don't know.

      This is not to suggest that you don't already personally see it the same way I do. But almost nobody else does.

    3. Think Einstein was the one who said that:

      "Everything should be made as simple as possible,
      but not simpler"


      Oh, look. A group photo from the BOE!


    4. Is the interest really the problem?

    5. You don't understand how lending works.

      When a loan is made, it is not just a loan - it is also a deposit. The bank records the loan as a debit to my loan account, and it credits my current account with a new deposit for the amount of the loan. That deposit is created "ex nihilo", but it is real money that can really be spent on real products. I can buy you a beer with money that the bank has kindly put into my current account just as easily as I can with money I put in my current account myself. Deposits created as part of lending and deposits made by customers are indistinguishable.

      Even if the loan is granted as a credit line such as an overdraft, so recorded as a credit limit rather than an actual deposit into an account, when it is drawn money is really paid to another real person who really puts it in their real bank account. That money is also created "ex nihilo".

      Balances on deposit accounts (including current accounts) are included in in broad money measures, regardless of whether those balances are created by banks making loans or customers depositing money (which itself could be the product of lending). Therefore lending inflates broad money. That's how bank lending works.

  7. Global demands for a monetary order that cannot be used to bail out banks, fund government, raise money for war and defraud savers and protect debtors will overwhelm resistance to short term pain. Long term gain, short term pain. The BoE, the actual, physical property, will be sold to the highest bidder.

    1. You are calling for a completely private monetary system and hard money? Why do you think that would improve things?

  8. I am pleading for you to allow competition based on the rule of law, based upon contract between consenting adults. Passion is a (beautiful) part of human nature, but it is not limited to only producing positive outcomes, and with elastic forms of money, no matter how smart or well intentioned the monopoly board is, things fall apart.

    No paper money system has ever lasted in the history of humanity.

    Charlie Rose already makes the point to George Osborne that you will require a new exchange to list "public property" on for sale (http://www.charlierose.com/view/interview/12702). But that's ok. That's a contract between parties to produce as positive a result as is possible. The idea of a "French" company or a "British" company or a "Chinese" company is old thinking. Businesses are owned by people, not entire populations.

    1. The rule of law is a function of government. I do not prevent competition in banking - I applaud and encourage it. But the law itself is a natural monopoly which properly belongs to government.

      The historical evidence is that completely private banking systems are subject to destabilising runs and frequent crises. That's why we have central banks - or rather it is why the function of central banks changed from financing governments to propping up banks. People's livelihoods, people's savings, people's prosperity depend on there being a stable financial system. Maintaining that is therefore also a proper function of government. That the financial system has not been stable in recent years is an indictment of governments that have been only to happy to allow financial institutions to self-regulate.

      No specie money system has ever lasted either. It is in the nature of money systems that they are affected by politics and therefore do not last. When empires collapse so do currencies, and it doesn't matter what they are made of.

  9. The rule of law is a function of individuals (who can, of course, be employed by a government). Not all people are required to work for the government, are they? After all, if every one was a public servant, what would happen to the public? There would be no one for us to serve - a room full of butlers all staring at each other in perplexity! You assure yourself with the word "properly" as if one needs to argue the point that nature is proper. No, my dear, we can all agree on that, but to say that nature intended for a particular group of individuals to hold monopoly over law making does seem a bit outdated. The divine right of kings, remember, was not that popular, you know, John Locke and everything.

    You can not prevent competition in banking even if you want to, that's the point. Like legal jurisdictions competing against each other for corporate clients in a global market, so to do central banks compete against each other.

    I am not sure you can show us any historical evidence of anything (in nature) that is perfectly stable. Neither do I wish to suggest that inelastic monetary orders have been or would be perfect. Indeed, the precise point of maintaining the idea of 'perfection' as an idea in ones own head is only given practical meaning because it is not attainable. Perfection is a subject idea that is not physically attainable.

    Swapping the people from the BOE into HSBC is not likely to solve much, unfortunately.

    1. It is necessary for there to be a group of people whose job it is to make and enforce law. The only law that is created and enforced by individuals is the law of the jungle - or of those abandoning ship: when individualism rules, "every man for himself" is the law. That may be appropriate in an existential crisis, but as a blueprint for a social order it is destructive.

      However, this post is not about the law, nor about any of the other subjects you raise. You appear to be using this blogsite to grandstand your own ideology rather than discussing the subject of the post. While I welcome constructive discussion on my posts, I do expect people to abide by my rules, which are:

      - please restrict your comments to the subject of the post

      - please be polite and refrain from personal attacks on me or on any other commenters here.

      I am happy to post comments from you that address the subject of this post, but I will not publish any more off-topic comments.

  10. This comment has been removed by a blog administrator.

    1. Anonymous.

      I have asked you to confine yourself to the topic of this post, and I warned you that I would not publish any more off topic comments. The comment you have just made is off topic and therefore deleted. If you wish to comment, please abide by the rules of this blogsite, which are:

      - confine your comments to the subject of the post
      - be polite and refrain from personal attacks.

      This blogsite is not the place to promote your personal ideology.

  11. Thinking in terms of possible solutions to the crisis:
    1) Pyramid schemes and bubbles based on expansion of money do not work well in the long run - because the expansion cannot continue ad infinitum. Its just simple math and not a political point. Unfortunately - I really wish it would 'work', but math truths would prevent it. So what does work mathematically? see number 2)

    2) If we want to increase demand and supply in a more stable way then the math answer would be to create (print) a lump sum and re-circulate that same sum rather than add more and more as in a bubble or ponzi. The math works a treat because the supply of money does not go up and up.

    So, if supply of goods can be increased and demand can match it then the lump sum circulating can be increased proportionately until one of them falters, then stop printing immediately or disaster.
    If demand falls because consumers simply do not want the goods, then the lump sum must be again be halted or decreased - then the math equation balances.

  12. In nature when things happen fast, like volcanoes, avalanches, forest fires, there is some long time where conditions are building up that make a chain reaction possible. Then the positive feedback loop starts and things happen fast. The same seems to be true in finance.


  13. If an avalanche happens because a little rabbit runs across the snow, it is wrong to hold the rabbit responsible for the whole destruction of the town that follows. The same is true in finance. There will always be some trigger that sets off the chain reaction, but really it was the people that setup the dominoes and not the kid that tipped one over that caused things. If the trigger you found had not happened some other trigger would have. If you could go back in time and somehow stop that one it would not have prevented the collapse, just delayed it a few days.


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