On the LIBOR scandal

17 Jul

A feature of economic crises is that they propel into the spotlight the more obscure parts of markets and of capitalism. The Eurozone crisis has made everyone roughly conversant about government bonds and sovereign debt. Acronyms like the EFSF and the EFSM, triple A ratings and CDSs (credit default swaps), are regularly bandied about. The BBC’s website now has a handy online dictionary, the crisis jargon-buster, that defines various economic terms, from base rates through to liquidity traps. The murky world of lenders of last resort and the practices of seignorage have also entered into public discussion. Most recently, it has been the turn of LIBOR, otherwise known as the London inter-bank offered rate.

LIBOR, as its name would suggest, is the rate at which banks in London lend to each other. It is determined as a kind of average of the different estimates given by the banks of how much they think they would need to pay by way of interest to borrow money. Those estimates are given daily and LIBOR is calculated for different kinds of loan instruments and in different currencies. Banks in a bad way and likely to pay more for their loans would be expected to submit higher estimates. Banks with solid balance sheets would submit lower estimates. One would expect LIBOR in good times of financial calm to be low and steady. One would expect it to rise in dangerous moments of finance crisis (see here for the late 2008 movements of LIBOR).

The scandal is based on the rather intuitive idea that given that banks are setting themselves the rate at which they have to borrow and lend, they have a strong incentive to fiddle those rates. The discussion underway at the moment has a strong whiff of the unreal about it. Complaints are made about the temptation to manipulate and the lack of honesty in setting LIBOR. But what else do we expect to see? Are we meant to be surprised that banks are not the best judge of their own financial health, a least when such judgements will have self-fulfilling knock-on effects for them? And that they should shy away from honestly communicating the state of their balance sheets to other competing banks within the City? Is it not obvious that banks in a bad way would tend to systematically propose rates that are lower than what their troubled loan book would suggest? At the very least, the indignation betrays a seriously naïve view of how markets work. It is also not surprising that the Bank of England should have been complicit in the manipulation of this inter-bank rate given its proximity to the government’s involvement in mopping up the massive losses made by British banks after the Lehman collapse. It was after all in the Bank of England’s interest to make it as easy as possible for British banks to have access to liquidity. Otherwise, claim Bank of England officials, the inter-bank loans market would have dried up altogether and brought some banks down with it.

Making sense of this kind of scandal needs more than a bout of shoulder-shrugging “well, what do you expect?” from cynics. It needs a strong done of realism about the nature of markets and of capitalism. Redirecting private accumulation towards public ends has always been a matter of political struggle and state coercion. Political control over economic activity did not happen by accident. The indignation we see today about the LIBOR scandal needs to be transformed into a political movement capable of articulating a vision that goes well beyond the myth of munificent and self-regulating markets.

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