What Is Finance, Really?

At one level and in most economics textbooks, this is an easy question with a rather encouraging answer.  The financial sector connects savers and borrowers – providing “intermediation services”.  You want to save for retirement and would obviously like your savings to earn a respectable rate of return.  I have a business idea but not enough money to make it happen by myself.  So you put your money in the bank and the bank makes me a loan.  Or I issue securities – stocks and bonds – which you or your pension fund can buy. 

In this view, finance is win-win for everyone involved.  And financial flows of some kind are essential to any modern economy – at least since 1800, finance has played an important role in US economic development.

Unfortunately, two hundred years of experience with real world finance reveal that it also has at least three serious pathologies – features that can go seriously wrong and derail an economy.

First, the financial sector often acquires or aspires to political power.  The fact that banks have a great deal of cash on hand always makes it easy or tempting to buy some political favors, and to obtain privilege and power for big financial enterprises.  President Andrew Jackson had exactly this struggle with the Second Bank of the United States in the 1830s.

Second, the financial sector can obtain disproportionate power over industry.  The “money trust” idea of the early 20th century may have been somewhat exaggerated – money cannot be corralled as effectively by private players as can, say, copper or steel – but there is no doubt that 100 years ago, Wall Street banks dominated the process of consolidating railroads and of creating pernicious industrial trusts. Trust-busting required taking on the country’s most powerful financiers (pdf).

Third, finance can also go crazy, running up speculative frenzies.  This is what happened the 1920s, leading to the Great Crash of 1929 and the struggle to effectively constrain finance during and after the long, depressed 1930s.

Which kind of financial sector pathologies do we face today? Unfortunately: all of the above.  And, not just in nature but also in size, we face a financial sector much more potentially debilitating than anything stared down by A. Jackson, T. Roosevelt, or F.D. Roosevelt.

In our previous showdowns with finance, the sector was small.  During the nineteenth century, the value of financial intermediation services was no more than 1 or 2 percent of GDP, and in the early 20th century, the extent to which real resources – including talented people – were drawn into this sector remained very limited.  J.P. Morgan, in his heyday, had great economic and political power, but he never employed more than 100 people.

With the growth of a much bigger and more diversified economy after World War II, there was some increase in financial activity as a share of GDP, but the really big jump came after the deregulation of the 1980s.  Just a few years ago, finance accounted for an astonishing – and unprecedented for the US – 40 percent of all corporate profits, and even today the sector generates around 7% of what we measure as GDP (for more numbers over time, see this presentation.)  Even ardent defenders of finance now concede that the sector may or even should end up significantly smaller as a share of the economy (James Surowiecki; Adair Turner). 

But at current scale, the financial sector has great ability, through political donations and other means, to maintain its lightly regulated environment – there is nothing (other than the proposed consumer protection agency for financial products) to which the industry has ever objected in the administration’s financial reform proposals.  And yet the amount of risk-taking that this sector can pursue remains mind-boggling, and its ability to “put” the cost of big failed bets onto the government is undiminished.  Financial “innovation” remains mad and bad, and when it all goes wrong – you know who gets the bill.  The implications for your future taxes and job security are not good.

We need finance, but finance as it currently operates in the United States has become a problem.  Yet, with the headline numbers for the economy beginning to improve, the impetus for any real reform of this sector – within the US or internationally – starts to fade.  The likely future is: more of the same, at least until we find a Jackson or a Roosevelt.

By Simon Johnson

This is a slightly edited version of a column that appeared on the NYT.com’s Economix blog.  It is reproduced here with permission.  If you would like to use the entire post, please contact the New York Times.  Fair use rules apply for short quotations.

96 responses to “What Is Finance, Really?

  1. Good points. Funny thing is these pathologies were already noted in “Finance Capital” (1910) by Rudolf Hilferding, the Marxist economist and twice treasury secretary of the Weimarer Republic.

    He came to the conclusion that a financial oligarchy will prey on and collude with government, a development preluding the end of capitalism. Hmmm … hopefully he’s not right on that ;-)

  2. “Yet, with the headline numbers for the economy beginning to improve, the impetus for any real reform of this sector – within the US or internationally – starts to fade.”

    This is the biggest fear of the critics and consequently you tend to see this boogeyman around every corner. The economy isn’t starting to improve, the worst is yet to come, and the bankers have managed to make such a mess that it cannot be contained.

    A little faith and patience is in order here.

  3. Capitalism will never be over. It will always live in our minds and hearts.

    Something like this that was this big and this important and this great will never die. Oh, for a few years – maybe many years – it’ll be considered passé and ridiculous. It will be misrepresented and caricatured and sneered at, or – worse – completely ignored. People will laugh about printing money, Countrywide, exotic derivatives and corporate welfare and people saying real estate prices can never go down, but we had nothing to do with those things and still loved capitalism. Those who didn’t understand will never understand: capitalism was much more, and much better, than all that. Capitalism was too great, and too much fun, to be gone forever! It’s got to come back someday. I just hope it will be in our own lifetimes.
    …Sorry, I’ve got a job interview this afternoon and I was just trying to get revved up, but… most of what I said, I, um… believe.

  4. I can’t help but agree. With national, state and local governments borrowing up to the hilt to prop up unproductive sectors of the economy (or just keep things going), it’s only a matter of time before this unsustainable scheme collapses. Perhaps just long enough for the financiers to take the money and run.

  5. Reminds me of one of my favorite articles.

    “Business is renting you a car at the airport. Finance is something else.”

  6. To quote Nassim Taleb:

    “Finance is a scam.”

  7. One could have made these same observations 100 years or even 200 years ago. Why is it always the same modus operandi? Why is it that any regulations and reforms are always dismantled? Given how successful Jackson and Rosevelt ultimately were, what makes you think another politican of their ilk and yet another set of reforms can solve this?

    Hegel remarks somewhere that all facts and personages of great importance in world history occur, as it were, thrice. He forgot to add: the first time as tragedy, the second as farce, the third time as late-night cable tv infomercials.

  8. I think the reason is distorted thinking about markets, regulation and government on parts of the US citizenry. That might have historical reasons. Markets are always good, regulation is always bad and government is always evil.

    Even decent educated people show this prejustice. Post something about health-care on an Austrian economist blog and dare to mention that you’re from Europe, in my case Austria ;-) They will go bezerk.

    You’ll end up discussing euthanasia and a government either full of Nazis or Communists. Some moderates might settle with Socialists.

  9. The textbook definition of finance that you use implies that the financial sector is merely an intermediary shuffling money from here to there.

    Not so.

    The financial sector not only provides intermediation services for other people’s money, it creates money through the extension of credit. Despite Mises’ pronouncement in “Human Action” that the existence of a central bank like the Federal Reserve eliminated the ability of the financial sector except at the will of the central bank, a 1990 Fed paper showed that to that day credit was being extended 6-12 months before the money backing that credit was created. Perhaps this explains the failure of monetarism: when money is endogenous and not exogoneous, as fiat-money models assume, central banks will have much less control over money supply than expected by Friedman and others.

    The fact that the financial sector exerts substantial control over the money supply (and, therefore, inflation) inherently gives it political power. They don’t need to seek power. They already have it, and we cannot stop it, we can only hope to contain it by setting hard limits on leverage and “innovation” (e.g., what the Ponzi scheme was called before it was outlawed).

    The financial sector’s political power in the U.S. has been amplified by the collapse of the U.S. industrial sector. I agree with Kevin Phillips assessment in “Bad Money” that, since the repeal of Glass-Steagall, the “financial services sector” reported by the BEA excludes a significant portion of the activity of the financial services sector, which I think your 7% number represents. When you consider mortgage lending and real estate operations, which the BEA excludes from its “fincials services” reporting, the percentage of GDP for the financial sector is on the order of 20%, not 7%.

    And the financial sector’s direct contribution of 20% to the GDP does not tell the whole story. To the extent that the financial sector extends credit that is immediately spent, it boosts GDP directly and, just as importantly, indirectly by encouraging further investment by businesses to meet surging demand. Business investment, of course, is often achieved through the extension of credit. The mortgage equity withdrawal (MEW) data compiled by Calculated Risk shows that the direct effects of MEW in 2002 made the difference between the U.S. economy expanding and contracting. When you consider the indirect, quasi-multiplier effect of that private stimulus, the financial sector’s real contribution to U.S. GDP is far more than 20%.

    The problem that we have today is what do we have that can replace the component of the financial sector’s contribution to GDP that we would regulate away to properly constrain finance, which has run amok for at least the last eight years, if not longer? After the Great Depression, we still had a robust industrial base, which we have since squandered. It takes a lot of time and effort to rebuild something like that, and U.S. tax policy and GAAP accounting rules currently discourage domestic investment.

    At the end of the day, I don’t think we will find another Jackson or Roosevelt until we hand politicians a more holistic way to view the health of the economy. Keynes did that for Roosevelt, but not all of Keynes’ observations remain true today, and those that have survived have been perverted in many ways. One of the major problems is that the health of the U.S. economy is inextricably linked to GDP growth, but not at all consumption, which GDP actually measures, is created equal. (Kuznets, who invented the GDP metric, warned lawmakers that GDP measures the quantity of consumption, not its quality.) GDP growth fueled predominantly by the services industries, as it is today, is not of the same quality as GDP growth fueled by industry, nor is it sustainable in the long run. In fact, I think the over-reliance on the consumption of services (which are often subject to supercompetitive pricing due to local monopolies/duopolies) is ultimately cannibalizing the economy. When you can get away with charging whatever price you want without delivering value equal to what you charge, it makes your business and the GDP look darn good, but it is, at the end of the day, nothing but a hold-up.

  10. The twin evils of finance are unbridled speculation and usury. The banks formerly financed industry but big business long ago turned to the bond market, leaving only real estate and (relatively) small business to the bankers. The first mania was country lending (the seventies), the next was mergers, then, successively, commercial real estate, the stock market, commodities (mainly oil) and residential mortgages. What is most ridiculous about the usury side is that money hasn’t really been scarce since Nixon closed the gold window. But the banks are a monopoly all offering the same usurious terms to consumers, who have become the borrowers of last resort. We lost a wonderful opportunity to fix this by not letting the big banks go bust. The idea that finance produces profits is nonsense. What finance collects is rents. If the government is going to supply all the capital, why not ease the terms on the ultimate borrowers, who might thereby be enabled to rekindle demand? The whole current approach to this mess is so transparently idiotic that it remains remarkable why anyone is contemplating a recovery at all. Lets see what the conventional wisdom is in six months. The euphoria cannot last much longer.

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  12. What happens to percentage of GDP when you include insurance products, car financing and other forms of retail credit?

  13. This column describes another reason that the “Citizen’s United” case is so important. If corporations (in this case banks) get into the business of supporting individual candidates, we could never hope to properly regulate finance again (not that we are doing such a hot job currently).

  14. Also, if you break up monopolies/duopolies, GDP looks worse under your analysis. That’s yet another hit to the comforting (but misleading) GDP figures. Regardless of what we should do, what do you see happening?

  15. D. Christopher Leonard

    It seems unlikely that the U.S. shall find another Roosevelt (weather another Jackson is even desirable is another question). One doesn’t have to accept the extreme formulation that the state is the executive committee of the bourgeoisie to recognize that the state is always dominated by elites and inter-elite competition. What characterizes the last 35 years is the coming to power of F.I.R.E and the decline of traditional blocs (heavy industry) and regional blocs. Investment banks/brokerages provide all the key personnel in administrations be they democratic or republican (they go back and forth between the ‘private sector’ and the state). If the U.S. had real political parties (the only coherent one is the right wing of the republican party) there might be real contestation for political power and, hence policy alternatives. But we have none and, furthermore, the likely bases of wide-spread social mobilization now and in the near term, are on the right. And financial elites have no difficulty climbing into bed with modern-day Father Coughlins. The Weimer republic mentioned by Stephan may be a more potent analogy than he recognized.

  16. well isn’t capitalism about that you want to keep to yourself what you managed to grab?
    in the sense that any chimpanzee will defend the banana he was first to snatch?
    if that is so then it is so basic that it inevitably will survive just as much as basic altruistic behaviour will survive

    what hopefully will get pushed around a bit and have to do some penance is blown-up language and ever more intricate theories which presumably are only the human way of howling like wolves

    I at least distrust anything that isn’t as simple as with a chunk of beef you can cook a good soup

  17. What exactly is his point in that article – that it is a bad thing to transfer ownership interest in a company? The “business” exists to create shareholder value.

    I suspect that article would seem less convincing had the author not conveniently neglected any discussion of risk.

  18. Jackson hated the banks, which got him elected. He had a horrible history in regard to ethnic cleansing of the native Americans.

    TR is a better model. He tended to do what he wanted making end runs around congress, not unlike the GWB years. We sure could use someone with his spine to break up the too big to fail even bigger banks.

  19. The point is that, to a naïve person, financiers appear to reap rewards wildly incommensurate with… whatever it is that they do, exactly.

    For example, if a businessman (or woman) rents cars to 1 million people at a profit of $10 each, it is easy to see why that might be worth $10 million.

    On the other hand, if a financier performs a leveraged buy-out of a perfectly sound business, loads it up with debt, pays himself (or herself) a massive dividend, then spins the business back off as an IPO, it is a little harder to see why that might be worth $10 million.

    In general, there is something intuitively wrong about a system that allows so many to earn so much for doing so little. To a naïve person, anyway.

    I am pretty sure that is the point of the article.

  20. I am not a Mises fan – but you raise an important comment:

    “The financial sector not only provides intermediation services for other people’s money, it creates money through the extension of credit.”

    That money is backed by promise of future repayment, which incorporates time discounting and (as Bond Girl notes) risk management.

    Recall Obama’s inaugural speech – “credit is the lifeblood of the modern economy”. This is identical to saying that “debt is the lifeblood of the modern economy”. That’s because debt is money. And money is a large chunk of our contractual system for keeping our massively specialized production and distribution systems functioning.

    The question becomes whether the money supply, which is ultimately based on federal govt. obligations (and future tax revenue), should be so heavily privatized and so unregulated… If we allow this, then from time to time (every time the business cyle takes a downturn) we’ll be faced with a choice of either punishing ourselves (and risking world economic implosion) in order to punish those at fault or encouraging bad behavior due to moral hazard. Or something in between.

    But back to point – one “real” value that finance brings is in the decentralized knowledge needed to allocate money where it is most efficient to invest, with the presumption that this knowledge is backed by people “willing to put their money where their mouth is” (aka, price revelation).

    The problem is risk asymmetry and downright mass psychology. A capital cushion of 4% is just insufficient to absorb the downside of creating money (via debt) to allocate to a particular investment activity. In other words, just too much debt sitting on top of too little base money – our money supply is an inverted pyramid – with limited individual downside and massive systemic instability.

    (On the other hand, govt. has a social interest in encouraging _good_ risk taking behavior. Societies that are excessively risk averse (Japan?) have just as many problems as societies that are risk prone.)

    As Per Kurkowski never tires of saying, a LOT could be accomplished just by upping capital asset ratios across the board. The challenge is managing this transition (which requires putting more base money into the system). That means a money supply with more “cash” and less debt. If you think of “cash” as government-backed money and “debt” as private-backed money, then this means taking power away from the markets and giving it back to the government (at least during the transition period, while debt is being sucked out of the economy and cash is being injected into it). That’s why banks and private finaciers are fighting tooth and nail. It is, deeply, about “Who gets to print the money?” The banks, or Treasury? (And who backstops the obligations…)

  21. At the expense of sounding trite, I think all this amounts to is that the greedy are outsmarting the nongreedy. Those concerned only for enriching themselves, the long term viability of their country be damned, are outsmarting those who want to provide for all Americans & maintain a strong country & therefore a strong economy long term.

  22. Please wade through introductory spiel.

    Last October I was fortunate to work on a construction project with an ecclecticly trained psychologist. His father was a problem gambler. He pointed out that the finance industry always attracts ‘gambler’ types. Most compulsive gamlbers gamble until they go broke. Only a few have the discipline to win, walk away, and save. The (perhaps unconscious) realization of this after the wreckage of ’29 led to intelligent regulation. Forgetting the realization led to indiscriminate deregulation.

    My acquaintance the psychologist wass not surprised by the financial meltdown. Imagine that!

  23. StatsGuy: “As Per Kurkowski never tires of saying, a LOT could be accomplished just by upping capital asset ratios across the board. The challenge is managing this transition (which requires putting more base money into the system). That means a money supply with more “cash” and less debt. If you think of “cash” as government-backed money and “debt” as private-backed money, then this means taking power away from the markets and giving it back to the government (at least during the transition period, while debt is being sucked out of the economy and cash is being injected into it). That’s why banks and private finaciers are fighting tooth and nail. It is, deeply, about “Who gets to print the money?” The banks, or Treasury? (And who backstops the obligations…)”

    Short term, we are going to need more stimulus, and a good way to do that would be for gov’t to pay people to do things — and print the money to pay them. Kill two birds with one stone. :)

  24. “The likely future is: more of the same, at least until we find a Jackson or a Roosevelt.”
    FOUND: Simon Johnson can do it — UNFOOL the people by getting these histories in their faces, ONGOINGLY:
    “Real Homes, Real Dow” at
    http://homepage.mac.com/ttsmyf/RHandRD.html

    And, the foregoing two mispricings abetted the two ‘misbehavings’ here (second chart):
    “Real Dow & Real Homes & Personal Saving & Debt Burden” at
    http://homepage.mac.com/ttsmyf/RD_RJShomes_PSav.html

  25. I would offer that because of the finance sector, we no longer have a viable industrial base. Why waste money capitalizing factories, and systems, and networks, and paying decent wages and benefits to skilled employee’s – when a few predatorclass insiders can simply conjure imponderable amounts of money out the myst in the form of PONZI scheme irredeemable debt products, or socalled innovate finance. The finance sector as it stands today provides NO meaningful services or benefit to the greater society when measured against the potential for bubble/bust crisis, cataclysmic economic upheaval, and the brutal redistribution of trillons of dollars of wealth and resources from the poor and middle class to the offshore accounts of the predatorclass, 1% of population. The finance sector as it stands today is a dire threat to health and security of the American people. The give nothing to society, and the rob, pillage, and disadvantage the poor and middleclass populations of society. This system must be dismantled and rebuilt with more concrete structural underpinnings of equanimity and adherance to and respect for the rule of law.

    As Simon points out – we need a leader or a team of leaders with the courage and determination of a Jackson or Roosevelt to stand up to the most powerful predatorclass shaitans and shades in the finance sector. Tragically, I don’t see any hope for these kinds of courageous principled leaders coming to power, so – we will all face either more of the same and a rapidly widening divide between thehaves and thehavenots, or some real horrorshow backlashes and reprecussions that won’t be pretty or predictable.

  26. Sorry for the unclosed anchor tag!

  27. Dunno about “a leader or a team of leaders.” The ‘man on the white horse” has a rather bad history, to say the least.

    Could we perhaps settle for a return to Constitutional government, the separation of powers, and the rule of law — especially as applied to lawless elites?

  28. Funny, I tend to distrust chunks of beef. Do they have hormomes? antibiotics? madcow disease? nitrates? too much cholesterol? gristle? …

  29. You seem to feel that hard work should be rewarded. But our society says otherwise: creating shareholder value is rewarded. It’s really not their fault it’s so easy to create shareholder value.

    That’s how society is supposed to work in theory. In practice, NOT creating shareholder value is rewarded just about as much.

  30. Also, I think you should know that the financier who made the $10M on that deal probably spent close to 0 time on it. His talented and skilled minions (getting $10,000 apiece), actually did whatever it is they did to get it.

  31. Correct me if I’m wrong, but isn’t the whole idea to push everyone but the financiers so deeply into debt that they can never get out from under it?

  32. sorry to had hurt your gastric imagination and to hear that all good old stuff has been contaminated
    the saying is German and probably older than I am i.e. a long time before hormones and all the other fancy enhancers and it is used as a rebuff whenever you feel proselytized – and the over-inflated language balloons of the economic community somehow touch that nerve of protest in me http://www.google.com/search?hl=en&client=safari&rls=en&as_q=&as_epq=ich+glaube+nur+daß+ein+Pfund+Rindfleisch+eine+gute+suppe+gibt&as_oq=&as_eq=&num=10&lr=lang_de&as_filetype=&ft=i&as_sitesearch=&as_qdr=all&as_rights=&as_occt=any&cr=&as_nlo=&as_nhi=&safe=images

  33. I am confused. Wasn’t the whole point of the bailouts to “improve the balance sheets” of the banks, by handing over the “cash” to balance out the “debt.”?

  34. though I always regarded myself as a kind of mercenary or even a prostitute I object to be called a minion for the kind of work I did to make a living
    not everybody is equipped with the nerves of steel it takes to work free lance or as an entrepreneur

  35. no better way to establish yourself as supreme ruler …

  36. Socialist Critic

    Going back to the points made in the original post, I would like to follow up Stephan’s mention of Hilferding. Oftentimes, neoclassical economists neglect the politics inherent in the economy. The Bolsheviks had a compelling argument to this effect: economics is fundamentally political. Finance in our society is about the allocation of resources, the division of wealth, and the maintenance of class structure. These are all political functions. The network of relations that form within banks, between banks and corporations, between these institutions and the government, between boards of directors, investors and executives constitute the formation “finance capital.” Capitalism in its imperialist stage essentially designates finance capital as the distributor of society’s resources.

    Given this situation, the notion of shifting this function to the capitalist state does not make sense. The reason is that it presumes the bourgeois class power that is behind our politicians does not exist. What really needs to happen is an upsurge of working class organization and power such as occurred in the 1930s. This is the only way power can be wrested from the financial oligarchy currently dictating politics. From there we have the basis of making such decisions: do we continue on to socialism (abolishing finance capital and replacing it with a dictatorship of the working class) or settle for European-style social democracy (allowing it to remain but severely limiting its power).

    Unfortunately, to ask such a question now doesn’t make much sense either. The most highly organized part of our society, as someone mentioned, is the radical right. Right-wing militia groups have begun to grow extremely fast and have achieved a mainstream presence now. I think it is likely this growth will continue given the long-term high unemployment rate and pauperization of the working class. This is scary. I don’t know if the Weimar Republic analogy is accurate, but it is scary. The atomization of American society and the lack of organization on the left is ultimately what will allow these reactionaries to take advantage of the economic crisis if and when it becomes a political one.

  37. I don’t know why there can’t be a clean sweep of congress and state government to drive out democrats and republicans who don’t represent us, and replace them with third party people who do.

  38. it’s a pity you probably don’t understand German and there is no transcript of the conversation – but here is just the right kind of supplement for your argument (as you presumably very well know the Nazis appealed very much to the nationalist right)
    http://podcast-mp3.dradio.de/podcast/2009/08/09/dlf_20090809_0738_ebcf870a.mp3
    anyway Hans Mommsen says that the industrialists hoped to reign in the unions by supporting Hitler (the big landowners of the east had other dreams for acquiring their goals via using him) and Sebastian Haffner claimed that the left couldn’t get its act together because synchronising their beliefs too often seemed more urgent than unified action

  39. As long as we’re looking so far back to argue about the appropriate size of sectors relative to the value of their intermediation:
    http://www.usgovernmentspending.com/us_20th_century_chart.html

  40. David Goldstein

    >What really needs to happen is an upsurge of working class organization and power such as occurred in the 1930s

    Hmmmm, then things are going to have to get 1930’s bad, because it took a few years of suffering for anything to happen.

  41. “A little faith and patience is in order here” is also the default response of anyone operating a Ponzi scheme.

    Of course you may be right. Or you may be in on the fix. Can’t tell either way, can we.

    cougar

  42. Nemo,

    I know plenty of ordinary investors that make money from short selling and the like. Is that wrong?

    I have a sense that it is not the activity that is offensive so much as the matter of scale.

  43. Exactly. Those 40% profit in the finance industry corresponded to less wealth outside of it where the work was done.

  44. Short sellers and the like won’t be bailed out if they have been wrong, they risk their own money. Short sellers fulfill an important function in the economy: sniffing out the rats. If you want fraud and bad business exposed early (and who wouldn’t), you should allow rewards for the researchers. For example, Goldman went short on MBS and earned a lot of money with it while their MBS department was still packaging securities – I don’t blame Goldman for that, rather I would say that for once they fulfilled their function of preventing an even larger bubble.

  45. A few months back, I actually dug into the underlying data that Kevin Phillips presents in Figure 2.1 of the book, and what I recall was that to get his numbers, you had to include insurance, all types of loans and credit. That is also the implication of the sentence after he describes what the Figure shows, but I wanted to stick with how he phrased things in the first sentence because I did not have time to go back and double check, and I didn’t want to put words in his mouth . . . I do believe that the 20% number reflects all aspects of the financial sector including insurance companies . . .

  46. That’s because once enriched they’ll be doing OK no matter what happens.

    There is a certain traitorous edge to greed.

    cougar

  47. Those are human traits. Most people undervalue risk, and exaggerate physical threats. And humans seem to be inherently greedy, probably due to having evolved during times of shortage.

    So you don’t have to be a clinically diagnosed addict to have a gambling problem. You need only be human. By extension, the children playing with 15 zeros are just playing out the same dramas that were in play 5,000 years ago. Except that back then there were may be 1,000 people who directly cared, whereas now there are perhaps 1,000,000,000 who do.

    Same game. Bigger prize. Harder fall.

    cougar

  48. Yep. If we actually develop free markets with real competition in some of these services sectors, the costs will come down, and GDP will go along with them.

    I’m basically with Simon. I fear that we will not see the changes that are needed because what Bush/Paulson/Bernanke and Obama/Geithner/Bernanke have done (1) ran up a big tab in an extremely short period of time and (2) masked the underlying systemic problems sufficiently that we’re seeing the same types of complaints that were made 4 years into the New Deal after less than 6 months of the stimulus bill. When you couple these facts with the current political environment, I don’t see anybody having the necessary combination of political will to seek meaningful change along with a compelling solution that forces bipartisanship in a polarized world.

    And I’m glad that you didn’t ask me what I thought we should do because I don’t know, other than trying to get economists, lawyers and accountants together to develop the next layer of economic abstraction, the one that considers the interplay of differences in national economic policy, business law and regulation, and accounting policies. We went from microeconomics to macroeconomics. Maybe somebody exploring “globe-economics” will develop the insights necessary to understand how globalization affects economic decision-making to enable legislators to create laws and regulations that promote globalization without cannibalizing national economies, as we seem to be doing now.

  49. A laudable sentiment. However once the thin veil of trust is breached and fragile democratic institutions are contaminated with the rot of corruption, there is no saving them.

    Burn it up. Start over.

    The US founding fathers said much the same thing, BTW. The general idea appeared to be that democracy could best defend itself through self-immolation. But then, those guys were prepared to hang for an idea so setting fire to things probably seemed pretty tame at the time.

    cougar

  50. Except that they had inside information – they knew their own dept. was bleeding buckets, and therefore so must everyone else. They simply resorted to cannibalism faster than their rivals. I’m all for short selling, but GS cheated.

  51. Much of the government money went to rent-seeking employment (execs), and was effectively squandered on non-productive activity and consumption. Much of it will be “paid back”, effectively by subsidizing rates for banks to borrow in order to permit really high spreads on loans, and also by allowing oligopolistic banks to extract money through fees. The banks are fine if the government prints money, as long as it goes to them, and does not come with attached restrictions on their future ability to print money.

  52. StatsGuy,

    I don’t care much for Mises, either, or the Austrian school of economics, for that matter. The idea that they nailed economics a hundred years ago when the nature of the economy has changed so much since then is a bit naive. Schumpeter’s concept of “creative destruction” applies to economics, too.

    That being said, the Austrian school in many ways is the closest to orthodox neoclassical economics, whith does not recognize the role of credit in money creation. The only other school of economic thought that I know of that acknowledges endogenous money are Post Keynsians like Prof. Steve Keen. Although Mises dismisses endogenous money as a thing of the past, at least he admits it as a real phenomenon. He was just wrong about its demise.

    I agree with you on the size of the challenge,and I don’t think anybody is up to it.

  53. Yes, but this has to be temporary – that’s the argument about getting the genie back in the bottle. Expanding base money might be good in the short term, but when we hit the target capital/asset ratios, we would need to shift govt. funding back to a taxation model. Otherwise, badness.

    Many unsophisticated anti-inflationistas look at base money and flip out, not understanding velocity. Others do understand velocity, and are fearful of what happens when it ticks up again.

    As to cash hoarding… one of the things about an insufficient base money supply is that if the demand to hold cash (for security) increases and new cash is not added to meet the demand, the price of cash goes up (e.g. we get deflation). This exactly parallels SJ’s argument that, long term, we may be better off if foreign governments could hold IMF obligations, so that one govt’s security (foreign reserves) did not need to be bought with another govt’s jeopardy (debt).

  54. Simon, thanks for this post. It is about time! I have been waiting for someone to put this financial mess into the perspective of the financial history of the last 200 years, or longer. Back in the early part of this century when I would look at the sector percentages of my mutual fund I would notice how large the financial sector was. Not being very knowledgeable in finance or investing I let it pass. However, I intuitively had a sense that finance should be a much smaller part of the economy than I was seeing. Intuitively it seemed like finance relative to the larger economy should be somewhat like the HR department is to a corporation – a necessary but relatively small part. Thanks for this post. You have confirmed what I suspected was true many years ago.

  55. Correct. Welcome to the future-past.

  56. Yakkis —

    You seem to feel that hard work should be rewarded.

    More precisely, I feel that genuine productivity should be rewarded. Value creation should be rewarded. Not “shareholder value”, but real value; as in the difference between raw materials and a finished product, or between someone who is sick and someone who is healthy, or between a blank page and a sonnet.

  57. Yes, one might say we have not suffered enough for real change to happen. So, do we make the necessary changes before the really bad stuff happens? Does any one see the connection between the economic meltdown with the prospects for NO real change in our economic system and our collective refusal to do anything significant about global warming? Does any one see the connection between financial economics and environmental economics?

  58. I know plenty of ordinary investors that make money from short selling and the like. Is that wrong?

    No more wrong than making money by playing poker… But I am no longer so sure it is more right, either.

    I suppose scale has something to do with it. I view the financial system as part of the “gears” of society, like (say) garbage collection. There is nothing wrong with being a garbage collector; it is a necessary function. But they will never be paid as much as the top innovators and producers. Neither should those in the financial sector, in my opinion.

    That we, as a society, give so much of our wealth to people for doing approximately nothing represents a serious market failure, in my view.

  59. regarding short selling: it is my understanding that when short-selling securities the short seller must use securities owned by a broker or by someone else who owns the stock in that company. Is the actual owner of the stock being used in the short-selling informed that their stock is being used in this manner? If not why not?

  60. Since I like reading about economics this was an interesting day. Prof Johnson’s article discusses history of finance in the US. In the The Times Magazine, (NYT), Prof Krugman wrote an essay on finance in history of thought. (http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=8&bl&ei=5087&en=7d0e3cac5b9a733a&ex=1252123200)

    Prof Johnson concludes “Yet, with the headline numbers for the economy beginning to improve, the impetus for any real reform of this sector – within the US or internationally – starts to fade. The likely future is: more of the same, at least until we find a Jackson or a Roosevelt.”

    And, Prof Krugman is hopeful that behavioral finance is going to help identify ‘crowd madness and irrational exuberance’.

    But then, Mr. Greenspan ‘warned’ everyone that irrational exuberance had taken hold back in 1996 – I have trouble with the notion that ‘exuberance’ of humans might become a regulatory measure… (what other ‘abnormal’ behaviors will come under the microscope?)

    I think that ‘what is finance’ is a big and crucial question that affects everyone. And, even though both articles are very valuable and contain many truths, I also believe that a different epistemological approach towards this theoretical problem is needed to offer some hope to unemployed and homeless people so that they won’t just crawl out of the current ‘pit’ to be hurled right back into another one in a few years.

  61. Hmmmm does this mean that the IMF SDR international currency (store of value etc) is a good deal for us?

    It seems we are bedeviled by our national financial management problems being exacerbated by also being a global reserve currency? I appreciate the Wall St advantage gained but the present global model seems like a car with square wheels and most passengers are uncomfortable?

    Maybe we should support an easing into the SDR model, say 10% per year rather than big bang? Then global systems could monitor the changes ratre and adjust if something is derailing?

    What do you think StatsGuy?

  62. We need a smaller federal government also. Finance would have been a smaller piece of the pie had big brother let big banks take the hit. Yes, it would have been painful and more acute but in the end the malaise would have probably ended sooner than it will under the current set of circumstances.

  63. I will just point to my response in yesterday’s blog: that the fact that the economy is substantially out of balance is creating incredible hazard, moral and otherwise, and I, like you, am waiting for our political leadership to get tne “nads” to act to control the various oligarchies that have stepped up their attempts to control those who we elected to care for this country. Thus far, while a few in our leadership have decried the current status of the finance, health care and energy sectors, very little has been done to reach of effective ways to rebalance our economy. We are currently scaring the bejesus out of those who live in other countries, as well as deeply and negatively affecting our populace.

    If things continue to trend this way, the payment due the piper, and very soon, will be very, very steep indeed. I think that we may have about two years to get things right, but maybe not so long.

  64. Bayard,

    Good post. I hope we have two years.

  65. “I, like you, am waiting for our political leadership to get tne “nads” to act to control the various oligarchies that have stepped up their attempts to control those who we elected to care for this country”

    Don’t hold your breath! (Not meant to be glib… just pointing out the near futility here.)

  66. I taught myself about short selling via this graphic http://www.handelsblatt.com/finanzen/boerse-maerkte/_b=2046564,_p=12,_t=ftprint,doc_page=0;printpage
    that left me with a question:
    according to the graphic there is a time gap between the loan and its repayment during which the “shorter” is flush with cash which other than a poker player he presumably not hords before him on the table but puts to some use.
    Could it be that it’s use is “renting” new stocks to short-sell with it thus multiplying his/her debt/risk? and then doing it with the next cash intake again? thus multiplying his debt with each new shorting adventure? and seeming ever more credit-worthy to the next bank he/she goes to for the next loan of stocks?

    As this looks like a hugely enhanced form of bill-jobbing (Wechselreiterei) to me which at least in my youth was considered a criminal offence I guess that either the graphic is wrong or I misunderstand something.

  67. With all due respect, and appreciation, the most fundamental problem of the financial system is none of the preceding. It is that MONEY CREATION HAS BEEN PUT IN PRIVATE HANDS. This would have bewildered most of the past leaders of the civilizations on which the present civilization is founded. It was taken for granted, for millennia, that the definition of the state is that it, and only it, created the money used in the realm. To endow private individuals not representing the state with that power is to create parallel states within the state. Past leaders would have seen this as civil war and gangsterism in the offing.

    In the Imperium Francorum the vast empire of the franks that founded the philosophical and political core of what is now known as the West, private money makers were called counterfeiters, and their punishment was to be boiled alive in special cages. Later on, though, bankers became all important, as they bankrolled the French and British crowns.

    The modern politico-financial system rests on the idea of fractional reserve: banks keep only a fraction of their deposits, and loan the rest. This makes bank run possible.
    By its nature, the practice of fractional reserve banking expands the “money supply” (the money used in the realm) beyond what it would otherwise be. Because of the prevalence of fractional reserve banking, the broad money supply is a multiple larger than the amount of base money created by a country’s central bank. That multiple (called the money multiplier) is determined by the reserve requirement imposed by financial regulators (themselves in the pockets of those they regulate).

    But that, of course is not the important point. The important point is that the money creators are left free to create money and give it to whoever they like, such as themselves, their friends, accomplices and business partners.

    As it is, fractional reserve is an invitation to gangsterism. Having all politicians inside the pockets is just a consequence.

    Should one outlaw reserve banking? No, because it expands the money nicely (historically, not having enough money around has blocked economically many a civilization). To avoid the gangsterism though, the pecuniary interest of bankers ought to be disconnected from their professional activity (financing worthy projects). For this a strong deontology, assorted with strong punishments for the fraudsters, should be implemented. To facilitate this, bankers ought to be put under oath, like doctors, and even made into officers of the state, at least formally speaking.

    Their salaries ought to be detached from their daily activities, and their bonuses ought to be attributed in the fullness of time, only for projects whose completion has proven meritorious as a public utility.

    Radical? Yes. Unavoidable? Not necessarily; one could collapse civilization instead. It has happened before, when the plutocracy found some similar devious trick to grab all too many of the riches.

    Patrice Ayme
    http://patriceayme.wordpress.com/

  68. in today’s ft.com both Timothy Geithner and ECB’s Jean-Claude Trichet have a piece – here are the head-lines
    “Financial stability depends on more capital”
    “Europe has mapped its monetary exit”
    I know for me its useless to read the stuff because I will not get the “real” meaning, assumed there is one – but maybe the savvy among you will be able to tell me what it “predicts” for the future trans-atlantic relations

  69. “Imperium Francorum the vast empire of the franks that founded the philosophical and political core of what is now known as the West”

    well well – is that La Grande Nation claiming a heritage?

    how about the decided republicanism of the city states of North Italy, how about …, how about …
    I am very glad that I do not live with the cultural heritage of one vast empire but with an infinitely diverse heritage shaped by influences of inter alia Arab and Orthodox and Konfuzius and Buddha and hopefully a lot of others
    I myself of course am biased towards the highly literate cultures which the Franks for a long time definitely were not … (i.e. while the Venetians carried of Byzantine art to their own city during the sack of Constantinople the Franks preferred to go on a rampage destroying as much as possible – why carry of a mosaic if all you want is the gold …)

  70. Bondgirl, here’s what I think the point of the article is (from the last line of it):

    “The Journal warned, ‘If a buyout or acquisition deal doesn’t materialize for Avis, stock and bond investors will have to focus on the fundamentals of its car-rental business.’ ”

    Multiple mergers/sales of a company within a decade or two can have a debilitating impact on the overall culture of a company – with a corresponding drain on its ability to conduct its business. So much attention needs to be focused on merging systems, developing a new, unified culture.

    So much money is paid out in fees to the lawyers and bankers who broker the deals.

    The actual business of the organization can really get the shaft. With a big impact on shareholder value.

  71. “I know plenty of ordinary investors that make money from short selling and the like. Is that wrong?

    I have a sense that it is not the activity that is offensive so much as the matter of scale.”

    Investing is not running a business. It’s playing the market. There is nothing wrong with the investments and mergers, but somebody somewhere needs to be focusing on running the actual business that a particular company provides. I think that’s where a terrible schism in our economy has occurred.

    (And in all honesty, I think we need to start questioning the shareholder value of adding things like astronomical flower and dry cleaning budgets to the retirement packages of CEOs a la Jack Welch – the issue of compensation is becoming something that can easily impact shareholder value in a negative way.)

  72. StatsGuy, when did debt become the one pillar of our economy to remain standing?

    That’s a question I’ve wondered about since Paulson first defined the crisis for us – that our ability to loan and borrow had been decimated by the crash, so we needed to infuse all this federal cash into the system to loosen up the credit market.

    (http://wardonwords.blogspot.com/2008/11/word-of-day-debt.html)

  73. the first merger we took in our stride, working for the indisputably dominating company (what it did to the others did not filter through to us, presumably they had to adjust, period!), the next one was a totally different stories there one of the companies to be “absorbed” by us (we being the richest of the three) was a child of the big outfit which had bought us. Thus they had the better connections. As a consequence over years turf wars were fought all the way down to the cubicle level …
    but of course Mao-style permanent revolution was supposed to be a good thing – makes the life of those idiotic wage-workers less boring, keeps them alert and creative ;(

  74. I just sent the following letter to the Financial Times which they will not publish as I am a writer no grata to them… God knows why? http://bit.ly/XJYxY

    Mr Geithner, and the rest of you regulators… you are so wrong.

    Sir Timothy Geithner writes that “Stability depends on more capital” September 4, and he is so wrong. Stability depends almost exclusively on getting the right sustainable growth since with the wrong kind of growth you would need 100 per cent of capital and even then you probably only your real stability until you find yourself ten feet under the ground.

    The hard truth Geithner needs to understand, and come to terms with, is that even if the credit rating agencies had been absolutely right in their ratings, the end results for the economy would be wrong; because subsidizing risk adverseness and taxing risk-taking, that is something that only a society that has had enough and wants to lie down and die does… and we can’t expect the whole world to be baby-boomers… can we?

    Of course the regulators need to increase the current capital requirements for banks, but only for those operations where they decreased them so dramatically, like for instance allowing a 62.5 to 1 leverage when lending to anyone able enough to hustle up an AAA.

    Mr Geithner please give us one single reason for why the regulators should specially favour banks lending to clients rated AAA. To me that is a pure senseless discrimination that will not lead us anywhere except over the next subprime cliff.

  75. I think we’ve had this conversation… I’ll dig up the posts.

    IMF SDR for future debt may be a good idea, but converting existing US dollar obligations to SDRs would be a disaster; it removes the US ability to devalue the dollar (which is necessary for trade stability), because devaluing the dollar could trigget a hyperinflationary spiral as the US must acquire accelerating amounts of foreign currency to pay back debt. I think Baseline has taken this position too…

    http://baselinescenario.com/2009/06/01/china-pushes-hard/

  76. I don’t know… If I recall, the Fed first realized/publicly admitted that private debt = money in around 1994 or so. My sense is the Austrians (Scot mentions Mises) intuitively understood this a lot earlier.

  77. I have to say, I don’t know if I’m so eager to model our leader after Andrew Jackson either – we may emotionally empathize with populism, but Jackson’s policies are often accused of triggering the Panic of 1837, America’s “First Depression” and an international credit and currency crisis that lasted ~7 years. And this was at a time when a huge chunk of America was still subsistence agriculture or home manufacturing. (How many people today grow their own food?) Some argue it took an exogenous shock like the Gold Rush to end it, due to the general incompetence and anti-interventionist attitude of Jackson and Van Buren’s governments.

    The real question here is this – is there any way to recover from our current disastrous state without enduring a decade-long depression due to credit contraction? And is the only way to trim the sails of finance back to some reasonable level involve a crippling economic disaster for the rest of the population? I will be honest – I am fearful of such a solution.

    The seems to – one way or another – require a strong government hand. Whether the end results is renewed regulatory power, or a semi-privatized regulatory solution (like BG has proposed), setting up the new regime at the very least requires strong leadership.

    And it basically requires a charismatic leader with a bully pulpit going to war on the public stage against big finance, which has a HUGE media platform. And a captive audience of individuals with a, uh, limited understanding of reality.

  78. Re using IMF SDR’s as the global reserve currency store

    StatsGuy writes in part:
    converting existing US dollar obligations to SDRs would be a disaster; it removes the US ability to devalue the dollar (which is necessary for trade stability), because devaluing the dollar could trigget a hyperinflationary spiral as the US must acquire accelerating amounts of foreign currency to pay back debt.
    —————————————–

    Yes, I appreciate this but isn’t the situation you outline exactly where all other countries are if they devalue? Surely we can handle the same rules?

    My thought is that our Treasury folk are currently shielded from reality and will never face up to resolving current account deficits. If we don’t address this problem now we may end up facing it because other countries don’t wish to continue funding our trade imbalance?

    US debt does not necessarily all have to be transferred to SDR’s but could remain as now. Start afresh with the SDR function and manage a progressive ‘buyout’ of dollar balances as our trading performance improves. Holders of debt will be happy if they are earning acceptable interest rate. This is similar to the toxic asset bank proposal for our bank’s toxic asset valuation problems? Also a lot of these balances are probably being used by the banks to make derivatives market plays and reducing their monopoly money stash could be a good thing?

    The details? The only alternative seems to be continue as we are? Is this really the best option and where does it lead?

    What about our next generation’s prospects? We can’t leave them to banker’s tender mercies can we?

  79. D. Christopher Leonard

    In other words, the problem is political (is in political economy). There may well be a number of potential technical policies that could reign-in risk taking in finance, regulatory reform [i.e. much tighter oversight of banks as in Canada], and manage the credit crisis} but there are no political blocs that can effectuate them as state policies. As you note, an effective state policy requires a ‘strong government hand’ and the structure of our national government institutions makes this virtually impossible (My inclinations for the state are more diregiste). Historically, the national government hasn’t solved problems through effective policy as much as been bailed out by contingent events. For example, the second recession of 1937-8 and the Roosevelt administration’s incapacity to push through ‘stimulus’ spending on the consumption side.
    I’ve recently re-read several works on the Depression/New Deal – Brinkly’s End of Reform, and Sklar’s Corporate Reconstruction of American Capitalism. Makes for very sobering reading.
    In any case, the problems are inherently political in character and policy choices (however technically sound they may be) are at the mercy of a polity in profound disarray.

  80. Daniel Habtemariam

    Bayard,

    I think you’ve nailed the eventual conclusion on all of our minds.

    In my experience, though, once you start talking about regulations and interventions on the oligarchies’ affairs, you’re met with boos and hisses and cries of socialsm! from an unignorable sector of the populace. We have a schizophrenic American electorate, who’re dissatisfied whenever you’re hinting at a resistance to unconstrained capitalism and even more dissatisfied at the resultant effects to the economy brought on capitalism. The reasonable people in the middle are dwindling in numbers.

    In two years, if we get this wrong, we’ll really be resembling the prototypical oligopolistic economies of Latin America, as Simon has suggested.

  81. StatsGuy,
    …just want to add to your points on SDRs’ that the US would (in addition to losing control of the trade and currency links (diminished as those are)) – also lose it’s spot as a world political leader.

    and are we really ready for that? And, this takes us back to previous discusions on China…

    on a coffee break,
    mc

  82. Why would you want to “reign-in risk taking” in finance? To me it seems that given that the crisis happened in the safest assets, houses and mortgages, safest land, USA, and safest instruments AAA what you had was a misguided risk-adverseness http://bit.ly/174NQC

  83. I missed stating that our treasury denominated debt is probably 80% held by ourselves so only the foreign component is a problem re SDR usage.

    So we can manage the domestic economy complete with related Treasury bonds and seperately manage our interface to global trading partners.

    Conclusion: The problem is not too hard?
    ————————————————-
    PS. I definitely warm to the idea of bank leverage being tightly regulated as required. Would 7:1 be a good starting point?
    ——————————————-
    Now how do we make this happen? well I see the Washington Kool-aid company staff (about 600?) needs to be told by the shareholders,
    ‘we put you there to fix things so fix them now. No more banker’s kool-aid distribution.’

  84. Silke: please.

    The Franks spoke originally a form of lower Deutch, a form of Dutch. Fact is when Brunehaut was queen the empire was already gigantic. It became more so as it extended soon from Northern Spain to and including Poland, and so on. Snippets are not the big picture. The sack of Constantinople by a Frankish army in 1204, was a spur of the moment thing which is neither here nor there. And Venice was basically a march state of the Imperium Francorum, being under its protection…

    I am talking about a particular thread of history as far as finance is concerned, not whether Buddha was a Frank or not. True, the Franks were more tolerant than the Arabs, but that was not the subject here…

    Be biased if you please, but I am not… ;-)! It’s not because Bismarck had a big statue pointed at France, that I stayed fixated that way.

  85. what you had were people who did not tell the truth from investment bankers to regulators to credit agencies to mortgage lenders to … what you had were people who through false representations did the best they could to transfer as much money from the lower 99% to the upper 1%. But this does not preclude the fact that risk taking is necessary in finance.

  86. Right on! Let us never forget that no matter what they say out there the losses occurred because extremely risk adverse investors were offered a couple of basis points more on what they had all the reasons to think were as safe as investments there are. That many other managed to make a lot of money on that is a completely different issue.

  87. David Goldsetin

    >Yes, one might say we have not suffered enough for real change to happen. So, do we make the necessary changes before the really bad stuff happens?

    What I really meant by my statement is that until people are feeling hit harder by what we have been partially sheltered with in bailouts and stimulus, they will sit on their hands.

    I voted for Obama, because I felt he was the only viable candidate for the job. He is a good man and I believe he has the best intentions, but he faces very powerful and wealthy opponents, but more than that, a still apathetic American public, who for the most part, went home after the election, thinking problem solved.

  88. David Goldstein

    What I really meant by my statement is that until people are feeling hit harder by what we have been partially sheltered with in bailouts and stimulus, they will sit on their hands.

    I voted for Obama, because I felt he was the only viable candidate for the job. He is a good man and I believe he has the best intentions, but he faces very powerful and wealthy opponents, but more than that, a still apathetic American public, who for the most part, went home after the election, thinking problem solved.

  89. David Goldstein

    Minor complaint – the inability to edit a post is irritating to some as anal as I am! :-)

  90. Or maybe the fact that the finance sector made up 40% of our GDP indicates that we’re really not measuring the right things with GDP! Anything that’s 40% finance can’t be very good.

  91. Finance is anything the war mongers at the Bank for International Settlements says it is.Fiat currency is like the divine right of kings…….a shackle from our past ignorance and institutional fear of facing the mystery of existence once consciousness kicks in.
    More Tom Paines;excelsior (something better).War is a crime.Transparency,Justice Accountablity.

  92. Some thoughts on creating money through credit

    Since many of the cognoscenti read this blog, I would appreciate some feedback. Many thanks. :)

    The Money Multiplier: Suppose that the reserve requirement for loans is 50%. Say that bank A lends out half its money, which ends up in bank B, which lends out half of that, etc., etc. In the limit the money on loan doubles. That is obvious if we suppose that there is only one bank. When it can no longer lend, half of its money will be equal to the amount of money it started with. In real life, loans are not made to the ultimate extent, but the potential is there.

    The inflation of reserves: Suppose that all of the loans are due on the same day. (That sounds like a bad idea, but I have heard that in feudal Japan loans were due on New Year’s Eve. Part of the the New Year’s celebration had to do with being free of debt. Anyway, bear with me for the purpose of illustration.) All of a sudden the money in the bank shrinks back to what it was — almost. What about the interest? Where does it come from? (Remember, we are assuming that this is how we create money. All the money is in the bank.) Well, it does not come from anywhere else. That means that there are going to be loan losses. Some of the money is not going to be paid back. Where is it? In the bank, of course. The amount in the bank will be equal to the original amount plus the loan losses. This is a kind of inflation.

    The creation of money via loans is temporary, as that money disappears when the loan is paid back. The inflation of reserves via losses is permanent (without other mechanisms to reduce it). It is hidden by the fact that loans are not due all at once, but are spread out over time. However, the losses are free to be used by the banks to make new loans, so this inflation of reserves is potentially transferred to inflation in the amount of money on loan.

    There is a significant issue in the creation of new reserves through loan losses. There are social costs associated with these losses. As a society we have chosen to increase our money supply in part through defaults and bankruptcies. Whether that is a good idea or not I will leave aside for now.

    Reserve requirements: Let us say that we have a specific target for the inflation of reserves. What reserve requirements are consistent with that policy? Well, that is underdetermined. Let us add another criterion. Let us maximize the expected return on investment of the loans. The application of Kelly’s theorem pegs reserve requirements to the interest charged. The higher the interest, the greater the reserve requirement. (There is a similarity to Basel II, as less risky loans will be made at lower interest rates, which have smaller reserve requirements.)

    Let me illustrate that with a table. I am assuming a target of 5%. (Note that the inflation of reserves in real life will be less, as not all loans that could be made will be.)

    Interest % – – – – – Reserve requirement %

    06 – – – – – – – – – – 8.7
    08 – – – – – – – – – – 20.9
    10 – – – – – – – – – – 29.3
    15 – – – – – – – – – – 42.3
    20 – – – – – – – – – – 50.0
    25 – – – – – – – – – – 55.3
    30 – – – – – – – – – – 59.2

    Note that these requirements have nothing directly to do with payouts of depositors’ money. That is a separate issue. They do have to do with the solvency of the lender. That is because, to maximize the expected return on investment, the lender must not go broke. Since they have nothing to do with depositors, they apply to any person or institution whose business is lending (and hence, creating) money.

    There are those who would say that such reserve requirements constitute a tax on the lender. Au contraire. It is just that they maximize the expected return on investment rather than the expected immediate profit. The ability to make loans tomorrow does not figure into expected immediate profit. This difference in viewpoint and, dare I say, definition of rational self-interest, is important, but again, I shall leave it aside for the moment. In any event, if we are going to create money via private lending, it is appropriate to have such reserve requirements. The long term solvency of the system is important.

    A couple of comments: While not an anti-usury measure, increasing reserve requirements with the interest rate acts as a check. If your credit card company were to up your rate from 10% to 30%, they would have to double their reserves for your account. They might not want to do that.

    The reserve requirements are pegged to interest rates, not credit ratings. Of course, there is a relation between the two. But the interest rate is the key factor. I did not account for possible miscalculations of risk on the part of the lender, but I trust that the overall picture is representative.

    I also did not attempt to deal with other factors, such as the bond market. I would appreciate any observations about how such requirements would fit into the economy as a whole.

    Many thanks, :)

    Min

  93. Min

    If you wanted to follows the Basel risk adverse philosophy your proposal of reserve requirements has some merits in that it allows each banks to set their own reserve requirement based on their own criteria or risk reflected in how high or low interest rates they charge. That part I like, since it does not bound the market to the opinions of some few credit rating agencies. Of course it could not be precisely as you indicate, based on the nominal interest rates, as these will fluctuate independently of risk, but one could think of using the spreads charged over some reference rate like Libor.

    That said I am totally opposed to it, just as I am opposed to the current Basel mechanism, because the interest charged to the client already includes the market premium on risk and with this system the regulators imposes an additional cost or tax for risk-taking (a tax on the borrower Min) and in relative terms subsidizes what is perceived to have a lower financial risk, and I do not believe it is the responsibility of banks to pursue high or low risks but the right risks.

    This method, just like the current Basel, leverages the mistakes of the market by means of vicious feedback mechanisms like the lower rates you charge you client the lower capital requirements and so the lower rate you can charge him, or, the higher rate you charge the client the higher capital requirements and so the higher rates you have to charge. And this stimulates the whole financial sector to search out the risk free and that to me sounds too much like a world that has decided to lie down and die.

    The current system and what you propose, makes life easier for those who presumably already have it easier and harder on those who presumably have it harder and that to me sounds like only exasperating the differences there are in our World. For the development and justice minded technically the Basel Committee directives drives up the Gini coefficient in the world.