The Economist gets it wrong, again
About 10 days ago, The Economist published three articles on General Electric and mixing industrials with banking. Those articles follow GE’s decision to divest its banking business, GE Capital.
In its editorial (the follow-up article is available here), The Economist declares that:
GE shows why industrial firms should avoid owning big finance operations. Occasional successes such as Warren Buffett’s Berkshire Hathaway can combine insurance with hot dogs. But most manufacturers are even worse at managing financial risk than banks are—and they are harder to supervise. A blow-up at the finance arm can sink the entire company.
In another short article, the newspapers attempts to warn industrial CEOs not “to turn your firm into Goldman Sachs”:
The case for a split is clear. Managers are even worse at dealing with financial risk than bankers are. A blow-up in a firm’s financial arm can hurt its main business. And giving tycoons access to savers’ cash can lead them into all sorts of temptation.
Well, that’s not really true. What The Economist is describing is the situation in which a few large companies have been allowed to set up banking arms. This is indeed a situation to avoid as it limits entrants in the market and as a result gives an artificially high market share to those who could set up banking activities, which often transform into TBTF entities and put their parent company at risk if ever they fail. In the end, you end up with a few huge banks and a few very large banking arms owned by non-financial corporations. But this is not a free market outcome. The Economist is suggesting that we restrict banking to banks. It will not make the TBTF problem disappear but reinforce it.
We want the exact opposite of what The Economist is describing. We want every single company, every Google, Amazon, Apple or Walmart, to be able to set up a banking or finance arm if it wishes to, as long as it believes it can convince customers that it is able to provide a cheaper and more efficient alternative/product*. The more banks on the market the more likely market shares are going to be granular and the balance sheet of each entity limited in size. In turn, this competitive landscape would make the TBTF issue disappear and customers benefit. Finally, as each banking entity remains relatively small under competitive pressure, it is also less likely to endanger the financial health of its parent company (or of the whole banking system) if ever it collapses.
*And many of those companies are already entering the financial systems, in particular in the payment space, with some success.
You argue for more banking actors to compete in allocating capital.
i)There is a group which argues that people should be able to issue their own credit interest free. A public body will verify if you are solvent enough to pay down the principal and then issues currency in return for a promissory note. The principal is then paid down and retired from circulation.
I think this would do a better job of allocating capital and cheaper than then current model. It will hugely lower costs for businesses and households as people who issue credit only have to pay down principal and not interest.
this group has a growing online presence: but this is one of their more succinct websites. https://australia4mpe.wordpress.com/category/mpe-for-dummies/
ii)You also make the case it would be more stable with more banking actors ,as market shares will be more “granular”.
But I would have to say if you look at the way banks behave and inflate property prices they all cyclically over extend their balance sheets. Minsky of course pointed this out .
Even If the industry is separated into little units, the banks will all lend into asset/property speculation causing a property boom and consequent debt implosion. The mini banks will be over exposed to non-performing loans, the interbank market will shrink up and credit for productive businesses will dry up and consequently unemployment will rise and demand fall.
Michael Hudson and Fred Harrison point out that the only way to prevent banks from creating debt binges ,and asset price inflation, is too prevent the capitalisation of land rental income and to tax it through a land value tax.
iii)I really think you should write up your critique of Scott Fullwiler . I think the MMT are right about the mechanics of endogenous money when making a loan, and they are probably right about how Central bank provision of reserves doesn’t necessarily result in hyperinflation, as bank lending behaviour won’t necessarily change.
But if you follow through on their logic ,I don’t really understand how they explain the credit crunch and recession ,because if banks are not limited in making loans then what was the credit crisis??
As I understand it the banks were unable to acquire the reserves necessary to continue making profitable loans. This was the case because some of the banks had too many non performing loans/debt instruments (the whole US subprime mortgage business).The ability of banks to lend without securing reserves is not the same as banks in aggregate being able to lend without reserves. There was a systematic credit crunch.
Your blog post surprised me,I had no idea that banks had to pay back central banks for reserves I initially thought they were provided on a as needed basis.
I met an old friend who works for one of the big rating agencies, rating banks. I was confused as Initially I always thought that banks only had to meet artificial capital requirements stipulated by Basel banking accords I-III. But I suppose she must also look at the bank’s cost of acquiring reserves ,it must be very interesting to have a financial accountants perspective on banks stability and balances sheets. Your post points out that both you and Scott Fulliwer agree that banks are pricing constrained. Some MMT thinkers stipulate that banks can always lend to credit worthy borrowers. This makes no sense to me as the start of recession is when credit lines to businesses are rescinded by banks. There was nothing inherently wrong with those businesses or anything that demonstrated they were insufficiently credit worthy. The first cause of the real economy recession is the withdrawal of bank credit from businesses, leading to failure/unemployment reduced demand and therefore other businesses fail. Banking credit crunch>real economy recession and unemployment.
Also I am not entirely sure I understand why banks clamour to obtain customers deposits,why do the want these liabilities….a cheap way of meeting capital or even reserve requirements?
Glad I came across your blog, Since ’08 I haven’t really paid much attention to classical economic liberals as I saw that perspective as being undermined by the GFC. And the other problems with neoliberalism generally.
good to have a broad perspective to read from.
Thanks for reading
Date: Wed, 29 Apr 2015 22:48:36 +0000
Hi Jake, sorry for replying only now!
i) I doubt this would be that efficient. First, a public body that would verify such applications would be subject to political pressure and has anyway imperfect knowledge. Also, as future is uncertain, who decides what risk to take? Nobody is 100% solvent. Solvability depends on many different factors, leading to a spectrum of risks.
ii) I have written a number of blog posts on the distorting effect of banking regulation on the housing market. It is much more capital efficient to lend for real estate purposes than to SMEs. So I don’t think banks have an ‘inherent’ tendency to fuel housing bubbles. It’s actually quite a new phenomenon.
iii) You cover a lot of ground here, but yes I see a few issues with the endogenous money view of banking (of which MMT). Their view implies that banks are little incentivised to seek external funding (wholesale funding is expensive, unless secure, and only demand deposits are cheap. But banks try to attract more expensive saving deposits).