Giving interest an economic function does not in itself explain how banks create value. Economists have traditionally resolved the ‘banking problem’ by assuming that banks create value in other ways, and use their interest differential (the difference between borrowing and lending rates) as an indirect way to capture this value, because it comes from delivering services that cannot be directly priced. Banking, it is argued, provides three main ‘services’: ‘maturity transformation’ (the conversion of short-term deposits into mortgages and business loans); liquidity (the instant availability of cash through a short-term loan or overdraft for businesses and households that need to pay for something); and, perhaps most importantly, credit assessment (vetting loan applications to decide who is creditworthy and what the terms of the loan should be). As well as channelling funds from lenders to borrowers, banks run the various payments systems linking buyers to sellers. These activities, especially the transformation of short-term deposits into long-term loans and the guarantee of liquidity to customers with overdrafts, also mean a transfer of risk to banks from other private-sector firms. This bundle of services collectively constitutes ‘financial intermediation’. It is assumed that, instead of directly charging for these services, banks impose an indirect charge by lending at higher interest rates than they borrow at.
The cost of ‘financial intermediation services, indirectly measured’ (FISIM) is calculated by the extent to which banks can mark up their customers’ borrowing rates over the lowest available interest rate. National statisticians assume a ‘reference rate’ of interest that borrowers and lenders would be happy to pay and receive (the ‘pure’ cost of borrowing). They measure FISIM as the extent to which banks can push lenders’ rates below and/or borrowers’ rates above this reference rate, multiplied by the outstanding stock of loans.
The persistence of this interest differential is, according to the economists who invented FISIM, a sign that banks are doing a useful job. If the gap between their lending rates and borrowing rates goes up, they must be getting better at that job. That’s especially true given that, since the late 1990s, major banks have succeeded in imposing more direct charges for their services as well as maintaining their ‘indirect’ charge through the interest-rate gap.8
According to this reasoning, banks make a positive contribution to national output, and their ability to raise the cost of borrowing above the cost of lending is a principal measure of that contribution. The addition of FISIM to the national accounts was first proposed in 1953, but until the 1990s the services it represented were assumed to be fully consumed by financial and non-financial companies, so none made it through into final output. The 1993 SNA revision, however, began the process of counting FISIM as value added, so that it contributed to GDP. This turned what had previously been viewed as a deadweight cost into a source of added value overnight. The change was formally floated at the International Association of Official Statistics conference in 2002, and incorporated into most national accounts just in time for the 2008 financial crisis.9
Banking services are of course necessary to keep the economy’s wheels turning. But it does not follow that interest and other charges on the users of financial services are a productive ‘output’. If all firms could finance their business investments through retained earnings (the profits they don’t distribute to shareholders), and all households could pay for theirs through savings, the private sector would not need to borrow, no interest would be paid and bank loans would be redundant.
National accounting conventions recognize this incongruity by treating the cost of financial services (FISIM plus direct fees and charges) as a cost of production for firms or governments. This ‘production’ from financial institutions that funds the activities of firms and governments immediately disappears into ‘intermediate consumption’ by the public and non-financial private sectors. It is only the flow of goods and services from non-financial firms (and government) that counts as final production. But exceptions are made for financial services provided to a country’s households and non-resident businesses; these services, as well as direct fees and charges imposed by financial institutions, are treated as a final output, counting towards GDP alongside everything else that households and non-residents consume. The steady growth in household borrowing in the UK, US and most other OECD countries since the 1990s has automatically boosted banks’ measured contribution to GDP, through the rising flow of interest payments they collect from households. The increasingly hazardous nature of lending to subprime and already indebted households further boosted this measured contribution, since it resulted in a higher premium of borrowers’ rates over the reference rate with inadequate adjustment for the increased risks.10 The alleged under-reporting of key interbank lending rates, commonly used as the reference rate, may have worsened the exaggeration during 2008.
FISIM has ensured that the financial sector’s contribution to GDP has kept growing since the financial turbulence of 2008–9, especially in the US and UK. But if an intermediation service becomes more efficient, it should absorb less of its clients’ output rather than more; it should make a smaller contribution to GDP the more efficient it gets. Estate agents or realtors, for example, generate income through commission on each property sale. If they become more efficient, competition will drive down commission rates and the remaining players will survive on lower commission by reducing costs – making a smaller contribution to GDP.
The rules are different for finance. National accounts now state that we are better off when more of our income flows to people who ‘manage’ our money, or who gamble with their own. If professional investors profit by investing in property during a boom, new ways of accounting will register the profit as a rise in their GDP contribution. Short-selling (or ‘shorting’), which involves borrowing an asset and selling it in the expectation of buying it back after its price has fallen,11 is another speculative activity whose growth contributes to GDP under the new form of measurement. If money is made by shorting property-related investments before a slump, as investors such as the hedge fund manager John Paulson famously did before the 2008 crash, the profit increases GDP. But surely if, for example, bus fares kept rising in real terms, we’d demand to know why bus companies were becoming less efficient, and take action against operators who used monopoly power to push up their prices? But when the cost of financial intermediation keeps rising in real terms, we celebrate the emergence of a vibrant and successful banking and insurance sector.
According to theories that view the financial sector as productive, ever-expanding finance does not harm the economy; indeed, it actually facilitates the circulation of goods and services. Yet all too often investment funds and banks act to increase their profits rather than channel the proceeds into other forms of investment, such as green technology. Macquarie, the Australian bank which used post-privatization acquisitions to become one of the world’s largest infrastructure investors, quickly became known for securing additional debts against these assets so that more of their revenues were channelled into interest payments, alongside distributions to shareholders. After acquiring Thames Water in 2006, it used securitization to raise the company’s debt from £3.2 billion to £7.8 billion by 2012, while avoiding major infrastructure investment,12 The strategy raised alarm among environmentalists when, in 2017, Macquarie acquired the Green Investment Bank, a major financer of renewable energy and conservation projects set up by the UK government five years earlier. Moreover, once financiers realize that very little value stands behind their liabilities, they try to issue even more debt to refinance themselves. When they cannot continue to do so, a debt deflation occurs, such as the one that began in the US and Europe in 2007–8 and was still depressing global growth rates ten years later. Society at large then bears the costs of the speculative mania: unemployment rises and wages are held down, especially for those left behind during the previous economic expansion. In other words, value is extracted from labour’s share of earnings in order to restore
corporate profits.
It is, then, difficult to think about the financial sector as anything but a rentier: a value extractor. This, indeed, was the economic verdict on finance before the 1970s, incorporated into national accounts, until a decision was taken to ascribe ‘value added’ to banks and their financial-market activities. That decision redesignated, as results of productive activity, financial profits that economists previously had little problem ascribing to banks’ monopoly power, associated with economies of scale and governments’ recognition that the biggest were ‘too big to fail’. The redrawing of the production boundary to include finance was in part a response to banks’ lobbying, which was itself a feature of their market power and influence. By showing finance as a large and growing source of national output, it overthrew the logic of previous financial regulation. Where beforehand such regulation had been seen as a safeguard against reckless and rent-seeking behaviour, it was now portrayed as a shackle suppressing a valuable trade in money and risk.
DEREGULATION AND THE SEEDS OF THE CRASH
Financial sectors were heavily regulated in the early 1970s, even in countries with large international financial centres such as the US and UK. Governments viewed regulation as essential, because a long international history of bank crashes and failed or fraudulent investment schemes showed how, left to themselves, financial firms could easily lose depositors’ money and, in so doing, disrupt real economic activity and even cause social unrest. When banks competed, they tended to offer ever more improbably high returns to savers by funding ever more risky investment projects, until disaster (and bankruptcy) struck. But while such competitive instability was averted by restricting entry, and giving banks some monopoly power, they still inflicted damage on the rest of the economy in other ways – by artificially inflating the price of loans, and co-ordinating their buying and selling to cause artificial boom and bust in the prices of key commodities. Small banks were especially vulnerable because their (and clients’) activities were insufficiently spread across different industries and geographical regions. But big banks quickly became ‘too big to fail’, assured of expensive government rescue when overextended because their collapse would do too much economic damage. Such assurances only led them to behave even more recklessly.
Governments’ appetite for financial regulation increased after the global depression of the 1930s, heralded by the collapse of insufficiently regulated stock markets and banks, and the world war to which this indirectly contributed. In 1933, following the Wall Street Crash, the US had separated commercial banks (financial institutions which took deposits) from investment banks (financial firms raising money for companies through debt and equity issues, corporate mergers and acquisitions, and trading in securities for their own account) under the Glass–Steagall Act. The Act’s regulations were in some respects strengthened by the Bretton Woods Agreement of 1944. In line with the so-called ‘Keynes Plan’, the Bretton Woods system imposed tight curbs on international capital movements in order to preserve a system of fixed exchange rates – thereby ruling out most of the cross-border investments and currency trades which had previously been major sources of instability and speculative profits. The Bretton Woods Agreement also required governments to maintain tight restrictions on their domestic financial sectors – including high minimum ratios of capital to assets and liquid reserves to total bank assets, interest rate caps and, in the US, strict legal separation of commercial and investment banking. The cornerstone of the Bretton Woods currency system was the gold standard, under which the dollar was convertible into gold at $35 an ounce.
Such measures made it hard for financial institutions to shift their business to low-tax or low-regulation jurisdictions. The rules reflected policymakers’ consensus that financial institutions acted at best like a lubricant for the ‘real’ motors of the economy – agriculture, manufacturing and business services – and were not significantly productive in themselves. It was feared that a deregulated financial sector could become excessively speculative, causing disruption domestically and to the external value of currencies. But in the 1960s, as the idea of ‘light-touch’ regulation became increasingly attractive, such measures were increasingly viewed on both sides of the Atlantic as an obstacle to circumvent.
During this time, banks never ceased to lobby against the regulations that deprived them of significant markets, and others (like the Glass–Steagall Act) which restricted their scope to combine operations in different markets. As well as pushing for an end to regulations, banks proved adept at persuading politicians that restrictive regulations were unworkable, by finding ways to work around them. Bans on speculative derivatives trading, enacted in the US in the 1930s because of its role in magnifying the 1929 Crash and Great Depression, were effectively sidestepped by the growth of unregulated over-the-counter derivatives trading, which grew explosively in the 1980s and defied subsequent efforts at re-regulation.13 Banks’ invention of ‘offshore’ currencies, to sidestep cross-border capital controls, was especially effective. In 1944, the Bretton Woods system had pegged the value of the dollar to gold. But when the post-war boom, based on manufacturing, tailed off around 1970, ‘light-touch’ financial regulation increasingly appealed to policymakers on both sides of the Atlantic. The financial sector reacted to this interest by developing a new currency, the Eurodollar.
As non-US companies, mainly in Europe, accumulated dollars from exports to the US and from oil sales, financiers realized they could borrow and lend in these dollars, which would be outside the control of European governments because they had not issued the currency. UK banks were keen as early as 1957 to mobilize their dollar-denominated deposits, as the chronic balance-of-payments deficit forced the government to impose controls on their use of sterling for foreign transactions.14 Russian banks stepped up their use of Eurodollars in fear of financial sanctions from the US, and were joined by US banks as they correctly anticipated the suspension of convertibility by the US in response to its worsening US external deficit. London became the centre of the Eurodollar market, which grew into a global one. Rather than being reinvested in the US economy to build new factories or research laboratories, Eurodollars were siphoned off to developing countries in search of a higher yield than was available in developed economies at the time. The result was what has been called the ‘dollar shortage’, meaning that the currency was insufficient even for the country that issued it – the US.15 In 1971, faced also with the cost of the Vietnam War and mounting inflation, President Richard M. Nixon stepped in to avert a vacuum in the vaults of the US Bullion Depository at Fort Knox by suspending the dollar’s convertibility into gold. It was a dramatic move which signalled the end of the Bretton Woods system and the start of a search for a new way to manage international trade and payments, which was far more market-driven. There followed a period of zero growth and high inflation (‘stagflation’), exacerbated by OPEC quadrupling the oil price in the 1970s. By 1980, the gold price had reached $850 an ounce.
The economic difficulties industrial economies faced were regarded by some as a crisis of capitalism. What was not anticipated at the time was that financial markets would be hailed as the way out of the crisis. Finance turned into a growth hormone that would restore and sustain economic expansion.
The deregulation and transformation of finance was both a response to, and a cause of, huge social and economic changes which began in the 1970s. Globalization increased competition, particularly in manufacturing, and in Western countries many communities built on manufacturing – from toys to steel – saw those jobs head east to Asia. The rust belts of the American Midwest, northern England and regions of Continental Europe such as Wallonia in Belgium suffered wrenching social dislocation. Energy prices soared, driving up inflation and further increasing pressure on household budgets. The resulting slower economic growth held down wage rises in richer countries, and hence also the taxes raised by governments. Inequalities of income and wealth widened as profits’ share of national income re
lative to wages grew, in turn partly reflecting the weakening of workers’ bargaining power, for example by restricting the rights of trade unions and diluting labour laws.
The competing financial centres of London and New York worked out that they could attract more business by lightening their regulatory touch, with lower costs of compliance. In the US there was perceived to be a shortage of credit for small businesses and home buyers. In fact the real issue was the price of credit, which economists tended to blame on a combination of regulation forcing costs up and banks’ monopoly power pushing charges up; the response was to allow more competition between lenders. From the 1960s, Federal banking regulators, interpreting Glass–Steagall with increasing generosity, allowed financial institutions to undertake a growing range of activities. Household borrowing began to climb steeply. Under the Heath government in 1971, the UK adopted a temporary policy known as ‘Competition and Credit Control’, whereby quantitative ceilings on bank lending were lifted and reserve ratios for commercial banks were reduced.16 In 1978 minimum commissions were abolished on the New York Stock Exchange, clearing the way for competition and higher trading volumes. A year later, the Thatcher government in the UK abolished exchange controls.
Then, in 1986, Big Bang financial reforms in the City of London did away with fixed commissions for buying and selling shares on the London Stock Exchange, allowed foreigners to own a majority stake in UK stockbrokers, and introduced dual capacity which allowed market makers to be brokers and vice versa. Most of London’s stockbroking and market-making firms were absorbed by much bigger foreign and domestic banks. In the late 1990s, supercharged by the IT revolution, the volume of securities trading rocketed. Commercial banks could now use their huge balance sheets, based on customers’ deposits, to speculate. Their investment banking arms, along with independent investment banks such as Goldman Sachs, developed financial instruments of increasingly mind-blowing complexity.
The Value of Everything (UK) Page 14