THE LORDS OF (MONEY) CREATION
Large financial firms were, however, careful to secure a lightening of regulation, rather than the complete deregulation advocated by free-marketeers such as the Nobel Prize-winning economist Friedrich Hayek. Their reasoning was as follows. To maintain their high profits, the big commercial and investment banks still needed regulators who would keep potential competitors out of the market. Existing big players are therefore helped if banking licences are restricted. Ironically, the disastrous big bank behaviour that triggered the 2008 crash forced regulators (especially in Europe) into further lengthening and complicating an already arduous process for obtaining a new licence, frustrating their plans to unleash a hungry horde of ‘challenger banks’. In issuing licences sparingly, governments and central banks were quietly admitting something they were still reluctant to announce publicly: the extraordinary power of private-sector bank lending to affect the pace of money creation, and therefore economic growth.
That banks create money is still a highly contested notion. It was politically unmentionable in 1980s America and Europe, where economic policy was predicated on a ‘monetarism’ in which governments precisely controlled the supply of money, whose growth determined inflation. Banks traditionally presented themselves purely as financial intermediaries, usefully channelling household depositors’ savings into business borrowers’ investment. Mainstream economists accepted this characterization, and its implication that banks play a vital economic role in ‘mobilizing’ savings. Banks are not only empowered to create money as well as channel it from one part of the economy to another; they also do remarkably little to turn households’ savings into business investment. In fact, in the US case, when the flow of funds is analysed in detail, households ‘invest’ their savings entirely in the consumption of durable goods while large businesses finance their investment through their own retained profits.17
They also had to overlook the fact that money appears from nowhere when firms or households invest more than their savings, and borrow the difference. When a bank makes you a loan, say for a mortgage, it does not hand over cash. It credits your account with the amount of the mortgage. Instantly, money is created. But at the same time the bank has also created a liability on itself (the new deposits in your account), and banks must ensure they have sufficient reserves or cash (both forms of central bank money) to meet requests by you for payments to other banks or cash withdrawals. They must also hold capital in reserve in case loans are not repaid, in order to prevent insolvency. Both of these create constraints on bank lending and mean that banks generally refrain from lending to people and firms that do not fulfil certain criteria such as creditworthiness or expected profitability. Money creation also occurs when you pay for dinner with a credit or debit card. As a matter of fact, only about 3 per cent of the money in the UK economy is cash (or what is sometimes called fiat money, i.e. any legal tender backed by government). Banks create all the rest. It wasn’t until after the 2008 crisis that the Bank of England admitted that ‘loans create deposits’, and not vice versa.18
So licensing and regulation gave smaller banks a significant cost disadvantage compared to big ones, which can spread the bureaucratic costs (and risks) more widely and raise funds more cheaply. This made it harder for new competitors to enter the market. For existing players, there was a lot of monopoly rent to extract, and they could easily co-ordinate between them to avoid excessive competition without needing formal (illegal) cartel arrangements, while customers trusted them – rarely questioning their practices or financial health – precisely because regulators were watching over them. For example, it took an investigation by the UK’s Competition Commission in 2000 to establish that the country’s Big Four banks had been operating a complex monopoly on services for small businesses, using their 90 per cent market share to extract £2 billion in annual profit and push their average return on equity up to 36 per cent, by mutually agreeing not to compete.19 If banks’ gambles ever endangered their solvency, the government would have to rescue them with public money. This implicit guarantee of a public bailout lowered the biggest players’ cost of raising capital, which further cemented their market power.
FINANCE AND THE ‘REAL’ ECONOMY
For centuries, income earned by charging interest had been viewed as a subtraction from productive enterprise rather than a symbol of it. This was both a moral and an economic judgement. As we have seen, the Roman Church banned the charging of interest for most of the Middle Ages, while Enlightenment philosophers such as John Locke, writing in 1692, saw bankers merely as middlemen, ‘eating’ up a share of the gains of trade rather than creating any gains themselves.20 Even before the formal study of economics began in the late eighteenth century, many intellectuals and writers had concluded that banks did not produce value and often did not operate in the public interest at all.
For the physiocrats, finance didn’t belong in the agricultural sector and was therefore seen as unproductive. Adam Smith took a similar view, though he also rarely mentioned bankers explicitly. According to Smith, bankers cannot create more than they get; for him, the idea of making money from money does not work in the aggregate – although it certainly helps the bankers fill their own pockets.
Karl Marx introduced another idea. He located the financial sector in the circulation phase of the circuit of capital, where value created in production is realized through distribution and ultimately used up in consumption. For Marx, finance is a catalyst, transforming money capital into production capital (the means of production such as factories, machinery and living labour – the labour power of workers). Hence any income is paid out of the value generated by others. Rather than adding to value, finance simply takes part of the surplus value generated through the production process – and there is no hard-and-fast rule as to how much it should take. Taking (not uncommonly) reassurance about capitalism from its arch-opponent, twentieth-century economists assumed that financial profits would always be limited by (and total less than) the sum of productive firms’ profits, and might even move up and down to even out the flow of profits in the ‘real’ economy.
But this story came under attack after the crisis. Trade in financial instruments had vastly outgrown trade in real products and was stimulating the very price fluctuations from which profits are made – by creating opportunities to buy low and sell high. In fact, systemic fluctuations have led to a crash historically every fifteen to twenty years.21 Crashes reveal the investment banks’ ‘risk-taking’ service – which justified their inclusion in GDP accounting – to be a hollow boast. It is the taxpayer who is called on to take the real risk, bailing out the banks. But even the most influential critics of finance in the twentieth century – Keynes and Minsky – did not succeed in fundamentally challenging the privileged place of financial institutions in economic policy and in the national accounts. Keynes’s attention was deflected (and Minsky’s early warnings obscured) by the fact that financial services’ share of national output was below 4 per cent and falling from 1933 to 1945, and did not move back above its 1930s level until the 1970s.
Writing in the 1930s, one of the most influential critics of finance, John Maynard Keynes, was upfront about what financial speculation entailed. In his lifetime he observed how financial markets and public attitudes to financial trading were changing, becoming ends in themselves rather than facilitators of growth in the real economy. When speculation spread from a rich leisure class to the wider population, it drove the stock market bubble that ushered in the Wall Street Crash and 1930s depression; but as public spending helped to restore people’s jobs and incomes, those with money again began to gamble it on stocks and shares. Wall Street was, he said, ‘regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield’. By this yardstick, Keynes commented, Wall Street could not ‘be claimed as one of the outstanding triumphs of laissez-faire capitalism – which is not surprising,
if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object’.22
That ‘different object’, in Keynes’s view, was not a form of production, but ‘betting’ – and the profits of the bookmaker were ‘a mere transfer’,23 a transfer which should be limited lest individuals ruin themselves and harm others in the process. Moreover, Keynes argued, since gambling is luck, there should be no pretence that financial speculation involved skill. Any reference to skill – or productiveness on the part of speculators – was a sign that somebody was trying to trick somebody else. Keynes also thought that the proceeds from such betting and speculating should go to the state to remove the incentive – a better word might be temptation – to reap private gains from it.24 He went on to stress the difference between this kind of speculation (value extraction) and finance for actual productive investment (value creation), which he saw as crucial for growth and which was only possible without the speculative apparatus around it. If ‘the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done’.25
The US economist Hyman Minsky, who was much influenced by Keynes, wrote extensively about the self-destabilizing dynamics of finance. In his work on financial instability26 he nested Keynes’s critique within an alternative theory of money. This theory, which began far from the mainstream but forced its way in when a bubble-bursting ‘Minsky moment’ broke the long boom in 2008, holds that the quantity of money in an economy is created by the interplay of economic forces rather than by an outside agency such as a country’s central bank. Although portrayed as all-powerful (and so responsible for all financial instability) by Milton Friedman and the ‘monetarists’ propelled to prominence by 1970s stagnation, central banks such as the US Federal Reserve can only indirectly and weakly control the private-sector banks and their money creation, by setting the base interest rate. Minsky charted the way in which the banking system would eventually end up moving to ‘speculative finance’, pursuing returns that depended on the appreciation of asset values rather than the generation of income from productive activity.
Banks and investment funds may believe they are deriving income from new production, and their individual ‘risk models’ will show that they will survive most conceivable financial shocks because of the diversification of their portfolios. But their incomes are ultimately transfers from other financial firms, and can suddenly dry up when one firm’s inability to meet a transfer obligation (defaulting on a loan, or withholding a dividend) forces others to do so in turn. That is what happened when Lehman Brothers, the American investment bank, collapsed in 2008, thereby precipitating the financial crisis.
As long as financial assets can be bought and sold in a reasonable amount of time without incurring losses, and debt can be rolled over to pay previous loans, markets are liquid and the economy runs smoothly. But once investors realize that borrowers are not earning enough to pay interest and principal (on which the interest is based), creditors stop financing them and try to sell their assets as soon as possible. Financial bubbles can be seen as the result of value being extracted; during financial crises value is actually destroyed. The fallout can be measured not only in output and job losses but also by the amount of money that governments had to pour into private banks because they were ‘too big to fail’: the quantitative easing (QE) schemes that followed the crisis might have been used to help sustain the economy, but ended up further propping up the banks. The figures involved were enormous. In the US, the Federal Reserve embarked on three different QE schemes, totalling $4.2 trillion over the period 2008–14. In the UK, the Bank of England undertook £375 billion of QE between 2009 and 2012, and in Europe, the ECB committed € 60 billion per month from January 2015 to March 2017.27
Back in the mid-1980s, to try to prevent the banking system from moving to speculative finance, Hyman Minsky formulated an economic recipe that can be summarized as ‘big government, big bank’. In his vision, government creates jobs by being the ‘employer of last resort’ and underwrites distressed financial operators’ balance sheets by being the ‘lender of last resort’.28 When the financial sector is so interconnected, it is very possible for one bank’s failure to become contagious, leading to the bankruptcy of banks all over the world. In order to avoid this ‘butterfly effect’, Minsky favoured strong regulation of financial intermediaries. In this he followed his mentor Keynes, who, as the post-war international order was being devised at Bretton Woods in 1944, advocated ‘the restoration of international loans and credit for legitimate purposes’, while stressing the necessity of ‘controlling short-term speculative movements or flights of currency whether out of debtor countries or from one creditor country to another’.29
According to Keynes and Minsky, the possibility of financial crisis was always present in the way that money circulated – not as a means of exchange, but as an end in itself (an idea based predominantly on Marx’s thinking). They believed that government had to intervene to avert or manage crises. Although controversial in the 1930s (due to its undertones of ‘socialism’ and central planning) and later (after the revival of free-market economics, including the idea of unregulated ‘free’ banking), the idea of intervention in markets was hardly novel or radical. Back in the eighteenth century, Adam Smith’s belief that a free market was one free from rent implied government action to eliminate rent. Modern-day free marketeers, who have gagged Smith while claiming his mantle, would not agree with him.
Financial regulators have focused on introducing more competition – through the break-up of large banks and the entry of new ‘challenger banks’ – as an essential step towards preventing another financial crisis. But this ‘quantity theory of competition’ – the assumption that the problem is just size and numbers, and not fundamental behaviour – avoids the uncomfortable reality that crises develop from the uncoordinated interaction of numerous players.
There is danger in a complex system with many players. Greater stability might be achieved when a few large companies serve the real economy, subject to heavy regulation in order to make sure that they concentrate on value creation and not value extraction. By contrast, deregulation designed to reinvigorate a part of the financial sector may well promote risk-taking behaviour – the opposite of what is intended. Lord Adair Turner, who took over as Chair of the UK financial regulator (then called the Financial Services Authority) in 2008, just as the system was crashing around it, reflected when the dust settled that: ‘financial services (particularly wholesale trading activities) include a large share of highly remunerated activities that are purely distributive in their indirect effects … the ability of national income accounts to distinguish between activities that are meaningfully value-creative and activities that are essentially distributive rent extraction is far from perfect’.30
Neither William J. Baumol (1922–2017), whose descriptions of ‘unproductive entrepreneurship’ could account for much financial activity but who is now a leading contributor to mainstream portfolio and capital-market theory, nor Turner, despite his subsequent leading role in the Institute for New Economic Thinking, discuss finance much in terms of value theory. Yet their thinking implies that finance should be fundamentally reformed to create value inside the production boundary, and that those of its elements outside the boundary should be drastically reduced, eliminated or competed away. Lord Turner’s more considered verdict, ten years on from the start of the crisis, was to bemoan the ever larger amount of debt needed to add an extra dollar to GDP, but then trace much of this to the bad aggregate effects of essentially good lending, which ‘private lenders do not and cannot be expected to take into account’. His prescriptions, requiring more and smarter financial regulation to monitor and control the system’s aggregate risks, actually imply additional and permanent effort by public authorities to make the marketplace safe for private bank (and shadow-bank) profit.
Over the past decades, Keynes’s and Minsky’s ins
ights and warnings about the potentially destructive nature of an unbridled financial sector have been totally ignored. Today, the economic mainstream continues to argue that the bigger (measured by the number of actors) or ‘deeper’ financial markets are, the more likely they are to be efficient, revealing the ‘true’ price and therefore value of an asset in the sense defined by the Nobel Prize-winning US economist Eugene Fama.31 An ‘efficient’ market is, in Fama’s definition, one that prices every asset so that no further profit can be made by buying and reselling it. This way of thinking reconciles the case for large financial markets with the high incomes paid to employees in financial services, because incomes supposedly reflect the huge benefits of financial services to the economy.32
From the perspective of marginal utility, therefore, the expansion of finance is highly desirable and should increase its value added, and hence its positive contribution to GDP growth,33 even though it was only a convenient decision to treat finance as productive in the national accounts in the first place.34
But it is impossible to understand the rise of finance without analysing the background dynamics which allowed it to thrive: deregulation and rising inequality.
The Value of Everything (UK) Page 15