After just writing my booms and busts post below, I discovered a beautifully written blog article regarding the banking system, and how it functions in a capitalist society. It is a sound argument, and recognition of the important role played by the banking sector as described is a big justification for the bailout culture. Unfortunately I think there are some limitations to the working of the model today.
The article discusses how it is only really during boom periods that investors can be persuaded to invest in risky propositions without the curtain of opacity provided by the banking system. This is actually a sound argument – for example it was easy here in New Zealand for property developments and finance companies to gather capital from normally cautious Kiwis during the great property run-up of the 2000s. It raises a couple of interesting points.
It suggests that individual investor involvement on a large scale in ‘riskier’ investments fuels booms. I think it would be difficult to argue that this is a good thing. Although this obviously drives economic growth the crowd mentality tends to foster distorted growth in one area, rather than balanced growth across a variety of assets or initiatives. It also creates bubbles which tend to greatly exacerbate the normal business cycle of expanding and contracting debt. An argument could be made that the post-World War II years of stability were caused precisely by steady investment by the banking and financial sector (and significantly the government in many Western economies) rather than by wider direct speculation. This can be argued to be due to ‘investor memory’ caused by the Great Depression. Contrast this with ‘investor amnesia’ in the eighties and beyond as that earlier generation left the market. This resulted in a greater appetite for riskier assets and less need for opacity (e.g. the tech boom).
The second point is to apply this model to today’s scenario. There is no doubt that at the moment capital is risk adverse. It is being hoarded in banks and ‘safe havens’ and from a capital allocation standpoint one would think that opacity is a positive. Unfortunately the model in the article of the ‘beneficent bank’ allocating capital and allowing risky but potentially productive enterprises to develop is, I believe, a little old fashioned. Banks for some years have been more interested in short term highly leveraged bets, and the GFC shows how poorly capital was being allocated by those institutions managing the curtain of opacity. Additionally due to the level of insolvency of most of these institutions (virtually all of them kept alive by the succor of central banks) the increasing level of private sector deposits typical in a downturn (which would promote investment and recovery in the real economy) is instead being funneled in a so far futile attempt to make hideous bank balance sheets look reasonable. In the real world of commerce and entrepreneurship credit is scarce. The veil of opacity is being used to allow depositors to rebuild banking institutions left shattered after years of mismanagement, rather than allowing wider economic rebuilding, investment and risk taking.
The opacity model is a very useful one, however there seem to be signs that the transformation of banks into financial behemoths has disrupted this process. Additionally it is clogging the wheels of recovery that turned in previous business cycles. The takeaway is that significant reforms to our financial institutions are essential. They are necessary to transform them back into vehicles of economic investment where the ‘placebo sugar’ mentioned in the article is applied to the broader economy, rather than the bankers themselves!