Financial dislocation

Financial dislocation

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The conventional view of the financial system is that it acts as an intermediary function, converting the money created by central banks into a form that can be used in the wider economy and circulating it through lending and deposit-taking. The unconventional monetary policy instruments that have been used by central banks to reflate economies since the financial crisis (and in the case of Japan, for much longer) make use of this model. One way or another, the additional money created by central banks was supposed to find its way out into the wider economy, stimulating new investment, creating jobs and generally increasing economic activity.

But this isn't happening. Economies in the developed world remain flat, while the additional money created by QE has gone to inflate asset bubbles and increase inflation in emerging markets. Why has the additional money not gone where it was intended to go?

The problem is twofold - damaged banks, and risk-averse corporations. Banks that have risky balance sheets and low levels of capital, and that are under regulatory pressure to reduce their risks and improve their capitalisation, don't lend. Or rather, they only take on low-risk lending (prime mortgages, for example), and if they offer higher-risk lending such as small business finance, it is at very high rates. Meanwhile larger corporations that can raise finance in the capital markets are refinancing debt at lower rates and buying back equity rather than investing for the future. The two main channels - banks and large corporations - by which money reaches the wider economy are blocked. Not wholly, admittedly - but the flow of funds through them has reduced to a trickle. Rather like water, there is not enough money in some places - so small businesses, for example, die of thirst - while in other places productive activity is being washed away by rivers of unnecessary cash. Central banks have flooded the world with money on the assumption that the transmission mechanisms are working properly. The evidence is that they are not.

How did we end up in this situation? It is easy to blame it on the financial crisis. But I think the problem is much deeper. It really concerns the way in which the financial system views itself and the dysfunctional nature of its relationship with the wider economy.

The conventional view of the financial system as an intermediary, enabling and regulating flows of money to the wider economy which is the generator of economic activity, is not consistent with the financial system's view of itself. I've talked before about the "looking-glass world of finance". In the recent BIS report, the skewed, self-centred view that the financial system has of itself and its work is very apparent. Various people have commented on the sheer economic idiocy of BIS's suggestion that monetary policy should be tightened AND countries should embark on fiscal consolidation to make their debt "safer". But from BIS's point of view - representing as it does the interests of the financial sector - it makes complete sense.

You see, the financial sector has come to see what it does as real economic activity. Moving money around efficiently and profitably has become an end in itself. Whether or not those movements of money actually facilitate activity in the wider economy is of little concern. So blocked transmission channels don't matter. As long as the financial system has lots of liquidity, everything is fine and economies will gradually recover. And monetary policy makers buy into this: they maintain liquidity in the financial sector in the belief that the money will somehow find its way out into the wider economy, when actually all it is doing is increasing the scale of money flows around the financial sector while the wider economy remains parched.

BIS's argument is that the purpose of government debt is to provide safe assets for the financial sector. A plentiful supply of safe assets other than cash improves the flow of funding around the financial system, enables risk-averse investors to find safe homes for their money and provides opportunities for portfolio hedging. At the moment there is a scarcity of safe assets due to increased demand, collateral hoarding and actual shortages - exacerbated, it has to be said, by the very monetary policy instruments that have produced all the excess money. But BIS's stated concern is the shortage of safe assets caused by the decline in quality of sovereign debt in recent years. BIS's strategy for easing the safe asset shortage is for countries to squeeze money out of their economies to create primary surpluses, thus reassuring investors that debt will continue to be serviced in the future. The fact that primary surpluses coupled, in many cases, with trade deficits imply contraction for the private sector in those countries - many of which are already suffering economic stagnation or even deflation - is of no concern to BIS. As far as BIS is concerned, the provision of safe assets to the financial system is far more important than the economic health of the countries providing those assets, or the well-being of their populations. I have to say this is an extremely short-sighted view: the debt of an economy that is contracting does not remain safe for very long, since the ability to maintain a primary surplus depends on economic activity in the private sector generating tax revenue in excess of government spending needs. But this view amply demonstrates the dislocation of the financial system from the wider economy.

It is not hard to imagine how toxic this is. The Archbishop of Canterbury recently remarked that we needed to stop thinking of finance as a "system" and start thinking of finance as a living being. I would take that further and say that we need to think of the economy as a living being, of which finance is an important part. And I am reminded of St. Paul's observation that when one part of the body starts to think that other parts don't matter, the whole body is in danger. This is what is happening. The heart and lungs have started to think that as long as blood is flowing freely between them - from heart to lungs and back again - the whole body will recover. Not only that, but well-meaning cardiologists, seeing the start of gangrene in the feet, are providing copious blood transfusions in the hope that somehow, if they provide enough blood, it will start flowing around the rest of the body. But the circulation to the rest of the body has slowed to a trickle. And the blood is pooling in the chest cavity, slowing the circulation of blood even between the heart and the lungs and making it difficult for the patient to breathe.

Actually, despite my criticisms, BIS is halfway to recognising the real problem.  It advises correctly that unconventional monetary policy is having unfortunate effects on the financial system and should be ended. And it is explicitly critical of the world's failure to deal with undercapitalised and dysfunctional banks. Unfortunately it recommends use of public funds YET again to recapitalise weak banks, which as the weakest banks are associated with the most highly-indebted sovereigns seems like asking for the moon - though I suspect BIS's comments are really aimed at the European Union, which is dithering about use of the ESM to recapitalise banks directly. BIS calls for real banking union in the EU, including common resolution, common supervision and common deposit insurance. I fear this is also asking for the moon, since Germany has explicitly ruled out all of these.

But the underlying problem - that the financial system's relationship with the real economy is distorted - urgently needs addressing. No amount of recapitalising banks and improving financial flows will work if the financial system is dislocated from the real economy. Movements of money around the financial system are not in themselves productive economic activity, however much financial people might like to think they are: they are only productive when they enable people and businesses in the wider economy to do something useful. Damaged and dysfunctional institutions in the financial sector short-circuiting the flow of funds to the wider economy results in slow economic death.

There is a view that if we maintain the transfusions - or even increase them - eventually the financial sector will heal itself and money will start flowing to the rest of the body. This may perhaps be true. But we don't have time. We have already waited 5 years for the financial sector to recover from its heart attack, but it is still stuck on a drip in intensive care. And the rest of the body is slowly dying - as is evidenced by high unemployment figures, particularly among the young, falling wages, extensive misuse of skills and under-employment. We cannot wait any longer for the financial system to heal itself. Somehow, we must get money out into the wider economy by other means, so that people and businesses can start investing productively, generating jobs and incomes. Until that process is well under way, BIS's idea of widespread fiscal consolidation to improve the supply of safe assets would be very dangerous, squashing what little real economic activity there is.

I would remind BIS that the path to primary surpluses and sustainable debt service lies in improving economic activity, not in fiscal consolidation as an end in itself. If fiscal consolidation and structural reforms will result in improved economic activity in the longer term, then they are certainly worth doing. But without adequate flows of money to the wider economy, fiscal consolidation can only make things worse. The broken money transmission channels must be fixed first.

So we need to put the patient on bypass. When the financial sector will not lend productively, and corporations will not invest for a future return, circumvent them. When the financial sector's instinct for self-preservation leads it to short-circuit the flows of funds to the wider economy, find alternative ways of transmitting money. Kill the sacred cows - and the laws, in the case of the EU - that prevent governments funding productive activity in their own economies. Invest directly in the businesses and the people that will drive real economic recovery:

  • Have state investment banks providing funding directly to businesses (as I've suggested previously, this could be at arms-length via a GSE-type structure).
  • Support and encourage the growth of new, diverse forms of financial provider, especially those that embrace and use the technology that is our future. 
  • Provide financial support to people of all ages financially so that they can train, retrain and look for the jobs that best suit their skills - rather than forcing them into any job, however unsuitable, just to get them off the unemployment register. 
  • Provide microfinance to entrepreneurially-minded people to enable them to create the jobs that best suit their skills. 
  • Provide a basic income for people who work unpaid in socially useful and productive activities - after all, these too contribute to the economy and therefore to the recovery, and many of those activities may become the paid jobs of the future.

This is by no means an exhaustive list of direct government interventions that to my mind would be a far better use of resources than pouring yet more money into propping up a damaged financial system.

Having said that.....a vibrant, diverse economy needs a vibrant, diverse financial sector, incorporating large banks and capital markets as well as small providers and state funding. I am no supporter of Soviet-style nationalised banking systems, and have only (reluctantly) suggested  that the state takes over provision of funding to the wider economy because the financial system is not doing its job. I see that as a transitional stage while the financial system is reconnected with the economy it is intended to serve. The goal, for me, is a redesigned financial system that actually acts as the intermediary that it is supposed to be, and that uses new technologies to support new industries with the aim of improving the economy as a whole and the well-being of its citizens. Because in the end, the well-being of people is the purpose of all economic activity.

Thanks to John Van Reenen for the title of this post.

Related links:

When governments become banks - Coppola Comment

83rd Annual Report - Bank of International Settlements (BIS)

....and the 82nd Annual report too, it's remarkably similar.

Good Banks debate with Justin Welby - St. Paul's Institute (video)

BIS fears fresh bank crisis from global bond spike - Daily Telegraph (paywall)

The BIS loses its mind - Naked Capitalism

The twilight of the central banker - The Economist (from 2012, but still relevant)

Educated, with a dead-beat job - Reuters

A broken model - Frances Coppola at Pieria

The case for basic income - Stumbling & Mumbling

Bible reference is 1 Corinthians 12:12-26, NIV.


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