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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Maybe a state-run version of Wonga, with lower interest rates, lending to the real economy?

It's perverse that fiscal consolidation (or deficit reduction) and QE both conspire to reduce the supply of safe assets (government bonds) just when such assets are needed by the banks to make themselves safer places for depositors. Of course the safest bonds are those issued by governments which issue their own currency, since the default risk is negligible. The UK falls into this happy group, our continental cousins, alas, do not.

Were the UK government to scrap QE and end fiscal consolidation the supply of bonds could significantly increase. This would suit the financial sector. But if the bond issue proceeds were invested by the government in, say, capital projects in the real economy would this be beneficial? Because fiscal multipliers are nowadays so low, even for capital projects, such investments would not be self-financing (they would have a negative NPV). As for private firms, a negative NPV signifies that such investments should not be undertaken lest value is destroyed. The upshot of this seems to be that conventional fiscal policy can not be relied upon to restore UK growth. And as Frances says, the money transmission mechanism is currently broken so monetary policy is not an option either.

Given this, I favour the supply-side (?) measures that Frances lists. State investment banks, which would provide finance directly to the real economy, would (at least partially) compensate for the broken money transmission mechanism. They would also provide competition for incumbent banks which may impel them to accelerate measures to repair their balance sheets. The objection that the state has no business or competence to run banks does not stand up to much scrutiny. Banking expertise can be bought in and if the state can organise the affairs of a complex nation then a managing small localised banks should be a breeze

Although the state banks would be obliged to use commercial criteria in their lending decisions they could also be given the mission of assisting with local capital formation (investments in people, ideas, entrepreneurship and providing micro-finance, etc). Banks that lend solely to social enterprises on commercial terms already exist in the UK and their ethos could be adopted and copied by the state banks.

Hitting the nail on the head as usual.

In theory competition between the banks should solve this but there are problems there.

As you have pointed out on your blog, the state of industry IT is lamentably stuck in the past which makes it difficult for newcomers. We have seen this when (fairly) innovative approaches have entered the market like Egg for example, only to be swallowed eventually by Barclays in this case, who promptly shut down most of the innovative aspects of Egg. Another example is the Beneficial Bank (HFC Bank) in the UK had a joint current account and credit card facility. It was taken over by HSBC with the same effect.

I used to think this was just nasty competition but perhaps it is a case that they just can't integrate the newcomer's software into their own dinosaur. Whichever way, it is a win-win for Barclays and HSBC - it kills the competition and enables them to increase their loan book.

In addition, the big 4 control the movement of money between banks so they have a complete stranglehold over the economy. If RBS had gone down, it could have taken the money movement systems with it.

So shouldn't there be some sort of liberalisation by the Bank of England

a) to define the internal software standards used by all banks, possibly defining the software itself built using open source models which would make it much easier and cheaper for new banks to enter. Hooks and filters could be defined for banks that wished to add extra features. It has always bothered me that according to Which? magazine a few years ago, there were 14 ways of calculating credit card interest. I can only think of one.

b) for the BoE to take over running the money movement systems which could be outsourced (not to one of the big 4). This would mean much easier access to the payments system for new and innovative banks, which can be encouraged.

Just my £0.02's worth for today!

To my last post I meant to add this excellent idea of getting money where it's needed:

The Energy Bill Revolution: I quote:

"We call on the Government to use the money it gets from our carbon taxes to make our homes super-energy efficient – driving down our energy bills forever."
"There is, for example, enough carbon tax revenue to treat 600,000 fuel poor households every year, providing each of them with a grant worth on average £6,500 to install energy efficiency measures. This would reduce their energy bills by an average £310 a year.
Recycling carbon revenue to make homes super-energy efficient could bring 9 out of 10 homes out of fuel poverty. It could also be used to quadruple savings in carbon emissions compared to the Government’s new energy efficiency schemes and create up to 200,000 jobs – exactly what we need to support the UK’s economic recovery."

But the Osborne barrier problem again: his likely hidden reaction: "Reducing the use of gas may reduce the profits my chums can get from shale gas, and Big Six profits. Why should I care about those in Fuel Poverty or carbon emissions? The Stern report said climate change will have greatest effect on poor people &/or in poor countries - that means least effect on economically important people - such as me and my chums, and the billionaires I work for - so why should I care? and in any case - the idea of anthropogenic global warming must be ignored - as climate change legislation would threaten the value of oil and gas reserves - and our shares and dividends and pensions."

Apologies for arguably going off-message in last paragraph - but it's to show how Osborne is a tedious barrier to good economic ideas becoming a reality - and his myths and deceptions need to be strongly challenged - especially on TV.

Appendix 2 to my previous 'comment'

In my comment below, I forgot to mention that the most promising target for direct/bypass money input should be the green economy - the sector that's actually growing (unless it gets slashed by Osborne) - especially energy efficiency in buildings - which means jobs with little or no carbon footprint. It is disgraceful that the wall insulation sector is collapsing because the Green Deal is so uselessly unattractive to the main target - people on low incomes and possibly also in fuel poverty.
Yet the new Green Investment bank is funding extension of the life of coal-burning power stations by funding them to co-burn wood pellets from clear-felling of forests in N.America - including biodiverse 'old growth' ancient woodland. This results in carbon emissions at least as high as coal (there is a carbon debt), and loss of biodiversity. So this is how new Gov banks can be abused by gov when Osborne is in charge.

Henry Adams

Dr T.H.L. Adams - Consultant Ecologist – my website’s ‘hub’ page NB: read up re FRACKING – re Tar Sands

Firstly my comments will be simplistic as I'm not an economist but an ecologist - and happy to be corrected.
Yes I fully agree with most of the almost all of Frances's article. The financial system is not doing what should be its main job, and should be by-passed until it has been rectified. But there are several baulks to achieving this:
Firstly the Tories get c.50% of their funding from the financial sector - so Osborne has a conflict of interest here and cannot be trusted to do what needs doing (in fact he's continuing to over-support the importance of the now quasi-parasitical financial sector while he digs the deficit-hole deeper by reducing tax revenues from the SME activity he should be increasing more directly).
So maybe we should hope for Labour to win the next election? But here we have a problem that the last labour government appeared to defer niaively to the banks for advice - and that was one of their main big errors - in being clueless about the impending crash, not their over-spending (though they did do some of that - it didn't cause the crash nor the resulting increase in deficit & national debt - that was due to a sudden drop in tax revenues after the crash, not due to the over-spending.
But Labour seems to be quiet in addressing this. Also Osborne ignores that fact - and focusses on reducing the deficit and national debt with austerity as being the top priority in helping the UK economy, when in reality the level of the public debt has almost negligible effect on the UK economy, and in reality it is the big size of the private debt that has grid-locked the economy - coupled with the associated self-interest of the financial sector that you point out. It is blindingly obvious to a non-economist like me that Osborne's focus on the deficit is fundamentally inappropriate in recessional times (but should be remembered in 'better' times), and is just prioritized as a myth to falsely justify austerity to deliberately further increase inequality though ostensibly in pursuit of a lean (read mean) government ideology which is in reality becoming a corporatocracy (not a democracy - serving the 1% who gain from the inequality).
There is no empirical evidence left to justify the deficit-reduction/austerity myth (now the R&R paper has been shown to be based on spreadsheet errors). It's obvious that austerity decreases the tax revenue take and it is that that keeps large the deficit - not just government spending.
Although I appear to be digressing off-topic here - it is really to point out that in order to get keen take up of your good ideas Frances - you need to first help explode to the whole electorate (and to the deluded BBC) what an emperor's clothes of myths that Osborne's policies are shakily based on. Then it will be easier to show the need for your ideas in a more convincing way to them.
Milli/Balls are right now going along with the deficit/debt myth system instead of trying to debunk it. Is it because he himself is deluded by it or because he is too cowardly to debunk it because he reckons it is now too entrenched in the public and media psyche by the repetitive Coalition propaganda that it is a false perception that he just has to go along with?
We really have to first educate the media esp BBC and the public as to these myths - so that mindsets are no longer diverted and clouded by such red herrings and can positively and clearly focus on what needs to be done - to get the money to lubricate where it's needed - to simultaneously and gradually increase demand and supply (ensure they match) in the real (but-non-bank) economy by decreasing inequality (a £1000 to each person Ad-air-Turner debt-free 'helicopter' drop would have been better than the QE, but there are better methods eg living wage), and funding SMEs using e.g. your by-pass methods or similar.

Could debunking Osborne's myths to media and the public be the first pre-requisite step to enable getting traction for your ideas in the reality world beyond the world of fascinating academic discussions?

PS: I must add a criticism: You said "under conventional view ... money created by central banks" - maybe you should have reminded the readers of the obvious - that 97% of money in circulation is digital bubble-money created by banks as (pseudo-)loans (eg mortgages) - and that the central bank created money is small in comparison. And also that this power of the banks to create such 'bubble money' - coupled with their selfish direction of travel - that is a key factor at the heat of the problem, and that tends to be ignored (or maybe accepted as an unchangeable fact?).

Now I await some flak!?

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