Moneychanging without mystery

Bankers are in an understandably cynical mood. Their industry is being traduced by the politicians who are most to blame for the financial crisis of 2007-08, and redesigned by central bankers and regulators whose earlier efforts failed to avert the crisis in the first place. Details differ, but there is broad consensus among regulators around the world that the bigger banks should exit some activities, shift others to market utilities, adopt more onerous liquidity and capital ratios, cut leverage, put more securitized assets on the balance sheet, reward their risk-takers less generously, and pay more taxes. Doubtless there are some regulators who believe that by implementing these measures they will reduce the incidence of credit booms and busts, but it is hard to avoid the conclusion that what they and their political masters really need is a scapegoat for their own errors and omissions. To believe that regulators think otherwise is to believe that they are uniquely ingenuous, or have read no history, including the history of their own profession. Yet even their self-regarding efforts resonate with the public. This is not because the public thinks the politicians and the regulators are right to portray bankers as the sole authors of the crisis, or even because they crave expiation for their own debt-fueled contribution to it. Banker-bashing registers with people because they have long felt that there was something insidious about banking, and especially about its ability to breed money from money. Regulators are condemned never to believe such artless intuition, but it may well be a surer guide to what happened, and how to prevent it from happening again, than any number of official analyses and regulatory reforms. For what happened in 2007-08 was not unusual. An IMF study of the 20 years that elapsed between 1975 and 1995 identified 112 systemic banking crises in 93 countries, and a further 51 near-systemic crises in another 46 countries. In my own quarter century in the financial markets, I have witnessed the failure of Continental Illinois, and of Johnson Matthey and BCCI, the crash of October 1987, the collapse of Drexel Burnham Lambert in 1990, the prolonged $150 billion savings and loan disaster, the tequila crisis of 1994, the Asian contagion of 1997, the collapse of LTCM and the Russian default in 1998, the pricking of the TMT bubble in 2000, the Argentine dgringolade at the turn of the last century, and the successive liquidity crises of 2007-08 that sank AIG, Bear Stearns, Lehman Brothers, Northern Rock and many other banks and quasi-banks on both sides of the Atlantic. A book on my shelves, packed with graphs and equations, has the plaintive title, Why are there so many banking crises? Published in 2008, the lectures it contains were first delivered at the turn of the century. If the answer they gavethat all we need is better regulationwas questionable then, it is risible now. Yet not risible enough for the regulators of today not to identify alleged gaps in the previous regulatory systems, and advance ideas for closing them. This meets the well-known definition of insanity so perfectly that it is tempting to conclude that regulators need not larger budgets, but psychiatric treatment. But their immunity to their own failureindeed, their ability to profit from it in the shape of fatter budgets and wider and deeper powerssuggests there is another explanation. This is that the real beneficiaries of a dysfunctional financial system are not bankers at all, and perhaps not even regulators either, but politicians. After all, there is universal agreement that the immediate cause of every period of financial instability is the expansion of credit. The most cursory reading of Kindleberger is sufficient to persuade anyone that every speculative mania in the history of the world is initiated and sustained by the easy availability of credit. In a modern economy, banks are the principal source of the expansion of credit. Businesses and households buy credit from banks because, in the words of the notorious credit card advertisement, it takes the waiting out of wanting. It summons the future to the present, by enabling businesses and consumers to skip the need to save before investing or buying. By increasing the pace of investment and consumption, credit inflates asset values. House prices driven by mortgage lending are the obvious instance of this. But stock markets, which also represent claims on real resources, rise in value too. Mark-to-market accounting injects these distorted values directly into commercial decision-making by companies and their bankers. This encourages the issue of yet more credit to both companies and households, as the collateral they can post to the banks has also increased in value. In a recent speech, Financial Services Authority (FSA) Chairman Adair Turner deplored the increase during the last 30 years in household and commercial indebtedness, the multiplication of financial trading as a proportion of the real economy, and the increased complexity of financial instruments in general, and structure credit products in particular. But what did he expect of an economy no longer reliant on saving to fund investment, and in which consumers can fund lavish purchases by borrowing against current income? Markets in which an abundance of credit is driving asset prices upward are bound to spawn a host of financial engineers. They include investment banks and hedge funds, which multiply returns by the application of leverage, and SIVs and conduits. Regulators are right to ponder the impact of these forms of speculation on the real economy. Like all forms of arbitrage, they are zero-sum activities: The gains of some are equal to the losses of others. They do not add a jot to the stock of wealth, but merely redistribute it in an arbitrary way. The emblematic exemplars of this art are the private equity managers, whose practitioners would never invest their clients savings in a startup, but instead generate spectacular returns by acquiring, leveraging, merging and selling existing companies into rising stock markets. While it is unkind to describe what passes for innovation in finance-capitalism as socially useless, it is not inaccurate to see much of it as mere variation on familiar themes: selling the net present value of future cash flows; shifting exposures off balance sheets; arbitraging taxes and regulations; and skirting capital requirements, notably through securitization. Bankers are of course encouraged in this chicanery by misguided taxation (notably the more generous treatment of debt over equity) and regulation (particularly in the field of capital adequacy) and perhaps especially by legal privilege (the limited liability that allows large bets to be placed with money belonging to others) and moral hazard (the knowledge that almost every bank is too important to fail). But it is by such means that the expansion of credit distorts the real economy. A credit-fueled economy is bound to generate more investment and expenditure mistakes than one that takes the steeper path of deferred gratification. Cheap credit makes investments appear more profitable than they are, encouraging companies to launch ventures that would be wholly uneconomic to finance out of real capital. Companies, like banks, cease to finance themselves properly (with equity) and borrow (with encouragement from the tax system). They run down their holdings of cash, on which the returns are low. So do retail savers, who also sense better returns from borrowing to invest. The entire system of industry and commerce becomes less stable, and mistakes become legion. In the United Kingdom, around 220,000 businesses die every year. In the United States, the equivalent number is more than 700,000. Consumers, likewise, make errors of credit-induced optimism. Substantial purchases are judged not by the damage they cause to the net worth of the buyer, but by their financeability out of current income. As every real estate agent and double-glazing salesman knows, the secret of the sale lies not in the value of the purchase, but in its financing. So it is understandable why the most shameless hucksters of them all adore the illusion of prosperity a credit boom can conjure up: People vote for politicians that make them feel better off, even if they are in reality becoming worse off. It is equally understandable why, when the credit boom ends in the inevitable bust, politicians prefer to blame the operators of the system rather than the system itself. Yet this particular hypocrisy is a more than usual case of political expedience. Both politicians and regulators are condemned by personal and professional interest to portray the epiphenomena of the crisishedge funds, private equity funds, securitization, credit default swaps and the other paraphernalia of modern financial engineeringnot as symptoms, but as first cause. This is because the alternative is to tell the truth. And the truth is that there is a great canker at the heart of modern finance, which neither politicians nor regulators nor bankers have the incentive, let alone the moral courage, to resect: leveraged fractional reserve banking, or the right of banks to use and reuse the property of their customers. Most businesses venture their own capital, or capital they have raised from others, and make money by selling goods or services to customers. Banks alone can make money out of nothing. They do this by lending not only up to the amount of cash deposited with them by their customers, but many times that amount. Unlike investors, which must choose between competing demands on the real resources they own, banks do not have to forego some other use of the money in order to lend it to a borrower. Indeed, they can lend the same money to many different borrowers at the same time. They simply create multiple loans by book-entries on the asset side of their balance sheets, trusting that offsetting liabilities will appear in the form of deposits on the other side of the balance sheet as the proceeds of the loans are paid to third parties. It is an axiom of fractional reserve banking that every loan creates a deposit. The viability of the entire system of credit in modern economies depends on the ability of all types of banksinvestment banks as much as commercial banksto finance their lending in this way, in the money markets, every day.Leveraged fractional reserve banking has become so much an accepted feature of modern commercial civilizations that it is easy to forget how extraordinary it is that banks should be allowed to finance themselves by using the property of their customers. More extraordinary still is the fact that they do not use that property once only, but many dozens of times. Contractual liabilities are incurred, quite deliberately, that the regulators know the banks could never simultaneously honor. Modern banking depends on the fiction that banks are looking after the money of their depositors, when the reality is that the depositors are lending money to the banks, and the banks are then lending that same money again and again to a lengthening list of third parties. Going into the crisis in 2007-08, the American banking system supported deposits worth 100 times its reserves of cash. In other words, 100 people could lay claim to every dollar on deposit with an American bank. There are many schemes, not unlike this, which the regulators would be prosecuting for fraud. But when it comes to banks, the authorities actually underwrite the practice, by setting up central banks to act as lenders of last resort. The practice, written into modern banking at the point of its creation by the goldsmith bankers of early modern Europe, was once immensely controversial. As it happens, custodians are apt to trace the origins of their own business to the goldsmith bankers, because they took into custody the valuables of their customers. What tends to be overlooked is how quickly the goldsmith bankers worked out how to exploit the assets entrusted to them by issuing receipts for far greater amounts of gold than they actually held in their vaults. By this means, they created the modern system of banking, in which multiple claims come to exist on each deposit. In a recognizably similar way, the investment and custodian banks of today use the cash and securities belonging to their clients to finance their own businesses and generate revenue through investing the cash and lending the securities. The sinister-sounding rehypothecation that was at the heart of the losses crystallized by the collapse of Lehman Brothers was not a new-fangled idea at all, but something as old as banking itself: the creation of multiple legitimate claims to the same asset.This is why banking is such a dangerous activity. Its viability hinges on the hope that not everybody will ask for their property back at the same time and, if they do, that central banks (and ultimately taxpayers) will make up the shortfall. In theory, leveraged fractional reserve banking enables economies to grow faster, by skipping the more painful path of investing only out of savings. It is at least questionable whether it has any long-term effect on output at all (as opposed to redistributing wealth in an arbitrary fashion), but what is not in doubt is the fact that fractional reserve banking imposes on every economy where it is practiced a cycle of credit that lurches from boom to bust with nauseating regularity. This is not extrinsic to it either. Cheap credit increases investment and expenditure, driving up the cost of land, machinery and labor, forcing companies and households to run down their holdings of cash and borrow more. At some point this divergence between the cash being deposited with banks and the credit being advanced by banks must come to a halt. In this way, every credit boom must end in a credit crunch. The only oddity is why, after several hundred years of experience of this predictable and repetitive process, the authorities still believe they can manage the amplitude of the credit cycle successfully. Indeed, far from questioning their competence to do so, they are now busily engaged in trying to ignite the next upward revolution of the credit cycle by cutting interest rates to zero, expanding the supply of money by quantitative easing, increasing government borrowing to finance counter-cyclical expenditure, and recapitalizing banks, in the explicitly stated expectation that they should use this official largesse to start lending to businesses and consumers again. This demand is contradicted by simultaneous regulatory efforts to force banks to hold more capital relative to the risks they take. A report by J.P. Morgan estimates that, even after the recent softening of the likely capital and other requirements, the regulatory burden will still cut the return on equity of the largest global banks by more than a quarter. If returns are lower, banks will take less risk, no matter how much more capital they have. The polite label for policies that aim to fix a credit bust by fostering a credit boom is Keynesian. It is better described as the economics of the hair-of-the-dog, in which the government gorges itself on fiscal and monetary stimulants in a desperate attempt to postpone the hangover: the liquidation of all the unprofitable and erroneous investments made during the boom. After 2 years of near-zero interest rates, and massive fiscal and monetary stimuli on both sides of the Atlantic, the hair-of-the-dog does not appear to be working at the speed anticipated. One explanation is that the credit crunch destroyed real resources, and not just the paper gains of the financial engineers. This effect is familiar from the housing markets, where negative equity has a power to alarm elected politicians rivaled only by the bond markets. But companies as well as households are currently struggling with a lack of capital and cash in relation to their debt. Until businesses and consumers have rebuilt their balance sheets, economies will struggle to grow, no matter how hard governments try to inflate their problems away. In the last 20 years, the Japanese authorities have surely tested hair-of-the-dog economics to destruction. Besides, the sight and stench of politicians excoriating the banks for causing the crisis, while simultaneously blaming them for failing to lend enough to guarantee recovery, is populist politics at its most unprincipled. It is time for a fresh approach.Such an approach would not try to restart the bank-driven system of credit under the cloak of blaming the bankers for everything that happened. It would instead take this latest crisis as the final proof that the entire system of fractional reserve banking is inherently unstable, and damaging to real economic growth, and must be replaced. The alternative to fractional reserve banking is simply its opposite: full, or 100% reserving. In other words, every deposit would be matched by a holding of cash or cash equivalents of the same value. Sight deposits (money in custody with the bank) could not be lent at all, although time deposits (money lent to the bank) could be. Here, oddly enough, custody offers some interesting parallels. If fractional reserve banking were replaced by 100% reserving, banks would cease to be issuers of IOUs to account holders, and become merely safe custodians of the cash belonging to customers. Like other assets in custody, that cash would disappear from the balance sheets of the banks, where it currently shows up as a loan by the customer to the bank. The logical consequence of this removal of a substantial proportion of bank liabilities is a large asset surplus. That surplus could be used to generate the income to pay for the custody services, or to pay down the public debt that is currently weighing down the wider economy. But the most intriguing possibilities lie in the nature of the new banking system that might emerge. Banks would have to start charging fees for operating bank accounts and making transfers, resulting effectively in a negative rate of interest. Only time deposits would pay interest, earned in the form of loans to businesses and individuals of matching duration, or at least time-weighted durations. Retail and commercial banking would become the safe, utility businesses that some politicians and central bankers say they want. Banks could still be credit intermediaries, collecting net interest margin by taking the risk of the borrower onto their own balance sheet. Some would act purely as brokers, bringing lenders and borrowers together. The banking industry would almost certainly shrink, because negative rates of interest and matching maturities will give holders of cash an incentive to invest outside the system. This will reduce the volume of deposits that banks would have to on-lend, but potentially raise the overall rate of economic growth by putting money to work more productively. Businesses may also cease to use banks as money transfer agents, on grounds of cost, and opt instead to net what they owe and are owed through central clearing utilities, with only modest net amounts of money passing through the banking system. Most importantly, there would be no need for a central bank, because there would be no need for a lender of last resort in a system where deposits are fully backed by cash, making bank runs impossible. In fact, the entire apparatus of state regulation and control of the financial markets could be dismantled, and a genuine market in real capital restored, in which rates and terms of interest are not set by the authorities, and then distorted by the manufacture of excessive amounts of credit, but by the interaction of holders and borrowers of real capital and their different time horizons. A system of this kind could scarcely be more unlike the versatile morals of fractional reserve banking (in which multiple claims to the same asset are created on the explicit understanding that they cannot be fulfilled simultaneously) or the paradoxical nostrums of neo-Keynesian economics (in which the more people save the poorer they become, and the more they spend the richer they will be). Investment would depend not on the ersatz capital of the credit cycle, but would depend instead on a combination of stubbornly accrued savings and carefully calibrated loans. Such a system might even restore honesty to more than money, for it is not fanciful to argue that leveraged fractional reserve banking has defiled the character of the financial marketplace as surely as it has debauched its currency. The petty lies and larcenies of men and women whose sole measure of self esteem is a monetary one, and who have sacrificed even personal honor to a form of self-aggrandizement that depends on there always being a dumber dollar behind, bear daily witness to its arbitrariness. Yet even the reputation of the least forgivable of bankers could scarcely sit lower than those of politicians and regulators who attribute present difficulties to market failure, in the full knowledge that banking was the least liberal part of the capitalist system. It is an industry in which governments monopolize the issue of money and central banks are the last bastions of central planning, adjusting liquidity and rates of interest and exchange in response to statistical data whose relationship to reality is tenuous at best. That the crisis has proved such a brilliant device for the extension of government control over private property is the bitterest of the many ironies of this most expensive and longstanding of government failures.