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Thursday, October 15, 2009

Restrict Speculative Credit to Prevent Banking Crisis

by Richard A Werner

The Daily Yomiuri (October 06 2009)

One of the topics on the agenda of the Group of Twenty leaders was how to deal with banks, in order to avoid banking crises in the future. "We are not going to walk away from the greatest economic crisis since the Great Depression and leave unchanged, and leave in place, the tragic vulnerabilities that caused this crisis", said U.S. Treasury Secretary Timothy Geithner. "Where reckless behavior and a lack of responsibility led to crisis, we will not allow a return to banking as usual", the G20 communique stated. Sadly, it looks like this is exactly what will happen.

Many politicians have claimed in the past 200 years that their specific pet legislation will be the one that will end the endless recurrence of banking crises. Yet, banking crises have been one of the more reliable features of our economic systems - particularly reliable in their increasing occurrence in the past forty years. The key is, of course, a recognition of what actually caused the crisis.

The policy proposals that editorial writers, opinion-makers and now G-20 leaders favor are the introduction of higher, "anti-cyclical" capital requirements for banks, a cap on "leverage" and "living wills" for their windup. Also discussed, as an outside option, is a so-called Tobin tax on short-term financial transactions, rules on bonuses and restrictions on hedge funds. Unfortunately, all of these proposals miss the mark; they won't prevent a recurrence of banking crises and may have unintended negative consequences.

The higher capital adequacy requirements likely due in 2012 are feared by cooperative bank leaders in France and Germany to cripple the not-for-profit banks, which did not misbehave, and reduce their stable, long-term and badly needed lending to small firms. It is ironic, because it is exactly the not-for-profit cooperative banks and credit unions that some leaders - such as Pope Benedict XVI in his latest encyclical letter - have singled out as a viable and realistic alternative to the destructive for-profit short-term capitalism of the major banks.

There are also problems with tighter regulation of hedge funds and the Tobin tax on financial transactions. It hardly makes sense in market-based economies to try to suppress speculation per se. These are but symptoms, while the disease continues to fester. Yet the patient could be cured with one, simpler policy response.

Let us remember how hedge funds work. They employ trading teams or automated programs that execute vast numbers of transactions. A big secret of the hedge fund industry is that despite their intricate trading strategies they normally aim only at miniscule monthly returns of, say, 0.1 percent - but try to achieve those reliably. Where do the remaining returns come from, to make up the twenty percent annually that they aspire to? A bigger secret: These are due you and me. Yes, the general public deserves the credit for more than ninety percent of hedge funds' returns.

Here is why. If hedge funds produce 0.1 percent per month through their trading, they can still earn ten or twenty times as much for their investors - and a big chunk in performance bonuses for themselves. How does their financial alchemy work? It has nothing to do with complex derivatives strategies, portfolio optimization by quantitative analysis wizards or fancy algorithms executed in split-seconds by supercomputers. It is due to something that is old-fashioned and has not changed for many centuries: plain old bank credit. Banks will provide a "loan" of, say, twenty times the money invested in the fund, so that the fund can multiply its bets and returns by a factor of twenty.

Bank credit, however, is money creation: In the fractional reserve systems we employ, there is no such thing as a bank loan. When I lend out my car to my neighbor, I cannot drive it at the same time. That is not how banks work. When what is called a "loan" is granted, banks don't make a transfer of money, but create credit "out of nothing" and thereby increase the money supply. This is possible, because in our financial system privately owned banks have been given the public privilege to create money - which is something that affects us all.

About 98 percent of the money supply is created and allocated by banks - private, short-term profit-oriented operators. The financial crisis is about the misuse of this privilege. Credit used for the creation of new goods and services is sustainable in the long run: it generates income streams that can service loans and repay principal, and it is noninflationary (more money is created, but more goods and services become available). Sadly, if given a choice, banks would rather not lend in this way: Unlike credit for financial transactions, it won't generate exponential growth of loan books, quick windfall profits and overflowing bonus pools for the bankers.

Still, the fault is not really with the banks. Surprisingly, they had not been asked by governments to consider what type of loans are good for the economy, sustainable in aggregate or conducive for a stable financial system. They have only been told to maximize their short-term profits, on the theory that this will be best for all. This they did, and thus created much credit for use in speculative financial transactions. The trouble is the fallacy of composition: Such credit creation will push up the prices of the financial or property assets concerned, creating the familiar property and equity bubbles. Each transaction looks sound to bankers, auditors and regulators alike: It is backed by high and rising asset values. But these are a function of the speculative credit extended by banks. Thus speculative credit is never sustainable: When the music stops - when speculative bank credit stops - the asset bubble bursts. Speculators go bust. Banks with them.

I warned in my 2005 book about the dangers of the "recurring banking crises", highlighting Britain. I also identified the simple regulation that would end the cycle of booms and busts and banking crises: Let the speculators continue to speculate - as is difficult to prevent anyhow. If the system is well-designed, they should only be able to harm themselves. But severely restrict bank credit used for speculative purposes. So let the hedge funds try to get their "leverage" elsewhere - for instance from the allegedly so efficient capital markets. (And let's see how much of their returns remain when they have to earn them themselves).

So forget about a Tobin tax or stricter regulations of hedge funds. Forget about new caps on "leverage" or complex counter-cyclical capital requirements (who determines where we are in the cycle, anyway? how meaningful are leverage ratios, when banks create both loans and deposits simultaneously?). Instead, prohibit banks from lending for transactions that are not part of GDP. Our statisticians have long identified those: They are the financial transactions. And bank loan officers ask potential borrowers detailed questions about the use of loans and banks impose restrictions on it. It is not difficult for banks, therefore, to implement strict rules about which types of credit can be extended and which can't. It is credit for non-GDP transactions that busted the world's financial system, so let's prohibit it (or cap it). We shall not miss it.

Is this workable? It has worked well for decades in many countries. Credit controls like this, which limit the speculative and hence wasteful use of newly created money and concentrate the use of newly created money on more productive activities such as investments in new technologies, can deliver high growth without either consumer price or asset price inflation. Such credit allocation and control is what created the Japanese and the Chinese economic miracles - and it is why China this year became the first country to emerge from the crisis: China used the "window guidance" mechanism (which it had copied from Japan) in order to increase credit creation. Until recently, all central banks controlled bank credit directly, and imposed quantitative and qualitative restrictions. That's because it is simply the most important macroeconomic factor in any economy. It is ironic that after the financial crisis, the governments of Britain, France and Germany imposed various - haphazard - forms of direct controls on bank lending in an effort to expand lending to small firms. Had proper controls on credit for non-GDP transactions been imposed on banks previously, there would not have been a financial bubble, or a global financial crisis.


Werner is author of New Paradigm in Macroeconomics (Palgrave Macmillan, 2005) and professor of international banking at the University of Southampton.

(c) The Yomiuri Shimbun.

Bill Totten


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