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Hassan Bougrine and Mario Seccareccia Introduction The theory of the monetary circuit (TMC), especially as developed and extended by Alain Parguez over the last four decades, finds its origins in the broad post-Keynesian theory of money as these ideas first emerged from the nineteenth-century anti-metalist tradition of the Banking School. Following the ideas of Thomas Tooke, John Fullarton and other Banking School theorists, the TMC places the banking sector at the centerstage of the money-supply process with banks creating endogenous credit-money (see Parguez and Seccareccia 2000). At the same time, as Hyman P. Minsky (1994) had noted, there is a dual aspect to banking: “Banking plays two roles in a modern capitalist economy: it supplies the means of payments and it channels resources into the capital development of an economy” (Minsky 1994, p. 1) As a byproduct of the financing of production and capital accumulation but, also, as a result of banks’ legal status in being able to issue their liability that would be generally accepted as means of payments, already by the early nineteenth century the banking industry acquired a unique role because its “output”, the community’s means of payments, could be produced ex nihilo at virtually zero marginal resource cost. With the nation’s money supply being purely demand-determined, and with the banking industry being able to supply this private means of payments at practically zero marginal cost, money can never be conceptualized or analyzed on the basis of the neoclassical scarcity principle, with interest rates being determined in the “money market” with a money demand schedule confronting a vertical money supply curve. However, even with the rejection of the scarcity principle and the recognition that creditmoney creation is demand-determined, this does not mean that fluctuations in the supply of credit are determined merely by simple changes in the volume of production and the rate of capital accumulation. They are also affected by changes in a whole variety of credit-worthiness considerations, which can have major consequences on the volume of credit supplied or “rationed” and, therefore, on the entire macro-economy. In commenting on the flux/reflux mechanism in the TMC, Parguez (1986) makes it quite clear that while money is by its very nature endogenous, credit can be allocated via the judicious use of both price and non-price criteria: “The quantity of money is determined by the desire of banks to supply credit to business enterprises. Banks can never create too much money! They can, however, create less than the finance demanded by business enterprises!” [authors’ translation] (Parguez 1986, p. 29) The experience of bank lending during the financial crisis of 2008-9 certainly does attest to how credit restriction can significantly damage the real economy, as fears of insolvency and greater preference for liquidity took hold of the financial markets (Seccareccia 2012-13). The provision of credit-money, which would serve the traditional dual purpose of financing production and creating the community’s means of payments at almost zero 1
marginal resource cost and conferring beneficial externalities to the whole community, is important to an understanding of the public good nature of money. If we were to apply, therefore, some standard Pigouvian principles (pertaining to externalities) one would conclude that, despite its seemingly private nature, the banking sector, including the central bank, produces what is perhaps one of the most “public” of public goods (because of the tremendous externalities), in this case, by supplying an economy’s means of payments but also by supplying the credit-money advances to sustain production and growth. Changes in what commercial banks “produce”, as well as changes in the costs of what they produce, could permeate practically all economic activities. Historically, since the 19th Century, governments have recognized these externalities and banks were offered a license or a “charter” to exploit this monetary “commons” by undertaking commercial banking largely on the basis of their social role in providing the community’s means of payments, namely bank deposits for safe-keeping. In addition, with the introduction of government deposit insurance and, more broadly, the development of central banking, especially the all-important liquidity provision that the central bank offers to commercial banks as lender of last resort, this makes these “producers” of this public good privately-owned, yet “quasi-public”, institutions themselves because of the support they receive from a critical public institution, the central bank, as dispenser of liquidity. Following Minsky who had argued that “financial reform needs to confront the public nature of much that is private” (Minsky 1986, p. 354), Wray (2010) makes this point quite forcefully when he asserts: “Banks that receive government protection in the form of liquidity and (partial) solvency guarantees are essentially public-private partnerships.” (Wray 2010, p. 26) It is, therefore, not surprising that, in the absence of a clear dividing line between the private and public nature of these financial institutions, this can lead to undesirable outcomes whereby private gains are often achieved at the expense of what eventually become socialized costs, as experienced during the financial crisis of 2008. The purpose of this chapter is to consider what options are available to address the spectacular market failure that had been triggered by the dramatic institutional transformations preceding the financial crisis. During the last few decades, the center of banking activity switched from the traditional sphere of financing production to the financial sphere that fed a growing casino economy in which, as John Maynard Keynes had already surmised in the 1930s, “industry” was being replaced by “speculation” as the principal driving force of capitalist development. The question to which we wish to address is: can the banking system be redesigned to meet the new challenges arising from the financial crisis and how far can we really deviate from the status quo ante? We conclude that perhaps the best route to follow is merely to revert back to a world where the public ownership of a significant portion of the banking sector is the norm. From the Early Commercial Banking Phase to the Financialized Phase of Minsky’s Money Manager Capitalism The previous quote from Minsky (1994) regarding the dual nature of banking requires, however, a certain modification in light of the TMC. It is, of course, true that banks (including the central bank) issue the public’s means of payments appearing on the liability side of their balance sheet (nowadays commercial banks do so through an array
of bank deposits, electronic purses, etc., while, during the nineteenth century, it was through the issue of their own private bank notes). On the other hand, according to the basic model of commercial banking, banks traditionally only supported capital formation indirectly (on the asset side of their balance sheet) by advancing short-term credit for the financing of production in both the consumption- and investment-goods sectors. This was done historically in accordance with the Real Bills doctrine, namely via the financing of circulating capital expenditures, even though banks did not always abide by this simple doctrine and frequently did finance fixed-capital investments at their peril, as during the railway boom era in the nineteenth century. This is well depicted in the standard model of the monetary circuit to be found already in Parguez (1975), illustrated below, and which has been elsewhere described as the model of the pre-financialization phase of capitalist development (see Seccareccia 2012-3). Figure 1: The Logical Structure of the Monetary Circuit within the Commercial Banking Phase
As discussed in detail in Seccareccia (1996) and Bougrine and Seccareccia (2002), the old Banking School principle that highlighted the flux/reflux mechanism is well understood within the context of this circuitist perspective on banking. Banks first advance the initial credit (M) to business enterprises (they also pay some interest on outstanding deposits, as well as provide income to their bank workers, namely iM and Yb) who then spend it on generating household employment income ( Yw) (with s being the propensity to save). The portion of overall household income ( Yw + iM + Yb ) that is consumed ((1-s)Y) goes directly towards allowing firms to extinguish their debts, while
the remainder must be obtained by firms via the floating of securities ( B) in the financial markets to capture household saving (Sh). This model of commercial banking depicts well the role that the State had legally bestowed on banks as creators of money through their loan/deposit making activity which generated the initial financing of production. Saving and the long-term financing of investment (or final finance) were brought together in the intermediation process within the financial markets (via the purchase/sale of stocks and bonds), but the latter played a subordinate role in ensuring the flux/reflux mechanism. Eventually, as the financial system evolved, commercial banking became the initial layer upon which were created multiple layers of banking. Once specialized institutions began to appear in the intermediation process already by the end of the 19th Century with trust and mortgage companies (or what generically can be termed investment banks and non-bank financial intermediaries (NBFI)), these institutions sought actively to capture household savings in the financial markets, thereby channeling these funds for long-term borrowing. This system was stable as long as waves of optimism would not induce agents in these financial markets to leverage themselves excessively, which can then implode into a debt deflation of the type analyzed by Irving Fisher during the 1930s. When it did, as in the Great Crash of 1929, the financial markets could bring down the whole house of cards, including the commercial banks because of the contagion, as agents sought to become liquid (as highlighted by the broken line at the bottom of Figure 1), thereby preventing the closure of the circuit as liquidity preference (φ) rises. Perhaps, more importantly, the system was stable as long as commercial banks themselves would not move away from the primary supportive role of financing production, and would not themselves play an active, and more incestuous, role in the financial markets. A product of the Great Depression was the Glass-Steagall Act which sought the institutional separation of commercial and investment banking exactly because of the dangers of this explosive mixture (Russell 2008). During the postwar period and especially over the last few decades, there have been important institutional developments which have made this relationship between banking institutions and the financial markets ever more insidious (see Tymoigne, 2011, and Carvalho de Rezende, 2011). The most important of these is the emergence of a more dangerous form of securitization which, while better separating the initial issuer of a loan and the final holder, has actually led to a de facto fusion between the activities of commercial banks and those of the financial markets with “universal” banks being involved in all the various layers of banking, thereby generating important perverse incentives. Both Tymoigne (2011) and Lavoie (2012-13) show why securitization is not a new phenomenon. Indeed, as Lavoie (2012-13) points out, this is analogous to a form of liability management originating already in the nineteenth century whereby a bank would issue a mortgage and, instead of passively waiting as a mere deposit taker, would actively issue securities based on the mortgage loans. In this case, however, the mortgage remained on the asset side of the originating bank’s balance sheet, even though engaged in securitization on the liability side. Instead, the 1980s brand of asset securitization became something else that was progressively quite pernicious in spawning systemic risk, because of all the moral hazard and perverse incentives that it generated. With the loosening of the earlier regulatory structure together with the hardening of capital
adequacy requirements in the late 1980s, the modern form of securitization and the use of off-balance sheet vehicles or conduits, associated with the increasing financialization of the economy, had now to do with asset management rather than liability management (Lavoie 2012-13) 1— a financial innovation that contributed to a Minsky-style Ponzi process in the mortgage industry (Tymoigne, 2011) about which Minsky himself showed serious concern (Minsky 1987). As displayed in Figure 2 below, which has been adapted from Durbin (2010, p. 207), the original bank mortgages appearing on the asset side of a bank’s balance sheet would be sold to a special purpose entity (SPE) or vehicle (SPV). Once off the original bank’s balance sheet, these pooled mortgages would then be redesigned and packaged into various tranches of mortgage-backed securities (MBS) or collateralized debt obligations (CDO) and sold to investment banks internationally. Given the perverse incentives generated by this new “originate to distribute” model of banking, these transformed multi-product banks moved away from the traditional model of banking that had earlier been focused on advancing credit for productive purposes. Figure 2: The Modern Process of Securitization
As shown in Figure 3 below, during this modern era of financialization the banks/financial markets nexus was solidified. Especially since the 1990s, where the focus of bank lending shifted from the business sector to the household sector, banks found it more profitable to transform the banking process into one giant transactions machine more interested in making commissions in the financial markets than in lending for productive purposes. As shown by the solid lines, what moved the system forward was household borrowing, Mh, while the business sector was becoming a net lender. We witnessed, therefore, a reversal of the firms/bank nexus, as the household sector became ever more caught up in this casino-type economy and dependent on bank lending to finance both its consumption and the speculative frenzy, especially in the housing market.
Figure 3: Financialized Monetary Circuit with Commercial Banking and Financial Markets Nexus
The “originate to distribute” model of banking a number ofto perverse (1) It led to fewer commitments from created commercial banks engageincentives: in the more socially desirable, though less lucrative, traditional activity of bank lending based on the capacity of credit-worthy borrowers to service their debts and banks became more attracted by the commissions that they could collect via off-balance sheet asset securitization; even if the whole process had become in essence a kind of Ponzi scheme, as was a significant portion of the sub-prime market. (2) It led to perverse casino-type behavior with the dices stacked so that the bank originating the loan could exit by selling an overpriced security. At the same time, it could be selling Credit Default Swaps (CDSs) by betting that the borrowing agent would not be able to meet his/her obligations. As long as there were willing customers within the “shadow banking system” to hold these CDOs or Mortgage-Backed securities (MBSs), and real estate prices continued to rise, the Ponzi system could be sustained. Once an important link in the chain broke with the bursting of the U.S. housing market, resulting partly from the rising interest rates in 2005-2006, this whole fragile system would collapse, as occurred in 2007-2008. How Can the Banking System Be Reformed? There have been a number of new proposals, as well as actual recently-enacted legislation, to regulate better the financial system, the most well known being the DoddFrank Wall Street Reform and Consumer Protection Act of 2010 in the U.S. The American legislation seeks to re-regulate better the financial industry, especially by providing less opaqueness and more transparency in the derivatives market (by separating 6
trading from banking proper via the adoption of a watered-down version of the Volcker rule), tightening regulations of credit rating agencies, and ending the “too big to fail" culture that had apparently permeated the financial sector. The central focus on the issue of size (i.e., the “too big to fail”) and insufficient concern with deeper structural issues having even more profound detrimental externalities that would have necessitated more radical proposals, could very well insure the repeat of another banking and financial crisis (see comments especially by James K. Galbraith at the Levy Economics Institute (2011)). Nothing in the Dodd-Frank Act, or some of the proposed legislated changes in Europe, have attempted to revamp seriously the structure of financial markets and banking incentives so that banks would return to their primary supportive role of the prefinancialization era. This is because policymakers internationally all accept the same neoclassical belief in the importance of a free market in financial instruments. As Tropeano (2011) notes: “The inspiring idea [behind these current reforms] is that financial innovation must be encouraged because it increases consumers’ welfare and, by summing across all individuals, the whole of society’s welfare. All the effort is concentrated in redesigning the regulatory and supervisory tools to deal with the whole range of new products and to be able to more accurately measure the risks arising from them than was done in the past.” (Tropeano 2011, p. 45) Hence, the primary purpose is not to question the current structure as depicted in Figures 2 and 3 above, but merely to see how the existing structure can be made to work better so that some of the problems of moral hazard are sufficiently dealt with via some minor corrective measures, such as the concern over the issue of “too big to fail”. This is why these recent changes in the regulatory structure will not solve the underlying problems that led to the crisis. Indeed, an obvious example of why, for instance, the focus on “too big to fail” is not as critical as it has been made out to be by some policy makers, is to look merely at the experience with Canadian banking during the financial crisis. The major Canadian banks are relatively large and the Canadian banking sector is also highly oligopolistic with many of these banks being within the top ten of North American ranking (by asset size). Yet, Canada neither experienced a serious subprime crisis nor did it require major outright bailouts as both American and European banks did (see Correa and Seccareccia 2009; and Seccareccia, 2012-13), even though Canadian banks did obtain a high degree of government support as well (Macdonald 2012). Moreover, as Kregel (2012a, p. 3) points out, the breaking up of large, complex financial conglomerates would not lead to more effective regulation simply by creating a large number of small financial institutions engaged in the same complex activities. The problem is not the size of these financial holding companies; it is primarily the nature of these complex activities that needs to be regulated. Among heterodox economists, there are at least three proposals that have been put forth in recent years: (1) The across-the-board abolition of what Lavoie (2012-13) refers to as the modern form of securitization; (2) “Narrow” banking (or 100% money) as first proposed by Chicago economists in the 1930s and its modern variants; (3) Public ownership of banking institutions and their treatment as public utilities. Let us briefly look at these one by one.
(i) “Ban Securitization” Banking Policy There has been much discussion among heterodox economists historically even before the financial crisis that supported some re-regulation of the banking sector. However, prior to the financial crisis, much of the discussion in the United States was to consider retaining some variant of the Glass-Steagall features in a post-Glass-Steagall world and opposition to universal banking (Minsky 1995). Some of the discussion pointed also to reconsider creating a reserve system that focuses on the asset side of banks’ balance sheet and not the liability side so as to better control credit allocation. For instance, over the last decade, Palley (2000, 2004) and D’Arista (2009) have favored some system of assetbased reserve requirements as a way of chocking off speculative bubbles that are often at the origin of financial crises. While such ideas have circulated, the latter proposal seems to succumb to some of the same criticism going back to Moore (1988) that drew attention to the ineffectiveness of reserve requirements, in this case on the liability side, because they can be easily circumvented. Why would regulating the asset side be any different in being able to circumvent such regulations, especially since reserves are fungible and any reserves allocated for a specific purpose cannot be isolated in banks’ balance sheets (Toporowski 2007)? Moreover, some would argue that, when off-balance sheet activities have become ever more prevalent, an approach to banking regulation that focuses on imposing reserve requirements on the asset side of the balance sheet may seem to be somewhat off the mark, since the problem is not only what remains on the asset side of a commercial bank’s balance sheet but also what has been removed via securitization. Because of this latter concern, some have pointed to the need for dealing with what has been the most disruptive of these developments that precipitated the subprime crisis and, eventually, the 2008 financial crisis — the new form of securitization that became popular over the last two decades. While there are a number of heterodox economists who would like to see the abolition of this perverse form of securitization with a return to a more restricted system of “originate and hold” banking, that is, a straight “hold to maturity” approach to banking (Auerback, 2009), no one has perhaps been as clear and articulate on this policy as Warren Mosler (2012). Much of the “shadow banking” associated with the so-called deepening of the financial markets and their flooding with ever more exotic financial derivatives (as shown in Figure 3 above) and with the FIRA sector reaching ever new heights as an unproductive share of GDP, can perhaps be easily reined in via a number of key legislative changes that would remove this harmful, yet lucrative, form of securitization. The purpose would be to bring under control the casino instincts rampant in the financial markets. Instead of seeking to provide stability by regulating the liability side of the banking system, as had happened historically since the 19th Century, Mosler has argued in favor of regulating the asset side, by defining more precisely the assets that ought to be held by the banks once loans are issued, including possibly the minimum capital requirements, and by preventing them from being sold off in the financial markets, thereby removing them from bank balance sheets. The objective would be to ban the new form of securitization which was at the heart of the crisis in 2007-2009. The Mosler proposal can be reduced to the following policy directives, which we hereby paraphrase:
1. Banks should only be permitted to lend directly to borrowers and to keep their loans in their balance sheets. Banks should not be engaged in any secondary market activity by selling loans and other financial assets to a third party. 2. Domestic banks should not be allowed to contract in LIBOR (this pertains to controlling the cost of credit financing domestically). 3. Banks should not be allowed to hold any assets ‘off balance sheets’, which would mean no ownership of subsidiaries, namely in the form of special purpose vehicles (SPVs). 4. Banks should not be allowed to accept financial assets as collateral for loans. 5. No offshore lending. 6. Banks should not be allowed to buy/sell credit default insurance (CDSs). 7. Banks should not be allowed to engage in proprietary trading or any profit lending beyond basic lending. 8. Banks should provide loans on the basis of good underwriting via credit analysis rather than market evaluation and the authorities should prohibit mark to market of bank assets. Mosler (2012, pp. 54-56) Although not all pertain to securitization, most of these rules are easily understood in a common sense way so as to remove perverse incentives that have plagued the financial sector. Indeed, they have been discussed a great deal in the literature, since they pertain to many aspects of bank behavior and not merely to the issue of securitization per se, especially points 1, 4, 5, and 8. For instance, the first of these proposals is by far the most important since securitization is all about the creation of a secondary market for bank loans via collateral debt obligations (CDOs); while the sixth proposal seeks to remove some of the moral hazard problems that are associated with the selling of CDSs. However, an important problem with these proposals is that they rest heavily on the ability of regulators in their supervisory role to detect and remove altogether these illicit activities. Indeed, in addition to the perennial problem of circumventing innovations, to which we already referred when discussing asset-based reserve requirements, there are no incentive systems within the private banking sector itself that would work to enforce these regulations as, perhaps, might be the case with a publiclyowned institution that would be accountable to parliament or the government and whose job of the bank administrator would depend on enforcing those regulations — a standard principal-agent problem. Even mainstream economists would recognize that there are at least three main forms of market failure in the area of finance: (i) the problem of information asymmetry which the prohibition of asset securitization would only partly succeed in dealing with; (ii) the problem of systemic risk arising from the existence of externalities or spillover effects, which, once again, the elimination of securitization would not fully remove, and (iii) the problem of fraud “epidemics”, which, as William Black (2005) has recognized, does not pertain only to the securitization process but permeates all aspects of financial activities. For these reasons, some have pointed to the need for greater structural measures to prevent another financial crisis. Narrow Banking: Varieties of Options to Reduce the Elasticity of the Monetary System
While attempts to restrict bank behavior, as with the Mosler proposal, which can be seen as a process of “narrowing” the scope of banking operations, under the portmanteau term “narrow banking”, one finds a number of distinct plans whose objective is not always clear but which has a long history going back to the 1930s original “Chicago Plan” of the New Deal era, by regulating through the liability side of banks’ balance sheets. The original “100% money” plan going back to Irving Fisher and Henry Simons was, in a sense, an attempt to stand on its head the standard commercial banking model as described in the traditional theory of the monetary circuit. Based on a neoclassical assessment of the causes of the crisis and the ensuing debt deflation (resulting from excessive private spending in relation to savings), these writers had concluded that what was necessary was to ensure that the economy ought to behave much as it would under an ideal pure commodity money system in which banks would be reduced to the role of pure financial intermediation. The essence of the Fisher plan was to break the link between money and credit advances, which was the by-product of fractional reserve banking and hence “to divorce the process of creating and destroying money from the business of banking” (Fisher 1935, p. xvii), all in an attempt to restore “the conservative safetydeposit system of the old goldsmiths, before they began lending out improperly what was entrusted to them for safe-keeping.” (Fisher 1935, p. 18). The Fisher plan sought to restore the traditional neoclassical mechanism by preventing commercial banks from financing the flow of production in excess of business revenues, thereby preventing banks from creating money, by legislating 100% reserve requirements, or what may be dubbed “nationalizing” money (Seccareccia 1994). The plan may well have prevented banks from engaging in excessive leveraging and thus avoiding bank failures as a result of the debt deflation; however, the plan would also have prevented commercial banks from performing their normal function in creating ex nihilo credit-money to sustain production and growth. Banks would become pure financial intermediaries between borrowers and lenders. Unless there is deficit spending by the state (as even recognized by Friedman (1960), a system of full reserve banking would be stuck in a world in which, at best, only zero growth could be achieved. Moreover, already during the 1930s, a number of mainstream writers, such as Lin (1937) and Hayek (1937), questioned the efficacy of a policy that rested on controls of the liability side of the banks. The question was: a 100% of which deposits? For instance, Hayek’s (1937) critique may well be worth quoting in extenso: “The most serious question which it raises … is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … the question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. Historical precedent rather suggests that we must be wary in this respect. The Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance? And can we even to-day draw a sharp line between what is money and what is not? Are there not already all sorts of ‘near-moneys’ like saving
deposits, overdraft facilities, bills of exchange, etc., which satisfy at any rate the demand for liquid reserves nearly as well as money?” Hayek’s (1937, pp. 82-3) In part, perhaps, because of these types of criticisms, the Chicago Plan had been rejected by the U.S. Congress in 1935 and to this day there are few examples of full reserve commercial banking. On the other hand, some of the current proposals in favor of “narrow banking” do find their origins in the New Deal discussions over both the 100% reserve requirements and Glass-Steagall separation of banking activities, but, not at all along the same lines as the original New Deal Act. As emphasized by some of its contemporary supporters, such as John Kay (2009), narrow banking would protect the non financial sector from the instabilities in the financial sector by insulating the commercial banking sector from the consequences of the casino behavior of the investment banking sector. Indeed, groups such as the American Monetary Institute in the U.S. and the Committee on Monetary and Economic Reform in Canada still subscribe largely to the original Fisher plan. However, the list is quite long both among mainstream and heterodox economists in support of hybrid versions of this banking proposal. In addition to Maurice Allais and Milton Friedman, numerous variants of this basic model of narrow banking have been proposed over the last quarter century by James Tobin (1987), Robert Litan (1987), Ronnie Phillips (1992, 1995a), and more recently by such disparate economists as Paul de Grauwe (2009) and John Kay (2009). As Kregel (2012a, 2012b) points out, even Hyman P. Minsky once dabbled with it, perhaps under the influence of Ronnie Phillips at the Jerome Levy Economics Institute, even though he eventually abandoned it (see Phillips 1995b, p. 171; Kregel 2012b, pp. 5-6). There are a variety of hybrid models of narrow banking that do not go as far as the original 100% reserve requirements that seek to create a subset of the financial sector that would be prevented from engaging in credit creation and thereby leading to the “socialization” of the transactions and payments side of the banking system and ensuring that the latter functions as a public utility. For instance, Kay (2009) proposed what he describes as a new Glass-Steagall with two types of banking institutions. The narrow banks would be focused on providing two key services to the non-financial sector, namely the payment systems and deposit taking. Hence, only narrow banks would be allowed to specialize in these services by taking deposits from the public (including qualifying for deposit protection) and accessing the payments systems. Moreover, they would be strictly regulated on the asset side. The proposals in place differ as to degree to which these banks would be permitted to engage in lending. Some, who would like to see the system much closer to the 1930s 100% reserves, would permit only the holding of low risk type of securities, such as government securities, and therefore would not be lending, while other proposals would permit some degree of lending, by obtaining the money from suppliers of wholesale funds (Kay 2009, p. 52). Clearly, if allowed, they would not be holding a monopoly of bank lending, since the other investment banks and financial institutions would be engaged in providing lending for capital formation. The tradeoff for the depositors would be that the lower interest returns on their deposits would be compensated by lower risk of loss because of the reduced threat of bank insolvency. It is argued that, by separating the deposit and lending activities, a greater element of stability throughout the financial system would be ensured and the casino features of highly leveraged institutions on the lending side would not be able to do serious damages to the narrow banks.
A number of writers have found such proposals strongly appealing since they do appear to address an important concern pertaining to the need for stability in the financial system. However, circuitist economists would feel somewhat uncomfortable with the consequences of these proposed institutional transformations of the banking system. First, as also emphasized by Kregel (2012b), these proposals contradict the very essence of the Post-Keynesian and circuitist conception of banks as creators of money through their credit expansion. By preventing this credit creation process altogether (as with the 100% reserve requirement) or by severely circumscribing their domain (as with narrow banking), the elasticity of supply of the banking system to meet the public demand for credit would either decline sharply or fall to zero, as in the extreme case of 100% reserve requirements. Indeed, in commenting on Minsky’s view on narrow banking, Wray (2010) points out that, although not categorically rejecting narrow banking, Minsky “simply believed it addresses only a peripheral problem, safety and soundness of the payments and savings systems. It does not address promotion of the capital development of the economy.” Wray (2010: 28) Indeed, on the Minskian criteria of the twin role of banks, as Kregel (2012b) affirms: “A narrow bank on this definition is not a bank, but simply a safe house or piggy bank for government issue of coins and currency.” Kregel (2012b, p. 7) Secondly, the purpose of most of these proposals in support of narrow banking is that they would set-up deposit-taking “safe banks” (such as the quintessential post-office savings bank) that would eliminate losses on deposits and prevent bank runs, as during the 1930s. However, the problem faced during the financial crisis was not one of deposit losses. In fact, an institution like Lehman was not even involved in retail banking and, yet, its failure practically brought down the whole banking system. The problem was the domino effect arising from the loss of confidence within the banking system triggered by the widespread holding of securitized toxic assets. Thirdly, as pointed out by Goodhart (2009), the boundary problem between the narrow banks and the “other” lending banks could actually accentuate pro-cyclical movements rather than mitigate them. Goodhart (2009) writes: “So, during normal conditions there will be an incentive for savers and depositors to put their money with the unprotected, but higher yielding, institutions beyond the boundary. … Of course, when there is a crisis the savers and depositors who shifted towards the higher-yielding institutions will come rushing back either to cash or to the protected sector. But that will worsen the pro-cyclicality of the whole system by encouraging pro-cyclical fluctuations across the boundary as the economy moves from good times to bad.” (Goodhart 2009, p. 2) Hence, while the narrow banking proposal does address some of the concerns not presently addressed within the current system of universal banks, many on the PostKeynesian and circuitist camp would feel somewhat uneasy with this proposal, much as Minsky did. From “Nationalizing Money” to Nationalizing Commercial Banks It is often argued that, if the banking sector is in fact characterized by such significant externalities and ought to be run as a public utility, it ought also to be owned by the government, as is often the case in certain strategic industries, such as electricity, water and sewage systems, and public transport. Moreover, as certain circuitist writers have
argued, unlike the non-financial business sector, the banking sector as a whole is not really constrained by the amount of capital that it owns to conduct the business of banking. In contrast to the Basil Accords, if banking can be properly performed regardless of the paid-up capital, then why should banks be private for-profit capitalistic firms run on the basis of an incentive system that is inappropriate to that industry (see Vallageas 2012)? One of the widely used arguments by neoclassical economists and advocates of free markets is that government ownership of enterprises is politically motivated, inefficient and inevitably results in slower economic growth. In most countries, this served as a justification for a major wave of deregulation of markets and privatization of public enterprises that began in the 1970s. As is well known, the liberalization policies that ensued targeted all sectors of the economy, including the financial sector (see Figure 4). It was argued that financial liberalization would bring about a more efficient and competitive banking system, which in turn will promote growth and development. In a study from a decade ago using cross-country regressions based on data from 92 countries, La Porta, Lopez-de-Silanes, and Shleifer (2002) concluded: First, government ownership of banks is large and pervasive around the world even in the 1990s. Second, such ownership is larger in countries with low levels of per capita income, underdeveloped financial systems, interventionist and inefficient governments, and poor protection of property rights. Third, government ownership of banks in 1970 is associated with slower subsequent financial development. Finally, government ownership of banks is associated with lower subsequent growth of per capita income, and in particular with lower productivity growth . . . These negative associations are not weaker in the less developed countries. (La Porta, Lopez-de-Silanes, and Shleifer, 2002, p. 290) In other words, the authors claim that government ownership of banks appears to be the culprit and cause of the major ills modern economies have suffered. Their policy recommendations are obvious: financial and economic development, particularly in poor countries, requires the elimination of government ownership of banks, further privatization, and more deregulation. The available data between 1970 and 2005 indicate that these recommendations have been taken literally and implemented rigorously in most countries. As can be seen in Figure 4, from 1970 to 1995, privatization of public banks occurred in every country in our sample with the exception of Ireland, the Netherlands and Sweden. By 1995, public banks – as defined in the data – were completely eliminated in four of the G-7 countries (Canada, Japan, UK and US). Some of the other drastic reductions of government-owned banks during this period took place in Russia, which underwent the shock therapy program of fast-track privatization – thus lowering the government’s share from 100 to just over 30%. Interestingly, the same trend occurred in France (from nearly 75% to 17%), Italy (from 75% to 35%), and Portugal (from 100% to 25%). In their assessment of the macroeconomic effects of the banking-sector liberalization during this period, Goodhart et al. (2004, p. 592) argued that “the relationship between liberalization and a subsequent asset price boom–bust has been a common phenomenon, common to Western as well as Asian countries, in developed as well as developing countries, and that financial liberalization appears to have strengthened the financial accelerator mechanism by increasing the sensitivity of bank
lending to property price fluctuations” – adding that “. . . the result was a danger of a boom–bust cycle . . . [and that] . . . this became the experience in Scandinavia in the early 1990s, Japan in the 1990s, and much of East Asia in 1997/8; much the same syndrome may await India and China when they eventually liberalize.” (Goodhart et al. 2004, p. 594). Figure 4 Government ownership of banks: Share of the assets of the top 10 banks owned or controlled by the government
Source: La Porta et al., 2002. GB70 and GB95 refer to government’s share in the top 10 banks in 1970 and 1995, respectively.
In spite of these results, the trend toward more liberalization continued during the period 1995-2005, as shown in Figure 5. The data in Figure 5 refer to the share of assets in banks that are 50% or more government-owned and therefore are not directly comparable with data from Figure 4. However, using this somewhat different definition of government ownership, we note that with the exceptions of Germany and Portugal, government ownership was reduced dramatically everywhere or completely eliminated. The most dramatic changes during this period occurred in Greece, Iceland and Norway where government ownership of banks was eliminated by 2005 whereas in 1995 it was as high as 84%, 71.3% and 62.4%, respectively. Although no data are available after 2005, we know that this trend of privatizing public banks has continued in most countries throughout the rest of the decade – and certainly up until the beginning of the worldwide financial crisis that began in 2007-8. In fact, the crisis coincided with the climax of financial deregulation and privatization in the banking sector. Figure 5 Government ownership of banks: Share of assets in banks that are 50% or more government owned
Source: The World Bank data (WB 2005) are for the year 2005 and are available from http://econ.worldbank.org/, data for 1995 (LaPorta 95) are taken from La Porta et al., 2002.
It is important to note that the current crisis prompted several governments to bailout some failing banks and other financial institutions, usually by wholly acquiring or by purchasing a large share of assets in these corporations, which increased government ownership of banks in several countries. Indeed, Hau and Thum (2009) found that “[a]s a consequence of recent government sponsored bank recapitalization plans, state ownership in banks is likely to experience a dramatic increase. Even countries like the US and the UK, where state ownership in banks was never important, now feature a partially stateowned banking sector.” Hau and Thum (2009, p. 704) Nationalization and other bailout transactions in time of crisis explain the relative rise in public banks in Germany, for instance, as can be seen in Figure 5. However, after experimenting with financial liberalization for almost half a century, it is now widely accepted that the global financial system has become more unstable and bank failures more frequent so that, as a result, banks have not always served the economy as well as the proponents of liberalization had argued. According to various accounts, the latest global financial crisis was the worst since the Great Depression because it shook the very foundations of the capitalist system. Indeed, as the crisis worsened, governments around the world injected massive sums of money to bail out or to purchase some failing private enterprises, including banks. The latter action is clearly contrary to the ‘fast-track’ privatization that has been going on since the 1970s. This raises important questions: Is public banking a viable alternative to private banking? Can public banks be made more efficient? And can they serve the public interest better? As we have argued previously, in the circuit theory (Parguez, 1996) it is impossible for firms to carry out their production plans unless they receive financing from banks in the form of liquidity advances. Banks therefore play the central role in promoting and sustaining economic activity. The primary function of banks is to finance productive activity, which creates jobs and contributes to the well-being of citizens. A priori, it does not matter whether these banks are private or public institutions – as long as the credit flow is running smoothly and credit is not arbitrarily withheld to create artificial scarcity.
The artificial scarcity of (credit) capital is something that had in fact preoccupied Keynes already in the 1930s. Indeed, Keynes (1936, p. 376) noted that “[t]he owner of capital can obtain interest because capital is scarce just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital”. One of Keynes’ concerns was to eliminate “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital”. Keynes (1936, pp. 375-376) believed that “. . . it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce.”. However, in order to achieve this objective – and “. . . on the basis of the general social advantage”, Keynes expected to see the State “... taking an ever greater responsibility for directly organizing investment ...” (Keynes 1936, p. 164) because “the duty of ordering the current volume of investment cannot safely be left in private hands” (Keynes 1936, p. 320). Given that a government-owned bank does not have to be motivated by profitmaking, we expect public banks to be different from private banks in their lending behaviour. Moreover, public banks should be – and often are – created with the specific mandate that they must support the local economy, particularly during a slowdown or a recession. The overriding objective of a public bank – and indeed its very raison d’être – should be to serve local businesses and households by advancing credit and not to engage in the high stakes derivatives market as occurred prior to the financial crisis. In fact, this restriction should also apply – and much more so – to a private bank because, as was discussed earlier, when banks start acting as intermediaries between their customers and complex financial markets, they lose their primary function as substitutes – and become simple complementary institutions – to these markets. This shift marked the evolution of banking toward what Minsky (1992) referred to as the ‘money manager phase’ of capitalism and is considered as the source of financial instability (Wray, 2011). It can therefore be legitimately argued that, the presence of public banks can actually contribute to improving the efficiency of credit markets. In most developed countries, public banks have traditionally been a major source of funding for small businesses, infrastructure development, housing construction, and other investments for social purposes. For example, since the end of the Second World War, Germany developed (and maintained up until now) a large system of public banks to finance the re-building of its economy. These banks acted as universal banks in the sense that they provided short-term lending as well as financing for long-term investment. Mattey (2010) reports that according to legislation “in Germany local public banks (Sparkassen) are obliged to ‘ensure an appropriate and sufficient provision of money and loans to all parts of the population and especially to small and medium-sized enterprises’” (emphasis added). Mattey (2010, p. 45) Indeed, data from the German loan market indicate that “. . . a relatively higher share of firms with a low (self-reported) degree of creditworthiness, i.e. risky firms, borrow from public banks (73%) than from private banks (19%). For firms with a high degree of creditworthiness, i.e. safe firms, the difference is less pronounced (51% vs. 30%)” (Mattey 2010, p. 46). For this reason, in its annual consumer survey in 16 European countries, Reader’s Digest (2011) reported that the most trusted banks by Europeans (Europe-Wide Winners) during the period 2007-2011 were government-
owned banks, cooperative banks, and credit unions. From this perspective, public banks are performing a critical – and indeed vital – social function, much like public utilities, and therefore their profitability should cause less concern for policymakers. The primary goal of a bank should not be the focus on profit but the support of socially useful initiatives and activities that generate a benefit for the whole community. These are the essential elements of what can be called the portrait of an ideal bank. However, some writers have claimed that during the recent crises, state-owned banks have suffered disproportionately higher losses in comparison to private banks and attributed this poor performance to problems of inefficiency and incompetence of their board members (Hau and Thum, 2009). Others emphasized the presence of moral hazard due to State guarantees1 and expected government bailout (Mishkin, 2006). These are misleading and unfounded statements. For instance, the crucial variable in the study by Hau and Thum (i.e., bank losses) is based on self-reported losses, which is problematic because as Tenreyro (2009) argued “privately owned banks have a bigger incentive to hide losses (temporarily at least) in the hope of better performance in the near future” and that “not all banks use the same accounting method . . . A group of banks in the sample [in Hau and Thum’s study] used market-value accounting; another used historical-value accounting, and yet a third group ... switched from market- to historicalvalue accounting in the midst of the crisis.” Tenreyro (2009, p. 744) Moreover, there is no clear evidence to support the claim that public banks are less efficient than private banks. In fact, a recent study of the Russian banking system by Karas et al. (2010, p. 213) found that public banks are more efficient than private banks 2. Chen et al. (2005) found that in China state-owned commercial banks are more efficient that joint-stock commercial banks. Using data from 17 European transition economies, Grigorian and Manole (2006) concluded that privatization of banks does not lead to increased efficiency. A similar result was found by Bonin et al. (2005) who studied the same issue in 11 transition economies and found that government-owned banks are not significantly less efficient than domestic private banks. Bonin et al. (2005) added that “we find no discernible evidence that government ownership makes a difference to profit efficiency relative to private domestic ownership” Bonin et al. (2005, p. 48). This is further supported by Micco et al. (2007) who used a large dataset covering 179 countries. The dataset was revised to focus on commercial banks during the period 1995-2002. The results of this study are interesting because while they “support the idea that in developing countries public banks are less profitable than private banks”, the evidence is not as clear in developed countries. Indeed, Micco et al. (2007) reported that “When we look at industrial countries, we find no statistically significant difference between the ROA [return on assets] of public banks and that of similar private banks”. (Micco et al. 2007, p. 227) Commenting on the difference in performance between public banks in developing and industrial countries, Micco et al. (2007) concluded by saying that “An
There was a widespread argument that these state guarantees tend to distort competition in favor of public banks so in 2001 the European Commission took legal action against government-owned banks in Germany, which lost their state guarantees following the EU decision in 2005. 2 Karas et al. (2010, p. 214) make it clear that their results are for the period after the 1998 crisis and emphasize the fact that “At present, the vast majority of Russian banks are not burdened by lingering Soviet deficiencies. Most private banks are de novo banks, as the privatized ‘spetsbanki’ faltered in the period 1992–1999. Most public banks are also de novo. They were created after the collapse of the Soviet Union by government bodies such as state enterprises, cities and federal, regional or local governments.”
alternative interpretation is that in industrial countries public banks have ceased to play a development role and merely mimic the behavior of private banks, whereas in developing countries public banks still play a development role and their low profitability is due to the fact that, rather than maximizing profits, they respond to a social mandate.” (Micco et al. 2007, p. 227) Indeed, the difference in mandate is another reason why we should be doubtful about the supposed underperformance of government-owned banks. As mentioned above, public banks are obliged to assist local businesses and contribute to other socially beneficial expenditures, which are not directly profitable. In fact, if we compare the mission statements of one public bank (Bayerische Landesbank) to a private bank (Deutsche Bank) from the sample used by Hau and Thum (2009), here’s what we find:
“The mission of Bayerische Landesbank is improving the welfare of society at large. The Group is committed to furthering public causes in various ways – from promoting the economy through donations to charitable organizations, to actively protecting the environment, and to fostering the arts, culture and sciences...” “Deutsche Bank’s Mission: We compete to be the leading global provider of financial solutions for demanding clients, creating exceptional value for our shareholders and people. Identity: Deutsche Bank is a leading global investment bank with a strong and profitable private clients franchise. Its businesses are mutually reinforcing.” (quoted in Tenreyro, 2009, p. 45)
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