Market trade-offs

Ed Miliband's promise to introduce more competition into banking has faced some intelligent criticism. But it also raises some fundamental tradeoffs we face in thinking about states and markets. These are:

1. Shareholder value vs a vibrant market. Jonathan points out that the fall in bank shares after Miliband's speech is just what we'd expect to see as investors anticipate lower monopoly profits. This highlights the fact that a truly healthy market is not good for shareholders, simply because it means that profits are low and risky. If you want to see a well-functioning market, look at the fruit and veg traders on Leicester market. None of them goes home in a Bentley. For this reason, any attempt to introduce genuine competition will be resisted by fierce lobbying.

2. Anti-statism vs pro-markets. Miliband's call for state action to increase competition isn't as paradoxical as it seems. It's consistent with Polanyi's claim that the emergence of a market economy requires all sorts of state interventions. Insofar as this is the case, supporters of a free market economy cannot be anti-statist.

Of course, this view has its critics. It's possible that, in the long-run, bank competition will be increased by market developments such as alternative currencies and P2P lending. And Eamonn Butler claims that deregulation would increase bank competition.

I agree, up to a point; red tape often favours incumbents and deters entry. But I suspect that even in a dereglated industry, entry into banking would be difficult simply because of high capital requirements and the need for goodwill and brand power to induce depositors to trust the new entrant.

3. Competition vs stability. Joseph Schumpeter noted that competition "incessantly revolutionizes the economic structure" and unleashes a "perennial gale of creative destruction". A truly competitive banking system would be an unstable one, with some banks collapsing. This is not a bug, but a feature; productivity increases precisely because (pdf) firms exit the industry.

This, though, poses the question: do we really have the systems in place that would allow majorish high street lenders to go bust without seriously adverse effects upon lending and confidence? Does Miliband really want to test this?

This point generalizes. Schumpeter was, of course, not the first to note the instability of a competitive economy.94 years earlier, some guys wrote:

Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the bourgeois epoch from all earlier ones. All fixed, fast-frozen relations, with their train of ancient and venerable prejudices and opinions, are swept away, all new-formed ones become antiquated before they can ossify. All that is solid melts into air, all that is holy is profaned.

Which brings me to a fourth trade-off - that between a market economy and old-style conservatism. The Oakeshottian conservative, who is averse (pdf) to change, should see much to fear in a truly dynamic market economy. There are - as Polanyi recognized - strong reasons why most advanced societies have retreated from free market economics.

Comments

[Luis Enrique]

When I think of what's wrong with banking, most of it has to do with investment banking, so I find the focus on high street banks hard to understand (well, from a fixing finance point of view, if not from a political point of view).

I know Northern Rock collapsed, but afaik that could have been dealt with with some simple rules on sources of funding.

Can anybody point me towards any evidence that there's much wrong with high street banking? Does high street banking generate excess profits?

[Richard]

"It's consistent with Polanyi's claim that the emergence of a market economy requires all sorts of state interventions. Insofar as this is the case, supporters of a free market economy cannot be anti-statist."

I must confess I've never quite got this point. Given that markets are a result of voluntary contracting, I'm unsure why state intervention would be necessary for this. Does he mean for example the state abolishing local local laws restricting competition? And in a genuinely free market economy, what is to stop people voluntarily refraining from engaging in market activities with their colleagues if they do not wish to?

[The Stigler]

Luis Enrique,

Some years ago I worked for a Building Society. Dozens of them in the industry back then.

And while some had higher costs than others, the fact is that it really made very little difference to borrowers and savers. The cost of running building societies is big, but compared to the total sums, miniscule.

People assume that there's not enough competition in banking, but the reality is that the difference is so fine that no-one can be bothered switching.

[Jonathan Finegold]

Chris,

What do you think of the free banking literature? The picture they paint of a deregulated banking industry seems to fit a monopolistically competitive model.

[Frances Coppola]

Luis,

Crikey, where do I start....

EVERY BANK that failed or nearly failed in the UK in the financial crisis did so because of problems in retail banking. The only one where investment banking was a significant contributor was RBS, but even there commercial property was a much bigger problem.

Historically, virtually all banking crises around the world have at heart been crises of retail banking, usually associated with residential and/or commercial property lending. The 2008 crisis was no exception: the driver was highly risky and fraudulent real estate lending by mortgage originators. Yes, they were responding to demand from investment banks, and in some cases the investment banks and the originators were in common ownership, but the ultimate cause of the US crisis, too, was retail banking, not investment banking. I am really, really tired of people blaming investment banking for problems that originate in retail banking.

The fundamental problem with basic retail banking is that it is not profitable. That is why we have had persistent mis-selling in retail banking since the 1980s. There is no easy solution to this: paring banking back to its fundamentals and denying banks the opportunity to make money by cross-selling higher-value products, often to people who don't understand them and don't need them, simply exposes the fundamental problem that they can't really make money from vanilla retail banking.

So in answer to your question, the problem with retail banking is not that it generates excess profits, but that it doesn't generate enough profit. It is a fundamentally unprofitable industry whose core functions are economic and social necessities. We haven't yet taken on board what that means for the future of high street banking.

[Luis Enrique]

Frances,

Well, thank you for the corrective. I should have said I was talking about the UK. But now I think on it, I remember reading about the loan book at hbos being v bad. Don't know about Lloyd's or Barclays or HSBC.

But if you're right the policy focus on competition is entirely misplaced. If they aren't making any money, evidently they are competitive enough.

[Paolo Siciliani]

Some intelligent criticism you say? Let me put it this way, if bankers were caught conspiring along these lines - "fine, from now on none of us will be allowed to gain more than, say, 20% market share, so no point trying to poach my customers, stay quiet and enjoy the benefits of stable market quotas" - .... they would face criminal prosecution for a cartel offence.

I guess many commentators are mixing up breaking up banks with market shares caps. One could argue that by breaking up the market structure is reshuffled and the competitive dynamics is free to take its course, but to impose permanent caps just means choking off that dynamics from the start - the two remedies are fundamentally incongruent!

[Blissex]

«state action to increase competition isn't as paradoxical as it seems. It's consistent with Polanyi's claim that the emergence of a market economy requires all sorts of state interventions. Insofar as this is the case, supporters of a free market economy cannot be anti-statist.»

These two statements are based on a gross confusion between "free" markets and "competitive" markets, two very different concepts and realities, because:

* Free markets often are not competitive, as some market participants have significantly more leverage than others. Free markets tend to benefit incumbents and others with greater leverage.
* In the propaganda economics used by the right-wing only *perfectly competitive* (infinite markets for infinite good with infinite participants with the same demand schedules trading across all time) markets deliver the claimed benefits.

This confusion is usually one of the standard tricks used by right-wing propagandists, so it is surprising to see a marxian fall for it.

It takes a lot of effort to keep markets *competitive*; many free markets become rather uncompetitive.

[Blissex]

«The fundamental problem with basic retail banking is that it is not profitable. That is why we have had persistent mis-selling in retail banking since the 1980s.»

Do I understand well that you are arguing that poor innocent bankers are forced to defraud their customers because they can't make profit on their base services and they need to subsidize them?

Because that is what I read above and here:

«There is no easy solution to this: paring banking back to its fundamentals and denying banks the opportunity to make money by cross-selling higher-value products, often to people who don't understand them and don't need them, simply exposes the fundamental problem that they can't really make money from vanilla retail banking.»

That on the face of it is just banker propaganda, because of several reasons:

* Customer fraud is endemic in other financial sector businesses, like insurance, where there are no retail service to subsidize.

* It is a rather common choice of many businesses to market "loss leaders" in order to capture customers to cross sell on far less good value items. Marketing loss leaders does not justify fraud.

* If the argument is that basic retail banking is not profitable because it is "free" to customer who are net lenders to banks, how is that possible? Because since 1980 computer technology has reduced in a colossal way the costs of transactions and record keeping, and before 1980 retail banking fees were not that high either.

* I the the problem may be that the lending by customers to the banks at near 0% is no longer profitable to the banks as the BoE does the same on a wholesale scale, but that's something that has happened far more recently than 1980, and still does not justify screwing the customers to make that up, as after all the 0% lending banks get from the BoE is enormously profitable to them, as intended.

* If basic retail banking were unprofitable on its own, the obvious answer would be to reduce overcapacity to the point where its price could go up. But since 1980 the major UK banks have been ever more eagerly expanded their retail networks, not shrunk them, and in general to turn them into bigger boiler rooms for fraudulent products.

[Frances Coppola]

Blissex,

All I have done is point out that traditional retail banking is a twilight industry. Indeed it has been since the 1980s, which is why we have seen swathes of mis-selling since the 1980s. The reason for this is the technological change that you mention but clearly don't understand.

I am certainly not suggesting that fraud and mis-selling are acceptable. On the contrary. Retail banking as we know it is doomed. What will replace it I don't yet know and neither do you.

I have written about this extensively: can I suggest you read rather more of my work before accusing me of issuing "banking propaganda"?