Why fix banks?

Do we need banks? Frances raises this question. She says:

Lack of spending in an economy (shortage of aggregate demand) is caused by distributional scarcity of money, not by lack of loans. It is not necessary to restore lending in order to encourage spending. It is necessary to replace the money that is not being created by banks.

She's right. The famous "helicopter drop" - more realistically, a money-financed fiscal expansion - might well* do more to boost aggregate demand than measures to boost credit supply such as the Funding for Lending Scheme or "targeted" LTROs.  

But this poses the question. If governments can bypass banks by simply printing money, why bother to fix the banking system at all? Why not just let it be a dysfunctional casino?

The question gains force from the likelihood that, in practice, measures to improve bank lending are in effect subsidies to bankers. I suspect that the reason bank shares did so well after the ECB's announcement last week isn't so much that investors are looking forward to a brighter economic future, but simply that LTROs are yet more hand-outs.

There is, though, an answer here. It's not that helicopter money would be inflationary; in the euro area, higher inflation is something to be desired. Nor is it much of a problem that such a policy would create a merely "artificial" boom; I've always been irritated by Austrians' tendency to dismiss some economic actions as less genuine than others in violation of Hayek's justified warnings about the boundedness of individual knowledge.

Instead, the reason to fix the banks lies in allocative efficiency. One function of banks - albeit one they have always performed indifferently - isn't merely to create money but to screen investment projects, financing good ones and rejecting bad. A simple helicopter drop isn't sufficient to ensure that enough money flows to the businesses or potential businesses that need it.

You might object that it's silly to worry about allocational efficiency when the economy's depressed: as James Tobin said, "It takes a heap of Harberger triangles to fill an Okun gap."

However, the inefficiency caused by inadequate bank lending isn't merely a static one. It matters for growth too. As Jonathan Haskel and colleagues have shown (pdf), a lot of productivity growth comes from "external restructuring" - from new establishments opening and older, inefficient ones closing. A lack of bank lending prevents this restructuring and so slows down productivity growth. I don't think it's an accident that UK productivity growth has slumped since the financial crisis.

In this sense, Frances isn't entirely correct. We do need to restore lending. How much we need to do so depends upon one's view of secular stagnation; if there's no demand for loans because there are no profitable investment opportunities, the need isn't as urgent as it would be if firms were credit-constrained**.

What would be nice, though, is if a way could be found to fix banks that wasn't simply a back-door subsidy. But it would be idealistic to hope for this.

* Subject to the caveat that some debt-constrained recipients of the money might use their windfall to pay down their debts.

** CBI surveys show that only a tiny fraction of manufacturers aren't investing because of a lack of external finance. I'm not sure how convincing this is. The CBI surveys only existing firms rather than those that don't exist but might if their would-be founders could get credit. And firms might be constrained from investing by the fear that credit might dry up in future even if it's available now.

Comments

[Metatone]

One thing worth noting is that the UK is a special case - we're apparently useless at productivity improvement inside firms. The figures for S. Korea and Germany suggest that market entry/exit doesn't have to be the only motive force.

Problem with the CBI surveys, credit has been constrained for manufacturers for so long that they don't even realise how easily by comparison competitors in other parts of the world (e.g. Germany) can get bank financing... that means they blame other factors...

Mind you, generalised lack of demand remains a problem. The businesses I'm involved (B2B ones) in are still doing most of our business in the USA - the UK is a dead zone for corporate investment... consumer spending is bubbling along in some sectors, but manufacturing is typically only partially B2C...

[Frances Coppola]

I'm not arguing that we should not have an effective banking sector. Nor am I necessarily arguing that we should not repair banks, though I do wonder if some of our present ones are beyond repair. I'm saying that damaged banks take time to heal, and while they are healing some other distributional mechanism is needed. Damaged banks are rubbish at capital allocation - in fact banks generally aren't all that good at capital allocation, but damaged ones are much worse. Unfortunately there is no quick fix that restores lending to higher-risk borrowers such as SMEs. Apart, that is, from a state investment bank.

There is also the problem that we have not written down excessive household and corporate debt from before the crisis, and while that remains the case it is difficult to see how lending alone can be an effective mechanism for creating and distributing the means of exchange.

[LovellPropguru]

Having worked in banks, lending constraint has nothing to do with an absence of investment opportunities, but the lacks of skills to spot them - and the risks involved in them.

Lending has become the least regarded of activities by banks and if they could completely computerise lending (it's already partly computerised - just look at the comment by the TSB Head a few months ago when asked about lending) they would automate it.

[Luis Enrique]

I do to know what distributional scarcity of money means. Who isn't spending because they lack access to money? This is a different thing from people not spending because they are too poor or because they wish to pay off debts or accumulate savings. That could be solved by redistribution of income or wealth, and is nothing to do with money per se. If you gave me equities or bonds or wrote off my mortgage I'd spend more, but access to money is not something I worry about. Helicopter drops make recipients better off, their efficacy needn't have anything to do with scarcity of money.