Economics vs bankers

Simon Wren-Lewis says that “finance gets away with so much partly through a process of mystification”, and that economists must help to cut the sector back to size. This is an important point.

One of the great ideological tricks of bankers has been to present their own vested interests in the language of economic logic, thus giving an apparently technocratic justification for what is in reality mere rent-seeking. Not only have politicians fallen for this, but so too have some on the left. They’ve looked at bankers’ misuse of economics, and inferred that economics is an ideological subject used to justify inequality. This, though, throws out the baby with the bathwater. It deprives the left of one of their potentially most useful tools – the fact that conventional economics undermines the self-regard of the financial sector.

I mean this in six senses.

 - Economics tells us that actively managed funds are a rip-off. Most of them under-perform (pdf) the market, but charge extra fees for doing so. The efficient markets hypothesis says that investors would be better off in tracker funds. And in this context, it is correct.

 - Bankers claim that policies to make banks safer, such as higher capital requirements, would reduce lending. As Anat Admati and Martin Hellwig have (pdf) shown, such claims are false and self-serving.

 - Many economists, such as John Kay support “narrow banking” – the separation of retail from “casino” banking. Bankers oppose this not so much because it is insufficient to ensure financial stability, but because financial conglomerates suit them well. As John says, the retail deposit base “carries an explicit or implicit government guarantee and can be used to leverage a range of other, more exciting, financial activities.”

 - Banks get a huge subsidy from the government because the implicit promise to bail them out in bad times reduces their borrowing costs. As the Bank of England points out, much of this subsidy ends up in the pockets of senior employees. Whatever else explains bankers’ pay, it is emphatically not “free market ideology”.

 - Econ 101 says that people respond to incentives. And as William Black says, the incentive structures in banks – generated by asymmetric information and principal-agent failures – favoured criminal activity, such as fraudulent lending in the run-up to the 2008 crisis and PPI mis-selling. As John Quiggin says, it’s plausible that banks make at least $500bn a year from anti-social activity such as tax dodging and market rigging.

 - From customers’ point of view, the financial sector has not increased efficiency for decades: Thomas Philippon points out that the costs (pdf) of financial intermediation in the US, measured by gaps between borrowing and lending rates, haven’t changed since the 1880s, and Guillaume Bazot shows that they have risen in Europe since the 1950s. If technical change has made banking more efficient, those gains have flowed to bankers rather than to customers.

 - The financial sector is hopeless at beneficial financial innovation. There are countless potentially useful products (such as the macro markets advocated by Robert Shiller) which should exist but don’t, at least in a significant or low-cost form. What innovation the industry has practised in recent years has – except for some ETFs - generally been dangerous, such as credit derivatives or high-charging funds. In most sectors, there’s a gap between the private and social returns to innovation – but this is especially high in finance.

My point here is not just that the financial system is deeply dysfunctional and serves the interests of state-subsidized rent-seekers much better than those of customers. It’s also that this fact is evident through the lens of standard economics. Conventional economics is not only correct in same ways, but can serve a radical purpose.

Comments

[Bob]

Good article Chris. MMT suggests asset side regulation in regards to banking. In other words if a loan does not fit certain criteria it becomes a gift, as better than changing the price of lending. Lending is tailored towards capital development.

Full article on banking reform here:

http://www.3spoken.co.uk/2013/05/making-banks-work.html

What is your view on these ideas?

[Pro Cynic]

I'm surprised that on a blog such as this 'bankers' is used as a catch-all term for anyone working in the financial sector.

[Magnus]

All so true Chris.

But the most important point is this:

"One of the great ideological tricks of bankers has been to present their own vested interests in the language of economic logic."

That they have achieved this isn't because economists have failed to make all the points that you make. As you say, it's all mainstream stuff.

(Though that doesn't stop the armchair blog-commentariat from blaming the academics.)

The issue is that the financial sector has managed to systematically co-opt both government and the entire media to support its activities.

What we've really got is economists vs bankers, the media, government, and indeed the lazy left (who unconsciously align with the bankers in their anti-intellectualism).

[Luis Enrique]

the question I would like to see answered is why banks are able to charge such high fees for what they do - where does their pricing power come from, and who is paying over the odds for what.

I think Quiggin is right that profits aren't the number of interest, because rents are shared between shareholders and (some) employees.

There are some obvious possibilities - for example, banks control access to a small network of investors capable of purchasing large chunks of stock, and if going to the right bank can add x% to the sale price when you shift a lot of stock then - in absence of effective competition - they can extract much of that. I'd like to see us experiment with a state-run cost-price online IPO and rights-issues platform, or something, to see if they can be undercut.

But other parts of what banks do - prop trading etc. - who they make money from and how, I do not understand terribly well.

as banks will tell you, the role of capital markets is to allocate capital efficiently and raise productivity. Raising productivity means producing stuff at less cost. By same logic we should want to get banking services at lower cost too. Rather than try to legislate how much bankers are paid we should try to remove their pricing power, so that they charge less and don't have so much revenue to pay to their top traders and execs in the first place.

[Ralph Musgrave]

I do like Simon Wren-Lewis's claim that economists can de-mystify banking. Trouble is that economists themselves are experts at mystifying their craft with a view to making it look like they're technically competent. As Tony Yates said in a recent tweet, writing incomprehensible papers is part of the job of an economist.

Second, re Bob’s claim that MMT suggests asset side regulation of banks, MMT as such just doesn’t have much to say about banking. MMT basically says much the same as Keynes. Indeed, one of the criticisms of MMT is that it doesn’t say anything Keynes didn’t say.

Of course individual MMTers have views on banking (e.g. the article Bob links to). But that’s not the same as saying MMT as such has much to say about banking.

As to the idea that regulators should concentrate on banks’ assets, the entire thrust of recent regulation has been on the LIABILITY side of banks’ balance sheets: in particular on banks’ capital ratios. Moreover, there are plenty of people at the top of the profession who, while they don’t agree with the details of recent bank re-regulation, agree that it’s the liability side that is important. I’m thinking of Milton Friedman, Lawrence Kotlikoff and John Kay to name just three.

[Matt Usselmann]

"What innovation the industry has practised in recent years has – except for some ETFs - generally been dangerous, such as credit derivatives or high-charging funds."

ETFs are pretty dangerous too as they are based mainly on derivatives.

Anything based on derivatives, or high frequency trading (fx/equities) is valuable to bankers, generating high fee income, but the economic value to society at large is highly questionable.

Now, only banks can "invent" derivatives, value them differently , and both make a profit as they swap and trade imaginary obligations between themselves.

That generates GDP (fee income) and produces high salaries for the management, but, again, does not increase the efficiency of anything else in the real economy. The cash-flow generated to pay these high returns to management is subsidised from other parts of the bank.

Banking is rife for some thorough micro analysis of economic benefit, which would detail that there is really NONE WHATSOEVER for society as a whole of activities which are making bankers rich.

Economists have not done their job at all,.

Or lets put it another way (in case somebody sees some value in derivatives). In China banks' balance sheet are not stuffed full with derivatives, as they are in the West. Derivvatives in Chinese balance sheets do not exist. Yet China manages to increase living standards to its population, achieve sound economic growth, spends three times as much on renewable energy than US, etc.

It is time economist shine some light into the mystification of derivatives (and other piracy methods by banks), and explain that they are just a mechanism for management to enrich themselves, that they have NO VALUE to society at large, and should therefore be abolished, or taxed with a hefty financial transaction tax.

[exbanker]

"Anything based on derivatives, or high frequency trading (fx/equities) is valuable to bankers, generating high fee income, but the economic value to society at large is highly questionable."

This is an overstatement. E.g. "simple" derivatives like vanilla swaps provide cost effective interest rate hedges to the real economy and thus provide economic value to society. Even vanilla options and bermudans have clear economic purpose (e.g. pretty much every mortgage in the US has in-built bermudan optionality (the mortgage taker can re-finance). If the issuer can't hedge this, they need to stop lending.
I agree however that there is little economic value (and often significant risk) in most "exotic" derivatives. These can be useful for sophisticated investors to express detailed views (e.g. about asset price ranges or correlations), but they are overpriced and are all too often bought by unsophisticated investors who don't fully understand the risks.

[Luis Enrique]

Matt,

did this pass you by?

http://www.nber.org/papers/w11728

also, why on earth would a bank do this: "The cash-flow generated to pay these high returns to management is subsidised from other parts of the bank"

and another also: there's plenty of research on benefits (or otherwise) of futures trading for farmers
when it can just charge fees (or make a spread)?

[Luis Enrique]

oops. this bit
"when it can just charge fees (or make a spread)?"
should have come after para about cross-subsidising

[jrh]

This is before we even get onto questioning the basis of a debt based money system, which conflates debt with a unit of exchange and measurement; where private institutions control the creation of 90% of what is deemed money in circulation.

[Nanikore]

Nice post Chris, but really mainstream economists also have a lot to answer for when it came to 2008. They had their eyes off the ball. It was the historians and the heterodoxy who remembered the inherent instability of the financial sector and the reasons why retail and wholesale banking should be separated. You are right mainstream economics was used by the financial sector for rent seeking, but mainstream economists did not put up any resistance. The EMH came to be seen as supporting the idea that markets self-regulate and so therefore came to strengthen the hand those pushing for financial deregulation, not those who were concerned about a free for all going on in the sector (who really had to fight to be heard). It basically comes back to model-based analysis; people just can't see outside it.

[Magnus]

@Nanikore

The mistake you make is "mainstream economics was used by the financial sector for rent seeking"

No it wasn't. Arguing for deregulation in the face of established market failures is violation of mainstream economics.

But the fact that you perceive that deregulation = mainstream economics is exactly telling of the great ideological trick which Chris is describing.