Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 9 May 2016

Economists versus bankers

Nearly a year and a half ago I wrote a post about encouraging dialogue between economists and other social scientists. I concluded with the following three paragraphs:

Let me take a real world economic problem: the response to the financial crisis. Some have suggested that banks have become too large and need to be broken up, or that the activities of high street banking need to be separated from the activities of the casino. Your economic analysis tells you that networks of many small entities can be as subject to crises as networks involving a few large banks. You are also able to devise a system of Chinese walls that mean that the activities of the casino can be separated from those of the high street even within the same company, and your political masters seem to prefer this approach. You recognise that different assets differ in their liquidity, and so you devise complex weighting algorithms for computing capital ratios. Your suggestions form the basis of negotiations between officials and bankers, and a set of rules and regulations are agreed.

Over the next few years you watch in dismay as your complex system begins to unravel. The CEOs of the large banks seem to constantly have the ear of politicians, who in turn gradually compromise your elaborate controls to render them less and less effective. Those in charge of administering the rules find it much more lucrative to work for the banks, and so regulators gradually lose expertise and resolve.

And you realise that right from the start you made the wrong choice. You decided to focus on what you knew, which was how to design systems that worked well as long as those systems remained unchanged, but which were not robust to intervention by self-interested parties. In short, they were too open to rent-seeking. You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished. And you recall a conversation with your social science colleague when this all started, who might have been trying to tell you this if only you had understood the words he was using.”

I was afterwards asked whether I had one particular UK economist, John Vickers, in mind when I wrote this. He chaired, at the government’s request, a commission on banking reform. He has become increasingly vocal about how his original commission’s proposals (pdf) are being watered down and how the Bank of England appears to be putting public money at risk once again. (For his detailed assessment, see this paper. And here is what another commission member, Martin Wolf, thinks about the financial sector. Adam Barber details how the attitude of the UK government has changed. In the US this very issue became an important point of difference between Clinton and Sanders.)

The honest answer is that I did not have him in mind. It was a fictional account designed to make a point, and so I took elements from different debates which together apply to no one country or individual. The point is that in finance good reforms are those that can best resist political or economic manipulation by banks, and perhaps economists in general have been slower to see that than some of their colleagues in other social sciences..

It would probably be fair to say that before the financial crisis economists got on pretty well with the financial sector. There was a common interest in monetary policy (although the motivation for that interest might have been different) and the sector was a useful source of funds for conferences and (for a few) consultancy. Most economists did not look too hard at what the financial sector was actually doing, although those that did often raised serious questions. Behind this nice piece by Ben Chu is an army of academic research which suggests that fees paid to manage funds are a waste of money.

The situation changed after the financial crisis, for obvious reasons. Since then economists have increasingly questioned whether the whole business model behind banking is sound. In particular they have questioned why banks should be so different from other companies in terms of the amount of equity capital they hold in relation to their assets. These economists include the previous governor of the Bank of England, Mervyn King. They have also questioned whether one of the side effects of current regulation is to maintain the monopoly power of big banks.

If all that was not bad enough, we have the influence that the financial sector has on monetary policy. Mainstream macro has put a lot of emphasis on the importance of day to day monetary policy being independent of politicians, and far too little on it being independent of the influence of finance and bankers. Paul Krugman has talked about the links between interest rates and bank profits and how that might ‘guide’ the views of bankers. If you want to see a clear case of that, read this FT op-ed by David Folkerts-Landau, chief economist at Deutsche Bank.

The article could not be more wrong. The reason the Eurozone has performed so badly compared to the US, Japan and even the UK is not because of lack of structural reform, but because of the relative reluctance of the ECB to stimulate the economy. Rates were raised in 2011, and Quantitative Easing delayed until 2015. The article is full of hopeless lapses in logic. If there is any sense here at all, it is that high unemployment is required as a political incentive to undertake structural reform. So the ECB “has become the number one threat to the eurozone” because it has allowed politicians to put that reform off.

Here I can do no better than quote Adair Turner. “Vague references to “structural reform” should ideally be banned, with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved. If the core problem is inadequate global demand, only monetary or fiscal policy can solve it.” In the Eurozone the core problem is lack of aggregate demand, as below target inflation shows.

Why this hostility from German bankers to low or negative rates? What the author does not tell you is that the profits of German banks, and the viability of other parts of the German financial system, are particularly (IMF pdf, box 1.3) vulnerable to low rates. (For those that can access it, Wolfgang Münchau in the FT provides an excellent summary.) And also that the profitability of Deutsche Bank is not great right now, as Frances Coppola notes. In the UK or US if this kind of nonsense from bankers appears in the press it gets a lot of kick back from economists - in Germany perhaps less so.

So who cares if economists have crossed swords with bankers? It matters because finance gets away with so much partly through a process of mystification. Mystification is how banks can perpetrate widespread fraud on consumers and businesses. When bankers say that being forced to ‘put aside’ more capital keeps money out of the economy it sounds plausible to many, even though it is completely false. (Admati and Hellwig (pdf) list 30 other similar false claims.) There is also a belief that because bankers are involved in financial markets, they must know something about how the macroeconomy works, a belief which the FT op-ed shows is clearly false. In all these cases, economists can provide demystification.

If we are ever to cut finance down to size (metaphorically, and perhaps also literally), economists are going to be vital in the battle to do so.


  1. Excellent and important piece.
    So much "economics" reporting comes out of interviews with bankers and traders...

    1. «much "economics" reporting comes out of interviews with bankers and traders»

      Just as there are sell-side analysts, there are "sell-side" journalists, and Economists, politicians, ...

  2. Given what bankers managed to in the first decade of the 21st century, namely to bring the financial system to its knees and then be rewarded for it, I personally would not hold much hope of economists bringing the finance industry to book.


  3. IF economists are vital to cut finance down to size, they should explain how that GDP generated (about 8% of GDP) is made up.

    And if you were to cut that down to, say, 4% of GDP, which bits of the finance activities can be safely eliminated.

    That eliminated GDP, paid by all of us in high finance charges, is now available for all of us to put into additional consumption.

    That should really be the job of economists, explaining who would win from, say a financial tranasaction tax and higher equity in banks. So the financial sector loses, but the rest of the economy gains.

  4. I am not sure that the German public discussion is one of "economists vs. bankers". It's much more likely that bankers have more influence over public discourse in the UK and US than in Germany.

    Instead, the *economics* community in Germany is averse to negative interest rates, quantitative easing etc - just look at Hans Werner-Sinn, or statements from leading officials in the Bundesbank. I think this is because of a different intellectual hinterland in Germany (something I actually first learned from one of your old blog posts on Ordoliberalism).

    I don't know why this is the case, but I think it likely that bankers in Germany reflect, rather than cause, the state of public economic discourse there.

    1. I agree. Just posted something about Hans Werner Sinn's column in Die Zeit. The attacks against the ECBs are getting really scary.
      My German is not too good, you can correct my attempt at a summary if you think I misunderstood something.

  5. I like the idea that economists are of help in the “demystification” process. Problem is that economists are very much INTO MYSTIFICATION and with a view to making themselves look more technically competent than they really are.

    As for the people who are making huge efforts to promote a much simpler and thus less “mysterious” bank system, they’re to a large extent AMATEURS: e.g. me, Positive Money and the New Economics Foundation. The latter lot advocate full reserve banking, the rules of which can be written on the back of an envelope, and which should thus be far easier to enforce than existing bank regulations.

    1. I completely agree on the first part, but on second...
      Do you know that comunist countries all had 100% reserves?

      But still, that did not prevent banks from issuing credit.
      You know that credit becomes deposit and then goes into reserves? So, credits become its own reserves.
      That would only lessen interbank credits and loans to state. It would force banks out of investments just as Glass-Stegall did.
      And it would force states to finance with HM, just as communist countries did.

      Let me repeat again. 100% reserve banking was praktice of communist states and states finaced with printing money. This enabled record growth for 20 years untill oil price shock disturbed the economies that could not know how to handle inflation.
      It also produced population with debt free and equity rich society.

  6. I read the mentioned article and I really don't understand the argument. Raising capital requirement reduces bank leverage: it's equivalent to raising rates, isn't it? I am pretty sure that's what I have learned in my macro courses.
    Or are you arguing that banks could find as many equity investors as they find bondholders? I find that doubtful to be honest. You are basically arguing that the increased risk has no effect which seems wrong...
    Obviously you could offset such issue with higher base money (since we cannot cut rates right now), so it is possible to run an economy with much higher capital requirements for banks, but it's not a free lunch.
    Capital requirements are necessary to correct a market failure: the banking system is illiquid by definition and it's difficult to understand if a company is insolvent when it is illiquid. So there is no obvious reason to believe the current capital requirement are perfect (or that the optimal capital requirement is static for that matter). Raising them might very well be optimal, but it's hardly obvious that it is...

    1. According to the Modigliani Miller theory (thought up by two Nobel laureate economists, Franco Modigliani and Merton Miller), raising the capital ratio of a bank (or indeed ANY corporation) has no effect on the cost of funding the corporation. The MM theory is correct, I think. Google has a capital ratio of 90% and is doing just fine!!

      Next, you make a point which is absolutely CENTRAL to this issue, which is that if raising capital ratios do in fact raise funding costs a bit, that is irrelevant in that the deflationary effect of that is easily countered by standard stimulatory measures: you suggest “higher base money”, which is fine by me. The Vickers commission failed to spot that “irrelevance” point.

      Thus the CRUCIAL question is this. Which is better: high capital ratios (maybe 100%) with possible higher interest rates, or lower capital ratios with lower interest rates? My answer is the former, and for the simple reason that the latter (the existing system) is subsidised, and subsidies reduce GDP unless there’s a good social justification for them. The subsidy, briefly, is as follows.

      Under the existing system, private banks can effectively print money and lend it out. Any organisation which has that power (banks, car makers, you name it) is effectively being subsidised. The only difference between respectable banks and back street conterfeiters is that the former print money and lend it, whereas the latter print money and spend it. Both are effectively subsidised by the population at large.

  7. Actually I read the Admati and Hellwig paper a bit more carefully, and I think I understand their point. They are arguing that the subsidies we give banks (mostly in terms of deposit insurance) are inefficient (since they are excessive). They are arguing that society as a whole is not getting enough benefit from that subsidy. This is a reasonable position to take.
    But I think they are twisting the truth when they argue that changing capital requirements will not change bank activity. Removing a subsidy, reduces the amount of the activity. I think this is pretty standard claim. Arguing that we are now subsidising an activity too much does not invalidate this. So I think you can argue that such reduction will have net positive impacts, but not that it doesn't affect bank behaviour. This last statement I think is wrong.
    I also think that it's clear that there should be some level of subsidy to the banking system: the benefits you get from a stable financial system are still pretty huge.
    The basic statement that we should reduce banking subsidies given the financial crisis is totally sound. Not acknowledging that this has the potential to backfire if pushed too far is in my opinion wrong. Comparing the leverage of the banking system with the leverage of a normal industrial company is nonsense...

    1. «twisting the truth»

      Look many/most Economist are clever and don't twist the truth, they just are economical with it: when they say something is "true", they mean that it is "true in this model" and that *as a rule* the model has been carefully constructed so its long list of special-case assumptions necessarily imply the specific "truth" being "proven".

      So for example when an Economist says that the Modigliani-Miller theorem, or comparative advantage, or marginal distribution of income, or Ricardian equivalence, are "true", that just means that they have been able to construct a very special-case model based on a long list of ridiculous assumptions in which they can sort-of prove that, and then to celebrate they start singing the lyrics of "The Methodology of Positive Economics", of the "greatest hits" (as in "bulls-hitting") from old fraud M Friedman.

      «when they argue that changing capital requirements will not change bank activity. Removing a subsidy, reduces the amount of the activity. I think this is pretty standard claim.»

      Suppose that the subsidy makes very-risky and often-fraudulent lending cheaper and easier. Then cutting the subsidy reduces that. "Communism never worked and never will" :-).

      «there should be some level of subsidy to the banking system: the benefits you get from a stable financial system are still pretty huge»

      There is a simple way to have a «stable financial system»: just backstop any losses it makes, even when due to massively negligent or fraudulent business. This approach has been tried for 30 years and it has worked very well. The only instability the financial system has shown occurred when the USA government decided to show the world what happens when the backstop is removed, as in the case of Lehman Brothers.

      Having a *solvent* government committed to write a blank check to banks is so far the only way that works to get a «stable financial system», as H Minsky argued decades ago; but as H Minsky also argued, stability is destabilizing, as that commitment to a blank check is also and indeed largely subsidy to make very risky and fraudulent business, and the check gets larger every time, until the sucker-of-first-resort is no longer solvent (situation described for banana-republics in a well known article by S Johnson in "The Atlantic").

      So since stopping subsidizing the banks is pretty difficult, to avoid the subsidy becoming largely a subsidy to negligence and fraud the latter must be limited in some way, and it turns out that as our blogger argues, and many before him had, including JK Galbraith in "The Great Crash 1929" government regulation gets captured, so a better system relies on countervailing interests, that is a political, not technical, solution is required.

    2. Anon,

      You claim that subsidies for banks are justified because “the benefits you get from a stable financial system are still pretty huge.”

      The answer to that is that an entirely stable financial system (or more specifically bank system) is possible with no subsidy at all. For example bank failure is just plain impossible under full reserve banking (or “100% reserve” banking, as Milton Friedman called it). That involves 100% capital ratios and no subsidy. A bank with a 100% capital ratio cannot possibly go insolvent, though in the event of incompetence, the value of its shares can fall dramatically, with the result that it probably gets taken over.

      For details on Friedman’s system, see his book “A Program for Monetary Stability”, Ch3 under the heading “How 100% reserves would work”. Positive Money advocates a similar system.

      Finally, you claim that “Comparing the leverage of the banking system with the leverage of a normal industrial company is nonsense...”. Well OK: I can point to a BANK with a 100% capital ratio which is doing very nicely. See:

      Also money market mutual funds in the US (which are banks of a sort) are being made to obey the rules of full reserve. I haven’t heard any stories about them being driven out of business.

  8. I'm a bit confused by the banking/monetary policy claim. Wouldn't the banking industry prefer MORE stimulative measures in order to steepen the yield curve, raise inflation expectations and long rates, and increase financialization of the economy? The EU's 2011 rate hikes haven't obviously benefited EU banks relative to U.S. banks.

  9. SW-L
    Aren't you deflecting a blame for mysticizm on bankers. It is economists who mystify banking and are mostly forbiden from discusing banking and its mechanisms.

    So, why do you not answer where our deposits go, where reserves come from, and where the money for state bonds come from?
    Why excess reserves did not produce inflation and raise borrowing for economy?
    Who in the world think about Ricardian equivalence besides economists?

    1. Banks do a very good job of mystification as evidenced by this paper:

      Which does not explain what it purports to show.

  10. «You realise that actually the best thing to have done was to break up the banks so that their political power was forever diminished.»
    «questioned why banks should be so different from other companies in terms of the amount of equity capital they hold in relation to their assets.»
    «monetary policy [ ... ] independent of the influence of finance and bankers.»
    «If we are ever to cut finance down to size»

    "communism never worked and never will" :-)

  11. Good post Simon. Bank lending needs to be constrained so they are less powerful and only focused on capital development lending. In addition it frees up a large amount of fiscal space.

    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 ("price of money".)

    What is your view on the MMT proposals by Neil Wilson and Warren Mosler?

  12. «break up the banks so that their political power was forever diminished»

    Excellent, and a very insightful observation I read somewhere that is good to repeat here is that the major effects of the abolition of Glass-Steagall in the USA was not on the commercial/investment separation, but related to the other main provision, that banks could open branches or buy another bank in a state different from their original one only if approved by the destination state's legislature.

    This meant that banks chartered in one state had a strong incentive to bribe their state's legislature to always say no to branch opening by other-state banks, and bank executives also had a strong incentive to bribe their state's legislature to forbid bank takeover from other-state banks.

    This considerably improved whole-USA bank regulation, because it meant that small or medium state banks kept existing in large numbers and maintained a keen interest in lobbying at the federal level against the expansion of "money centre" big banks. Therefore they were a countervailing power to that of "money centre" big banks, a power terrified by the potential ability of big "money centre" banks to milk the Fed for unlimited financing.

    Eventually the big banks bought the Democratic party too, once the unions became too small to fund it, and found in the "national champion" argument an excuse to demand that the USA financial system be "consolidated"; so the limits on branches and takeovers were eliminated, which allowed the big "money centre" banks to buy out or outcompete many of the smaller banks that were lobbying against them as the federal level (in a few rare cases, perhaps one or two, a state bank managed to become a "money centre" big bank).

  13. «how the attitude of the UK government has changed.»

    Different story in the UK from the USA. Looking back, in the 1980s the UK establishment decided that the trade unions were trying to take over the political system ("who runs the country?") by blackmail, trying to become masters and make the establishment servants, and the establishment started a decades long campaign to "reduce" the trade unions by undermining and then destroying the industries with the highest percentage of trade unionisation, as well anti-union and anti-employee legislation, and by zooming up southern house prices to bribe the southern working and middle class.

    Finance had a very low percentage of unionisation so it was instead favoured. Unfortunately the resulting bloating of finance has eventually led the finance system to think they can take over the political system ("who runs the country?") by bribery and blackmail, and turn the establishment from principals to trusties like in the USA. Plus the finance system's blackmail turned out to be far more costly in subsidies than the cost of keeping alive the old industries.

    I suspect, from various arguments and papers from establishment sources (like our blogger...) that most of the UK establishment have decided that the threat to their rule from the finance system is as existential as that of the trade unions was, and to "reduce" the financial system so it goes back to being the servant of the establishment and stops being the master. This is a painful choice for the establishment, so it is being done softly, because while tory MPs did not go down the pits in retirement, they expect to retire to well-paid, no-work, financial system directorships. As one keen observers in the USA noted:

    «John V. Rainbolt (Chairman, International Issues Subcommittee of the American Bar Association’s Committee on Futures and Derivatives Regulation): "Knowing the relevant history, a U.S. politician worth his or her salt should wonder if the Conservative government’s approach to market oversight has something to do with the number of Tory resumes on the street,»

    BTW he also continued:

    «and if a vote to duplicate U.K. market regulation communicates this disease, brought on by a rapid succession of Barings, Morgan Grenfell and Sumitomo problems, to name a few. British regulation, now recovering and making adjustments, failed not only to protect the public from the industry, but the industry from itself."»

    That was twenty years ago (during the B Born discussion on OFTC regulation of derivatives!) hahahaha, hahahahahahaha, hahahaha, haha.
    Or perhaps it is not funny.

    Anyhow there is still a difference between the USA and the UK in that the USA political class are mostly hacks who don't mind being very well paid agents, but the UK political class is still largely made of establishment members who think of themselves as the ruling class, not agents of the financial ruling class, and don't welcome challenges to their being the ruling class.

    BTW, excellent movie: "The Ruling Class" by O'Toole and company.

  14. Yes it is edifying to read Hans-Werner Sinn:

    Actually he explains that the low-rate policy is robbing the German 'savers' of their rightly-deserved interest. Something we hear everyday but he goes much further and does it with, I think, a rather unprecedented aggressiveness and nationalistic tone.

    What is remarkable is that there is no discussion at all of the economic background of the eurozone, it's as if monetary policy is disconnected from it.

    The low-rate policy is basically a transfer of wealth - indeed theft - from the creditor countries to the debtor countries, and the possibility that the ECB actually hits its inflation target is a scary perspective (it would deflate the debt burden!). ‎

    The ECB can remain independent, sure, but Germany should threaten to denounce the Maastricht treaty if it doesn't stop.

    So what new mandate should the ECB receive? Apparently it should be neither about employment nor about inflation (or perhaps a deflation target?), it should merely be to protect the German interests - at least what Sinn and his ilk think they are.

  15. Might I suggest 'unstructural reforms' in response? Humor goes a long way and everyone then talks about what that might be.

  16. All you really need is a good way to let banks go bust.

  17. If economists are to collectively make your argument effectively, they will first have to purge their ranks of the paid charlatans and the vocal ignoramuses carrying PhDs from notable schools. As it is, the remuneration from advocacy swamps the return from being right.

    1. «the remuneration from advocacy swamps the return from being right»

      And how do you propose to do this? By asking politely the "sell-side" Economists to become selfless philosopher-kings and struggle to make ends with a miserable professorial wage capped in practice to the $100k-$1,000k range? Do you want to condemn people like Mankiw, Hubbard, Summers to barely survive on a meager $600k a year?

      That seems wholly impractical to me, if not mean :-).

      More realistically, given that in anglo-american cultures "sell-side" Economists are pay-per-play, like many politicians and journalists and much else, the better solution is to ensure that paid advocacy is also funded for the "buy-side" and the "labor-side" too. When the trade unions were popular they could fund think tanks and consultancies to political economists that argued their case too. Now all parties and many famous Economies, journalists, politicians are "sponsored" by the "buy-side" only, and that that "only" is the real problem, not the "sponsored".

      If your interests are not aligned with the "sell-side" sponsors your own advocates too. If you want something to happen, pay for it. The middle and working classes seem to have forgotten that.

  18. Simon,
    Would you please consider using a slightly larger font, for the benefit of your older readers?
    Thank you

    1. If you have a mouse with a scroll wheel, and are using a windows computer (both of which are likely) - hold ctrl and scroll to zoom.

      alternatively hold ctrl and press + (on the far right of the keyboard) will do the trick in most broswers. (- to zoom out again).

  19. How about encouraging conversations between economists and actual scientists?


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