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.