(updated 8/14/2020 9:40pm PT)
How can we Structure the Financial System to be Compatible with a Shared Ownership Economy? (Part 2)
For Part One of this essay please see What Does Finance do for Society?
Part Two – Money and Banking
Let’s start with money and banking. Here is the web page I developed on the topic
In it I explain that there are four patterns of though we need to overcome in order to understand how the money and banking system works:
- There is no free lunch (actually money gets created out of nothing with an accounting entry)
- Money is a creature of the nation state (it is actually mostly created by the private sector)
- Money is uniform (US$ has actually different forms as part of a hierarchy – some US$ are better than others! )
- Money is a positive number (money is actually an IOU, so money can be a positive or negative number depending on which side of the IOU you look at)
The key design flows of the money and banking system are the following.
- All money is created as debt and no money is created to pay the interests on the debt
- The private banking sector has now effectively a quasi-monopoly on money creation
- The private banking sector reaps the money-creation benefits while the public bears the risk
- The private banking sector shapes the economy by deciding where to direct the money it creates often inflating bubbles in real estate and financial assets
Each of the points above would deserve a long essay but I will just state them for the time being.
The crucial understanding mostly lacking among the general public is that banks are not financial intermediaries gathering savings from the private sector and lending them to the productive economy. Banks actually have the awesome power to just create brand new electronic money when they make loans. Banks monetize the borrower’s promise to repay the loan. You don’t have to take my word for it. Here is the Bank of England Quarterly Bulletin 2014-Q1 Money Creation in the Modern Economy.
The underwriting function (deciding whom to lend money) is the second function of finance in John Kay’s description in my prior post. Lending to entrepreneurs or small businesses is hard for banks since they need to hold the risk of those loans on their books (a loan default would reduce the equity capital of the bank).
So most of the lending of commercial banks in the last two decades has been in real estate since those loans are collateralized and there is a developed market for selling most of those mortgages to Wall Street or to Fannie Mae and Freddie Mac. Since banks create the money they lend and since the mortgage lending is about fueling a competition among economic agents for the ownership of a limited stock of desirable real estate properties the result has been an inflation of real estate prices (and other hard assets like farmland) with cascading effects on the economy in terms of affordability and access to home ownership.
The picture above shows the aggregate balance sheet of commercial banks in the US in April of last year. Demand deposits is electronic money in checking accounts which was originally created by commercial banks when they made loans. You can see on the asset side of the balance sheet of commercial banks the loans that originated the electronic money on their liability side. (Another way of understanding banking is as a swap of IOUs – the borrower promises to repay the loan and the bank promises to make payment on the borrower’s behalf up to the amount borrowed. We use as money the liabilities of the banks!)
It is important to realize that commercial banks’ money creation activity is not neutral.
Prior to the 1980s a significant share of bank lending was indeed to businesses creating new products and services. If money is created to support growth in economic output, the new goods and services “absorb” that additional money in circulation and prevent inflation. If the money is created to provide consumer credit it has a tendency to create inflation in the price of consumer goods and services. More crucially, if money creation is funneled into either financial speculation or real estate lending it creates inflation and even bubbles in financial markets and in the real estate market.
Large banks also make loans to financial speculators and to leverage investment strategies causing on one hand increased fragility in the financial markets and on the other inflation of financial bubbles. Bank lending has also funded some of the massive share buyback on the part of large publicly traded companies – another way in which the stock market has been manipulated.
A key understanding is that only lending into productive activities creates value. The other type of lending, especially lending for real estate and financial speculation does not create new value, it simply shifts claims over existing assets. Think for example of the ease with which large corporations (and financial speculators on Wall Street!) received very low interest or forgivable loans from the government’s bailout or from the Federal Reserve lending facilities created to address the economic fallout of the COVID-19 pandemic. Now think about the challenge faced by smaller businesses in obtaining funding. The likely result is likely to be the acquisition by large corporations of smaller competitors or the purchase of their own shares on the stock market to manipulate their price. Large corporation therefore are able to shift ownership of the economic activity of their smaller competitors or or their own stock without creating any new economic value.
In 1930s, in response to the Great Depression caused by the financial collapse triggered by Wall Street, Congress passed legislation and created a set of institutions to constrain the excesses of the financial sector. The Glass-Steagall Act (1933) separated commercial banking from Wall Street and insurance. The FDIC (Federal Deposit Insurance Corporation) was created in 1933 to avoid runs on the banks and to restore public confidence in the banking sector. The SEC was created in 1934 to help restore investor confidence and maintain orderly financial markets. Those and other measures provided half a century of stability in the US financial system.
While the regulations put in place during the 30s started being chipped away in the 70s and 80s it was thanks to Bill Clinton that the regulatory breaks on the greed of the financial sector were removed with the passing of the Financial Services Modernization act of 1999 (colloquially known as the Citigroup Authorization Act) which repealed Glass-Steagall and the even more egregious Commodity Futures Modernization act of 2000, signed by Bill Clinton in December 21st as a lame duck president, prohibiting the regulation of over-the-counter derivatives!
The result has been massive consolidation and complexification of financial industry, the spectacular growth in the share of US corporate profits accounted by the financial sector and of course the financial collapse of the 2007 and 2008. Just as a visual representation of the complexity of the financial system here is the map of the shadow banking system – the chain of financial intermediaries that through the use of over-the-counter derivatives transformed pools of mortgages into tradable securities, which caused the collapse of the financial system in 2007-2008.
In the original report by the Federal Reserve of NY where this chart appears, it is suggested the chart be printed on a 4 feet by 3 feet poster to be legible. Needless to say, all this complexity did not improve the delivery of the four key useful services the finance sector provides society described in part one of this essay, but led instead to the enriching of the financial sector and its collapse in 2007-2008 requiring a massive government bailout!
The largest four banks in the US in 2007-2008 were too big to fail so now they are even bigger. They represent a systemic risk not only for the financial system but for society as a whole.
In part three and four I will deal with the Federal Reserve. In part five I will outline the changes required to bring the financial system into balance and to make it operate in the interest of society as a whole.