Dominic Hobson's Blogs

Dominic Hobson's Blog

Dominic Hobson is Editor-in-Chief of Global Custodian, the leading magazine covering the international securities services business.

The idea of finance as a parasite that lives at the expense of the real economy is an old one. More than two millennia before Occupy Wall Street declared itself “not anti-capital, just anti-theft,” and Occupy London launched a “campaign for monetary reform,” Aristotle warned that money-changing and lending at interest were perversions of the natural human inclination to satisfy wants and needs through production and exchange. What is worrying about the revival of this brand of thinking is not that it is misguided but that it resonates powerfully enough with the public and politicians to inhibit a truly searching investigation of the nature and consequences of the current systems of money and credit.

 

It is easy to conclude that finance is not part of the real economy. Economies grow by producing more for less, through the division of labor. This takes place not only on the local scale but on a global scale, through international trade. The result of producing more for less through the division of labor is a surplus, which in a modern economy takes the form not only of sacks of grain, but capital. This capital is then recycled into the real economy by a complex ecosystem of financial intermediaries made up of banks, broker-dealers, fund managers, insurers and institutional and retail investors, using an equally complex infrastructure of exchanges, clearing houses, depositories and national and international payments systems.

 

This financial ecosystem has evolved a long way away from “real” economic activities such as growing food, extracting minerals, processing raw materials in factories and transporting finished goods by land and sea. But this does not mean financial intermediaries and financial markets are not part of the real economy. In fact, they were and are densely involved with agriculture, mining, manufacturing and trade. Investment banking originated in the use of surplus capital to finance international trade through the discounting of bills. This is why they were once known as “merchant” bankers. It was only as their business evolved into the financing of governments (in the bond markets) and companies (in the equity markets) that they became known as “investment” bankers.

 

Even now, though they operate in highly sophisticated securities markets, investment bankers are still engaged in the origination, issue, underwriting and trading of claims on the revenues of governments and companies. They fund these activities not from capital but by borrowing from commercial banks and investors in the wholesale money markets, pledging the securities they trade as collateral for the loans. In the 1970s, breakthroughs in mathematical techniques and digital technology allowed banks to start trading claims on claims, and even claims on claims on claims, in the real economy. By the time the industry invented the CDO and the CDS, the financial system seemed to most people to have become so remote from the real economy that, far from the banking system servicing the real economy, the real economy appeared to exist only to service the banking system.

 

Nothing symbolized this apparent inversion better than the Bankers Trust executive who said of Procter & Gamble that “they would never be able to know how much money was taken out” of the derivative contract he sold them. By the time a Goldman Sachs trader confessed to his girlfriend a decade or so later that the financial instruments he was inventing were nothing but “pure intellectual masturbation”—and that even he did not understand their full implications once they were released into the real world—abstraction had reached the point of incomprehension. Yet the $195 million of losses Procter & Gamble incurred on the swaps, or the $1 billion of losses it is alleged were incurred by investors in the liabilities created by Fabrice Tourre, were anything but abstract. They were transfers of value, albeit of a highly circuitous kind, between participants in both the real economy and the financial economy.

 

Those losses and gains showed up in the profit and loss accounts of the counterparties to the trades. Eventually they showed up in their balance sheets too. And it is there, on the balance sheet, that the inseparability of the real and financial economies is at its most obvious. A balance sheet shows how underlying physical realities such as factories and stocks (assets) are financed by financial abstractions such as equities and bonds (liabilities). A balance sheet shows how capital (liabilities) is invested in productive people and machinery (assets) to generate the income that produces the profits that appear in the profit and loss account—and which eventually return to the balance sheet as additions to capital or dividends awaiting disbursement to shareholders (liabilities). The balance sheet is also where money dies, as productive assets are depreciated, or amortized, until they need to be replaced. On a balance sheet, in other words, the real and the financial are simply different expressions of a single phenomenon.

 

This insight offers an illuminating perspective on the current financial crisis. Why? Because a balance sheet, unlike a banking system, cannot be overcapitalized. Its assets and liabilities must balance. An excess of capital cannot build up on a balance sheet because a successful business cannot simply accumulate capital. It must put capital to work by building offices or factories, and filling them with people to make goods or machines, or provide services. If a business cannot think of anything remunerative to do with the capital it accumulates, it must return it to shareholders, so that they can invest it with another company that can find a profitable use for it. Ultimately, balance sheets insist that capital be put to use. Despite the strictures of Aristotle, capital cannot breed capital. The rate of interest reflects the ability of capital to earn a return in the real economy, and must by definition be lower than the return available in the real economy.

 

Fund managers know this. It is why (fees apart) they wish to put the capital entrusted to them to work in the markets rather than leave it in the bank. They know that only capital invested in productive activities, by however circuitous and abstracted a route through the financial markets, can breed more capital. The current balance sheets of the major central banks make this point plainly. That of the Federal Reserve has inflated by 218% in the last four years. The balance sheet of the Bank of England has grown by 197%, and that of the European Central Bank by 88%. But the accumulation of cash deposits at central banks is not the surplus capital generated by productive economies. It is something else entirely: money printed by central banks, returned to central banks by commercial banks too nervous even to lend it to each other, let alone invest it in the real economy. Nothing could illustrate more completely the breakdown of the links between the financial and the real economies than these massive accumulations of trillions of dollars of excess capital on the balance sheets of the central banks.

 

These piles of cash are the reductio ad absurdum of the monetarist-Keynesian consensus—essentially, maintaining a narrow gap between total spending and real output—that has governed orthodox economic policymaking since the 1970s. This orthodoxy holds that what causes economic downturns is shortages of money—not just notes and coins but bank deposits, which are the most important form of money. By this, the orthodoxy does not mean that nations can enrich themselves by printing money. Even unreconstructed Keynesians recognize that, in the long run, real output depends on real input—which is one reason why the consensus is open to the accusation of mistaking effect for cause. What follows is that money is not wealth. It simply measures, or reflects, wealth. This is well captured in the classic description of inflation as “too much money chasing too few goods.” Once the quantity of money is growing faster than production, it affects only the price level. If the quantity of money could be synchronized perfectly with the quantity of goods and services—if it was an exact reflection of the quantity of goods and services—money would be neutral.

 

Yet experience shows money is not neutral. The quantity of money does affect the real economy as well as the price level. The Great Depression, according to Milton Friedman and Anna Schwartz, was actually caused by a collapse of bank deposits. This is almost the only history modern central bankers know, which is why they have inflated the supply of money through quantitative easing, or buying assets from the private sector and paying for them by creating money on their own balance sheets, then depositing it in the bank accounts of the sellers. The limited impact of their efforts so far is a reminder of how hard it is to translate an obvious insight (keeping money in balance with production avoids both inflation and deflation) into practical policy measures. The problem is the complexity of the main transmission mechanism from money growth into real activity: bank credit. Because people in the real economy are continually creating money (by taking out loans) while others are destroying money (by repaying loans), the relationship between money and credit is extremely volatile, hard to monitor and almost impossible to predict.

 

Judging by the management of monetary policy during each of the many boom-to-bust cycles that have occurred since the mid-1970s alone, a better understanding of the relationship between money and credit would be a useful addition to the sum of human knowledge. In present circumstances, the creation of money is the exclusive preserve of the state (through the central bank) while credit is a creation of the private sector (through the commercial banks). The creation of credit is not controlled directly by the central banks but by indirect means only: the capital ratios agreed under successive Basel regimes and the accompanying liquidity requirements that force banks to hold cash and near-cash instruments so that they can meet obligations as they fall due. On this view, the issue of credit and the issue of money are separate activities. Yet it might be wiser to view money and credit as simply different expressions of the same phenomenon, just as they appear on a balance sheet. A house bought with mortgage or a motor car purchased with a loan secured on the vehicle requires a bank to issue money. That money, paid into a bank by the seller, is returned to the banking system as a deposit, creating scope for more lending.

 

This process creates the risk that the banks will issue more credit than there are goods and services to buy, causing asset price inflation of exactly the kind that occurred between 2002 and 2007. Orthodox monetary policy has sought to control this risk by limiting the issue of bank credit as a multiple of a fairly narrow measure of money, as measured by cash deposits and (in some jurisdictions) near-cash instruments such as repos and certificates of deposit. Orthodox policy also assumes that there is a natural constraint on the unlimited creation of credit, in the shape of a shortage of sufficiently profitable opportunities for investment, and so on the appetite to borrow. But this is to underestimate the dynamic nature of the interaction between money and credit, in which cause and effect become indistinguishable. Crudely speaking, because every loan creates a deposit, it encourages more lending. As money becomes more plentiful, it becomes cheaper, and the range of investments that appear to be profitable expands. The appetite to borrow outgrows any limit, natural or unnatural.

 

In short, an imbalance develops between the investment opportunities in the real economy and the volume of credit available to finance them from the financial economy. This is exactly how the real and the financial economies have interacted at all times since modern systems of banking and finance came into being in the 19th century. The entire pattern of economic fluctuation in history, of successive cycles of boom and bust, is the same. There is a movement from an excessive inflation of capital values relative to their income-producing capacity, followed by an excessive deflation of capital values relative to their income-producing capacity. In each case, the manufacture of credit on a narrow base of money issued by the central banks pushes the price of capital to a series of excessive highs, followed by a series of excessive lows. Given this history, treating money and credit not as part of a single process but as separately controllable elements is nonsensical. Accountants who draw up corporate balance sheets know that instinctively. Bankers, and central bankers, it seems, do not.

 

The irony is that bankers talk about their balance sheets a lot. They all employ credit committees and risk managers whose role is to ration the balance sheet between competing claims. For certain banks, particularly in this environment, the strength of their balance sheet has become their main competitive differentiator. Central bankers have encouraged them in this view, forcing them to increase the proportion of capital they hold relative to their assets, despite the fact this contradicts their policy of increasing the supply of money. Even now, banks are tightening credit lines and selling loan portfolios to fund managers to improve their capital ratios, reducing the volume of loans that turn into deposits, and so destroying money. Yet the way in which banks and central banks manage their balance sheets is startling in its utter disregard for common-or-garden prudence (another favorite word in the banking industry).

 

Most companies manage their balance sheets to ensure that the capital of the business is not eroded, and that any gains paid out to staff or shareholders are paid out of profits rather than capital. Banks and central banks do it differently. As their balance sheets inflate during the boom, banks engage in the excessive distribution of illusory gains to staff (as bonuses) and shareholders (as dividends). In the bust, those illusory gains come back to haunt the balance sheet as losses, eating capital and sinking share prices. In essence, the ability of banks to produce credit, almost at will, allows them to eat capital while appearing to generate income from lending money. If their creditworthiness shrinks to the point at which they cannot fund their balance sheets, they are then rescued by the central banks. By printing money, the central banks appropriate the capital of entire populations, generally through the subsequent inflation.

 

To that extent, the complaint of the protestors in New York and London is justified. Banks and central banks are indeed powerful arbiters of the fates of developed nations. Yet they are as much exemplars of the condition of our civilization as authors of it. Credit, it is increasingly obvious, is interchangeable with money. Spending capital, by selling claims on real assets in the form of credit, has become a form of monetary income for everybody. Mortgages and motor cars are merely the most prominent instances. But money is still not wealth. As they see their capital expropriated through some yet-to-be-decided combination of debt and currency devaluations, tax rises and inflation, the citizens of the United States and Western Europe will rediscover that fact. To become wealthy, they needed to put their capital to work creating new goods and services, not mortgage it in order to consume more goods and services yesterday and today. Capital used to be accumulated to be spent. Now it is being spent before it is even accumulated.

 

None of this changes anything fundamental. The purpose of production is still consumption. What makes economies grow is still borrowing, not lending. But not everybody can be a rentier, earning their living from lending or investing money. In the end, somebody has to use it productively, because even capital is subject to the second law of thermodynamics. It is not permanent. In a universe subject to the inexorability of rising levels of entropy, all businesses and all portfolios are nothing more than temporary islands of evanescent order. This is why, in the long run, accumulating and owning capital is much less important to the progress of our species than using it. The accumulation of manufactured money at the central banks of the developed world is a measure of the brokenness of the connections between the real and the financial economies. With so many unmet wants and needs in the world, and so many unfulfilled lives, what is happening to our way of life is not a depression or even a recession. It is a tragedy of the bitterest and most unforgivable kind.

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