Reflections from Europe | OCTOBER 5, 2009
Europeans Know Better: The Atlantic Cleavage on Financial Reform
For a recent on the timing of the recent financial crisis and incentives facing financial markets, see Gary Stern on Too Big to Fail with host Russ Roberts on EconTalk.
The Europeans, with honourable exceptions have always regarded the "Anglo-Saxon" theory and practice of finance with envious suspicion and unconcealed disapproval. Now that it stands there with egg on its face, European critics of it are sure of holding the moral and intellectual high ground. They are aggressively calling for a complete reconstruction of the financial system along characteristically European lines. Their proposals cluster around three main headings: the size and role of the banking system, its regulation and bankers' pay, especially the bonus system that is to public opinion as a red rag is to a high-spirited bull.
Lord Turner, chairman of the U.K. regulatory authority whose intelligence puts him in the very top rank of all the Heknowsbetters, has recently been wondering aloud that the British financial service sector might have grown too big for the good of the economy. It might then be salutary to make it shrink. (Amusingly, at about the same time Lloyd Blankstein, chief executive of Goldman Sachs and about the last person who ought to say such things without blushing, felt it advisable to say that many of Wall Street's new financial products may not be "economically and socially useful").
How can we tell that an industry is too big for the good of the economy and its products are "socially" not useful? The market tells it and we hear what it tells when profitability is declining and the products will not sell. However, the contrary was the case for many years, and this is why the worldwide financial services industry grew so much faster than the world economy. Changes in financial techniques, notably the transformation of non-marketable mortgages and loans into marketable assets and the distribution of risks via derivatives, have promoted higher economic growth which in turn created further demand for these financial services. If, as many believe, these developments came to a natural end in 2008, and if the bank failures and forced writedowns are the market's way of saying so, let us by all means stand by and see it happen. If, on the contrary, the mayhem in 2008 was provoked by ill-conceived policy measures from which it was right and proper to rescue the banks, then it is odd to want to shrink them by a new round of policy measures that are already promising to do much damage.
Named after economist James Tobin, the "Tobin tax" was a 1971 proposal to penalize short-term selling of currency by taxing all currency trades that cross international borders. The idea was not enacted, but it has been revived recently in Europe.
One such measure is the "Tobin tax" on all financial transactions. Hitherto, it was mostly the alter-mondialist cranks and grampuses who were ranting in its favour. Now Lord Turner wants it considered, Germany's socialist Finance Minister Pier Steinbruck wants it with a punitive rate that would truncate some types of useful dealings. The establishment in Paris is sighing for a way of imposing it without letting too many transactions escape to Singapore.
In any transaction, two parties, seller and buyer, lender and borrower gain or expect to, and there is some marginal gain for the whole economy. How the Heknowsbetters find that if the transaction is "financial", it should be punished is unfathomable.
On both sides of the Atlantic, but particularly in Europe, a stricter regulation is demanded, above all to force banks to raise more capital to support their balance sheets. If there were no regulation at all, banks could choose between being strongly or weakly capitalised. Strong capitalisation is costly, it dilutes the equity of existing shareholders, but it permits the bank to make riskier loans and to attract wholesale deposits at a cheaper rate of interest. Weaker capitalisation forces the bank to make do with retail deposits and to avoid making risky loans, but it reduces the cost of capital. Their existing customer base, the wishes of their shareholders and the temperament of their management would make some banks go for stronger, others for weaker capitalisation. Regulation of leverage and capital ratios means that the banks have no choice, "one size fits all" and Heknowsbetter determines the "size". One result is that many banks resort to off-balance sheet devices, another that many try to shrink their balance sheet to avoid having to raise more capital. The latter result, in turn, produces the "credit crunch" that governments, business and the general public plaintively reproach.
The Franco-German consensus diverges most sharply from the Anglo-American one in the matter of the remuneration of bankers. It believes that unlike pop singers and soccer players, bankers are paid far too much, which breeds a culture of greed, short-termism and reckless risk-taking—quite unlike the dear old Post Office. The trading desks of banks that deal in securities, commodities and derivatives for the bank's own account are hotbeds of immoral speculation, the traders manning the desks get obscenely high bonuses and the whole activity lacks economic and social utility. There is much anger that the "Anglo-Saxons" do not agree to jointly limiting bankers' pay and in particular the traders' bonuses. The Europeans cannot go it alone.
Admittedly, it is hard to see any good reason why traders should get seven and even eight-figure bonuses that enrage public opinion. However, there is no good reason either for fixing remunerations by public opinion poll. As to the "economic and social utility" of banks doing short-term trading for their own account, how can any Heknowsbetter tell that the trading produces none? Why, then, is it consistently profitable, sometimes (as in 2009) staggeringly so? Normally, useless trading at best breaks even over the years, and makes a net loss if the trader has to be paid. The only explanation for consistent though volatile profitability is that these markets are very imperfect, with wide spreads between offered and demanded prices, and if they trade profitably, the banks narrow the spreads and make these markets less imperfect. Such trading is for the good of all. It is true that, much of the good accrues to the banks themselves, and they give too much away in bonuses to their traders. That is no reason, though, for damning it as reckless, fly-by-night, shady and, to top it all, "immoral". Like any other financial service that consistently more than pays its way, it should not be discouraged, nor shrunk. Let the Heknowsbetters restrain themselves and spare it.