Choosing the vanilla type of financial institution has its advantages.
Listener: 18 October, 2008
Keywords: Macroeconomics & Money;
The more speculative end of the financial system is a casino, according to economist John Maynard Keynes. You gamble with your money: if you’re lucky you win more; if not you eventually lose it.
The plain vanilla end of finance does a useful job. Trading banks lend others’ deposits, spreading and reducing the risk from the individual lending directly, and taking a margin for the service. Some argue that the fancy hokey-pokey end does this too, but I can’t believe the enormous payments to some players are offset by the -economic gains from the risk reduction. It’s a casino making a marginal contribution to the economy but a whopping contribution to some, to the cost of others.
Investors/gamblers would not stay long if the casino was that transparent. And so it takes their money in exchange for financial assets – let’s call them IOUs. The value of the IOUs seems higher than the money the investor puts in, and therefore they are happy until the financial wheel stops spinning, as it did in August last year.
Suddenly investors find that many of the counter-parties (the “I”s in the IOU) cannot pay real money, because it has been taken by those lucky enough to have got out with the cash. (They say they are clever, but luck is probably more important.) The money has been transferred from the modest many to the rich few.
So those who invested in financial companies that have fallen over are, -typically, holding worthless or near-worthless deposits (which are but examples of IOUs). Worldwide, there are trillions of dollars of them, and these investors are going to have lower incomes – lower than when they began speculating in the financial casino.
It gets worse if the holders of the IOUs borrowed to fund their gambling spree, so they have real debts offset by the worthless IOUs. That is the stage we reached last month. No longer was the world -financial system just in a liquidity crisis where no one was willing to buy the IOUs. As the value of the IOUs has fallen, financial institutions are finding their balance sheets compromised.
This includes the once-mighty Lehman Brothers investment bank. (Note these institutions are not trading banks, but dealers in the fancier IOUs.) Its shareholders lost their money (shares are IOUs) and so may many of the depositors (the big investors), who will have inferior balance sheets. That could have knock-on effects. An almost similar situation applied to Merrill Lynch and the Halifax Bank of Scotland, which were bought by sounder institutions that paid what they judged the IOUs were worth, reducing the value of the businesses to the shareholders.
Some institutions were so big that the private sector could not buy them. So the US government – presiding over the greatest capitalist economy in the world – is now the owner of the world’s largest insurance company and mortgage banks. (At least our Government’s nationalisation gave it a railway and an airline, not a pile of IOUs.) The US Government plans to buy up the junk IOUs, putting them into a separate public institution, hoping to recover much of their value in the long run. Its balance sheet includes the sovereign right to tax, so the loss will be paid for by taxpayers, some of whom haven’t even been born. Someone must pay for the wealth of the lucky billionaires.
Why does the US Government bother? Partly because it’s privatising profits and nationalising losses. But by quarantining the junk in the public sector, the private-sector balance sheets are strengthened, -reducing the danger of their financial collapse and a serious international depression, as occurred in the 1930s.
<>The financial casino may be over for now, but the wheel of economic fortune wobbles on. I can’t tell you whether we will experience a depression or a long slow world recession. I do know we are not through it all yet. Despite the collapses of last month, we may not even be through the worst.