What burst forth in the 15th century could wither in the 21st - The Death of Banking
It was the fifteenth-century when the first modern banks flourished in Florence and Genoa and the seventeenth-century when fractional reserve banking developed in Amsterdam. Banking is a historical phenomenon, not a necessary element in the economic structure. Indeed, a myriad of economic structures are possible and it was only under the influence of powerful historical forces that the medieval usury laws were eventually eroded sufficiently to allow banking activity to come out of the shadows. With this understanding of banking’s contingent nature, we should not take for granted it will always be an important feature of the global economy. We should also note how the functions undertaken by institutions that call themselves banks have changed in the course of time. Whereas their main business in the early days was the discounting of bills and transfer of funds from one locality to another, banks nowadays see themselves in activities as far removed from their original raison d’être as wealth management and trading of securities. Even so, institutions that undertake only one or a few of these non-traditional functions are not usually regarded or treated as banks. The notion that banks are best placed to provide a full range of financial services with the greatest efficiency reflects 1980s levels of technology. But advance in the technology relating to data processing, key to most financial operations, has put in question banks’ advantage as providers of financial services and placed a question-mark over their future. What burst forth in the fifteenth-century could wither in the twenty-first.
Meanwhile, global policymakers continue to feel anxious about the unresponsiveness of the economies over which they preside to whatever actions they take. One of the more sagacious among them, Ms Yellen, while addressing the Economic Club of New York this week, pointed out that monetary policy as accommodative as in recent years would, on previous experience, have been expected to generate much stronger economic growth than has actually been achieved. The tenor of her remarks, with her emphasis on ‘proceeding cautiously’ with monetary normalisation, has been widely regarded as ‘dovish’. But that formula is, in truth, consistent with any decision the FOMC might take when it meets on 26-27 April. It will provide reassurance if the FOMC decides to take a further small step towards higher short rates or, in retrospect, will count as forward guidance if the Committee opts to leave the funds rate target unchanged. Financial markets have interpreted Ms Yellen’s words in the latter sense. Even so, the devil is in the footnotes, as is often the case with speeches of Federal Reserve officials. On this occasion, while commenting on the beneficial effects of expectations in stabilising hiring and spending decisions, she added the following footnote. ‘That said, market expectations are not always well aligned with the Committee’s baseline outlook for the federal funds rate. Market participants may hold different views about the economic outlook and the associated risks and at times may be confused about the FOMC’s strategy. In such situations, the Committee must do what it believes is appropriate while clearly explaining the rationale for its actions.’ She would not have made that observation unless she felt it needed to be made.
What is common to the Fed’s policy approach and that of other major central banks is the implicit assumption that their prime task is to avoid the deflation they believe has become a serious risk ever since the global financial crisis. Their aim is to push inflation back up to pre-crisis rates, which they expect will affect growth and employment positively. They are pursuing this goal with single-mindedness. Until very recently, they do not seem to have given much thought to the possibility they are facing not one challenge but several. But the run-up to last month’s G20 meeting saw central bankers playing down what monetary policy alone could achieve and calling for other measures, including structural reforms, to restore global growth. This was their first admission there might not be a set of monetary policy settings that would correct deviations in the economy from the desired trajectory. All the same, none of these comments specifically identified what else needed to be done. There still seems to be marked reluctance in official circles to acknowledge there is anything more than a deflation risk, similar to that which undermined confidence in Japan during the 1990s, casting a shadow over the economic outlook.when households and companies see the banks anxious about the future, they are themselves inclined to be cautious and to hold fire on spending commitments
To explain the tendency for growth to fall short of expectations solely on the basis of standard economic models, with no reference to structural change, requires some extreme assumptions. How else could the ultra-accommodative monetary policies of the advanced nations, sustained over several years, be squared with their weak inflation and below-par economic performance? To make sense of the situation, it would call for some hypothesis along the lines of the ‘secular stagnation’ that Prof Summers proposes. If the equilibrium real rate of interest has declined substantially in recent times, as this hypothesis assumes, then the observed phenomena can still be explained within a neo-Keynesian theoretical framework. But it does not follow from this that we can infer anything untoward has happened to the economic factors, which for much of the second half of the twentieth-century determined shifts in the equilibrium real rate of interest, to bring about its latest downward move. The ‘secular stagnation’ theory posits a fall in the demand for debt-financed investment. In support of this contention, its upholders point to the relatively small capital investment that leading companies of the ‘digital age’ have needed in order to achieve spectacular growth. But this is a selective approach to the data. It overlooks the enormous amounts of debt-financed investment that raw materials producers undertook before oil and commodity prices turned down in 2013. Since 2010, US private fixed non-residential investment has risen, in real terms, at an average annual rate of just over 5%. This was very much in line with the just under 5% annual rate of growth in this measure in the period from 1951 to 2007. Even were the argument that a larger proportion of capital investment is nowadays met from companies’ own resources, these would still be funds withdrawn from corporate deposits, thereby tipping the supply/demand balance for funds towards tightness. This would still underpin the equilibrium real rate of interest.
If there are serious doubts whether ‘secular stagnation’ really refers to anything happening in the real world, it appears we face an intractable problem in trying to explain the post-crisis behaviour of the advanced economies. There is no reason, though, why we should stick to the constraining assumption that structural change has no part to play in the explanation. We should watch carefully what is happening. The deflation risk appears less in the USA than in Japan and much less than in the euro zone. The US authorities acted more decisively in the wake of the financial crisis to repair their banking system than did officials in the euro zone and Japan. At the outset of the crisis, banks in the euro zone were probably weaker, in terms of their balance sheets, than those in Japan because the Japanese banks had already strengthened their capital positions to some extent in response to domestic pressures before the global turmoil erupted. Another relevant factor may be that banks play a larger role in providing funds for investment in the euro zone than they do in the USA.
Against this background, the ECB and other central banks with currencies heavily influenced by the euro’s movements have been adopting ever more stimulative monetary policies. They say this is in order to boost inflation. But they are well aware there is no direct link between short-term interest rates and securities prices, on the one hand, and consumer prices on the other. They expect their policies to be effective primarily through the credit channel, by encouraging banks to lend more and rendering households and companies confident enough to borrow more. Their problem is that, however easy they make conditions, the banks’ willingness to lend remains very limited. Further, when households and companies see the banks anxious about the future, they are themselves inclined to be cautious and to hold fire on spending commitments. Many of the central banks’ easing measures, it is tacitly agreed, aim directly at relieving pressure on banks and only indirectly, through a supposed link between the health of the banks and demand in the economy, at raising the inflation rate. For the central banks, the wealth effects that their purchases of assets generate for banks are probably more important than those benefiting other holders of assets. The reason why the ECB’s negative interest rate policy has become so controversial is that its adverse effects on banks arguably outweigh any favourable influence it might exert. By contrast, in the USA, where for the time being banks are in better shape, the Fed has felt able to begin withdrawing its exceptional monetary support in an economy where growth is near potential, inflation is edging higher and credit is flowing normally.warnings that banks’ business models may not be viable for much longer have to be taken seriously
If the relative strength (or weakness) of banks can make so much difference to economic conditions, warnings that banks’ business models may not be viable for much longer have to be taken seriously. Banks face not only legacy issues from the injudicious actions they took in the past, though these may be challenging enough especially for banks in some euro zone countries. Stress testing of banks has not proved all that successful in identifying future problems buried in banks’ balance sheets, if only because the stress scenarios have usually been drawn up in the light of weaknesses that have already been revealed and, to a large extent, rectified. A bigger threat, however, may come in future from developments that are likely to undermine the profitability of banks as they are presently organised. Most obviously, advances in technology are opening up avenues of credit intermediation that by-pass traditional banking operations. The danger is that banks will be left high and dry, with profit margins slashed (if they are able to make profits at all) and poor prospects for growth. The provision of credit will gravitate towards new, technology-based institutions. It seems unlikely that these credit channels will be established and controlled by existing banks, seeing that they face continuous pressure from regulatory capital requirements that will cramp their operations for the foreseeable future.
For those who welcome the advent of the ‘digital age’, the fresh competition from technology-based companies in the business of financial intermediation will seem like an advance in efficiency. For the central banks, however, it presents a headache. Their focus is likely to remain on the banks. Partly this will be because the statistics on which they base their actions are unlikely to keep pace with the transformation in the financial sector. The data they have will still relate primarily to the banks they recognise as such. They will be taking their cues from figures which may bear little relation to the underlying reality. But they will also be aware there is the possibility of real economic damage from the disruption that technology is bringing to the financial structure. They cannot afford to allow the traditional banking model to wither away because it is very unlikely that process would be orderly. So much present wealth and existing credit is tied up in the embattled banks, and would be at risk if the monetary authorities were to adopt a passive attitude to the sector.
It is as good as nailed down, therefore, that central banks will be pursuing monetary policies that are not strictly appropriate to whatever economic conditions are current, as they seek to forestall serious threats in the future stemming from the technological challenge to banks. All traditional banks face this challenge, not only those in the euro zone which have recently been attracting attention. The 1980s saw the final culmination of a more than five-hundred-year development, the end of an era, not the inception of a new and sustainable financial order.
About the author
Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.
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