The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, January 20, 2010

Updated: Left and Right Unite Around Narrow Banking

As sure as I wake up like clockwork at 2.30am every morning to stomp aimlessly around the house, raid the fridge, and bash out a few semi-conscious emails, there is going to be another global financial crisis in our lifetimes. And while I am not the gambling type, I would confidently wager that Australia is going to find itself in very serious strife. Because the next upheaval will likely originate in that industrialising, high-growth, politically unstable, and insensitive-to-the-rule-of-law region of the world that fixates Westerners like an irresistible narcotic: Asia (and China, more pointedly). And just as the transmission device for the recent contagion was banks that had overreached their domestic savings and loans domains and sucked far too hard on the impossible-for-myopic-management to ignore US lolly pop, history will inevitably repeat itself with the difference being that we substitute China for the US and Australian banks for their foreign cousins.

Now if there were any doubt that Australia is suffering from a mighty bout of sanctimonious ex post rationalisation and short-sighted hubris following the GFC it was well and truly removed by a recent report produced by some accountants, fund managers, and investment bankers arguing in favour of—surprise, surprise—Australia becoming a major financial services hub. Naturally in order to achieve this aim our authors advise that we must cut taxes (to compete against Luxembourg and the Cayman Islands!) and avoid overregulation of this sector. Of course. This predictable finding was euphemistically described by one commentator as “counter-cyclical”. I could not have put it better myself.

If I were to be diplomatic, I would say that surely this requires a more strategic approach. Should we not go back to first principles and ask ourselves what precisely the financial services industry contributes to Australia’s long-term economic welfare? Many positive things, no doubt. But should we be promoting one sometimes unproductive, prone-to-fail, and, in the absence of implicit and explicit taxpayer support, systematically destablising industry over and above others? Would it not be better to study all sectors of the economy and determine what, if any, areas furnish Australia with a defendable comparative advantage that we might try to harness?

A less-diplomatic critic might submit that Australia would have to be the only country of the face of mother earth seeking to expand its financial services industry right now. Flush with our fortuitous success in avoiding the worst of the GFC, we seem to be deaf to the near-universal—and rare—consensus amongst left- and right-wing economists in the more grounded northern hemisphere (or perhaps every part of our sphere that does not include Australia) that one of the main drivers of this crisis was the poor incentives that led to unsustainably strong growth in the finance sector as measured by its share of GDP. This is an industry, which, generally speaking, does not contribute to producing any tangible “things” (financiers facilitate “allocative efficiency”—think diversification, insurance, and risk management). There is also the widely discussed question regarding the economic costs associated with one industry absorbing so much talented human capital that is sacrificed at the alter of trading pieces of paper. Ponder all those PhDs and other academic savants that have been diverted away from pure research, science, technology, engineering and countless other productive purposes in pursuit of the incomparable remuneration afforded by financial services. I should know—we employ four of them full-time in our business!

This critic would be a lone local voice were he or she to remind us of the fact that the two countries worst affected by the crisis--the US and UK--had fostered the world’s two largest financial centres, New York and London. The other dubious example is, of course, Dubai, which had committed itself to becoming the financial epicentre of the Middle East.

While many of us sit luxuriating in our economic providence, it is unsettling to contemplate a counterfactual. How well would Australia had fared had not our island continent been situated in its unique Antipodal position on the outskirts of Asia? More significantly, what would really have separated Australia from, say, the UK had we not been bequeathed with our rich bounty of natural resources and consequently strong demand for migrant labour? Aside from our undoubted sporting prowess and superior physical qualities (chuckle), there are few if any differences between Australia and the UK. In fact, I have shown in the past that one of our saving graces during the GFC was that Australia's banking industry was less well-developed, and less integrated with the rest of the world, than their ambitious 'high street' contemporaries in the UK. Do we honestly believe that Australia’s economic outperformance can be attributed to the peerless foresight of our policymakers, and/or the sublime management skills of our bankers (erasing, of course, the memory of their experience during the last downturn in 1991)? Or is this blind hubris merely laying the foundations for the next crisis?

One of main explanations offered by knowledgeable observers, such as former RBA Governor Ian MacFarlane, as to why our banks skirted the worst pitfalls of their peers was that they had no need to expand overseas. Yet, as I have repeatedly highlighted here, this is exactly what they are now doing to capitalise on their newfound position of strength. And so we have the bizarre situation whereby taxpayer-backed banks are ignoring a key lesson from the GFC and rushing offshore—think NAB and Northern Rock, CBA’s advances in China, or ANZ’s relentless efforts to transform itself into a pan-Asian bank—notwithstanding their highly questionable track-record in previous forays (eg, NAB and Homeside in the US). They are also locked in an apparent race to diversify into non-core businesses, such as stockbroking and funds management. Am I the only one that sees the extreme contradictions underlying this logic? Is not the reason UK taxpayers now own 84% of the Royal Bank of Scotland exclusively attributable to its extension beyond core savings and loans into investment banking?

I have previously discussed at length the utility-like characteristics of banks, the fact that they are not ‘private concerns’ in the conventional sense, the multiplicity of direct and indirect public subsidies that they have to access due to the intrinsically frail asset-liability mismatch that is the basis of their business models, and the conflict between CEOs and shareholders that want to maximise short-to-medium term growth, and policymakers and taxpayers that want to minimize system instability and ensure that banks stick to their lower-risk (and hence lower-return) knitting of taking in savings and redistributing that money as credit to businesses and households throughout the economy (ie, forget investment banking, proprietary trading, stockbroking, and funds management). I have also relentlessly reminded policymakers that our system of prudential supervision (the practical incarnation of which is APRA) failed the first major banking challenge it faced by deploying taxpayer guarantees in direct contravention of the central tenets upon which it was founded, and the recommendations of the 1997 Wallis Inquiry that precipitated its establishment. This inexorably brings one to the question of Australia's future regulatory landscape, and exactly what activities banks generally, and too-big-to-fail institutions such as the big four oligarchs specifically, should be permitted to undertake.

In particular, the observations above lead one down the increasingly-discussed ‘narrow banking’ path. In short, if you want to be a bank that gets the benefit of taxpayer guarantees of deposits and wholesale funding, and RBA lender of last resort services during a crisis (ie, cheap lines of credit that nobody else will provide you with), then you can only engage in really boring (read low risk) savings and loan stuff. Forget all the other fancy business lines that CEOs and management consultants love to “diversify” into. Now you used to only hear these arguments from heterodox economists. But they have been seeping into the mainstream, as was most controversially evident when Mervyn King, the Governor of the Bank of England, came out and effectively put the case.

Advocacy of these ideas, which would involve a lot of re-regulation, is not ordinarily associated with libertarians, neo-liberals, or those who subscribe to the so-called “Chicago school” that promulgates maximizing private market activity while paring back far less efficient public sector influences.

I was, therefore, surprised to come across a fairly forceful endorsement of the narrow banking model from Professor John Cochrane, who is one of the 'efficient markets' prophets and a doyen of the Chicago school. By way of interesting context, Cochrane, who is also a leading academic researcher, remains a firm believer in the two cornerstones of neo-classical economics that have come in for most criticism following the GFC: the related ‘rational expectations’ and ‘efficient markets’ hypotheses. Accordingly, Cochrane is a Republican-style champion of smaller government, extensive deregulation, and the belief that the public sector should get out of the way of private markets. Yet check out Cochrane’s views on how we should regulate banks in a post-GFC world, which are patently of the radical narrow-banking ilk (my emphasis added):

Q: If you were hired as head of the White House Council of Economic Advisers, what would you tell the President?

I’d get fired in about five minutes. I’d start with a broad deregulatory approach to health care reform. There, I just got fired. Financial deregulation, yes, but going in the opposite direction to where they are going. Financial regulation based on getting out of this too-big-to-fail cycle. Setting it up so that those things that have to be protected are, but in as limited a way as possible. Simple, transparent reform.

And I think the government needs to encourage Wall Street to solve its own problems. Let’s go back to Bear Stearns. Here we had a proprietary trading group married to a brokerage. We discovered you could have runs on brokerage accounts—that was the systemic thing. So what I thought would happen after that is that Wall Street would say, “Oh wow, we’ve got a problem!” Marrying proprietary trading to brokerage is like managing gambling to bank deposits. What I thought Wall Street would say is: “We’ve got to separate these things. Customers want to know that their brokerage isn’t going to get dragged down by the proprietary trading desk, and we want to separate them fast so that Washington doesn’t come in and regulate us.” Unfortunately, that’s not what happened. What happened is that everybody said, “Aha, the Fed is going to bail us all out. We can keep this game going forever.”

So what I would like to see is a strong (statement): “You guys have got to set this us so it can go bankrupt next time around. And we are going to set it up so we don’t even have the legal authority to bail you out, so you’d better get cracking.”

[CJ: Here Cochrane is saying that the non-banking parts of these businesses need to be separated from the deposit-taking functions and allowed to fail, which is pretty much the definition of narrowing banking.]

Q: You mean a new Glass-Steagall act for Wall Street? Or some version thereof?

Yeah...Glass Steagall itself had a lot of problems, but some of the basic ideas are good.

Q: But the same principle—separating the casino from the utility?

Separating the casino from the dangerous contracts—yes. We all understand that you can’t run an institution that offers bank accounts and gambling in the same place
[CJ: Correction, everyone understands this except us]. We are trying to do that now in the hope that the regulators will watch the gamblers. That’s not going to work.

Q: It appears that there is liberal and conservative agreement on this issue [CJ: That is, the need to adopt a narrow banking approach].

Yes. Which brings me back to where you started. It’s not about liberal or conservative, and analysis of these things doesn’t have to be ideological. Let’s just think through what works and look hard at the evidence.

What this shows you is that the smartest participants in the debate don't conform to the fixed, black-and-white reductionism that many folks find intellectually convenient (I discussed this at length in my Obama post a few days ago). You can, therefore, find ostensibly radical right-wingers like Cochrane in violent agreement with equally radical social-democrats like Australia's own John Quiggin, who has been peddling the narrow banking line for some time now.