In the theory of a capitalist free market economy (whether a “Chicago Boys” extreme free market or a Keynesian), finance and banking is important. Very important. The role of financial institutions and banks is to direct financial capital (money) from those people who have a lot of it (have accumulated wealth, but aren’t ready to spend it yet) to those who have good ideas, technology and the entrepreneurial ability to produce goods. In the theory, these entrepreneurs need financial capital in order to invest in fixed, physical, and human capital. In other words, the entrepreneurs borrow or find “investors” who provide the cash. The entrepreneur or firm management uses the cash for a while and builds factories, buys tools, researches new products, and trains workers. This is done to produce goods and sell the goods at a profit. Once the firm makes profits from these activities, it pays “interest” or “dividends” to the people who provided the use of the financial capital. Presumably the profits generated are greater than the interest and debt payments and the entrepreneur gets the remaining profits.
In economic theory the role of the banks is to efficiently match up these “lenders”, people who have financial wealth, with “borrowers”. In economic theories that have their roots in 19th and early 20th century theory (think Classical, neo-liberal, communist, socialist, and even early Keynesian theories), the “borrowers” are entrepreneurs and firms who can profitably the money now by investing in new productive capacity. They build factories, buy machines, and accumulate inventory. Historically though, governments have always been larger borrowers than entrepreneurs. Since the 1920’s, though, “borrowers” have increasingly been consumers – typically middle and working class people in early or mid adulthood who are buying cars, homes, and consumer goods, or students investing their college education through student loans. Households in later years typically become net lenders as they accumulate savings for retirement and their incomes have grown.
But in reality banks do more than just match up lenders and borrowers. Banks actually create most of the spending money available to the economy. They do this through a process called fractional reserve banking. (A complete explanation of fractional reserve banking is beyond the scope of this course – see any Principles of Macroeconomics course, although a note should be made that contrary to the assertions of some Presidential candidates and other politicians, this “banks-create-money” process still occurs even under a gold standard) Banks create money by extending credit, by making loans. Banks take in deposits, a form of the bank borrowing from its customers, or by borrowing short-term from other banks and wealthy funds. People lend (deposit) to banks because banks promise a fairly certain, although small interest rate and promise safety and security so the money can be withdrawn on short notice. Banks then lend out these borrowed and deposited funds. Banks do not lend their own money. They are lending other peoples’ money. Typically the bank is making loans that are longer-term in nature, at higher risk on not being repaid, and at a higher interest rate. The bank profits by charging higher interest rates on the loans it makes and paying lower interest rates on the money the bank borrowers. The bank is said to make it’s profit on the spread in interest rates. If the banks do their jobs well, the economy performs well because financial capital gets directed to valuable, productive uses.
At this point we should note that, while economic theory says that the function of bankers is to efficiently match up lenders and borrowers so that financial capital is put to good use, that is not what bankers are trying to do. It is only a happy side-effect of a system when it works well. What banks are trying to do is to make as much profit as possible using other peoples’ money. Banks will lend for any purpose or to anyone as long as they think they will get paid and as long as the interest received is greater than the interest paid. Thus banks are willing and often enthusiastic about lending to speculators or traders who are not actually producing goods and services. In boom periods, these speculators often include other banks. The history of banking and capitalism is replete with episodes when bankers as group get a carried away and make excessive loans to each other and to other speculators. These periods are often referred to as asset bubbles. Speculators get loans to buy assets that way over priced compared to any real economic function, but the banks and speculators are counting the asset prices continuing to rise anyway. Eventually all bubbles pop. When that happens, the banks experience large losses and the borrowers find themselves hopelessly deep in debt with a worthless asset.
An example is the housing boom in the U.S. in the period late 1990’s until 2006. House prices continued to rise well above any reasonable economic foundation to support the house value. Banks aggressively sought to make as many mortgage loans as possible since they made large fees for making the initial loans and then could sell the loans to investors (overseas banks, hedge funds, pension funds, other banks) for more large profits. Banks aggressively, and at times, illegally sought out borrowers so they could make even more mortgage loans, including loans to people who had no possible way to ever pay them back. In this period the U.S. banking system directed an increasing flow of funds into the housing market, even when it became obvious that the U.S. already had way too much housing. At one point in 2007 the U.S. had 1.3 houses for every household and large numbers of newly built homes sat unsold in the deserts of California and Nevada. Eventually in 2006-7, house prices stopped rising. The bubble burst. Banks began to take massive losses on the bad loans. By late 2008, many of the largest banks were insolvent and unable to pay their own debts or meet the demands of depositors. Since these banks had lent money to each other, a collapse of even just a few such as Lehman Brothers and Merrill Lynch threatened all banks. A bank bailout by the government became necessary to prevent a complete collapse of banking and the loss of trillions of dollars in household savings and pensions.
The nature of banking has always been fraught with risks for both the bankers and the economy. Financial markets and banking are situations where fraud can easily happen. Poor judgement combined with a desperate search for “get richer quicker” schemes can easily cause banks to take excessive risks or direct financial capital to unproductive uses. Besides the misdirection of financial capital to asset bubbles such as the housing bubble described above, “crony capitalism” also is likely. In crony capitalism, bankers, who are themselves often rich and have access to large sums of money, will direct loans to projects or uses that certain politicians favor. Or banks may simply financially support the politicians’ election campaigns. In return, the banks get to charge higher interest rates or fees for the project which is actually being paid for ultimately from either taxes or foreign loans. Or, banks may get preferred legal treatment such as exemption from prosecution for fraud. Or, the banks may simply get a guarantee that any future losses will be subsidized or absorbed by government (a bailout).
This latter dynamic, wherein banks get express or implied guarantees against losses leads to further speculation in an economy. After all, the banker is now in the position of “heads and the loan pays off, then the banker wins profits” but “tails and the loans go bad, then the government takes the hit and the banker is OK”. Clearly the bankers now have incentives to take more risks.
Unfortunately the history of banking and financial institutions in capitalist (and pre-capitalist) economies is a several hundred year tale of recurring crises, panics, and depressions. Sometimes the bankers themselves suffer, but more often the consequences for the larger real economy and government are severe. In the Great Depression, 2/3 of all banks in the U.S. failed and in the process wiped out 14% of the life savings of their depositors. More recently, we have seen how in the U.S. in 2008 the U.S. government had to launch a $750 bailout program to save the largest banks. This program was supported by several trillion dollars more from the Federal Reserve Bank and from national governments throughout the world. One result was the longest, deepest, and most global recession since the Great Depression 80 years ago.
So what’s the issue? The issue as we move well into the 21st century is that banking and finance has truly become global and on a massive scale. The largest banks are, in a sense, beyond “multi-national”. “Multi-national” suggest operating within multiple nations. Today’s largest banks have become bigger than nations. They are beyond the ability of even the largest nation to regulate or control them. Should they fail, as Merrill Lynch, Lehman Brothers, AIG, and Bear Stearns did in 2008, their individual failures can bring down other supposedly healthier banks and even non-bank firms such as GM and Chrysler. They have become what is called “too big to fail (TBTF)”. Governments must bail them out when the banks made bad investments because otherwise the rest of the economy gets destroyed as a kind of “collateral damage”. Bankers know this. And that knowledge leads them to take even greater risks. No industry has experienced more “globalization” than banking and finance. Indeed, financial capital can move so quickly between nations, between economies, and without regulation that it has led to frequent crises: the Asian Contagion in the 1990’s, the Global Financial Meltdown in 2008. This emergence of a global financial élite has also squashed competition amongst themselves.
An “oligarchy” is an economic system (or society) wherein an élite few, usually the very richest, direct the economy. Most often the decisions made and policies followed in an “oligarchy” are intended primarily to further enrich those few, even at the expense of the rest of society. The global banks and financial institutions direct the flow of financial capital. Is this the best system for achieving society’s economic goals? What can nations do?