Watch the oven
The baking business runs very smoothly. Bread is delivered in the desired quantities, technology advances (sliced bread was not the last word) and consumer tastes are satisfied. Bakers usually receive modest but steady rewards for doing their job well. Barring wars, there are no baking crises.
But add an “n” to “baking” and the picture changes. The banking business, which collects savings and doles out loans and investments, works like yeast in industrial economies. The transformations of finance raise up factories and houses, while softening the pains from reversals of fortune. But as a business, banking is much less healthy than baking.
To start, finance shoppers cannot count on the ready availability of their daily bread: loans and savings with reasonable interest rates. Credit comes and goes with alarming speed. If bakers worked like bankers, one day the bread aisle would be overflowing and on sale, and the next there would be only a few mouldy rolls available at an extortionate price.
Also, banking makes remarkably little progress. The financial instruments that led to the South Sea Bubble in 1720 were different from those behind the subprime extravaganza that began in 2006. But the pattern – excessive borrowing and rising prices for financial assets leading to inappropriate investments, followed by a rapid market collapse – is virtually identical.
Then there is the way bankers get paid. Since their service is mediocre and erratic, any reasonable observer would award them meagrely – much less than bakers. But in fact bankers and other financiers are usually rolling in dough.
Finally, it hardly takes a war to create a banking crisis. They come with depressing regularity on their own. Indeed, according to economist Hyman Minsky, a few years of financial stability is sufficient to breed a massive bout of instability. The baking business is not so half-baked. High prices might encourage bakers to build a few too many ovens, but the excess is absorbed with little grief.
Why can’t bankers be more like bakers? Some might say that the comparison is foolish – banking is far more complex than baking. But the differences are not really that great. Sure, a complex merger is a lot more complicated than a fancy cake, but most financial transactions are fairly straightforward. It doesn’t take a rocket scientist to create savings accounts, mortgages or even share issues. Signs of financial excess should be almost as easy to interpret as unsold bread in the shops.
Bankers are more susceptible than bakers to the vagaries of governments and economic cycles, but the main problem with the finance trade is bad management, both at the banks themselves and at the banks’ regulators. In turn, the management failure can be traced back in large part to two lies – a noble one that is not sufficiently respected and an ignoble one that is too widely believed.
The noble lie
The noble lie is the foundation on which all banking is built – the ability of a bank’s depositors and borrowers both to consider the same funds as their own. It’s a lie because no bank, no matter how well capitalized, can always let each depositor cash every account.
It cannot be otherwise. Depositors want to be able to get their money out when they grow old, become ill or decide to buy something expensive. But banks work by funding investments which are pretty much permanent (houses and factories) or cannot be withdrawn without tripping up the economy (inventories and loans to cover temporary reversals).
The fiction of potentially unlimited withdrawal is not limited to bank accounts. Holders of the more advanced financial instruments – bonds, shares and derivatives – cannot all sell at once. If more than a few try, the market price drops sharply. If there is a stampede for the exit, the market disappears entirely.
The withdrawal lie is noble. Without it, only the very rich and tax-collecting governments would have the funds to construct anything durable. With the lie, everyone who has a few dollars in the bank participates in the building and fruits of prosperity.
But the admirable fiction should be handled with care. A depositor panic is an ever-present risk.
To keep it away, depositors must accept some limits on withdrawals, banks should be required to hold large amounts of cash in reserve, the links between those who provide and those who take funds should be kept clear and the riskiness of investments should be matched with the willingness of savers and investors to lose money.
Regulators need to develop – and respect – the banking equivalents of oven thermometers for ensuring that financial activity does not overheat. Sadly, they have consistently been remiss, from the South Sea Bubble onwards. All too often, undercapitalized institutions have been allowed to take inappropriate risks. The result has been the financial equivalent of a series of oven explosions.
The ignoble lie
The other lie encourages greed in individuals and collapses in economies. It is the claim that financial profits can consistently grow at a faster pace than overall prosperity. In other words, it is the belief that investors and markets can outperform the real economy forever.
Outperformance is undoubtedly possible for some periods for some investors (say, Warren Buffett through his whole career) and some markets (say, the stock market from 1980 to 2000). But for a whole economy, financial returns can only outperform the gross domestic product (GDP) when the share of the national income that comes in financial form – rent, interest, dividends and capital gains – is increasing. Otherwise, the winners and losers just cancel each other out.
The financial share of GDP can grow for years, but not forever. If everyone expects the banking oven to provide more financial bread and cakes than the economy can produce, disappointment is inevitable, sooner or later. But like gamblers who think or hope they can beat the odds, investors of all sorts generally believe their own portfolios will be winners.
When too many of them learn otherwise – when the ignoble performance lie is revealed – savers and investors may try to cash in. But if too many people or institutions attempt to take their money out of the markets all at once, they run smack into the noble lie. Prices fall and funds disappear. The result is a financial crisis.
A baker knows that bread which rises too much and too fast will collapse in the oven. But to judge from the widespread enthusiasm for rising share and real estate prices – among financial professionals as well as politicians and punters – the dangers of believing the ignoble lie are not sufficiently recognized. Only a few crusty sceptics seem to worry when asset prices rise much faster than incomes.
Banking can probably never become as peaceful a business as baking. But with the help of some lie-respecting and lie-detecting, banking could – and should – become a lot more wholesome and predictable.