Will We Miss the Banks When They’re Dead?

(Originally published here.)

In a previous post, I argued that banks are inherently unstable. Then I presented some ways to make them — and the rest of us — safer.

Some people think that this is the wrong objective. Risk and financial panics sound bad, the argument goes, but without them we would never invest in new technologies and infrastructure that improve our standard of living. Their counterintuitive conclusion is that distortive subsidies and devastating crises are the price we pay for civilization.

Steve Randy Waldman made this case the best. According to him, the flaw at the heart of every bank is actually a feature that encourages more risky investment than any rational person would choose to undertake:

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. . . . The winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis. In the context of an investment boom, individuals can be persuaded to take direct stakes in transparently risky projects. But absent such a boom, risk-averse individuals will rationally abstain. Each project in isolation will be deemed risky and unlikely to succeed. Savers will prefer low risk projects with modest but certain returns, like storing goods and commodities. Even taking stakes in a diversified basket of risky projects will be unattractive, unless an investor believes that many other investors will simultaneously do the same.

His memorable conclusion was that “you can have opacity and an industrial economy, or you can have transparency and herd goats.”

Michael Pettis made a similar argument in a recent column for the Financial Times: 

No growing economy has sustained a stable financial system. In fact, long-term wealth creation accrues most to societies in which the financial system most willingly funds risk-taking entrepreneurs. But the more a financial system is willing to finance risky new ventures, the greater the likelihood of banking instability.

That, perhaps, is why the system that delivered the subprime crisis also funded the computing and internet revolutions. The Belgian historian Raymond de Roover once explained that, in the 19th century, ‘reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.’

Too much financial stability, in other words, may actually reduce growth by limiting the transfer of resources to producers of wealth.

I have enormous respect for both Waldman and Pettis, but I think they may be overstating the case in favor of the status quo. Yes, the U.S.’s 19th century railway boom was made possible by reckless loans that were rarely repaid. But the most innovative firms — particularly those in information technology and pharmaceuticals — are allergic to debt and prefer to fund their risky investments with equity and retained earnings. The banks and “shadow banks” that fund themselves with short-term debt have proven to be much better at enabling speculative trading, leveraged buyouts, and real-estate bubbles than investments that actually improve our standard of living. It isn’t obvious that much will be lost if nonfinancial companies and regular people no longer funded these activities with their liquid savings.

(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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