Shifts and Shocks

At the end of last year, I read Shifts and Shocks by Martin Wolf. He is chief economics commentator at the Financial Times. He has also worked as an economist at the World Bank, so he part of the economic establishment.

I get frustrated with these establishment economists. They acknowledge that the monetary system is seriously flawed, and that the monetary authorities were unable to foresee, or prevent the Global Financial Crisis from occurring. They have no confidence that the monetary authorities will be able to prevent any future crisis. Yet they are unwilling to recommend serious changes to the monetary system.

I presume there are two reasons.

• Many members of the economic establishment have profited from the system, so they are unwilingl to eliminate future opportunities for their families and friends to prosper from the system in the future.
• They understand that the monetary system gives inordinate power to the state. As part of the establishment, they do not want to lose that power.

Martin Wolf is typical of the economic establishment.

There is a simple and telling reason why, notwithstanding all the regulatory reforms, the system is bound to fail again and again; it is designed to do so. The reason for this is that the fragility is built in. The financial system makes promises that, in certain states of the world, it cannot hope to keep. The reason for this is that institutions finance long-term, risk and often illiquid assets with short-term, safe and hilly liquid liabilities. The people who provide the funds regard their deposits and other loans as a very close substitute for ―if not exactly the same thing as—money. But the assets held by the institutions to which they have lent are not in the least like money; they are subject to significant solvency and liquidity risks. At a time of trouble, providers of funds will panic: it always makes sense to try to be among the first to leave a burning theatre or even a theatre that might burning. In withdrawing their funds, providers will trigger what they fear. The assets held by institutions will be dumped at fire-sale prices turning illiquidity into insolvency.

This is the world’s Faustian bargain. Some argue for a drastic solution: abolish it. Make term transforming finance, in general, and conventional banking, in particular illegal.

Wolf then quotes Charles Goodhart, whom he called the doyen of British analysts of finance as saying this solution is not wanted by anyone

The problem with proposals of this kind is that they run counter to the revealed preferences of saver for financial products that are both liquid and safe, and of borrowers for loans that do not have to be repaid until some know future distant date. It is one of the main functions of financial institutions to intermediate between the desires of savers and borrowers, ie to create financial mismatch. To make such a function illegal seems draconian.

Wolf makes the following assessment of Goodhart's response.

Goodhart is right in saying there is a strong preference for a financial system that mismatches maturity, not to mention riskiness. But one must ask: at what price?

Wolf seems to accept this argument, and concludes that the benefits outweigh the risk.

However, there is a flaw in Goodhart’s argument. Borrowers prefer long-term loans and they do not mind risk, because time is on their side. Savers want short-term and low risk. The system gives borrowers what they want, but it only gives savers half of what they want. They can get short terms, but not security. This is wrong. The money belongs to the savers, so they should be able to decide what they want. However the banks and financial authorities refuse to let them have it. Instead they give the borrowers what they want, because there is more profit in it for them.

There are plenty of other avenues for savers who want high risk and high return. We need banks that will provide savers with an deposit account that meets their requirements.