Steve Waldman offers a radical and unconventional cure to our financial mess.
Waldman is deadly serious and thinks our attachment to lending is based on dangerously flawed premises:
I am glad that the banks, for all the hundreds of billions of dollars we are giving them, are not lending. That is not because I want banks to improve the quality of their balance sheets. On the contrary, I don’t want banks at all, at least not banks anything like what we’ve had….
But credit is the lifeblood of a capitalist economy, right? I keep hearing that line. It’s a dumb line.
Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources. You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called “investing”. There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like “common stock” and “cumulative preferred equity”?
In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you’re on it. Almost certain to, um, cause problems, eventually. Our overall goal ought not be to kickstart the credit economy, but to kick the habit and move towards financing arrangements that are more equity-like than debt-like. That’s going to be hard to do, because historically, we’ve subsidized the hell out of debt financing, especially bank credit, and alternatives are underdeveloped.
But with the exception of war, no still-practiced human institution provokes catastrophe as regularly or as grandly as the misuse of debt. We ought to phase out banks as we’ve known them since before Bagehot’s time, and move to a regime of what are lately referred to as “narrow banks” (banks that lend only to the government that issues the currency of their deposits). We should encourage the development fine-grained equity markets and local-market investment funds to replace bank financing.
The rush to ramp up “consumer credit” is particularly dumb. Usually, financial investing involves funding wealth generating projects in exchange for a share of the anticipated wealth. Consumer credit funds current consumption in exchange for a share of, um, what exactly?
In theory, there’s a good answer: consumer credit funds current consumption in exchange for a share of anticipated future wealth that is believed to be endowed already. Economists talk about consumption smoothing, how it may be optimal for a consumer whose income is volatile to borrow during periods of low income and repay (or save) during periods of high income in order to maintain a constant standard of living. That’s very well in models where consumers know the true distribution of their future income, where the spread between borrowing and lending interest rates is not very large, and where consumer preferences are time-consistent. In practice, none of these conditions hold even approximately…
There are obvious wrinkles and objections — What about credit for cars, or home mortgages, or education? The analysis changes when the borrowing is exchanging one pre-existing long-term liability for another. (We are born short basic shelter, and, in much of America at least, short a cheap car as well.) Education can be viewed as an ordinary, wealth generating investment project that in theory could be equity rather than debt financed, but that might be too tricky in practice. It’s not my intention to suggest that consumer credit is always bad, only to defend the commonplace notion that for many people and under many circumstances, even loans that will be never be defaulted can be positively harmful, and as a matter of policy we should not be exhorting banks to issue or consumers to accept credit.
Note that in this deliberately provocative post, Waldman does not mention business borrowing. Presumably, business borrowing is to fund investment in profitable activities, be it financing inventory or the purchase of new equipment. But that may be more than a bit of a shibboleth. Consider this analysis from the New York Times’ Floyd Norris:
It is now becoming clear that the great news on the dividend front from 2004 through 2006 was not an indication of solid corporate performance; it was just another sign of lax lending standards. Lenders who willingly handed out money to homeowners with bad credit were even more generous to corporate borrowers….
From the fourth quarter of 2004 through the third quarter of 2008, the companies in the S.& P. 500 — generally the largest companies in the country — reported net earnings of $2.4 trillion. They paid $900 billion in dividends, but they also repurchased $1.7 trillion in shares.
As a group, shareholders were paid about $200 billion more than their companies earned over that four-year period. Suffering investors who held onto their shares during the 2008 plunge may want to reflect on the fact that investors who were dumping shares got roughly twice as much of the money as the loyal holders did.
In case you think this view is overstated, I heard repeatedly from people advising big corporations (lawyers, consultants) during the supposed good years that their clients were very reluctant to make investments of any kind, even expenditures that one would deem to be necessary to maintain brands and revenues, such as advertising. So while money is fungible, there is a lot of anecdotal evidence to suggest that big companies were non only not investing (in aggregate), they might have even been dis-investing.
Waldman does not elaborate on the need for more equity-like arrangements. One can argue that that comes from the fact that lenders take too much comfort from their status at the top of the capital structure, that it things come a cropper, they have the first crack at the carcass. But given the regularity with which banks rack up credit losses big enough to impair their survival, the due diligence is (over time) wanting. And to justify the cost and effort of more scrutiny, an investor would need more potential upside. But the flip side is a lot of businesses would be loath to give up equity (some of my lawyer buddies advise strongly against taking in angel investors if there is any way to borrow instead. If you have to go to the well too often, it is very easy for the founder group to wind up minority shareholders, and in every situation I have been close to save one, they have been forced out not long after that happens).
Now, the alert reading is thinking, if we let private borrowing shrink, we’ll have a horrid deflationary collapse! But Waldman has another remedy:
But if we let consumer credit contract, and if investment demand is derived from consumption demand, doesn’t that spell macroeconomic disaster? There is an alternative. It is called “transfers”…..The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid.
I’m trying to come up with a reasonable opposing view, a case for pushing consumer credit but opposing transfers. Perhaps you can help, because I just can’t do it. One might argue on philosophical grounds against coercive transfers, but coercive transfers are a precondition of restarting bank lending, and we’ve already made transfers to banks on such a scale that banning them now would be like robbing a jewelry store, then piously arguing future looters should be shot. One might argue that bank lending is “smarter” than public transfers would be, that the patterns of consumption and investment that result from private sector credit allocation will lead to superior productive capacity and more sustainable patterns of consumption than direct transfers. Given the awful quality of aggregate investment this decade and the volatility now faced by consumers who were recently credit flush but who under any reasonable lending standard must now be credit constrained, it is hard to be enthusiastic about the special wisdom of bank-mediated credit allocation.
Of course, once we start redistributing purchasing power, there’s the thorny question of who gets what. I have an answer to that, it is my new mantra. Transfer flat. Cut checks to every adult in the economy of interest, regardless of whether they pay taxes or have a job. Flat transfers are easy to understand and they pass the smell test for “fair”….
Yves here. I have no doubt some readers are patting themselves on the back. They have argued it would have been better to take the TARP money and just hand it out on a per capita basis (it come out to over $2000 per person). Unfortunately, it couldn’t quite be that tidy, since some money would have to be spent to clean up the dead banks.
We want an economy that serves some people dramatically more than others, in order to preserve incentives to produce and excel. But we also want an economy that meets every person’s basic needs, even those of people who are unable or unwilling to offer marketable goods or services. We won’t let people starve, so why not fund a basic income, however miserly, rather than relying on an inefficient social services bureaucracy or taxing the virtuous by relying on charity?
Tax Pigou and progressive. Transfer flat. Encourage equity. Contain the banks.
Recall that Milton Friedman and Richard Nixon advocated a negative income tax, which is pretty close to this construct.
Unfortunately, there is a completely different set of reasons that we have (and are likely to continue to have) an overly large financial sector. As Niall Ferguson discussed in his book The Cash Nexus, access to credit has long been important to war-making ability. The reason that England was able to punch above its weight in the 1700s and 1800s was that it was able to borrow more cheaply than France, even though France was the bigger economy. The English had professional tax collectors, who were far more effective in gathering revenue than the often corrupt French tax “farmers”. Thus there are reasons apart from the health of the economy to have an oversized credit machine at hand (although it isn’t clear to me how the securitized mortgage apparatus could be repurposed for war finance…..). At a minimum, financiers will inevitably have the ear of the government, which gives them considerable advantage in pressing their agenda.