Dirk Bezemer on Creating a Socially Useful Financial System

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"“Most of our credit system does not support economic growth in the sense of supporting transactions in goods and services,” he explains. “Most of our finance system, most bank loans, support increased asset prices, which have a number of detrimental effects on the economy.”

Debt going to asset markets can be helpful at a low level of debt (when overall debt is about 100% of GDP, Bezemer suggests. The U.S., by comparison, is now at more than 400%.). But when debt gets too high, servicing it becomes a big drain on the real economy. And this means lower economic growth.

But orthodox macroeconomic models won’t tell you any of this. “There are no models tracing credit, so a credit crisis will come out the blue,” Bezemer says. “We can do better than that.”

Bezemer shows that “on average, at higher levels of credit going to asset markets, there is a negative, inverse relation between international financial flows and fixed capital formation. And therefore you have lower growth.”

Supporting this credit addiction has very obvious symptoms. “It’s not a coincidence that we have excessive speculation in food prices right now,” he says. “All that money is still around.”

The solution, according to Bezemer, is pretty simple. We must greatly shrink the financial sector, while preserving the essential functions of credit allocation to the real economy. As Bezemer writes in his recent article for Eurointelligence, “The threat to growth today is not a shrinking of the financial sector, but it enormous size.”

Traditional approaches to this problem – austerity and quantitative easing (QE) – won’t work for precisely this reason, he suggests. Austerity starves the real sector while QE-like measures flood asset markets with credit. “We are doing the exact opposite of what we are supposed to do,” Bezemer says. “We need to get more credit to the real sector and less to the financial sector.”

“The mantra is that if we let banks go bankrupt, that will ruin the economy,” he adds. Yet, “this is a nifty inversion of the truth: it is precisely the support for banks’ balance sheets that will prolong our economic woes. But to see this, you need to think about balance sheets – which macroeconomics almost forbids one to do.” (http://ineteconomics.org/blog/inet/inet-spotlight-credit-what-credit-does-finance-and-economic-growth-uncoupled)


Discussion

Dirk Bezemer:

'the neglect of credit and debt in economic theory continues to produce muddled policy thinking. Take the tendency to protect banks lock, stock and barrel, at huge costs. The mantra is that if we let banks go bankrupt, that will ruin the economy. This is a nifty inversion of the truth: it is precisely the support for banks’ balance sheets that will prolong our economic woes. But to see this, you need to think about balance sheets – which macroeconomics almost forbids one to do.

Nothing more intricate is involved than the accounting equality that the financial sector’s assets are the real sector’s liabilities. But here comes the important bit: most of that debt growth has NOT been due to lending to the real sector – to nonfinancial firms, supporting growth in wages and profit. Almost all of it was due to mortgage lending and to credit to the nonbank financial sector credit, to inflate stocks and property prices and to create and trade options, futures, and other derivative instruments. These credit flows, and the activities they fuelled - share buybacks, leveraged buyouts, securitization - create no wage or profits for the many, but capital gains for the few, and a huge net debt burden on the economy.

Property and asset prices may be falling, but the debts that jacked them up are not. The threat to growth today is not a shrinking of the financial sector, but it enormous size. The accumulated claims by the nonbank financial sector cause a daily drain of purchasing power out of the economy in debt service. This is money that could be effective demand for goods and services, and stimulate economic growth. Nowadays, finance is stifling, not stimulating growth.

So what of the ‘save the banks’ policy? Why don’t we shed some (or all) of the triple increase in the size of the financial sector over the last decades? Of course we must jealously safeguard the payment system and retail banking: their collapse would spell disaster to the economy. But we must also save the economy by shrinking the debt, and inevitably that will mean shrinking the creditor. This is balance sheet logic. If we continue supporting finance in toto, we keep an artificially large waterhead on the economy alive. We continue the drain on the economy that could otherwise be growing. The economy will be pushed in many W-shaped recessions, and it would be a largely man-made disaster.

Instead, if financial firms living off capital gains go bust, this will not be the end of the world. It will improve market functioning and price discovery, and bring back asset prices to more normal levels. Balance sheet logic also indicates that there will be fallout among firms, households and pension funds. To the extent that this has real-sector repercussion via falling demand and incomes, there should be provisions to compensate. A good chunk of that can be financed by cuts in today’s blanket support for the financial sector.

There is a lot of thinking to do. So let’s start – but not on the faulty foundations of models without money." (http://www.eurointelligence.com/eurointelligence-news/home/singleview/article/finance-and-economic-growth-delinked.html)