Good article:


Lending must support the real economy
By Dirk Bezemer
Published: November 4 2009 22:21 Last updated: November 4 2009 22:21
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Economists have been mulling over the shape financial reforms should take. Robert Shiller wrote on these pages in defence of “financial democracy”, arguing that a wide range of financial products allows everyone to access liquidity and insure against risk. A week earlier in The New York Times, Paul Krugman pinpointed the way bankers are paid as the focal point of reforms. The problem with these discussions is that they introduce red herrings. Dear top economists, the problem is debt. Any solution that sidesteps this is a non-starter.
As I wrote in the FT last month, the crisis and recession were not all that difficult to predict once you started to look at the flow of funds – at credit and debt – and at the financial sector as separate from the real economy. Following the same logic, it should now be fairly uncontroversial what our long-term aim in financial reform is. It is to redirect lending away from bloating the financial sector and towards supporting the real economy, rather than loading it down with debt.
In the 1980-2007 era of cheap credit and deregulation, banks had every incentive to move from real-economy projects, yielding a profit, towards lending against rising asset prices, yielding a capital gain. In the 1990s and 2000s, loan volumes rose to unprecedented levels, supporting global assets booms in property, derivatives and the carry trade. The share of lending by US banks to the US financial sector – instead of to the real economy – went from 60 per cent of the outstanding loan stock in 1980 (up from 50 per cent in the 1950s) to more than 80 per cent in 2007.
But the price was growing indebtedness. Profit and capital gains may look much the same to the individual bank – a stream of revenues – but they have different macroeconomic consequences. Lending to the real sector is self-amortising: it creates a debt, but also the value-added to repay principal and interest. Such loans enlarge the economy in proportion to the debts created and are financially sustainable. By contrast, loans to create or buy financial assets and instruments are not, by themselves, self-amortizing. In a credit boom, successive owners may sell the asset at a profit, but their buyers will have to shoulder proportionally more debt in order to acquire the asset, balanced (for the time being) by the asset’s value. Asset trading may be individually profitable; but it is a zero sum game, sustainable only if the real economy furnishes enough money to support the rising debt burden. Beyond a point, the lure of capital gains diverts funds from real-sector investment, and households’ rising debt-service cuts demand for real-sector output. In both ways, excessive growth of financial asset markets is self-defeating.
This logic may be traced in the statistics (all figures from the Bureau of Economic Analysis). The US stock of loans to the real sector (as a proportion of gross domestic product) has remained roughly constant since the 1980s. In contrast, loans by US banks to other US banks have grown from 2.5 times GDP in 1980 to a factor of 5.8 in 2007 – all attributable to growth in loans to the financial sector. The US financial sector was over three times larger in 2007 compared with 1980.
Credit flowing into asset markets created a debt overhead while the real economy’s capacity to pay the debt declined. Demand for the real sector’s output also suffered as US households by 2007 were paying over a fifth of their after-tax, disposable income to the financial sector in debt servicing and financial fees. The US had become an economy trying to drive with the brakes on. The real-sector recession, after the 2007 financial crisis, occurred because the real economy had become overly dependent on continued lending against rising asset values. Those are the trends that financial reforms must curb.
A promising policy avenue is tax reform. During the asset boom of the last decades, taxes on capital gains in the US, UK and most other OECD economies have fallen sharply relative to value added tax and labour taxes. When the banks have recovered, they need a regulatory and policy climate that discourages the pursuit of capital gains for their own sake, and which favours growth of the real economy. Finance should be the economy’s handmaiden, not the other way round.
In this perspective, it is beside the point to focus on exorbitant bonuses or financial democracy. In fact, Mr Shiller’s proposal risks boosting yet again the volume of financial instruments and the debts they generate. Didn’t we once welcome credit derivatives for extending mortgage finance to the financially unreached? We forgot that such instruments need to have a basis in the real economy. Likewise, enthusiasm about the rally in asset markets (even as the real economy continued to contract) shows how widespread the confusion between the financial sector and the real economy is. The priority now is not to revitalise asset markets, but to transform a bloated and dysfunctional financial sector towards one that supports the real economy in a sustainable and cost-efficient way.
The writer is a fellow at the Research School of the Economics and Business Department, University of Groningen
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