Tuesday, 19 January 2010

Guest post by Rory O'Farrell: Gombeens and Gosplan

Rory O'Farrell: Much as the economy of the Soviet Union was criticized for having a bloated economic planning bureaucracy (Gosplan), the Irish financial sector should be criticized for its bloated size. In 2008 the sector absorbed over 10% of our economy. This is a huge price to pay for the ‘efficient allocation of capital’. On Wednesday, 13th January, the European Trade Union Institute (ETUI) organised a conference 'After the crisis - towards a sustainable growth model'. Though it had a European focus, many of the topics discussed are relevant to Ireland in creating an ‘exit-strategy’ for the financial sector from the recession. While Brian Lenihan has been acting as the financial sector’s fireman there has been a focus on short term (bank guarantee) and medium term measures (NAMA). Concrete long term proposals for changes to regulation have been largely absent from the public debate. What we want from the financial sector should be examined.

At the conference Hélène Schuberth (Austrian National Bank) said what is missing from the European discussion on financial market regulation is the question: what function should the financial system perform? Hélène Schuberth noted that the reform initiative has been minor, and does not emphasize that the financial sector should service the economy. She noted how the financial sector gains rents at the cost of the rest of the economy. While the financial system is supposedly a shock absorber this has been shown not to be true. Sony Kapoor (Re-Define) noted that this is not the first banking crisis. The financial system should be a means to a purpose. He stated that the financial sector is not competitive, and that in the US 30-40% of all corporate profits went to the financial sector, and this is taking rents from the real economy. He asked, if the human resource department of a firm was responsible for consuming 40% of the resources, would this be seen as a well functioning department? Competition within the financial sector is required. However the financial regulators favor large complex banks over smaller simpler banks. Sony Kapoor agreed that the massive state subsidies have contributed to the bloated size of the financial sector

Possible changes to banking regulation included a shift to Asset Based Reserve Requirements, as suggested by Tom Palley. Here, the reserve requirements of banks would be based on the amount of loans they have given rather than the amount of deposits they hold. Yanis Kitromiledes suggested a move back to public service banking or narrow banking. Karel Lanoo (CEPS) stated that so far the debate on a move to narrow banking has been merely academic, and that mutual banking and co-operative banks should be reconsidered. Competition policy should be used so that banks do not become too big to fail, and banking should be viewed as a utility, similar to gas and electricity.

In Ireland the financial sector gains a massive state subsidy in terms of free insurance as Irish banks are too big to fail. This takes the form of deposit guarantees, NAMA, and the implicit free insurance given by the government on banks risky activities. While the economy does benefit from employment in the International Financial Services Centre, these jobs are effectively subsided by the governments of these branches parent firms. Countries like Germany have no interest in subsidising such jobs in Ireland and it is only a matter of time before EU regulations will make such jobs untenable. While subsidies to other sectors such as agriculture have social benefits for rural Ireland, the financial sector subsidy results in large inequalities, and diverts talented workers from careers in areas such as engineering or computer science.

At the moment the Irish government is proposing contradictory policies of ‘stopping reckless lending’ and ‘getting lending going again’. No long-term plan has been put forward for the financial sector. The government should no longer promote the financial sector as an end in itself. In the Irish case it is interesting that there are no moves to increase competition in the financial sector. If anything the number of banks is being reduced. Competition can be increased by promoting mutually owned ‘boring banks’ that have been successful in the past. Also, with the notable exception of Irish Nationwide, the mutual financial sector (namely EBS and the credit unions) have not suffered as much as the rest of the financial sector. The massive state subsidy received by the Irish financial sector could be put to better use in the real, productive, economy. The financial sector should be made to pay its own way.

Luckily our first official language has given us the word gaimbín, meaning monetary interest, from which comes the word gombeen, an apt description for the leadership of the Irish financial sector.
Rory O'Farrell is an economist and researcher at the European Trade Union Institute in Brussels


Aidan R said...

This is a timely contribution. Do you have a link to any of the conference papers?

Anonymous said...

I should have a link available sometime this week. I will post it here as soon as it is available.

-Rory O'Farrell

Thedudeinthehat said...

a distinction needs to be made between the different types and roles of financial institutions. Retail banking, credit unions and investment vehicles (funds or banks). To say that the banking sector "absorbed 10% of the economy in 2008" could easily be flipped to say that the financial sector contributed 10% to the economy. Or tourism "absorbed" 20% of the economy.

Leads to an important question. Does Ireland want to be part of the worldwide "smart" economy? If so, having a well run, efficient financial industry can be a firm base for building R&D and Green industries here. If we show we haven't the stomach for modern finance- then why would we have the stomach for other strands of the smart economy.

So by all means we need a reformed Irish banking system. That will require more foreign banks not less, in terms of raising standards.

Rory O'Farrell said...

@ Thedudeinthehat

The economy should serve the public in providing the goods and services that people need. These include things like food, water, shelter, entertainment, heating, healthcare and so on.

Financial services don't provide any direct utility to the public. Nobody gets a 'buzz' from queueing in a bank to do foreign exchange or apply for a mortgage. Financial services are just an intermediary input that coordinates activities in a market economy that leads to consumer goods and services. To say finance contributed 10% to the economy is on par with saying the recent flooding contributed millions to the economy due to the cost of the clean up.

As for stomaching modern finance, I would say we should not stomach modern finance or the billions in bonuses. The point of the blog piece is that we should change modern finance. Is it part of a 'smart' economy to subsidise an unproductive sector to the tune of billions of euro?

tgmac said...

Hasn't the idea that Banking is somehow the arbiter, indeed progenitor, of a "smart" economy taken a bit of a knock? Just how intelligent are bankers and their industry when they precipitated a financial meltdown requiring trillions in currency units to remedy? I'll paraphrase a quote I think hits the nail on the head: why did bankers think up new ways of losing money when the old ways worked just fine.

To my outlook, we not only have to seperate banks by their functions but fundamentally review the role of money and money as an investment tool in any economy. Right now investment monies are nothing more than a rent on future production and productivity which in turn necessitates inflation. We won't mention how the new bogeyman, International Finance, is used quell the lumpen conformists into accepting future decreases in income while implicitly gauranteeing returns for monetary rentiers.

Anyhow. The point to start with in banking reform and regulation is simplicity. The modern form of finance hates simplicity.

Frank McGinn said...

I think the article reflects the extreme level of myopia some so called "economist's" suffer from. EBS has basically had to hive off its entire development book to NAMA while the stories surrounding the impendening insolvency of credit unions grows day by day. Please check your facts in future.

While i agree that NAMA in its proposed form lacks a formal strategy at present it is a necessary evil. The finanacial sector will undoubtedly continue to contract in line with market conditions this article completely ignores the function of banks in providing capital to promote entrepreneurship and innovation a significant requirement of any economy which hopes to grow in any meaningful fashion.

The real disgrace is the governments support for Anglo Irish Bank.

Rory O'Farrell said...

@ Frank McGinn

So far none of the credit unions have received capital injections from the government. Though many have problems, they have far outperformed Anglo, AIB, Bank of Ireland, etc. This is quite obvious. With regard to EBS, for an institution devoted almost entirely to property lending it has done ok when benchmarked against BOI, Anglo, AIB etc. EBS has not received a capital injection.

Rather than ignoring the role of banks in allocating capital, this is explicitly stated this in the opening paragraph.

An Saoi said...

The state of the Credit Union movement varies considerably. For example, the Revenue Credit Union is very strong, see the Sunday Business Post on the 6th Dec last.

Also have a look at the Basque Savings Bank BBK, www.bbk.es, which has a Tier 1 ratio of 14.3% at 30th June 2009, heavily directly invests in business as well as spending most of its surplus on Social Welfare, Basque language, Education & Sport (Athletic Club in particular). It also has an A1 rating from Moody's.

Charlie McCreevey sold the TSB, ICC etc. to cut taxes on speculation & speculators.At the same time £600M was stolen from the Social Insurance Fund to pay for othet tax cutting excesses. "Light touch" regulation and no alternatives were given to us with a skewed tax system and we loved it until the music stopped

Anonymous said...

I couldn't agree more with Frank's contribution. I would question the author's level of real world experience given the frail attempt at a response coupled with their overt far left wing sentiment- while we can all agree the bubble created in the property market in Ireland specifically was due irresponsible lending, poor regulation and government support through the tax system. However the financial system has shown itself to be a value adding function of all developed economies if looking at this from an empirical perspective.

Improved regulation, increased accountability for financial exec's and full implementation of basel 11 will move the financial system back to a stable footing.

This rather than a complete paradigm shift and a move back to failed social experiments is the real way forward.

Rory O'Farrell said...

I am curious as to which 'failed social experiments' you are referring to. Is it increasing competition in the financial sector? Is it recognising that (with the notable exception of Irish Nationwide) mutuals have performed better than stock held banks? Or perhaps expecting the financial sector to pay its own way, rather than continually rely on massive state assistance, is too much of a paradigm shift?

'Real world experience' has shown that the financial system has failed, not just in Ireland, but around the world. While bankers wish for a return to business as usual we should not fail to learn from the mistakes that have been made. Many of the regulations put in place after the Great Depression were repealed (such as the Glass-Steagall act in the US). We had learned from our mistakes then, but then decided to forget them.

While the financial intermediaries play an important role in a market economy should they really aborb 10% of our GDP, about twice what we spend on education? A debate must held as to what we expect from the financial sector. The British FSA found that much of City activity was socially useless. This is paid for out of state subsidies and economic rents gained from the productive economy. Only when it is decided what we want from the financial sector can regulations be decided upon to achieve these ends.

Rory O'Farrell said...

@ Aidan R

Below is a link with some papers from the conference. The contributions at the conference, as well as contributions of 25 other economists will be compiled as a book in March.

Anonymous said...

Rory - You make a lot of valid points but the reason why this point of view will not gain public support is because the tone is too extreme. I think that you could raise the same points but deliver the message in a less polarised way. In essence, you need to communicate in a more obamaesque fashion if you want to influence the centre-ground.

The centre-ground is where opinion polls are won and lost. This article preaches to a left-wing gallery – that’s like a mouse telling other mice that eating garbage is fun. Of course, the other mice will agree because they already do that. You need to speak to squirrels, who don’t eat garbage but nuts and even to the (supposed) enemy - fat cats, who sometimes eat mice.

I say supposed because ultimately, even fat cats have nothing against mice but they need to eat in order to survive. So, you need to gradually replace the diet of the fat cats with another sustainable staple.

Rory O'Farrell said...

@ Anonymous
Thank you for your comments.

With regard to speaking in an obamaesque fashion, Obama has today made an important announcement on the matter of financial regulation (one I largely agree with).