This article by Robert Solow is ostensibly a review of a book by Kevin Phillips. But read it because it is a nice introduction to the role that financial institutions play in allocating capital. (HT: Greg Mankiw)
Solow on financial institutions
Share
Previous post: Money and Politics
Next post: Gagging Google
{ 9 comments }
I don't think anyone needs to be reminded of the importance of our financial institutions in allocating capital. Apparently we do need reminding after 75+ years of the danger of allowing them to self regulate and to write their own laws.
Solow has the nerve to call Phillips a "Chicken Little " when total collapse of the system has so far been diverted by several major people funded government bail-outs. The sky HAS fallen.
What the banking institutions have done to this country is criminal and many many people need to go to jail. But yeah banks are important sources for allocating capital.
"write their own laws"
The professors have written many times of the tendency for regulation to be controlled by and implemented for the benefit of the regulated parties.
Solow's account of Gresham's Law implies that gold bullion is inherently unstable as a record of credit. Basically, Gresham says that any intrinsically less valuable token that can act as money will be preferred as money, so if paper is the least valuable token imaginable, and if paper tokens can act as money, then paper money is simply inevitable. Presumably, that's why I find so little precious metal used as money.
Or maybe it's that I must collect these tokens to pay taxes and other debts. … Yeah, that's it really.
Solow's account of Gresham's Law implies that gold bullion is inherently unstable as a record of credit.
I don't think it implies anything about gold being inherently anything, except perhaps inherently more valuable than paper. Federal Reserve Notes could theoretically be driven out of circulation the same way, if the state decreed that we accept, on par with paper money, something intrinsically less valuable than paper money.
That gold is inherently more valuable than paper is why gold is unstable as currency.
Like I said, if paper is the least valuable token, then paper money is inevitable. Electronic money arguably is cheaper now, and it is driving paper money out. The judgment implicit in "bad money" is simply misplaced.
A freer market in monetary tokens wouldn't give us gold coins as money these days, and it wouldn't give us 100% reserve banking either. It would give us Visa and MasterCard, and we'd create money every time we used them.
Wait. The market has already given us Visa and MasterCard, and they aren't gold tokens, and we do create money every time we use them.
I have not read Kevin Phillips´ book but from what I read here I will probably agree with Solow that it is not a good book. That said I also find Solow’s comments very much lacking. Allow me two brief comments.
1. Solow correctly says “The first function of the financial system is to "intermediate" in this process: to collect the savings in many forms–bank accounts, mutual funds, insurance-company reserves, direct purchases of stocks–and to allocate it to the firms and other entities that seem to have the most profitable ways to use it to build real capital”
But Solow does not see, much less points out, that over the last three decades there has been no reference whatsoever in the regulations as to how to ascertain this function is fulfilled. The financial regulators have only one thing in their mind, that of avoiding defaults, and they do not care a jota about the purpose of banks.
2. Solow correctly says “the second function of the financial sector is to arrange transactions that shift the bearing of commercial risks from those who are prepared to pay a fee to get rid of them to those who are less averse to risk and are willing to take them on in exchange for a fee. This is a complicated business, more or less by definition… Even the basic underlying risks are complicated, and reasonable people–let alone the unreasonable ones–may evaluate them very differently.
But Solow does not say a word about the craziness present when despite all those difficulties the financial regulators delegated into a few credit rating agencies the role of guiding the global traffic of the financial flows with their AAA signs… and setting us thereby up for the mother of systemic risks… such as those leading us over that precipice we now know as the badly issued subprime mortgages.
Solow might be a much worthy Nobel Prize winner, but given his and many of his colleagues silence on these vital issues, returning the Nobel Prize might be the most honorable thing for him to do.
That gold is inherently more valuable than paper is why gold is unstable as currency.
Anything more valuable than what the state decrees to be money becomes unstable as currency, once the state has the power to define money.
For a minute there I thought you might have been trying to say something useful or interesting, instead of just restating Gresham's Law, but blaming it on the gold.
Solow is off the mark here, because "collecting savings" has little to do with extending credit, so this function is not "first". "Savings" needn't precede the extension of credit at all, unless we're saying that a merchant accepting payment for a widget a month after surrendering the widget "saves" something for a month. We can say that, and the expression might be meaningful, but "saving" typically denotes something else.
Banks collect deposits, ideally, as a regulatory mechanism. Withdrawals signal that a bank has extended credit poorly. That's all. Obviously, this system works only if depositors stand to lose something if they don't withdraw when a bank's credit is questionable, so our banking system in the U.S. is practically useless for this purpose.
This regulatory scheme is only one of many possible schemes. Deposits are not necessary to extend credit at all, and banking systems with no reserve requirement exist as a matter of fact. These systems can be sounder than a system with a 10% reserve requirement or a 50% requirement or even a 100% requirement. The credit worthiness of borrowers is the issue, not the volume of deposits relative to the volume of credit extended.
The relationship between collecting deposits and extending monetary credit is regulatory at best and entirely fictitious at worst. In the U.S., it's largely fictitious. It's fictitious because depositors don't stand to lose when banks extend credit poorly.
Solow could be correct here, but free banks alone can't remove all risk from depositors.
If I'm a grocer, I may permit you to walk out of my store with a gallon of milk on Friday with only a promise that you'll pay me on Tuesday. I don't need a bank for this purpose, and neither do you. I then bear all of the risk.
I can instead pay a bank to share some of the risk, but a bank bearing all of the risk is a chimera, particularly if depositors don't also share the risk.
Insurance companies can be mismanaged too. In reality, in a truly free market system, insurance companies sometimes don't pay off on insurance policies. These companies quickly go broke precisely because their policy holders are poorly served.
Furthermore, since I (the grocer) more literally "extend the credit", pretending that some bank bears all of the risk is counterproductive. I see who walks out the door with my milk. I know s/he's walking out with milk and not Twinkies. She's more likely my neighbor than some banker's.
I agree that the silence is deafening.
That's not how Solow describes Gresham's Law. In fact, Gresham's referred specifically to a monetary system with precious metal tokens. It has nothing to do with central banking or paper money. "Bad money" drives out "good money", because free people prefer monetary tokens with no intrinsic value.
I don't know what interests you, but I haven't blamed anything on gold. Gold is not money. Gold can be a monetary token, and gold can be a commodity with a fixed price in a monetary system, but gold is not money even then. In any conceivable gold standard, the volume of money will far exceed the volume of gold, because money accounts for a much broader variety of transactions, not only transactions involving gold.
In fact, under a gold standard, people stop using gold as a monetary token altogether, preferring instead to bank their gold and use paper notes instead. That the price of gold is fixed in these notes does not equate gold with money. It only makes gold the standard of value, i.e. all other prices are defined in terms of the fixed price of gold.