THE WAR ON FINANCE / THE ECONOMIST BUTTONWOOD COLUMN ( A MUST READ )

Buttonwood

The war on finance

Attacking your creditors is an intriguing strategy

Feb 4th 2012
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THE man who the polls suggest will be the next French president, François Hollande, claims that finance is his “real adversary” in the coming election. Britain has just stripped the former chief executive of the Royal Bank of Scotland of his knighthood. Even Newt Gingrich is attacking the “vulture capitalists” in the private-equity industry. Perhaps the West is set for a “war on finance” along the lines of the “war on terror”, with similar uncertainty about how to define victory.



Politicians seem to have three main beefs with the financial sector. The first is that bankers earn too much. The second is that banks take reckless risks and then need rescuing by governments. And the third complaint is that investors in financial markets have undue influence over an economy through their ability to affect bond yields and equity prices.

The first two problems are really related. People do not worry too much about footballers’ high pay.


The problem with bankers is the extent to which they are subsidised by explicit and implicit taxpayer support. (Of course, you might worry about income inequality in general but that is not specific to banks and can be tackled by redistributive taxation.) It is hard to disagree with Paul Tucker of the Bank of England, who has written that: “Those who most espouse the disciplines of capitalism—bankers and financiers—should live by them.”



The problem of banks being “too big to fail” is being addressed, albeit slowly, by the higher capital ratios being imposed by regulators. Higher capital ratios should mean lower returns on equity; over time, this should lead to less rapid pay growth for bankers. Andrew Haldane, a colleague of Mr Tucker’s, has found that the pay of bank bosses correlated well with returns on equity, but not with returns on assets—in other words, managers prospered by gearing up bank balance-sheets. That is now harder to pull off.



The finance sector has also, in some people’s eyes, had a pernicious effect on politics. Like any other interest group, the industry lobbied on its own behalf and achieved some notable regulatory gains in the 1980s and 1990s, such as the abolition in America of the old Glass-Steagall divide between investment and commercial banking. Its doyens have gained powerful positions in government, although this may be down to the modern assumption that if people are rich they must be smart.



But this influence did not stop Congress passing the Dodd-Frank act, has yet to stop Britain’s planned divide between commercial and investment banking, and has not held up a host of new EU regulations. This suggests that democracy can overcome vested financial interest. Indeed, there are plenty of votes in bashing bankers, as Mr Hollande is only too aware.



The third political beef is a very longstanding complaint: recall, for example, Harold Wilson, a former British prime minister, and his rants about the “gnomes of Zurich” who were speculating against the pound. The German chancellor, Angela Merkel, called for “the primacy of politics over the markets” in 2010.



This seems an odd battle to fight. All euro-zone governments need to borrow money from the markets. The political message seems to be: “We hate private-sector creditors. We will penalise you by defaulting on your debts but not on debts to official creditors. We will endeavour to stop you protecting yourselves against our actions by making it difficult to collect on insurance in the credit-default-swaps market. Now, can we please borrow some money at a very cheap rate?”



The underlying complaint is that speculators drive up bond yields, making it harder for governments to finance themselves. As a result governments are forced into austerity programmes, against the wishes of their electors.



Yet the same markets are more than willing to lend money to governments in America, Britain and Germany at negative real (ie, after inflation) rates. This may be down to the influence of other buyers—central banks, commercial banks, pension funds—who are not that interested in maximising their return.



That suggests the problem might not be with the markets after all. What happens to countries like Greece which lose access to private-sector finance? They become dependent on the largesse of official creditors—the International Monetary Fund, the European Central Bank, other EU nations—which can be even more stringent in demanding austerity programmes. After a few bouts with the ECB, the 57-year-old Mr Hollande may end up wishing that his planned retirement age of 60 also applied to presidents.