Thursday, December 24, 2009

Why we are heading for the next economic crisis

With a total lack of economic reforms it seems clear that we are going towards the next bubble. The next crisis may make us look back to the present as a picknick.

For reason of its central position in the economy banks have government protection. This is supposed to result in a steady supply of credit to the business sector and private people. This protection and the access to cheap money from the central bank also constitute a hidden subsidy from the government for the banking sector. For this reason this protection has traditionally been reserved for commercial banks while business banks lack this protection.

Many people think that the Glass-Steagall act that regulated this separation was primarily for the protection of the commercial banks of the greater risks of the business banks. I don't agree. Glass-Steagall was introduced at about the same time that the US government introduced guarantees for the commercial banks. Its goal was to make sure the business banks didn't enjoy the same protection. This not only safed the government money. It also prevented ensuing distortions. Risk is a less important factor as it can be huge at commercial banks too: in periods of falling house prices commercial banks tend to suffer heavily.

Of course a separation between business banks and commercial banks has a price. A company need to keep contacts with two banks to get full service and both banks need to do extensive investigations to determine that it is safe to put money into a company. For this reason there is always the pressure from commercial banks to get more leeway to provide business services to companies. From ths 1970s this pressure succeeded and finally in 1999 Glass-Steagall was repealed.

This resulted in an extended financial sector that was de facto subsidized by the government. Of course this subsidy was hidden in guarantees and Central Bank loans but that didn't make it less real. Being subsidized this channel started to attract more and more money - at the expense of other channels. It was one of the factors that contributed to an increasingly endebted business sector.

In reaction to the credit crisis the banking sector was expanding and companies like Goldman Sachs got a status as bank. This certainly helped stabilize the crisis. But for the long term it was exactly the wrong development. Instead of expanding the guaranteed sector it should have been shrinked by forbidding banks to engage in activities outside their core or at least by making such activities unattractive by demanding large reserves. In addition banks should also be equired to have large reserves against any loans they make towards other financial institutions.

Such restrictions would actually help the recovery. Now much of the easy money disappears in all kind of speculation and such restrictions would make that less attractive.

The consequence of the present policies is that the easy money is stimulating bubbles while it contributes not much to permanent recovery. Sooner or later the new bubbles will burst. That time easy money will no longer be an option - many governments are too endebted - and we may face a real crisis.

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