6 June 2018

Two reforms to save capitalism


Michael Gove has today given a speech making the case for reforming capitalism. This is a theme some of us have been exploring for a decade, so it’s good to see a heavyweight intellectual Conservative taking up the cause.

We need, however, to be quite precise about what is wrong and how to address it. Otherwise there is a risk “reforming capitalism” ends up meaning “replacing capitalism”. And that would be entirely the wrong direction to go in. The way in which things have gone wrong are very specific and the solutions are therefore very concrete and can be narrowly specified in a way that would allow them to be definitively implemented. We know what’s wrong, and we can put it right if we choose to.

Over the past 45 years, and especially the past 20 years, there have been two fundamental failings of capitalism.

First, we introduced state insurance of bank deposits — introduced in the UK in 1979, under an EU directive — and subsequently of bank bonds (following the Continental Illinois bank failure of 1984). Deposits are loans to banks, for which the lender (the depositor) is paid interest. These deposits are then used to support risk-taking activities by the bank, such as lending to businesses or for mortgages or in investment banking activities. (Some commentators, incidentally, seem to imagine that if deposits were used only to support commercial loans and mortgages, everything would be okay. Nothing could be further from the truth. These are, by their nature, risk-taking activities like fancy investment banking.)

If the state insures bank deposits and bank bonds, banks will do three things. They will seek to grow bigger, taking on more of this insured debt to allow them to support more lending and other profitable activity. They will seek to support a higher proportion of their activity via debt rather than equity (for example, by paying out higher dividends to shareholders). And they will take more risks (since going bust has few consequences and little market discipline, as the state will bail out the debt anyway).

Banks in such a system will grow larger and larger, relative to the state, until eventually they become so big that the state guarantee itself becomes risky (the state might default rather than be able to bail the banks out). This is what happened in many states, such as Iceland, Ireland, Cyprus and Spain post-2008. It is an outcome that the UK only narrowly avoided.

Following excessive lending in the bailout guarantee phase, banks will then become excessively conservative after they are bailed out, lending too little and damaging credit flows in the economy for an extended period (as we say post-2008).

As well as these technical failings, such a system suffers from a huge moral failure: the state keeps the rich rich. Instead of bank depositors or those that lend to banks losing some of their money when the bank goes bust, they are bailed out by the state. So the rich get interest on their bank deposits in the good times, then the poor pay higher taxes to bail them out in the crash.

The other great failure of capitalism, especially in the past 20 years, is closely related. Policymakers have systematically kept interest rates excessively low for long periods specifically in order to prevent imprudent borrowers (especially for housing) from facing the disruptive consequences of their errors.

This is acceptable and normal as macroeconomic management for a year or two. But when policymakers deliberately keep interest rates too low for more than 15 years (as they have done in the UK since the mid-2000s), it is a moral failure. It means that those who, in the early to mid-2000s, correctly judged that it was unwise to take on high debts or that house prices were excessive, never got to see the fruits of their good judgement. The judgement they should have made was not about the economic environment or about their personal financial circumstances. Instead, they should have guessed what policy-makers would do: namely that they would intervene in the economy to prevent those that held assets from losing out.

Again, the system kept the rich rich.

Social mobility does not only require “ladders” — ways up. It also requires “snakes” — ways the wealthy and privileged can fall back down the pecking order. In our society, the state intervenes to abolish the snakes.

We can address this. Some good changes have already been made, especially to banking regulations. But two fundamental ones are still required.

First, we need to have a form of bank deposit that is completely safe — i.e. is not used to support other activities such as mortgages or commercial loans. Such deposits used to exist in the UK until the 1970s. They were in what were called “savings banks”. A savings bank deposit was 100 per cent backed by government bonds or a few other assets such as gold. Of course, such deposits paid little to no interest. They were for saving money, not investing it.

It would be impractical to resurrect the savings banks. But the government could require that any bank licensed to accept retail deposits must have, legally nested and ringfenced within it, a savings (or “storage deposit”) bank. So if you go to a bank and ask to deposit £1,000, the manager would say “Our savings deposits pay 0.1 per cent interest, are 100 per cent guaranteed by the state and totally safe. If, on the other hand, you fancy taking some risk, our ordinary deposits pay 3 per cent, but of course are not insured and you could lose some of your money if the bank’s loans and other profit-making activities go badly.”

If people have turned down safe deposits in order to make risk-taking deposits in banks, pressure to bail out depositors will vanish and justice will be restored to the system.

Second, in setting interest rates we need to establish a principle that, as well as being geared to an inflation target, rates should tend to return to a reference-level or band, set by the Chancellor in an annual letter, unless the Bank of England has a good reason to believe they need to stay outside that band. The bias should be to normalisation of rates, even if that has consequences for those that made errors in the past.

It is not the job of the state to keep the rich rich and lending at interest is ethically justified only by the risk of loss. Unless and until we really remember and internalise those two key moral tenets of capitalism, our system will remain fundamentally unjust and our only good argument against the hard Left will be that, although their criticisms are correct, their solutions will make things even worse. We can and must do better than that.

Andrew Lilico is an economist and political writer.