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Are banks useful?

November 30, 2010

A worthwhile but rather general article by John Cassidy in the New Yorker attacks the banking industry for being mostly socially useless.

Cassidy quotes Paul Woolley of the London School of Economics: “And once you recognize that markets are inefficient a lot of things change.”

While it’s hardly a revolutionary idea that markets are inefficient – it’s at least as old as Keynes – it’s worth remembering that banks, left to their own devices, can often do the opposite of what they are supposed to in mainstream economic theory, which is to allocate capital efficiently.

Rather than seeking the most productive outlet for the money that depositors and investors entrust to them, they may follow trends and surf bubbles. These activities shift capital into projects that have little or no long-term value, such as speculative real-estate developments in the swamps of Florida. Rather than acting in their customers’ best interests, financial institutions may peddle opaque investment products, like collateralized debt obligations. Privy to superior information, banks can charge hefty fees and drive up their own profits at the expense of clients who are induced to take on risks they don’t fully understand…

Banks direct capital into areas that are currently hot, making these areas hotter and encouraging others to join in. Markets trend away from their theoretical equilibrium in a collective misallocation of resources which is privately rational but collectively destructive. This is a kind of reflexive, herd behaviour identified by Keynes and which George Soros discusses in his book The Alchemy of Finance.

It’s exactly the opposite of what should happen, according to mainstream theory. Banks should be looking for areas that are potentially viable in the long-term, and which are undervalued – ie. precisely not hot.

But in reality, without regulation, they pursue ever more ridiculous investment ideas in a form of herd behaviour that is inimical to the social good.

The article is a useful reminder of the shortcomings of mainstream economic theory, and the role it played in the crisis. There’s been a lot of focus on the iniquitious behaviour of banks, but less discussion of the ideological role played by neoclassical economics, which said that banks shouldn’t be regulated too heavily, justifying inaction by policymakers.

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