Tuesday, April 14, 2009

Small is Beautiful

Let us move on from the irrelevance that is "smeargate" and write something serious about the economy, for no matter how irritating I might find the duplicitous machinations of the Tory spin machine and it's pretense that the Tories are polishing their halo's, politics should be about issues. So, today I'm going to talk about banks and whether small is beautiful.

Last week, George Osborne spoke to the RSA about the idea of breaking up Lloyds TSB and RBS suggesting that the existence of such large banks allowed them to behave irresponsibly. I have to admit that I have a lot of sympathy with this view, indeed I suggested the idea way back in July last year (although I first got the idea from this book). More recently, Simon Johnson, former IMF Chief Economist suggested the idea saying that any organisation too big to fail is too big to exist.

Splitting up the banks is, in my view, a good idea. A small, failing bank is less likely to get a government bailout and therfore less likely to take gigantic risks, but this alone is not going to save the financial sector and would not have prevented the current crisis. This was a far wider reaching crisis affecting most of the banking sector.

This is one thing that I don't think has been understood about this crisis, the idea that a number of banks would all take excessive risk is a crazy one, and that's because far from believing themselves to be taking risk, they thought they were taking steps to mitigate it. Credit Default Swaps, one of the main financial instruments that caused this crisis are essentially insurance policies against loans, the idea is that the lender pays a small amount to insure the loss should the debtor be unable to pay and the outstanding loan isn't covered by whatever the loan is secured against (e.g. a house).

It's not that the banks took excessive risk, it's that they fooled themselves into thinking that they weren't taking any risks. It's only when US house prices started to fall that the banks suddenly realised the level of their exposure. It's not just that the banks are too large, it is also a matter of regulating to prevent the kind of activity that allowed this risk to be taken and then hidden away.

Finance should ultimately be a means to an end, the unfortunate problem is that it's grown way beyond that. As Felix Salmon says on the US finance sector:

Financial services companies are meant to be intermediaries, middlemen. And any time that the middleman is taking 41% of the total profits in what’s meant to be a highly competitive industry, there’s something very wrong.

What we need is not just smaller banks, we need a smaller financial sector and this is where I think the Tories are in trouble and why I don't believe they can be trusted to put the finance genie back in the bottle. Labour's deference towards the city has always been reluctant. The Tories on the other hand are the party that set finance free, making policy changes that restricted the finance sector would be an admission that they were turning their backs on Thatcherism, something I'm not sure that they would be willing to do.

I do think that there is quite a lot to like about George Osborne's speech, it's clear that for all we might say about him, he does have a good grasp of the issues. The ultimate worry though is whether the Tories will be able to do what's necessary given the political capital they have invested in the status quo.

Crossposted on Common Endeavour

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