Admati and Hellwig: global finance is not an Olympic competition

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Anat Admati of Stanford Graduate School of Business

Bankers’ New Clothes: co-author Anat Admati, of Stanford Graduate School of Business

(Updated with Krugman comments.) Two years ago Anat Admati and Martin Hellwig published a popular book about banking, The Bankers’ New Clothes, which Martin Wolf in the FT described as “the most important book to emerge from the [Global Financial] Crisis.”

The book pulls off the trick of explaining a lot of technical points about banking in highly accessible detail, and perhaps its most valuable contribution is to have explained so clearly why it is foolish to run banks with only small amounts of loss-absorbing equity. Partly because of the way bank equity is so misleadingly portrayed in the media and elsewhere – as a cost to a bank, and by mindless extrapolation to an economy as a whole – bankers have been able to get away with blunting urgent reforms.

This is familiar terrain for us at Fools’ Gold, and the two authors are explicit about the “competitiveness” angle. (See their discussion of this on p193-1999 of the 2013 Princeton edition of Bankers’ New Clothes.)

The section starts with the very Foolsgoldish observation that bankers will lobby for changes that will (supposedly) make banks more competitive, then rely on the fact that everyone assumes that this will automatically make the economy more ‘competitive’ — whatever that c-word means in a whole-country context (people rarely stop to ask.)

Martin Hellwig

Co-author Martin Hellwig, Director of the Max Planck Institute for Collective Goods

So they unpack this. For starters:

“Representatives of banks and other industries often complain that government regulation unfairly harms their ability to compete with firms in other countries. . . For example, Jamie Dimon, CEO of JPMorgan Chase, Called Basel III [global banking reforms] ‘anti-American.’ According to him, Basel III is biased in favour of European institutions and might lead to Asian banks’ taking some of the U.S. market share.”

That is the kind of assertion which, you can be sure, will send endless politicians and pundits into a tizzy, whether true or not. Accusations fly back and forth in Washington, across the Atlantic, and beyond. Admati and Hellwig continue:

“In this blame game, everyone is calling for level playing fields, and everyone is blaming others for giving special privileges to their own banks.”

This is the classic recipe for a race to the bottom, where everyone is seemingly in a prisoner’s dilemma and has no choice but to join the race, at least from a perspective of national self-interest. The standard medicine to address this kind of situation, of course, is international co-ordination and co-operation.

Is this what Admati and Hellwig recommend? Not exactly, no. They have nothing against international co-operation – but as they note, it’s hard.

“International coordination of banking regulation has tended to reduce regulation to the lowest common denominator.”

Indeed. So is there another way?

Well yes, there is. It involves skewering myths – something that Fools’ Gold has been set up to do, and in much the same way that Admati and Hellwig are about to here, drawing on the work of (among others) David Ricardo.

An economy, they explain, is a system of production, exchange and consumption, where different groups of people specialise in different things.

“Specialising and doing something well necessarily means not being as good at other things, and nobody is the worse for it.
. . .
Politicians sometimes talk about countries’ being in competition with each other. This is a flawed argument . . . If financial institutions in the United Kingdom or Switzerland have leading positions in global financial markets, their successes are directly related to the inability of their countries’ firms to compete in other activities.
. . .
Banks in a country are not just competing with banks in other countries. They are also competing with industries in their own country. Most importantly, they are competing for people, particularly those with scarce talents, whom firms in other industries would also like to hire.
. . .
If the other industries cannot afford to pay high enough salaries, they do less well in competing for people. Consequently, they may not do as well in selling their products or services, either locally or globally.”

Martin Wolf and Paul Krugman, among others, have made versions of this argument. As Krugman put it in his essay Pop Internationalism, looking at a broader context beyond banking:

“The main competition going on is of U.S. industries against each other, over which sector is going to get the scarce resources of capital, skills and, yes, labor. Government support of an industry may help that industry compete against foreigners, but it also draws resources away from domestic industries.”

This is clearly related to arguments made elsewhere on this website specifically about tax: a corporate tax cut redistributes wealth to one sector (corporations) but at a cost to other sectors (ordinary taxpayers, small businesses, etc.) who suffer damage from reduced government services, higher deficits, or higher tax payments.

Admati and Hellwig summarise:

“For a country as a whole — or, more precisely, for the people in the country — the important question is not whether the country’s banks or car producers are successful in the global economy. The important question is whether resources, most importantly people, find their most productive uses.”

They then penetrate into some of the subtleties. How does one find out if people are serving their most productive uses? Well, in the absence of market distortions, then the most genuinely productive firms ought to attract the best people.

“Unless the market system is distorted, a firm’s success in its markets is a sign that the firm’s use of the talent and other resources it acquires is good for the overall economy.” A footnote adds: “this is the essence of the theory of international trade with competitive markets, one of the classics of economics, first developed by David Ricardo.”

But that’s not the end of the story. Markets are distorted, of course: not least “when firms do not bear the full costs of their activities and rely on others to pay some of the costs.” For example, when too-big-to-fail banks rely on hidden taxpayer subsidies. It’s rather like pollution in this respect.

“Naturally, firms suffer when they lose subsidies and can no longer impose some of their costs on others. In their lobbying, of course, they do not mention this. instead, they appeal to economic nationalism and warn of a loss of competitiveness in the global economy — as if they were their country’s entries in the global Olympics.
. . .
In sports, competitors often complain about rules and about umpires’ being biased in favour of others. The home media join in, knowing that their audience is rooting for the home team. The global economy, however, is not a sporting event.”

These arguments are similar to ones being made in the Finance Curse analysis – of which more, soon. And we will be publishing more articles about David Ricardo soon.



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