Where does all the money go?

Banking looks set for further growth even as it plays a less positive role in the economy

Despite all of their bad press, banks have an important function in the economy of getting surplus cash to where it is needed. But the role of banks seems to have changed from moving money around to instead focus on making money grow. This shift, while good for the banks themselves, has come with obvious costs to the point where we should look again at the role that banks play. Otherwise, an ever-bigger banking sector threatens to get out of hand and drag the economy down with it.

The reasoning behind why we have banks assumes that there is only so much money to go around. For one person to have more, someone else had to be willing to forgo spending what they had. Banks thus came into being as an intermediary, accepting deposits from savers and lending this money out to others. In this way, banks ensured that money moved within the economy to where it was needed while also making sure that the money was used wisely.

To make a business out of this, banks charged borrowers a higher interest rate that paid out to savers. Rules related to banking had meant that, to lend money out, banks first needed to secure funds from deposits. Changes in the interest rates at banks helped to balance things out if there were a shortage or an abundance of funds. Higher interest rates would, for example, entice in more savings, while limiting loans to the keener borrowers.

This traditional model of banking now seems to take on less importance with more money coming in than was needed in the economy. Perhaps the trigger for this was the oil shocks of the 1970s which generated piles of cash for the oil producing countries of the Middle East. With no capacity for the local economies to adsorb the money, funds flowed into the banking industry in the West. Whether by sheer chance or not, this seems coincides with the start of a push for increased deregulation.

Bankers were keen to free themselves from regulation as Western economies has reached a point of needing less funding. Industries that relying on lending, such as manufacturing, reached a plateau in the 1970s and fell into decline from thereon in. The service sector, which took over as the main source of growth and jobs, did not need the same level of investment. The rise of computerization further exacerbated this trend toward businesses needing fewer assets.

The extra cash at their disposal, with less opportunities to invest, may have pushed bankers into being more creative in the ways in which they put money to work. Investment banking took off to become the face of finance, leaving behind retail banks that do the donkey work of taking deposits and making loans. Money increasingly came easy to come by due to inflows as the global economy (powered by the rise of China) generated more money than could be put to use for investing in the economy.

This “glut of global savings” was one of the reasons given for the global financial crisis. The abundance of cash found its way into retail banks that were freed up to lend to almost anyone that wanted to buy a house. This generosity was based on demand for, what were at the time seen as, safe assets for investors looking for somewhere to park their cash. Despite having being reckless in some of their practices, few within finance were punished. The banks were also able to escape from having too many new rules imposed upon them as had been the case after the Great Depression.

With their momentum only slightly dented by the financial crisis, the finance sector continues to add to the funds it looks after. The size of this cash pile looks set to grow further as there is no foreseeable limit to the desire for those with money to want more. Demand for most other goods or services, anything from Harley Davidsons to haircuts, will reach a point whereby everyone has as much as they can afford. No such saturation point exists for finance. On top of this, bankers seem to be able to find a supply of new ways of putting money to work even if returns have been falling. Investors own increasing amounts of everything from farms to student accommodation as well as an increasing array of financial products.

Along with the extra profits this brings in for banks, the increase in scale relative to the rest of the economy bring greater influence. Finance takes on greater importance to the high levels of pay for its employees along with the money for taxes (and lobbying). This leverage puts banks at a strong position to get what they want from government as well as influencing the overall  economy. As shown by the lead-up to the global finance crisis, the economy itself is often shaped by the needs of finance, due to the sheer size of the funds involved, rather than the other way around.

In this way, it seems as if banks are working toward more narrow goals where some gain more than others, rather than its previous role where the economy as a whole would benefit. Further growth in the finance sector, as looks likely for reasons already described, may thus have a negative overall effect on the economy. The main way of addressing this imbalance would be for government to impose stricter rules relating to finance. Yet, even in the aftermath of the global financial crisis, the willingness or ability of governments to reign in the finance sector seems limited. It remains to see if too much of a good thing will be too good to turn down.