Just over the horizon

If you follow the world of money as closely as we do, you will not be at all surprised by the information contained in this brief post. If this is news to you, and you have more than 100,000 in any Eurozone bank, well, you may want to consider your choices in the near future.

Here’s a link to a recent speech by Andres Dombret of the Deutsche Bundesbank entitled

‘Banks – allowing them to fail’.

Here are some key points from the speech:

‘So which problem am I talking about? It is usually labelled the “too big to fail” problem. It refers to banks that are so big, so interconnected or so important that their failure might bring down the entire financial system. Consequently, the government has an incentive to step in and bail out these banks in order to prevent a systemic meltdown.

Banks that were deemed “too big to fail” therefore operated with implicit government support that was provided free of charge. Such support, however, can induce banks to engage in risky transactions. If things go well they take the profit, but if things go wrong the taxpayer foots the bill. Obviously, this is a less than optimal situation from any point of view but the banks’.

How can we solve this problem?’

‘We have to remind ourselves that the risk of failure is a core feature of any well-functioning market economy. It not only encourages competition, but also leads to a situation in which the best ultimately prevail. This is what Joseph Schumpeter famously called “creative destruction”. Allan Meltzer put an even finer point on it when he said: “Capitalism without failure is like religion without sin. It doesn’t work.”

With regard to banks that are deemed “too big to fail”, we therefore have to do away with the system that shields them at the taxpayer’s expense from the forces of “creative destruction”. To be clear, this by no means implies that we actually want banks to fail per se. But the threat of failure is a huge incentive for owners, creditors and other stakeholders to act prudently and with foresight.’

‘To sum up: many people blame untamed market forces for the financial crisis of 2008. I argue that it was, in fact, not too much market but too little that contributed to the near-collapse of the financial system. A core characteristic of any well-functioning market economy was absent from the financial sector, namely the threat of failure. Large banks operated with implicit government support that distorted their incentives for prudent behaviour and eventually cost taxpayers billions of euros.’

That’s our emphasis in the paragraph above.

Given the trajectory of the global economy and the trillions in lending by Eurozone banks to the developing world over the past 5 years, it is a safe assumption that the ECB’s preparations for dealing with failed banks (tidily, over a weekend) will not have been a wasted effort.

The world is about to experience significant turmoil; there will be winners and losers. The policy described above is nonetheless a huge leap forward for the world, and it seems we are entering the closing stages of the monetary madness we have endured since 1922.

Good luck.

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