Thursday, 3 December 2009

Why are bankers so rich?

"Why are bankers so rich?" was actually just about the first question I wanted to answer when I started studying economics. During my studies I got an inkling of an idea here and an inkling there, but I was never 100% convinced that I'd really cracked the question. That is until about an hour ago, when it came to me in a flash. I am now completely convinced I have the right answer. If you are a banker, you might like to look away now, you're not going to come out of this well.

My answer builds upon key concepts, many of which I have discussed in earlier blog entries. In particular:

"Money" does not mirror barter very well.
Most "savings" are just agreements between people.
There is a pretense at the heart of our pensions system.
Rational exuberance combined with Austrian School Business Cycle Theory.

When you put all these concepts together you should realise that a far far too large a fraction of money today circulates for the purposes of "investment". Way larger than could possibly be accounted for by the true needs of investment. Think about this for a second...

What is investment really?

I'd suggest that investment is things like
  • Borrowing money to build new factories.
  • Borrowing money to build new machines that make stuff.
  • Borrowing money to pay employees in the early stages of a new company before it starts to make a profit.
  • Borrowing money to research new manufacturing processes.
Now we do need plenty of that kind of thing going on, but how much is plenty? What fraction of mankind's manpower should go into that? 10%? 20%? even maybe 30%... but obviously there comes a point where it becomes too much. After all, at some point someone has to go and manufacture all the lovely stuff that can come about after the "investment". If 95% of mankind's efforts were all "investment", then almost nothing would ever get made! Personally I think that something like 10-15% is in the right ballpark. Now if 10-15% of mankind's work was involved in investment, and if we had barter system in place, then you would expect about 15% of bartering transactions to be concerned with this investing. However "money" does not reflect barter very well. Strange things can happen with "money" see here for example.

Now lets have a think about things which are non-investments or pseudo-investments (none of these activities significantly enhance mankind's ability to make stuff):
  • Borrowing money to speculate in the price of companies*.
  • Borrowing money to speculate on the price of housing.
  • Borrowing money to speculate on the price of commodities.
  • Lending money to someone who wants to have a new car/kitchen/holiday without having saved up to buy it.

* Now you may say that when an investor buys shares in a company he is putting real money into the company, the company gets the money and will often spend it on new machinery etc. But note that it is only the first purchase of shares that has this effect. All further exchanges of shares give nothing whatsoever to the original company and most (99%?) share transactions that go on in a stock exchange are secondary transactions.

Now lets think about what happens in our financial system.

Step 1. Politicians worldwide continuously pronounce "We must have more investment in our economy - lets keep interest rates low".
Step 2. We have a charade of a pensions system (read my blog entry) in which great chunks of society's money circulates for the purposes of "saving for our retirements".
Step 3. Our fractional reserve banking system allows money to be created to follow and exacerbate any speculative bubbles.
Step 4. People wanting "real" investments (potential factory owners and the like) have to compete with unproductive bubble investments for money. If the unproductive bubble investments are rising in value fast then it actually becomes hard to get real investments happening.... the politicians will then suggest lowering interest rates... which of course just feeds the bubble and does not solve the lack of "real" investments problem.

The upshot of these steps is that the vast majority of money transactions in our society take place for the purposes of "investing" in non-investments! Any amount at all would be a bad thing, but to have the majority of our money doing this is nothing short of a disaster. Now consider who is actually doing these transactions, and the answer is the banks. And of course they have to take their fees for their expertise managing these pseudo-investments!

That's why the banking sector is so bloated.

We do need a banking sector for organizing "real" investments. But their work in organizing pseudo-investments is a sham. People think that because the bankers are so rich, that they must be doing something really valuable. But for their pseudo-investment work this is not the case. The bankers are getting rich in just the same way as the mafia get rich. They are contributing nothing whilst taking our money.

The solution is to take action to reduce/eliminate pseudo investment. It should be illegal to borrow to speculate. The pensions system should be redesigned as described here.

The diagram below illustrates the situation. The paired arrows in each box represent money flowing back an forth in relation to that sector. The arrows underneath the boxes show the sums going to the banking sector. Notice that exchanges of money in ordinary trade results in very little going to the banks. Indeed if exchanges are carried out in cash, then the banks get zero, and even when debit cards are used the banks take only pennies for each transaction. In the case of "Real investments" though, the banks take a much bigger cut of the money flows, after all they have lent the people this money and they want their interest and fees for their expertise in arranging these loans (I have no objection to the banking sector collecting this particular flow of money). In a healthy economy there should be no other boxes in the diagram, unfortunately there is a huge third box called pseudo-investments, and again the banks charge interest and fees on these flows. The whole third box is a colossal waste of effort which achieves nothing other than providing a massive flow of money to bankers. And what's worse, a notion wastes the potentially useful manpower of the bankers, who would be better employed actually making stuff!


  1. If you think his post makes any sense please read the refutations here.
    and here