You always spend your own money better than any government

Allister Heath

IT was Milton Friedman who put it best. There are four ways to spend money, he once wrote. You can spend your own cash on yourself – you have a great incentive to economise and get the best bang for your buck. You can spend your own money on somebody else, perhaps by buying your neighbour a present. Again, you will seek to economise; but you won’t care as much about getting good value for money. “You will, of course, want to get something the recipient will like – provided that it also makes the right impression and does not take too much time and effort,” Friedman said.

Then you can spend somebody else’s money on yourself. Imagine a lunch on an expense account: you will try and spend as much as you can get away with, with limited incentive to economise, but seeking to get the best possible meal for the price. Last but not least, you could spend someone else’s money on yet another person. You will have little interest in economising – and won’t care too much about getting the greatest value for money.

In political terms, this last option – the least optimal of them all – is what happens when people who work for the government spend taxpayers’ money. No wonder public spending is never as efficient as what is achieved by private individuals – consumers, investors or entrepreneurs – spending their own hard-earned cash.

THERE are two kinds of regulatory changes: good ones and bad ones. I’m not stating the obvious: there are plenty of people who believe that, when it comes to banks at least, all regulation is good and anybody who disagrees is, by definition, either an idiot or in the pockets of lobbyists.

Thus much of the commentary surrounding the Volcker rule, which was passed yesterday in the US, was supportive; the criticism, when there was some, was inevitably that the rules were not “harsh” enough. As ever, the implicit assumption is that investment banking is “risky” (and that trades are “bets”) while loans to businesses and individuals are supposedly “safe”. The truth, needless to say, is that property lending and loans to small businesses are the riskiest form of banking; they too involve “proprietary bets with the bank’s balance sheet” and have sunk far more banks than trading ever has.

Loan losses were hugely greater than trading losses during the crisis; prop trading did not cause the recession or the bailouts. The Volcker rule is a waste of time that won’t make the financial system any safer. It will marginally cut liquidity and probably reduce hedging and thus increase risk. As to obvious prop trading, banks have already largely readjusted in anticipation; it will continue to take place in hedge funds and other institutions where it migrated to several years ago.

It would make more sense to focus on regulatory changes that genuinely address what caused the crisis. The most important change of all, resisted by some short-sighted City folk, is to ensure that resolution mechanisms are in place to allow even the largest, most complex of banks to be able to fail in a controlled manner. Bondholders need to be hit via bail-ins, staff contracts cancelled and banks resolved, dismantled and sold off, with depositors protected in the event of a crisis.

Too big to fail is the most dangerous idea that banking has ever seen. When a bank’s bondholders start to believe that they will be bailed out by taxpayers in extremis, they relax. They turn a blind eye to ever higher leverage, which benefits shareholders and staff, safe in the knowledge that nothing could possibly happen to them. But if they start to think that they could lose money, that their bonds could be converted into equity to recapitalise a troubled institution, they will become much more hawkish. Fear will start to balance out greed, and risk-seeking will be kept in check more carefully. We need real reforms, not yet more crowd pleasing tokenism.
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