Making Finance Fit for a Spiritual Economy

By Prof. Ed McKenna

In God Talks With Arjuna-The Bhagavad Gita: Royal Science of God-Realization, Paramahansa Yogananda’s commentary on the Bhagavad Gita, Yogananda writes that the Gita’s wisdom explains “.. how to live a balanced life that includes the actual contact of God…”.

As important as balance is for every person, it is just as important for the institutions within which people live and work. While people create institutions, institutions also shape people. Because of the significant amount of time that people spend within institutions, imbalances in institutions will lead to individual imbalances as well.

The economic crisis of 2008, the effects of which are still felt by many in all parts of the world, can be understood as the result of imbalances that developed within the world’s financial institutions. Because many of these imbalances still exist, the potential for yet another crisis looms large.

I. The Growth of Financial Institutions

Financial institutions play an important role in society. For example, there will always be differences between the amount that individuals and businesses desire to save and invest. I might wish to purchase a house, the price of which greatly exceeds my present income. If I can borrow now at reasonable rates and with a reasonable expectation of repayment from my future income, then the existence of financial institutions that channel income from savers to borrowers will make it possible for me to purchase a house. Businesses may also find that they need to temporarily borrow to finance their production needs, with the expectation that they will be able to repay when they sell the output they produce with the borrowed funds. Again, financial institutions help to make the production of goods and services possible. So, financial institutions play an important role in enabling the real economy (that part of the economy devoted to the production of goods and services) to meet the needs of society’s members.

Financial institutions also enable speculation. In a world of uncertainty, speculation will always occur. No one knows in advance which investments will work out best in meeting the needs and desires of people. Decisions will have to be undertaken as to how to best allocate funds for undertaking these risky investments, and financial institutions play an important role in making these types of decisions. When these decisions are made well, the wealth of society increases and more needs can be met.

But speculation can also amount to little more than gambling. In gambling, there is a winner and a loser, but no overall net gain. Likewise with excessive speculation, some gain when their speculative bets work out, but only at the expense of those who lose. And, when speculation becomes too great, the losses can also lead to adverse outcomes in the real economy, resulting in both the loss of output, and increases in unemployment.

From 1980 to 2006, the financial sector share of gross domestic product (which is a measure of the real output of the economy) grew from 4.9 to 8.6% in the United States, a growth rate of nearly 75%. While we would naturally expect the financial sector to grow as the size of the real economy grows, we would normally expect a rough balance between these two growth rates, resulting in the financial sector share remaining relatively constant. The fact that the share grew by nearly 75% indicates that finance was being undertaken not to enable the growth of the real economy, but to enable the growth of speculation. And this was the source of the first imbalance in the economy.

Most of this speculation took place in housing markets in the United States. Financial institutions believed that they had invented new financial instruments that would enable them to reduce risk, while at the same time making loans to people who previously would not have qualified as good credit risks. The financial institutions making these loans believed that they could calculate with greater certainty the likelihood that the new homeowners would repay their mortgage loans. Believing they could count on these mortgage payments, these financial institutions increased their own level of borrowing, believing that they could repay their loans from the mortgage payments that would be coming in each month. However, in retrospect, we now know that these financial institutions were not quite as certain about their speculation as we might have thought at the time. How do we know this? It turns out that many of the financial institutions that were making these mortgage loans were also purchasing insurance that would protect them in the event that the mortgage payments were not actually made. If financial institutions had really been confident about these new mortgage loans, there would have been no need for such insurance.

But even this level of speculation could perhaps be justified. We might think of it as being equivalent to someone who purchases a new home, but also purchases fire insurance to protect against the possibility of the new home burning down. But this was not the end of the speculative activity. Financial institutions that had not made new mortgage loans, and hence did not have a need to protect themselves in the event that the loans were not repaid, also began buying guarantees that they would be paid in the event that mortgage loans were not paid. Of course there had to be institutions willing to sell these guarantees. And here we had what amounted to a pure gamble, with both sides betting about the repayment of loans that neither side actually owned. This would be like your neighbors entering into a bet about whether your house would catch on fire! These types of speculative gambles were not made to enhance the capability of the real economy, they were simply bets. These were the types of activities that led to the phenomenal growth in the share of the financial sector.

As things turned out, many of the people receiving new home mortgage loans were, in fact, unable to make their mortgage payments. The fact that they had been given these loans was the result of a lack of oversight, poor decision-making, and outright corruption on the part of financial institutions. When the homeowners failed to make their mortgage payments, those financial institutions that had borrowed intending to repay their own loans from the income they would receive from mortgage payments, were also unable to repay their loans. This then required payment on the part of the insurance companies that had guaranteed to cover any losses from the failure of homeowners to make their mortgage payments. Unfortunately, they did not have the funds to make these payments. The interconnectedness of the financial sector meant that commitments that had been made to pay at a certain point in time could no longer be met. Lenders stopped lending, fearing they would not be repaid. But when lending stops, people cannot purchase new homes, and many businesses are unable to continue production because they rely on loans to make payments (such as wage payment) that occur before the receipt of revenue from the goods they produce. A problem that had begun in the financial sector now spread to the real economy, this was the source of the second great imbalance.

II. Protecting the Real Economy from Financial Sector Imbalances

One of the important lessons learned by economists as a result of the Great Depression is the need to regulate banking. The need arises from the special nature of banks, especially with regards to the importance of confidence (a psychological issue) in maintaining a stable financial system. Psychological factors can be highly unstable, especially when confidence is dependent upon myth. And in the case of banking, the public has long operated on the basis of myth. Most people believe that when they deposit their money in a bank, it just sits in the bank waiting for people to collect it at some future date. Even those who are more sophisticated and understand that banks must make loans if they are to make a profit, and hence believe that money is never sitting idly in bank vaults, misunderstand the true nature of money and banks. In the real world, banks make loans first, and then go out to find the necessary reserves required to meet the daily needs of bank customers for withdrawal of funds from the bank. Banks obtain these reserves either from other banks, or from a country’s Central bank, which in modern financial systems always stands ready to lend a bank any reserves that it requires. The amount of these reserves will always be a tiny fraction of the amount that bank customers have deposited in their accounts in the banks. In other words, if a bank’s customers were to suddenly descend upon a bank and ask for its deposits to be converted into cash, the bank would not be able to do it based on the amount of cash it is actually holding. Now this would not ordinarily be a problem except for the unusual psychology that prevails among the public with respect to banks. As long as they do not fully comprehend that the bank is not holding the customers “money”, everything is fine. But as soon as the public learns that a bank may not be holding a sufficient amount of money to meet its customer’s demands, people immediately run to the bank to try to convert their deposits into cash. Hence the existence of bank runs.

To guard against bank runs, a number of practices have developed. Most importantly from the public’s perception is the existence of insurance against bank runs. What this means is that even if a bank becomes insolvent, there is a public guarantee that bank depositors will always receive their money. This greatly reduces the likelihood that people will want to the bank to take out their money once they learn that their money is not actually in the bank. But there are other, equally important, regulations that maintain banking stability. For example, banks are required to keep a certain amount of capital (which represents economic wealth made available to the bank by its owners) on hand, which limits the amount of borrowing that can be undertaken by a bank. Also, the types of assets that a bank can purchase are limited to assets that are less risky, and hence whose value will not fluctuate greatly if the bank needs to convert its assets to obtain cash to pay its customers should a run on the bank develop.

These regulations worked well for more than 60 years, maintaining balance and stability in financial markets. However, during this time new types of financial institutions developed that were not subject to the types of regulations imposed upon traditional banks. Most of these new institutions were involved in making loans based on the expectations of receiving mortgage payments that I described above. When mortgage payments stopped, lenders who had deposited money in these new financial institutions became concerned that they would not be able to obtain their money when they required it. Because there was no public guarantee that these depositors would receive their funds even if the financial institutions became insolvent, there occurred a run on these new financial institutions, and this is what set off the financial crisis.

Thus, a lack of proper regulation lies at the root of current crises in financial institutions. But why is there a lack of proper regulation? This leads us towards a discussion of the third in balance in financial markets, and imbalance of economic and political power.

We might well ask why, if the riskiness of financial institutions is well understood, new regulations have not been passed to deal with the new types of assets and financial institutions. There are many reasons, however the following two ideas would be part of any story. Since 1980, the belief that unregulated markets can solve any economic problem has gained increasing dominance among elites. The former Chair of the Federal Reserve, Alan Greenspan, famously pronounced that the self-interest of those in charge of financial institutions would guarantee that they would not undertake excessively risky actions, and hence government intervention was not required (a view he came to reject after the 2008 financial crisis). Even more important has been the increasing concentration of income and wealth in the top 1% of the population. Increasing wealth not only enables the wealthy to disproportionately influence elections, but also enables the wealthy to shape what type of legislation will be passed by government. What this has meant in practice is that legislation is often passed that furthers the interest of the very financial elite whose risky actions require the passage of legislation in the first place.

An excellent example concerns the passage of the Volcker rule, which was an attempt by the Congress of the United States to limit the types of investment that financial institutions could take with deposits backed by government assurances, such as FDIC insurance in the event of bank failure. The law was passed in 2010, but has still not been fully implemented. Recently, reporting has revealed an attempt by large banks to modify the legislation in ways that would favor large financial institutions, including postponing until 2019 the actual implementation of some of the rule’s requirements. The great wealth possessed by these institutions enables them to influence and shape legislation even after it has already been passed by the government.

Here is another example that people may find difficult to believe, but nevertheless is true. Part of the Dodd-Frank Bill, passed in 2010, attempted to provide government with a tool that would enable them to take over large, failing banks during financial crises. The Government of the United States already possessed such power with respect to smaller banks, but the large size and complexity made such an undertaking difficult when it came to the largest financial institutions. The intent of the tool is to rein in excessive risk-taking on the part of the owners of financial institutions by facing them with the threat of loss of ownership of the investments they have made in financial institutions. Because these institutions are so complex, part of the legislation requires these financial institutions to provide a blueprint (referred to euphemistically as a “living will”) that would enable the government to know how to proceed with a takeover in the event of the institution’s failure. In other words, the institutions are being asked to provide a manual that will enable the government to take them over! You might think that the large financial institutions would be reluctant to provide such a blueprint, and you would be correct. As the Federal Reserve recently noted, the ‘ living wills’ that have so far been presented by the large financial institutions are totally inadequate to enable the government to carry out the legislative ends envisioned by the Dodd-Frank Bill. But is a reflection of the size and power of these large financial institutions that even a government as large and powerful as that of the United States feels itself inadequate to implement democratically passed legislation.

These examples pose a problem that spiritually-based economists will have to face. Prout has identified certain industries that are so important to the well-being of society that they must be regulated in the interest of society. These are referred to as “key” industries. Finance certainly qualifies as a key industry. But how shall this industry be regulated? Will we allow financial institutions to grow to unlimited size, as we do today, and then hope to pass rules that will limit their power? Or, do we need to break up large financial institutions to prevent the accumulation of power in the first place? Asking the question of which approach is more likely to bring about balance may provide insight as to how to proceed.