A continuing critique of a Michael Pettis Essay.
A sound system of national finance
The third pillar of the American System was the creation of an appropriate financial system. But what does that mean? It is hard to describe the American financial system in the 19th Century as stable and well-functioning. In fact the American banking system was chaotic, prone to crises, mismanaged, and often fraudulent, and yet the US grew very rapidly during that time.
***It is good to call this the “American system” because everyone knows it’s been around a mere 200 years. If we say the “British system” or the German system we might be misled since Germany is about 100 years younger than the USA and the British system only slightly older.
Americans like to think the USA is unique. The fact is all banking systems around the world were chaotic, prone to crises, mismanaged, and often fraudulent, and yet these countries grew very rapidly during that time.***
China’s banking system, on the other hand, is far more stable – in fact the favorite cliché of Chinese bankers is that while the system may not be efficient, it is very stable. What makes the Chinese banking system stable, of course, is that it is widely believed that the government stands fully behind the banks. It makes no difference, in other words, how weak the credit allocation decision is, because by controlling credit and the deposit rate, and by limiting alternatives for Chinese savers, the government guarantees both the liquidity and solvency of the banking system. As long as government credibility is intact, the banking system is unlikely to fail.
In that sense you can easily make the case the Chinese banks today are sounder than American banks in the 19th century. This might bode well for the future of the financial system in the short term, but in the long term it is not clear to me that monetary soundness and financial stability are necessarily correlated with more rapid growth.
***The Chinese banks today mimic the USA banks today. Why would they mimic 19th century banks? The Chinese would no more institute 19th century banking than install trolley cars instead of an airport at Pudong.***
I say this because I have seen no evidence that countries with sound and conservative financial systems grow faster than countries with looser and riskier financial systems (although they do seem to have fewer financial crises). In fact I have more than once made reference to Belgian bank historian Raymond de Roover’s provocative and profound comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.” Canada was blessed (or cursed, according to de Roover) in the 19thCentury with being part of the Britain, and so inheriting England’s much better managed financial system.
*** Boy, here again definitions and time frames cream out for specificity. What do we mean by development, reckless and when? Whatever the thesis here might be, the fact is all world banks today are so similar that any crash will mean that all crashes.
The idea that China’s banks or USA’s or the EU might go down independently is to miss that all great upheavals happen worldwide. Think of 1968 and China, France, Rome, Berlin, Chicago, etc.
Or the 1860s and the civil wars in USA, India, China, Japan. And back through history. Whatever relative merits of the banks that matter, when one goes down, all the ones that matter will go down,***
“Reckless” banking is hard to define, and certainly it is easy to make the case the Chinese banking has been reckless, especially in recent years, but it is a very different type of recklessness. Once again I cannot say with complete confidence how China’s version of its development model differs meaningfully with the American System on the subject of banking, but I would suggest there are at least two very important differences.
First, the American financial system then (and now) has been very good at providing money to risky new ventures. It provides capital on the basis not only of asset value but, more importantly, on future growth expectations, and risk-taking has been actively rewarded In China it isn’t clear that this is the case at all. Chinese banks favor large, well-connected, and often inefficient giants at the expense of risk-takers.
*** He speaks as if there is no WAMU. Enron, Worldcom, and for that matter Goldman Sachs? Whatever benefit Mr. Pettis is ascribing to USA, China is actually much better at it.***
Second, although both systems were prone to bad lending, the American banking system tended to correct very quickly – in the form of a crisis – and bad loans were written down and liquidated almost immediately. This was certainly painful in the sort term – especially if you were a depositor in the affected bank – but by writing down loans and liquidating assets three important objectives were achieved. Financial distress costs were quickly eliminated (writing down debt does that in ways I won’t get into because they are well-known and much discussed in corporate finance theory), capital allocation was driven by profitability, not by implicit guarantees, and assets were returned to economic usefulness quickly.
A classic example of the last of these objectives may be the response to the railway bubble of the 1860s. During and after the 1873 crisis, a number of railroads went bankrupt, including major lines like the Union Pacific and the Northern Pacific, the latter of which even brought down Jay Cooke & Company, the leading financier of the US government during the Civil War. After the crisis some major railway bonds traded as low as 15-20% of their original face value, and so they were purchased and reorganized at huge discounts. The new buyers were consequently able to cut freight and passenger costs dramatically, in some cases by over 50%, while still earning more than enough to cover the costs of buying the railroads, and this led to a collapse in transportation costs in the US.
Liquidation, in other words, provides an important economic value to the economy. It allows assets to be re-priced, which creates a boost to the economy and prevents those assets from acting as a deadweight loss. If the railroads hadn’t been liquidated, in other words, any reduction in costs was likely to be minimal and the railroads would have been far less useful to the development of the US economy.
*** The “national greatness” provided money for wasteful projects. When the projects failed, they were cleaned up quickly. Ye, this is far superior than what we have today with, 5 years in, we are still bailing out zombie banks daily. But If the state was not allowed to get involved in banking, we would not have had the bankrupt rail lines to begin with.
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