One damn theory after another (3)

How banks stopped being banks and took over the world.

Once upon a time, banks were places that people went to deposit their money for safekeeping (and a bit of interest) and that lent that money to people wanting to invest in businesses or to buy a house. No more.

Deregulation was the ruling economic and political theory of the 1980s. All that suffocating red tape would be cut away to free private entrepreneurs to work their magic and make everyone rich. We were back to a future that had little respect for the ability of the public sector to do anything efficiently. That future disinterred Adam Smith and David Ricardo, both of whom had said governments were economically unproductive. But they were writing 200 years before, when government money was mainly spent on wars and bling. Back then there was no public healthcare, education, transport, welfare – all the things we have now come to rely on governments to provide. It was an egregious misrepresentation of those founding philosophers, but that mindset was to drive economic and political policy for the next 30 years. It’s now known as neoliberalism, and we’ve seen what it can do.

Right in the middle of the campaigns for change were the banks and insurance companies.

Amid the ravages of the 1930s, governments around the world had brought in new rules to help prevent the same thing happening again. In the US, this took the form of the Banking Act of 1933, better known as the Glass-Steagall Act. It separated retail banking from the riskier aspects of finance. It separated the Main Street banks from those of Wall Street, preventing the Main Street banks from dealing in non-government securities (such as shares), or investing in those for themselves, or teaming up with companies that did such things. It returned banking to its roots, making it boring but very safe.

But this law, and others like it elsewhere, had enemies among the world’s richest and most powerful people. These were the people who funded election campaigns, who owned commercial news outlets and who increasingly came to own politicians – particularly American politicians. They chipped and chipped away until, by the 1990s and the Clinton administration, Glass-Steagall could be pronounced “effectively dead”. In that case, why not get rid of it entirely?

And so, in America and the world, that is what happened. Banks were allowed to become financial behemoths. More banking licences were issued. Financial “engineers” took advantage of the lower regulatory standards to create a dazzling plethora of “products” – derivatives which were based, ever more loosely, on real assets.

The derivative market began with simple, rational initiatives. Futures contracts allowed farmers to pre-sell their crops at a known price giving the seller and the buyer insurance against unforeseen volatility.

Quickly, the engineers turned the derivatives trade into a casino that appealed to speculators and gamblers but did little for the stability of the financial system. Warren Buffet, the legendary investor, described derivatives as “weapons of financial destruction”. A new word appeared in the lexicon: securitisation. This meant that various assets were bundled together into a saleable package, which was then (quickly) sold on to someone else – other financial outfits and various organisations around the world including local councils. Banks bought these products to sell them on quickly and to take a quick, easy profit. The eventual buyers did not have a clear idea of what was actually in these packages, so they relied heavily on the judgement of credit rating agencies. But the agencies had their own shortcomings: they often didn’t know either, and they were paid by the banks and non-bank institutions selling these new securitised products, not by the buyers and (crucially) not by the government either.

These new products included sub-prime “ninja” mortgages, which had been sold to people with no likelihood of repaying them. Ninja stood for “no income, no job, no assets”. These were packaged into the new securities along with high-quality mortgages and, often, other assets that had nothing to do with the housing market.

Because these packages were varied and included some low-risk elements, the rating agencies classed them as safe, effectively awarding triple-A credit ratings to sub-prime mortgages which were designed to fail.

It should have been clear to regulators that something was going to go wrong but this was still the era of light-touch regulation. In 2007, the inevitable happened. The ninja mortgages failed, long after the financial whizzkids had sliced and diced and sold them on, to be sliced and diced again and again, by other financial whizzkids clipping the ticket again and again.

Then, in 2007, the music stopped.

American sub-prime mortgagees defaulted in large numbers. That triggered the meltdown: financial outfits which were stuck with those failing mortgages in all those complex securitised products had no way of knowing precisely what they owned and how much they were likely to lose. Nor did anybody else. The global nature of modern finance ensured this was a global problem, originating in the US but not stopping there. When Lehman Brothers – until then, the big New York banks were thought to be too big to fail – was allowed to collapse, banks around the world stopped lending to each other out of fear the bank to which they would lend their money was about to go broke.

For a full week, the world’s financial system froze.

Eventually, reluctant governments and central banks – remember, this was the time of light-touch regulation and non-intervention – moved to get things going again. The bailouts began. And kept on going until trillions of dollars, pounds and euros were transferred from taxpayers into those profligate, reckless banks. They were, we were told, too big to fail after all.

The bailouts were so big and so complex that it was hard to work out just how much public money was involved. More recent research has found the bill for the US alone amounted to $US30 trillion.

Despite its central role in creating the Global Financial Crisis, Goldman went right on making huge amounts of money. Revenue and profits took a hit, but not for long. The CEO, Lloyd Blankfein, was paid $69 million in 2007 but in 2008 – for one year only – had his pay downgraded to only $1.1 million. On Wall Street, that is below the poverty line.

Blankfein has done very well for himself. In 2006 he became was Goldman’s CEO and Chief Operating Officer, taking over from Henry Paulsen, who left to become George W Bush’s Secretary to the Treasury. Blankfein stayed in the job until 2018 and is now described as “co-chairman”. Forbes magazine calculates his current personal wealth at $1.7 billion, making him the 2401^st richest person in the world.

In any reasonable system, the people whose overweening greed and sense of infinite entitlement who engineered such wreckage – people like Lloyd Blankfein – would go to prison for a good long time. Nobody went to gaol for the GFC. They became billionaires instead.

During the GFC, the company’s share price suffered for a while – but, again, not for long. As millions of people around the world were thrown out of work, as the financial system glued up, as thousands upon thousands of businesses went broke, and as governments struggled to keep their economies afloat – among all this, Goldman Sachs went right on making money.

The pandemic, with its lockdowns and another deep recession, had even less effect on the money machine. Once again, Goldman Sachs made money while millions of others were going broke.

Perhaps we shouldn’t be surprised. The whole financial sector has grown like a ravenous sarcoma, abandoning its original and useful function and instead corrupting and consuming the healthy tissue on which economic life depends. Independent UN studies estimated the sector at $33.54 trillion in 2024, growing at a 7.7% rate and comprising nearly 31% of the global economy.

On Wall Street, the global headquarters of all this grubbiness, more hay then ever is being made. By the end of 2025, 24% of all the profits in all the companies in America were being made by financial institutions.

There is a huge and ever-growing body of research evidence about the destructive effects of financialisation on the real economy. The themes recur: wealth and talent which would once have produced real goods and services are siphoned off into a whirlpool of unproductive money-shuffling and ticket-clipping. Non-financial companies are being drawn into that whirlwind, distracting them from their main social purpose of making real stuff that real people can use. Researchers for the UN Conference on Trade and Development (UNCTAD) found capital was being diverted from real investment in plant, equipment and infrastructure, with an inevitable hit to overall growth.

The alarm is coming even from the centre of global capitalism, the Bank for International Settlements in Basel, often described as the central bank for central banks.

A paper from the BIS’s Monetary and Economic Department found that “the growth of a country's financial system is a drag on productivity growth. That is, higher growth in the financial sector reduces real growth. In other words, financial booms are not, in general, growth-enhancing, likely because the financial sector competes with the rest of the economy for resources.

“Credit booms harm what we normally think of as the engines for growth – those that are more R&D intensive. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems.”

Financialisation, it turns out, is a major reason – and perhaps the main reason – for the decline in productivity growth throughout the developed world. That has consequences for masses of people who are unaware of why their standard of living is going backwards. Economies can afford wage increases that match inflation plus productivity growth. Without productivity, everyone suffers. Everyone, that is, except the financiers.

In a 2017 book, The Corporation, the authors point out that this is “a development that has been linked to, for instance, the rise of the notion of shareholder value”. And that theory – that the sole aim of any company’s managers should be to increase the wealth of their shareholders – can be traced directly to Milton Friedman and the monetarists, and their political followers like Margaret Thatcher and Ronald Reagan. It has meant other stakeholders in the economy – customers, suppliers, employees, the society at large – are only means to the end of making investors richer.

Reagan, Thatcher and Friedman are dead now but their idea remains. It’s still how the world does things.

Oh, Maynard, won’t you please come home?

Monetary policy, insisted Keynes, was too weak to control economies effectively. The main job could only be done by fiscal policy – by government taxation and spending.

Since the GFC and the pandemic, there has been renewed interest in Keynesian ideas. Governments have gone part of the way by injecting massive amounts of money into their economies to keep them from sinking into long-term depression. But the methods they used to distribute that cash was to use monetary measures. Keynes would be appalled.

In most countries, loans and guarantees during the GFC greatly outweighed direct grants and subsidies, which had an uneven but unknown long-term impact on government budgets. But the total amount put into national economies was huge: in Italy and Germany, it amounted to more than a third of annual GDP.

The pandemic recession was less damaging and stimulus, though still considerable, was less and delivered over a shorter period. Nevertheless, the negative long-term effects of this huge injection of money, mostly created by central banks and distributed indirectly through commercial banks, were mostly unforeseen.

The fixation on monetary policy by central banks and governments greatly increased the amount of money being injected, greatly lessened its effectiveness, increased inflation and hit living standards.

Central banks, trying to stimulate investment and consumption by lowering interest rates, hit the wall when rates reached zero and still weren’t being effective. As Keynes said, monetary policy is a weak instrument.

So an “unconventional method” was adopted: quantitative easing. Instead of buying new bonds directly from governments to fund stimulus and relief measures, central banks instead bought existing bonds from commercial banks, effectively transferring trillions of dollars from the public sector to private financial institutions. The main aim was to increase demand for bonds so prices would rise and current yields (which move in the opposite direction) to fall. Commercial interest rates would fall even further, and money would be injected into the banks so they could lend to borrowers at low rates, increasing economic activity.

The problem was that not a lot of companies wanted to borrow. At a time of falling demand, it made no sense to suddenly increase supply. As Keynes had said long ago, it was like pushing on a piece of string. Much of that new money went back to where it came from, this time not as a public asset but in commercial financial institutions’ accounts with central banks. It was good for those institutions: they’d effectively swapped assets carrying low fixed low interest rates for ones carrying variable interest at much higher rates. The government was now paying the commercial firms for the privilege of giving them public money.

But that newly created money didn’t go away. It waited until there was demand for it. Then it surged back into the national economies, creating twin surges of inflation: one following the GFC stimulus, the other following the pandemic stimulus.

While prices rose, wages languished. Real incomes fell, and the developed world sank into a cost-of-living mess from which it has yet to emerge. Electorates understandably lost faith in their governments and turned instead to charlatans promising magic: Trump in America, Farage in Britain and Hanson in Australia.

Most of that new money funded purchases of existing assets, particularly houses and shares. And so housing price rose and rose, as investors piled into the market, shoving aside owner-occupiers (and particularly younger first-home buyers). Wealth flowed to those who were already wealthy. Renters lost hope of ever buying their own house. And the world became more unfair.

There was another way. There always is.

There should have been a clue from the limited amount of extra money given to welfare recipients. That cash was spent, not saved – poor people have to spend – and demand was increased efficiently. There was a lot of bang for the governmental buck.

But rather than going to individuals and households, most of that newly-created stimulus money was funnelled into commercial banks – where it sat, doing little to boost demand, not addressing supply either, and being kept away from making the lives of ordinary people a bit better.

Instead, central banks could have used newly-created money to buy bonds directly from their governments to fund programs aimed primarily at individuals. That would have required much less expansion in the money supply; it would have created a fairer and more prosperous society; and it would have been much less inflationary. But that would have involved fiscal policy, and central banks around the globe (and their governmental technocrats) recognise only monetary policy.

It seems fundamentally irrational to ignore the most potent method of controlling prices and employment. Surely, that must change!

Fat chance.

Our unelected, unaccountable rulers

Neoliberalism is dead but its ghost haunts the secret places of every central bank.

By about 1990 it had become fashionable for governments to make their central banks independent of political – indeed, any external – direction. The idea was that politicians would inevitably manipulate interest rate decisions to suit their own short-term electoral advantage rather than the interests of the economy and the people.

A confluence of events – independence, falling trust in democracy and governments, and the focus on monetary policy – coalesced to turn career technocrats into economic potentates. Central banks are accountable to nobody other than themselves – or, perhaps, to other central banks.

Most have dual mandates – to maintain price stability (keeping inflation to around 2%-3%) inflation) and ensure full employment. The second is arguably more important than the first but it is routinely used as a tool to fight price rises. The theory is that there is a (questionable, possibly imaginary) level of unemployment at which prices will remain stable. It’s called the NAIRU, the non-accelerating inflation rate of unemployment. Even though nobody can say for sure just what the NAIRU is at any given time, it is used to determine whether interest rates should go up again. “Because neither expected inflation nor the NAIRU can be directly measured, they need to be estimated,” admitted the Reserve Banks of Australia.

In 1958 a New Zealand economist, Bill Phillips, noted a relationship between unemployment and inflation. When unemployment fell, prices rose. Phillips put his theory into a graph: the Phillips Curve. It looked like this:

For quite a long while it seemed to work but, like all economic theories so far devised, it was vulnerable to changing conditions. In the couple of decades since the GFC, that relationship has broken partly or wholly down, less like a curve and more like a straight line.

Central banks are undeterred. They’ve fiddled about with it but the basic idea remains unchanged. “It’s not dead," they say. “It’s just resting.”

That is the theoretical basis for millions of people being thrown out of work. That idea, endorsed and refined by Milton Friedman, determines interest rates all over the developed world. It lives because central banks, unaccountable and immovable, say so.

Governments could, of course, wrest back control. They won’t, though, because doing so would profoundly displease financial markets. The people who own capital – the rich – are also powerful. They control media and they control governments, particularly in the United States where it costs so much to get elected.

And so it is of no consequence whether the theories on which our economies and lives rest should be changed for something more suited to the times and the needs of the people. Something, perhaps, that you might find in a 90-year-old book by Maynard Keynes.

It just won’t happen.