Heresy of the week: Our banks don’t take enough risks

OK, here’s a question for you: On a per capita basis, what was the richest country on the world in the late 18th century? 

The answer, believe or not, is Haiti – thanks to its exports of sugar, which at the time was a highly valuable commodity.

There are many more fascinating facts and ideas in a brilliant essay by Michael Pettis on his China Financial Markets blog, which is all about how different countries make – and fail to make – the transition from poverty to prosperity.

In particular, he describes the so-called ‘American System’ – the model of development that allowed America to emerge as an economic superpower and which consisted of three pillars: protective tariffs for infant industries, public investment in infrastructure and a sound system of finance. 

It is a history that might seem to run counter to the idea of America as the home of untrammeled free enterprise. The fact that China is following much the same path to prosperity adds further grist to leftwing mills. However, as Pettis argues, there are key differences between the American and Chinese models, all of which demonstrate the limitations of state intervention.

For instance, though there is ample evidence to show that transitional trade barriers can help developing countries get their domestic industries off the ground, much more is required:

• “...it is not enough to protect industry from foreign competition. There must be a spur to domestic innovation, and this spur is probably competition that leads to advances in productivity and management organization. I would argue, for example, that countries that protected domestic industry but allowed their domestic markets to be captured and dominated by national champions were never likely to develop in the way the United States in the 19^th Century.”

Though fierce domestic competition rages across some parts of the Chinese economy, others are dominated by privileged State Owned Enterprises. These are recipients not only of explicit subsidies, but of implicit subsidies too – such as a license to pollute the environment or access to finance at artificially low rates of interest.

Pettis contrasts the Chinese financial system today with the banks that financed America’s economic ascent:

• “It is hard to describe the American financial system in the 19^th 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.
• “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.”

On the face of it, the Chinese system would seem the better one because it is more stable. But actually it allows consistently bad decisions to be made year after year, with no consequences for the decision makers. In the old American system, however, investors truly owned the risks that they took. Many of them lost their shirts, but others struck it rich – thus, overall, investment reached the leading edge of the economy and not just those businesses that happened to have the right connections to the centre.

Perhaps we in the west should ask ourselves whether our modern day banks are more like the American system of old or that of the People’s Republic of China.