On Breaking Banks, Bailouts and Bernie Bro

My last post directly about the US elections were when I tried to estimate Donald Trump’s net worth (verdict, closer to $4billion than $10). Since then, I’ve seen little to catch my interest in a rather uninspiring set of candidates until we got the maverick Grandpa, Vermont Senator Bernard Sanders going off on how he’d break up the biggest US banks. 

You can Google to read up on his talking points and his recent interviews about the subject. But in summary, Bernie believes we should break up the too big to fail banks, especially J.P. Morgan and also make it impossible for taxpayers, through the Fed to bail the banks out in terms of a crisis. 

The rhetoric is all well and good in a country that loves to hate on Wall Street (sometimes deservedly, sometimes not) but one thing we should never forget is that unintended consequences are a bitch. And also, that Bernie Sanders knows fuck all about banking. Let me explain.

US global power today is only partially maintained by its military might. A lot of it is economic, and to be even more specific, financial. Wall Street is a huge component of American power. That means that in an increasingly globalized world of trade and finance, banks are going to get bigger and you want yours to be among the biggest. There’s a reason why Russia tried to float an $8billion bond in the face of America’s sanctions and failed: American banks are the biggest source of purchasing power in the bond markets and when they said no to the deal, the other banks who want to remain on their good side said no as well. Same deal with Iran. Now if you break them up? European and Asian banks expand to fill up the vaccuum left and suddenly America’s place as the world’s center of financial Gravity is taken. Not good, at least for America and a large swathe of the world. 

That’s not the only reason big banks are important to the economy to be honest. There’s domestic market making where they hold vast amount of bonds and stocks so that when you want to buy say, Apple stock, they act as a seller and when you want to sell they act as your buyer. It’s an important function that we largely don’t think about but big banks do it much better. Less liquid financial markets are also less stable and more vulnerable to shocks. There are many other reasons, but I’ll spare you the laundry list.

But then, you say,  they can be big as they want but can they not depend on government bailouts when they inevitably hit troubled waters? Well see, they used to until the government decided the country was better served if the banks let them take on that responsibility. How so? 

Well banks are special in that while they’re a private industry, they serve a quasi public function of helping to manage the money supply. To spare you a whole lot of Arcania, let’s just say they help expand credit when demand for it is high and shrink it when the supply gets low. The nature of credit of course is that the bank has to owe people A who then owe other, bigger number of people B who owe even bigger number of people C. And in the same way, each level holds the assets of the preceding level as collateral for the loan owed them. The biggest banks kind of stay at the upstream source of that flow of credit which means they have ultimate obligation when all those loans come due. Of which they always do. And if it happens to be a period of economic shock, well everyone wants to be paid at once and at the same time selling off collateral so their values are falling. And who ends up holding the rapidly deflating bag? Of course the big banks. Now in the past, before yhe creation of the Fed, the banks used to go to the biggest bank among them, JP Morgan to bail them out when all the loans they made came due. JP Morgan essentially played the role of banker’s bank or lender of last resort. But as the economy got bigger, the role required more and more capital and in the view of the govt, a level of impartiality. So the Fed was created specifically to bail out the banks when the inevitable credit crunch happens. And that bailout is always a loan. It’s not free. They pay it back. That’s the Fed’s job. What they did in 2008?  Is exactly what they were set up to do. 

Also, because the government assumed that role, they sometimes influence the banks’ loan making. During the Clinton administration, the President pressed the banks to relax their mortgage lending standards in order to give more subprime borrowers a chance to buy houses which boosted the economy. They did because the government gave guarantees that if those loans failed? They’d pick up the tab. They did so they did.

Now if Bernie wants Washington to get out of Wall Street’s hair as well as break the banks up, then he’ll have to not only rewrite the rules of central banking and the Fed Act, but also be prepared for what that will do to the US and global economy. 

I don’t think he’s thought through that. 

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