Thursday, December 31, 2015

Banking and Free Markets

American financial institutions were once the envy of the world.  Average returns over the past 120 years in American stock markets have exceed 10 percent per annum, meaning that the average person with a diversified buy and hold strategy could have expected to double their money every eight years.  Private commercial banking fueled the enormous economic growth of the United States, despite the Great Depression and the Second World War.  The American middle class thrived and real wages in America soared past others in the developed and undeveloped world.

This is a record of unassailable success.  It was no surprise that the rest of the world began to emulate the American model. The Soviet empire crumbled, mostly because their economy was worthless.  Big government couldn't create a "workers' paradise" after all.

Europe rode the wave of the powerful American economic engine, in spite of its politicians.

Finally, Asian economies began their liftoff in the last two decades of the twentieth century and, as the new millennium approached, it appeared that peace and prosperity were permanent features of the American landscape.

That was then.  In scarcely a decade and a half, all of that promise of economic growth and economic freedom has given way to government overreach and economic stagnation.

Banking is probably the most interesting example of how big government can kill off free enterprise.  Banking once was a private business, but in the 1930s when more than one-third of all US commercial banks failed, the government initiated a deposit guarantee program and ushered in a regulatory regime that, at first, seemed almost benign.  Many banks weren't federally regulated at all, even after the 1930s.  The result: an enormous economic recovery that, by the mid 1960s, made America the economic envy of the world.

Gradually, over time, banking regulations increased, mostly from political motivation.  The Community Reinvestment Act is the poster child of government interference in banking.  This act has been used mainly to extort funds from banks to fund pet projects of politicians.  This seemed to be the signal that banking was no longer considered to be a private sector entity.  The sweeping Dodd-Frank legislation and the regulatory environment initiated by the Obama Administration all but eliminated lending decisions by bankers.  Regulators took over.

In China, the state controls the flow of bank loans.  The same is now true in the US.  Banks are no longer free to lend to who they want to lend.  They lend to who they are told to lend to.

As a result, commercial banking in America is now simply one more arm of a growing and grasping government distributing spoils to its friends and punishing its enemies.

What is replacing this now stagnant and politically polluted American (and European) commercial banking system is the rise of shadow banking -- lenders who aren't told who to lend to and how much to lend.  This started with hedge funds, but is growing to a variety of non-bank lenders who have moved heavily into mortgage lending both residential and commercial and are making major inroads into traditional commercial lending.

In time the market will move to shadow banking as traditional banking is seen as nothing more than an arm of the US government.

The same pattern shows up in investment banking as traditional market making activities  have been largely outlawed by Dodd-Frank, These are the market making activities that accompanied the extraordinary stock market returns of the past 120 years. Regulators could care less if the American stock market performance is now poised to mirror American economic performance -- pitiful at best.

It almost seems as if the Obama Administration was angry at the extraordinarily positive results of American economic growth -- historically 4 percent even after accounting for the 1930s and the 2007-2008 slump.  The Obama Administration now cheers an Obama record of 2 percent economic growth -- a growth rate that implies a declining real income for most Americans. Maybe if the Obama folks can get growth down to zero, they would really have something to celebrate! 

Economic stagnation and government run banking is the new normal in America.  You can hike the minimum wage to whatever level you desire and it will not improve this situation -- in fact, it will make the situation far, far worse (and has already done so).  Taxing the rich won't matter either.  As you transform your economy to the old Soviet and old China models, you will get the same results they got -- economic stagnation and declining living standards.

As for the stock market, forget it.  S&P earnings declined in 2015 as compared to 2014 and look for a similar pattern in the New Year.  S&P earnings ultimately have to fall in line with economic growth.  That does not spell a good future for the American stock market or the American middle class.

Now that both major political parties have given up on free markets and economic growth, the new agenda will increasingly be: how to divide up a dwindling pie.  That means politics will get more divisive and free markets will continue to be under attack from politicians.

That said, let's hope that entrepreneurs find a way around the shackles that now bind the American economy.  Technology and energy forestalled a complete economic stall since 2009. Technology and energy seem to be in trouble now, just as the most deleterious effects of ObamaCare are set to deal another body blow to the American economy.

Forget the Fed. What the US needs is the return of free markets.  Absent that, the future looks dim.

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