Fixing the Weakness Inherent in the Financial System

As the world economy seems to hurtle towards yet another recession, more and more, economists are lamenting the state of the world’s financial system, are lambasting the fact that 10 years subsequent to the financial meltdown of 2008, the world’s financial system is no more sounder today than it was prior to that monumental meltdown.

When Mathematics is done right, Mathematics don’t lie, always is truth; tis the reason some refer to Mathematics as the ‘Language of God’. In Financial Economics, there exist some stylized facts that are rooted in Mathematics.

Whenever Mathematics is done right, it’s predictions are inviolate, hence, it’s characterization as ‘Language of God’.

An important stylized fact of Financial Economics is what is referred to as Multiplier Effects. Whenever US$1 is, by virtue of activities in the real sector, transformed, via generation of returns on real activities, such as Manufacturing, Operation of a Restaurant, Farming etc., into US$1(1+r), where r is the return on investment, a return is generated, but there is not as yet any Multiplier Effect in an economy.

Suppose, however, that a manufacturing concern M, that transforms US$1 into US$(1+r) creates a service or supply opportunity for a smaller firm, X; given the smaller firm also generates a return that can be signified by US$1(1+x), in aggregate, while the manufacturing firm only retains US$(1+r) in it’s business, the entire economy has, as a result of that US$1 that was invested by M, accrued a total return of US$1(1+r)(1+x). The reason that the US$1(1+r)(1+x) is regarded as outcome of a Multiplier Effect resides in the fact that, absent existence of, and investment of US$1 by manufacturing entity, M, Company X would not exist, meaning the owner of X would not seek for another US$1 to invest, with outcome, society would not have realized the extra US$1(1+x). Now add the employment effect, which is, in presence of opportunities presented by Manufacturing Entity M, Company X is able to employ 10 persons. Let this employment benefit be denoted by Q. Now then, the entire benefit to society can be represented by {US$1[(1+x)+Q]}.

Multiplier Effects are generated by investments in the Real Sector, cannot be generated by investments in Stocks or Securities.

Absent generation of Multiplier Effects within a society, arrival at sustainable economic growth and development is a pipe dream.

Consider then, the current arrangement within which, with banks allowed to function as Holding Companies, deposits of commercial banks (Deposits) can be applied to investments in either of Stocks or in Manufacturing Concern, M.

If Deposits are invested in Stocks that already are listed on an Exchange, and that are not issuing any Seasoned (Additional) Equity, it is normative and incontestable that the Multiplier Effect for Society = ZERO.

If the same Deposits are loaned to Manufacturing Concern M, and as already assumed, M is successful, as already shown, there is arrival at Multiplier Effect for Society ={US$1[(1+x)+Q]}.

Whenever, in context of structure of banks as holding companies, deposits of commercial banking arms legally are applied to investments in stocks, as opposed to investments in the real sector, there potentially is a loss of {US$1[(1+x)+Q]} for the economy.

Whenever Deposits are applied towards trade-based speculation in securities markets, absent creation of any new real assets within the economy, Deposits generate a return, US$1(1+i) that, in entirety, is retained within the Bank Holding Company.

Suppose then, that returns available within stock markets are higher than returns that are available to commercial banks from lending of monies to firms in the real sector.

In absence of the bank holding company structure, for survival and profitability, Commercial Banks scour the economy looking for viable companies that can be construed to be relatively safe investments. Given there exists a tax benefit to debt for companies in the real sector, a profitable company can, in presence of a good deal on loan interest rates, be willing to take on some additional debt. This is the case because the cost of the debt can be lower than the cost implicit in application of it’s retained earnings to financing of the business. So then, Commercial Banks can, in presence of imperative of survival and profitability, and (were it to be possible) lower returns within the real sector, continue to generate Multiplier Effects within an economy.

In presence of the bank holding company structure, Commercial Banks simply can divert deposits towards investments in stock markets or securities. We arrive then at a lot of money from Banks chasing trades in stocks, with outcome stock returns become sensitive to demand and supply, resulting in stock returns that are highly volatile.

A Juxtaposition of the two scenarios above reveals not only loss of Multiplier Effects, but also, higher difficulty of survival for companies in the real sector; greater dependence of health of the economy on returns that are not associated with creation of any new assets, that is, reliance on paper wealth whose substance can be reaped by Banks, with outcome, when it transpires, it is society that is left holding the bust; and an economy that, in presence of returns that are more highly variable, attains to a state of fragility.

Iterate this state of an economy several years, and arrival at an economic recession is a certainty. Arrival at an economic recession is a certainty because the Mathematics to follow don’t lie.

{A negative for society (loss of Multiplier Effects)} + {Another negative for society (lower rates of survival for businesses in the real sector)} + {Stock returns earned by banks, which are retained in entirety within banks} + {Adverse effects of stock market busts that are fueled by speculation of banks, but that are borne by society}= In Aggregate, A Negative for Society.

At some point, the Negative Balance for Society is bound to become too large to be sustained, with outcome there is arrival at an economic recession.

But, how about all of these app based companies springing up all over the place? Why can’t Commercial Banks lend to these businesses?

Well, my friend, app based businesses have most of their assets as what are referred to as intangible assets, that is, the sorts of assets banks do not accept as Collateral for loans. Given it would be foolish for a company to offer it’s apps as collateral for loans, such that, in presence of some business turmoil, it loses it’s business in entirety, in equilibrium, app based businesses do not attempt to, and do not depend on bank loans for any of survival, maintenance of operations, or profitability of operations.

If a Manufacturing Entity defaults on a loan, such that an equipment specified as collateral is seized by a Commercial Bank, the company can make up for loss of the asset, remain in production of the good that is sold to consumers. In this scenario, the Collateral differs from what is sold by the company.

When an App Company loses it’s App to a lending bank in context of some financial turmoil, in presence of demand for the App, the business no longer is viable. In this scenario, the Collateral is the entire Business itself, is coincident with the good that is sold to the public.

Lending by Commercial Banks cannot be supported in an economy that progressively moves away from creation of new technological assets in the real sector.

If banks are to lend actively in the real sector, there is demand for real sector activities that generate real assets, such as factories, equipment, and new technologies, new technologies, which themselves have capacity for generation of Multiplier Effects.

But if the U.S. Economy continues to move away from innovations that create new and innovative real assets, there are less of firms that can support lending by Commercial Banks, with outcome more and more of deposits are reallocated to investments in stock markets, with outcome stock markets continue to be characterized by significant volatility and uncertainty.

In presence of heightening of uncertainty within stock markets, investments in the real sector, whose returns then become more uncertain, are less likely to be undertaken. We arrive then at a vicious cycle of underinvestment within the real sector. Eventually, underinvestment within the real sector induces ‘a bust’ of the stock market.

Diversion of Deposits towards investments in Stocks, with outcome stock markets are characterized by significant volatility and uncertainty, induces underinvestment within the real sector, and predicts a bust of the stock market at some future date.

If the fragility in the world’s financial system is to be fixed, there must be reinstatement of the Glass-Steagall Act, and the environment must remain conducive for bank lending, that is, must be conducive to financing of new and innovative manufacturing initiatives that produce, or are premised on new technologies.

Is it not reasonable that modern factories whose interior employees find inviting for work, and that produce new modern technologies provide opportunities for more productive labor than driving for Uber.

If they must, let regulators demand factories that compare to those of the app companies in lighting and desirability of the work environment, but if economies of the world are to regain any balance, reinstatement of the Glass-Steagall Act, and emergence of an environment that is conducive to investments in new and innovative manufacturing initiatives are, in context of Mathematics that don’t lie, shown to be musts.

This is all rooted in Mathematics of Multiplier Effects. When done right, Mathematics don’t lie.