In economies where services are dominant — and service industries in the UK (including banking) account for more than 80 per cent of employment — the role of banks requires radical redefinition.
Basic economic theory says that money serves three purposes: it’s a unit of account to enable people buying and selling things to talk in a common language. It’s a medium of exchange; people exchange a good for money and money for a good. Thirdly, it’s a store of value.
This is a peculiar definition. It’s like saying you define a car by its functions rather than by its characteristics.
Using the ideas contained in Economics2030, the confusion can be dispelled. The three functions of money can be reduced to two: those that involve the creation of value through constructive interaction at the level of the individual and those that support value creation, or the physical and social infrastructure that facilitates value-creation.
The unit of account and the medium of exchange, are, essentially, processes, mechanisms that make a money economy work. They don’t create value. The store of value function, however, is essentially a relationship. In this capacity, money defines the claim over resources by the holder of the money. This is where value is created.
Banks, more than any other types of firm, are essentially involved in making money out of money. Consequently, they are involved in processes as well as relationships. This constitutes a conflict of interest that will reduce economic efficiency. And, despite the fact that banks are deeply involved in service relationships, they are structured like tangible-era businesses. They have centralised bureaucracies, powerful senior managers at the top of pyramid-shaped decision-making structures and processes designed to capture huge amounts of information about the saving and borrowing of its customers, who are defined as members of large market segments: low-income, middle-income, high-income, high net-worth and so on.
The deficiencies of banks are identical to the deficiencies of government bureaucracies. The impossibility of economic calculation that Von Mises argued will always defeat government planners will also frustrate banks using tangible-era methods of operation in the service era. Less regulation or better regulation will not help financial institutions seeking to participate in the intuitively-defined communities where value-creating relations occur in services.
Similarly, government money and banking policy has been made incoherent by the challenge of managing money as a store of value, or a relationship, and money as a process. Initial analysis of the 2007/08 credit crunch suggests the crisis was caused by a shortage of money as a medium of exchange precipitated by a loss of confidence in money’s capacity to store value. Owners of money, either in the form of tradable shares or as bank deposits, converted it rapidly into cash, precipitating a collapse in equity values and the short-term resources commanded by the banking system. What threatened the wider economy was the absolute shortage of liquidity within bank payment systems. To counter this, governments across the world injected huge amounts of new money into the system to serve as a medium of exchange and keep trade going.
The processes of the financial services industry — liquidity and the system of financial regulation — facilitate value-creation. In finance, as in all other areas of the service economy, value-creation is maximised when individuals are liberated to interact constructively through unmediated relationships.
By increasing the amount of liquidity and depressing real interest rates, governments have distorted the cost of the processes required by individuals and the communities to create value. The result is that financial service relationships developed in the past will continue into the future, where they would have not otherwise have done. It is possible that these relationships were constructive. But it is equally possible that they were not. In short, well-intentioned government actions designed to increase production led to the emergence of unhealthy relationships, or at least increased the risk that they would emerge18.
But the banks have compounded the problem by introducing their own distortions into value-creation in the financial services sector. Derivatives devised to facilitate the market mediation of housing debt are doomed attempts to turn value-creating, unmediated interactive relationships into processes, tangibles that could be iteratively bought and sold. Market mediation of financial service industry relationship interactions leads to the destruction of the value that the market mediation is designed to capture.
By seeking to master the process as well as the relationship — business competences which are beyond a single organisation to deploy simultaneously — banks treated relationships like processes and presented processes as relationships. Often, they presented themselves as providing independent advice to their customers with the goal of securing deposits and loan transactions. Their massive capacity to store and transfer digitalised financial information was dressed-up as part of the value-creating activities of their customers rather a facilitating process. The process competences of banks, their ability to store digital data, outstripped their relationship capabilities. The need to deploy processes efficiently in the pursuit of profit overtook their capacity to develop and sustain productive relationships. The resulting shambles was at least partly the product of the banks’ own systems. Government regulation compounded a trend that had its own dynamic. Both business and government are, in fact, victims of tangible-era thought.
The fundamental challenge is to separate process from relationship in the financial services sector. This will allow financial service firms to concentrate on one of the two requisite competences.
One is the capacity to liberate employees to form unmediated interactive relationships with customers that lead to value-creation. This will demand organisations that are hierarchically flat and focus resources into the relationship between its customers and its employees. Financial relationship firms require little or no long-term capital. But they will have to have employees with outstanding competences in human interaction who understand that payments expressed as the exchange of gifts are the essential foundation of productive service relationships.
Alternatively, banks should focus on the process, or the capability to master the technology to store, process and transfer vast amounts of digitalised information with total security. Process activities tend to be capital-intensive and require hierarchical management and tight internal disciplines. The goal of financial process firms is to reduce cost, since that will add most to the value-creation in interactive relationships that is consequently translatable into higher profitability.
The role of government requires redefinition to reflect the facts of economic production in a service economy. Regulation of financial relationships should focus on training and standards rather than directives based on the assumption that financial relationship firms will always tend to be dishonest and their customers irrational or lazy. A successful relationship business active in other sectors should be allowed to develop financial relationship competences. There is, for instance, no in principle reason why retailers, hospitality specialists and even healthcare and education service providers should not enter the financial service relationship sector.
A stronger government role makes more sense in the financial process. Since the IT industry has substantial economies of scale, or a tendency for long-run average costs to fall, one financial service process firm will be more efficient than several. Having a single financial service process provider would also facilitate the adoption of a single set of standards and connections to financial relationship service providers wherever they may be. A single financial process system would also be far easier to monitor than many competing systems. Electronic systems are automatic and involve no human agency.
With no human agency, the need for close regulation evaporates. All that’s required is security, something which banks have demonstrated they are bad at. Time and again, banks and their clients have been robbed by the very people banks employ.
There is, therefore, an argument for the financial process, which comprises the digitalised financial information as well as the IT software and hardware, to be state-owned, or, at least, run on a low-profit basis. Events since the summer of 2007 suggest that is in fact the direction in which the banking industry of the UK at least may now be heading.
A possible model might be to contract out the electronic payments system to Google or a similar entity which has demonstrated the capacity to run a global IT system with high degrees of security. Google could cover the cost of running the system by selling advertising. This is exactly the model it uses to support its search engine activities. But the system itself should be owned and run for the public good, not private profit.
The electronic payments system is a part of the essential infrastructure of an economy and could be treated in the same way we treat our national road system. Banks still have admirers and defenders, but none would suggest that they should be put in charge of our motorways. Why then are they still allowed to run their monetary equivalent?
The idea that the financial processes, the tangible element of the financial services sector, should be publicly-owned will be greeted by shocked disbelief by Keynesian as well as free market economists.
But the argument in favour of owning financial processes has already been made by proponents of maximum market deregulation in other contexts.
According to the free market ideal, the only role for state is in defence and to provide a fair legal system. From the perspective of Economics2030, defence and the courts are not exceptional. They are processes — a part of the social infrastructure — which facilitate value creation by reassuring value-seeking individuals active within the intuitively-defined communities that make up a national economic community that they are safe from foreign aggression and secure from internal disruption.
If this argument is sound, it is logical for it to be extended to the financial service process system, because it is so vital to the interactive relationships that lead to value creation.
Nothing is more important to the long-term survival of a society than its ability to protect its savings, now mainly digitally stored in financial process networks.
And of all the conclusions that can be reached about the consequences of the 2007/08 credit crisis, the most compelling is that the status quo has actually undermined the capacity on a global basis for this goal to be secured.
A complete review of the implications for the state and banking of the rise of the service economy can be found here.