Frustrating Gresham’s Law

Must we keep seeing the bad money drive out the good?

Winston Churchill famously said that ‘democracy is the worst form of government – except for all the others that have been tried.’ He was clear-eyed about the shortcomings of democracy, but equally critical of the flaws in other systems, which he found to be more numerous, and more grave. He might have said the same of capitalism, but he didn’t, instead observing that ‘the inherent vice of capitalism is the unequal sharing of blessings. The inherent virtue of socialism is the equal sharing of misery.’

Capitalism used to be relatively easy to defend; its rivals were so eloquently betrayed by their works. We had only to point to the Trabant – assuming that the vehicle was at rest, and therefore not rendered invisible by the cloud of 2-stroke smoke that enveloped it when it was running – to make the point that, whatever merits socialism might have in principle, in practice, it was rubbish.

Recently, however, capitalism has been practiced in a way that has made it far harder to defend. In the first few years of this century, encouraged by perverse US government policy, money was lent in vast quantities to home-buyers who had no realistic prospect of paying it back. The mortgages that resulted were bundled together into abstruse financial instruments which found their way all over the world into the hands of individuals and institutions who had only the vaguest grasp of their underlying claim to value, and who, in effect, took their worth on faith alone. When the chickens came home to roost, the prospect of a wholesale collapse of the financial system prompted government (i.e. tax-payer) bail-outs of epic proportions. The result, as Thomas Sowell has pointed out, was that the individuals who had caused the GFC by their foolish lending and borrowing, and in many cases grown rich doing so, were spared the pain that they ought to have suffered at the expense of the individuals who had neither lent, nor borrowed foolishly.

It’s all wrong. The moral hazard that ought to govern behaviour in a well-regulated capitalist system had actually been reversed – the wise virgins were getting a free ride at the expense of the foolish virgins – and a decade and a half on, they still are. The bad money, in Gresham’s formulation, keeps driving out the good. So what’s to be done?

Well, apart from persuading governments to stop well-intentioned but naïve interventions in markets they don’t understand, something must be done to restore the moral hazard to the business of borrowing and lending money. Fractional banking has bestowed incalculable benefits on mankind, but it only works when foolish choices are duly punished. Players in the markets must no longer be able to privatise their profits, and socialise their losses. We ought to have no objection to people acquiring wealth beyond the dreams of avarice, but they should not be allowed to keep it if the industry they acquired it in goes pear-shaped and needs rescuing.

So here’s the Harrumpf proposal for restoring the health of our financial services sectors, while retaining its vibrant fecundity. I make no claim to intimate familiarity with the banking business, so I’ll welcome the comments and guidance on what follows.

Basically, if you want to work in the Harrumpfia financial services sector, you need a license, as dores your employer, issued by Harrumpfia’s Department of Financial Services. When you begin your career, you can earn up to the salary of a typical high school teacher, and be taxed accordingly. However, if you’re any good, you’ll start earning bonuses, on a scale that would be dizzying to a high school teacher. In Harrumpfia, these are tax-free. That’s right, folks, tax-free. There is a catch, however. Your bonuses will be paid into a fund managed by the Harrumpfia Department of Financial Services, and you will not have access to them until the expiry of a typical ‘business cycle’ – let’s say 7 years. If, during that period, your industry suffers a 2008-style melt-down, requiring any of its players to be rescued, the first recourse for the necessary funds will be your bonus.
In other words, foolish business decisions made by people with whom you share a market place, but with whom you are in competition, may cause you to lose your entire bonus stash, overnight. Conduct yourself in such a way that no such melt-down occurs, though, and you can walk away at the end of your career with all the Tuscan olive groves, Ferraris and ski lodges you can handle.

Such an arrangement would provide a compelling, two-fold incentive. Firstly, the knowledge that their wealth was on the line would surely have a salutary influence upon the professional conduct of individuals, while retaining, albeit with some deferral, the prospect of personal gain which has proved indispensable to the maintenance of a successful financial sector, serving the needs of the wider economy. Secondly, the holders of Financial Services licenses would be compelled to organise themselves into a latter-day guild, policing their industry both internally and externally (warning of the temptations of foreigners touting dodgy financial instruments); ensuring that no bank became too big to fail, invigilating the auditing of firms and generally applying the boundless ingenuity that currently sees them fleece their fellow citizens on a cyclical basis to ensuring the continued health of their industry.

What am I missing, Harrumpfers?

Tom Forrester-Paton

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