Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

The ‘banking problem’, therefore, presented an oddity for national accountants. Traditionally, commercial banks and most investment banks make much of their income from interest differentials: they receive higher interest on the loans they make to customers than the interest they pay on funds they borrow. The charging of interest is justified in several complementary ways. It is said, for instance, to be a ‘reward for waiting’, compensating lenders for not being able to enjoy their money immediately because they’re allowing someone else to use it. It may also be a reward for taking risk. If money is not spent right now, it might yield less satisfaction later: if, for instance, those who use it in the meantime should lose all or part of it, or if its purchasing power is eroded by rising prices or a falling exchange rate. Unless kept in a sock, all unspent money tends to be lent to others, with no guarantee that money lent now will be repaid in full and on time. Borrowers might lose it on a failed business venture, or simply steal it and refuse to repay. Far from being ‘usurious’, therefore, the payment of interest can be interpreted as the lender’s reward for running the risk of never seeing their money again. The greater this risk, the higher the interest they are justified in charging.

Giving interest an economic function does not in itself explain how banks create value. Economists have traditionally resolved the ‘banking problem’ by assuming that banks create value in other ways, and use their interest differential (the difference between borrowing and lending rates) as an indirect way to capture this value, because it comes from delivering services that cannot be directly priced. Banking, it is argued, provides three main ‘services’: ‘maturity transformation’ (the conversion of short-term deposits into mortgages and business loans); liquidity (the instant availability of cash through a short-term loan or overdraft for businesses and households that need to pay for something); and, perhaps most importantly, credit assessment (vetting loan applications to decide who is creditworthy and what the terms of the loan should be). As well as channelling funds from lenders to borrowers, banks run the various payments systems linking buyers to sellers. These activities, especially the transformation of short-term deposits into long-term loans and the guarantee of liquidity to customers with overdrafts, also mean a transfer of risk to banks from other private-sector firms. This bundle of services collectively constitutes ‘financial intermediation’. It is assumed that, instead of directly charging for these services, banks impose an indirect charge by lending at higher interest rates than they borrow at.

The cost of ‘financial intermediation services, indirectly measured’ (FISIM) is calculated by the extent to which banks can mark up their customers’ borrowing rates over the lowest available interest rate. National statisticians assume a ‘reference rate’ of interest that borrowers and lenders would be happy to pay and receive (the ‘pure’ cost of borrowing). They measure FISIM as the extent to which banks can push lenders’ rates below and/or borrowers’ rates above this reference rate, multiplied by the outstanding stock of loans.

The persistence of this interest differential is, according to the economists who invented FISIM, a sign that banks are doing a useful job. If the gap between their lending rates and borrowing rates goes up, they must be getting better at that job. That’s especially true given that, since the late 1990s, major banks have succeeded in imposing more direct charges for their services as well as maintaining their ‘indirect’ charge through the interest-rate gap. 8

According to this reasoning, banks make a positive contribution to national output, and their ability to raise the cost of borrowing above the cost of lending is a principal measure of that contribution. The addition of FISIM to the national accounts was first proposed in 1953, but until the 1990s the services it represented were assumed to be fully consumed by financial and non-financial companies, so none made it through into final output. The 1993 SNA revision, however, began the process of counting FISIM as value added, so that it contributed to GDP. This turned what had previously been viewed as a deadweight cost into a source of added value overnight .The change was formally floated at the International Association of Official Statistics conference in 2002, and incorporated into most national accounts just in time for the 2008 financial crisis. 9

Banking services are of course necessary to keep the economy’s wheels turning. But it does not follow that interest and other charges on the users of financial services are a productive ‘output’. If all firms could finance their business investments through retained earnings (the profits they don’t distribute to shareholders), and all households could pay for theirs through savings, the private sector would not need to borrow, no interest would be paid and bank loans would be redundant.

National accounting conventions recognize this incongruity by treating the cost of financial services (FISIM plus direct fees and charges) as a cost of production for firms or governments. This ‘production’ from financial institutions that funds the activities of firms and governments immediately disappears into ‘intermediate consumption’ by the public and non-financial private sectors. It is only the flow of goods and services from non-financial firms (and government) that counts as final production. But exceptions are made for financial services provided to a country’s households and non-resident businesses; these services, as well as direct fees and charges imposed by financial institutions, are treated as a final output, counting towards GDP alongside everything else that households and non-residents consume. The steady growth in household borrowing in the UK, US and most other OECD countries since the 1990s has automatically boosted banks’ measured contribution to GDP, through the rising flow of interest payments they collect from households. The increasingly hazardous nature of lending to subprime and already indebted households further boosted this measured contribution, since it resulted in a higher premium of borrowers’ rates over the reference rate with inadequate adjustment for the increased risks. 10The alleged under-reporting of key interbank lending rates, commonly used as the reference rate, may have worsened the exaggeration during 2008.

FISIM has ensured that the financial sector’s contribution to GDP has kept growing since the financial turbulence of 2008–9, especially in the US and UK. But if an intermediation service becomes more efficient, it should absorb less of its clients’ output rather than more; it should make a smaller contribution to GDP the more efficient it gets. Estate agents or realtors, for example, generate income through commission on each property sale. If they become more efficient, competition will drive down commission rates and the remaining players will survive on lower commission by reducing costs – making a smaller contribution to GDP.

The rules are different for finance. National accounts now state that we are better off when more of our income flows to people who ‘manage’ our money, or who gamble with their own. If professional investors profit by investing in property during a boom, new ways of accounting will register the profit as a rise in their GDP contribution. Short-selling (or ‘shorting’), which involves borrowing an asset and selling it in the expectation of buying it back after its price has fallen, 11is another speculative activity whose growth contributes to GDP under the new form of measurement. If money is made by shorting property-related investments before a slump, as investors such as the hedge fund manager John Paulson famously did before the 2008 crash, the profit increases GDP. But surely if, for example, bus fares kept rising in real terms, we’d demand to know why bus companies were becoming less efficient, and take action against operators who used monopoly power to push up their prices? But when the cost of financial intermediation keeps rising in real terms, we celebrate the emergence of a vibrant and successful banking and insurance sector.