[This Commentary originally appeared in the September 21, 1989 issue of The Mendon-Honeoye Falls-Lima Sentinel.]
Part Two – A Living Example of the Risk-Return Tradeoff
This is the second of two commentaries aimed at exploring a novel approach to determining our nations’ true standing in the world economy. Last week we looked at the risk-return tradeoff, the idea that risky investments are more likely to have higher returns (and larger losses) than safer investments.
Earlier this year, a Siberian valley explodes suddenly. The cause – a leaky gas pipeline. Low safety standards lead to a faulty job. People die. Property is destroyed.
You read about it all the time. Not-so-old bridges collapse, sending trainloads of passengers plummeting to an early demise. Third World ferries, overloaded with holiday travelers, capsize again and again. Athens and Frankfurt sport airports which appear to openly invite terrorists.
Across the globe, we see examples of why we are happy to be Americans. Not only do we possess a high standard of living, but our institutions follow the strictest of safety guidelines. For example, we feel secure knowing movie theaters only permit so many people in to see the show (thus increasing our chances of escaping a fire).
I must admit, government regulation has its advantages. I’d rather have my friends and relatives work in an OSHA-sanctioned factory than one that isn’t. I’d much sooner take medicine which has received approval from the FDA than consume some snake oil remedy. On the whole, while one can never be completely safe from harm, our nation remains immune from many of the ills of less stringent countries.
One could superficially conclude we must pay for our added safety, therefore resulting in a slower economy (as more money gets diverted to the bureaucracy, less goes into more productive pursuits).
Not so.
America’s high safety standards began even before Teddy Roosevelt, so disgusted with Upton Sinclair’s The Jungle, threw his dinner out the window and spearheaded legislation leading to ordinances in the meat packing industry. Yet, ol’ Teddy sure inspired.
Throughout the twentieth century, Congress provided laws which protected workers, consumers, businesses and citizens. Lawmakers concerned themselves mostly with the prevention of catastrophic failures. For example, with the Glass-Steagall Act and the Federal Deposit Insurance Corporation, never again would America’s banking industry – and its customers – suffer as it had in the Great Depression.
Still, despite all this government regulation, our country thrived economically. Granted, we had a war-ravaged world to build products for, but it is only today, fifty years after the start of World War II, that other countries have begun to appear to overtake our pecuniary prowess.
Laying all the blame for our financial doldrums on business-strangling safety legislation is a bit thickheaded. Most of the problem lies in our own expectations and inability to see the forest for the trees. Mind you, I am not saying that all regulatory legislation is good. Nor am I stating that most regulatory legislation is good. There are bad laws. Some laws, however, provide all of us with a blanket of protection.
You’re probably all confused by the preceding rhetoric, being it is a mixture of well worn Republican and Democrat policy platforms. The following pioneering thought, though, requires the above exposition…
A few weeks ago I attended a Rochester Rotary luncheon (to make up for missed Honeoye Falls Rotary dinners). The head of Chase-Lincoln Bank spoke eloquently on the future of the American banking industry. He sprinkled his speech with the usual prophecies of imminent ruin (generally at the hands of the more efficient Japanese). With the heartfelt understanding of what the concept of world economy entails, (as opposed to several nationalistic economies), I accepted the belief certain government anti-trust regulations put certain American industries in a bad position.
How could anyone expect our banks to compete against state-sponsored giants? As an example, the Chairman pointed out that ten years ago, the world’s ten largest banks were all American. Today, only one American bank can be counted in that number (and, of course, the top five banks are Japanese). He implied foreign banks make more money (i.e., yielding higher returns) than American banks primarily as a result of stultifying US government restrictions.
Suddenly, the thought occurred. What if our country’s “economic ruin” really represented a living example of the risk-return tradeoff?
Here’s the twist. What if foreign banks get better returns than American banks due to the inherent riskiness of foreign banks, not because of laws which handcuff American banks? Remember, the banking legislation which came out of the Great Depression limited the powers of banks so they wouldn’t fail as often. These laws benefited both the bank’s customers (who would worry less about losing their hard earned money) and the bank’s investors (who would worry less about losing their hard earned money).
Without American legislation to contend with, foreign banks can do a lot more than American banks. This insinuates foreign banks probably carry a lot more risk than American banks. Building upon the preceding premises, we would expect foreign banks to outperform American banks during periods of economic expansion. Since the early 1980’s, the world economy has been booming. Is it a coincidence that foreign banks have overtaken American banks during this period – or is it merely predictable?
Should we not therefore anticipate American banks will weather a worldwide recession much better than foreign banks? The significance of this conclusion cannot be understated. That foreign banks do better than American banks during prosperous times does not necessarily imply they are better managed (or better anything). The real test will come when the economy sours.
What applies to the banking industry may very well apply to all industries. We know quite a few American industries have survived the many post-war recessions. Will the less protected foreign economies be able to maintain their leadership position through the next recessionary phase?
Last Week #26: Can America Compete? – Part I (originally published September 14, 1989)
Next Week #28: Outfitting Today’s Athlete (originally published September 28, 1989)
[What is this and why is here? See Interested in Discovering My Time Machine? for more details.]
Author’s Comment: Wow! A lot has happened over the past 22 years. For one, we eliminated Glass-Steagall in the late 1990’s. For another, we experienced a complete collapse of the global banking system in September of 2008. Are the two related? No. Because the 2008 crisis had its seeds in housing policy and the credit market, the banking system would have collapsed with or without Glass-Steagall, which focused primarily on commingling equity portfolios onto a bank’s balance sheet, not the loan portfolios that have always appeared on a bank’s balance sheet. However, motivated by the same desire that led to the removal of Glass-Steagall, it was simple greed by the banks, their customers and the politicians – not lack of regulation – that, in all likelihood, led banks into the credit-crisis of 2008. Remember, the credit crises would not have occurred without the willing encouragement of Federal Housing policy and the willingness of people to seek loans well beyond their capacity to repay. At the heart of it, though, banks – and their investors – demanded higher returns. Federal policies promoted liberalized credit rules, borrowers rejoiced at the availability of easy money and banks eagerly seized upon the opportunity. But, inherent in all higher return scenarios dwells the reality of higher risk. Some of the more adventurous banks experienced the consequences of this higher risk, and – again as a result of government policy – we’ve all had to share in the downside of that risk. Ironically, I wrote a paper soon after this article was published on the fallacy of “too big to fail” in the commodities markets. I received the lowest grade of my graduate school career as a result of that paper when the professional simply refused to accept my criticism of the popular consensus. It sounds like that group think, along with aggressively bank management, short-sighted government policies and careless consumers, created a perfect economic storm which continues to rain on us today.
Incidentally, the top five banks today include only one Japanese bank. The other four are from Germany, France, Switzerland and America. In the 1980’s the top American bank was Citibank. Today, it is Bank of America.