9. Investments and Pseudo-investments: Which do Banks Prefer?

Listening to politicians, economists and bankers may well lead observers to believe the following:

• Bank lending is “investment”.

• “Investments” help the economy grow.

• The more “investing” that happens, the wealthier we’ll all be.

If these were all true then the fact that banks have an incentive to lend to as many people as possible for as many things as possible would be just fine. Their incentives would be perfectly aligned with what’s best for the economy as a whole. We’d have a win-win situation... but there is a problem. While there is an element of truth in each of the statements, in the current era of modern banking it turns out they are all more false than true. In this chapter we will examine why.

True investments

Let us be clear about what constitutes a true investment. Here are some examples:

• Lending to an existing business so that it can buy a new machine for its factory. This machine will produce widgets (whatever it is they manufacture) more efficiently than their existing machine and so increase output and company profits.

• Lending money to an entrepreneur so that they can start a new business. They need the loan in order to buy raw materials and pay staff in the early stages of the company before it starts to make a profit.

• Lending money to a company for it to research a new manufacturing process.

• Lending money to a company for it to build a new factory.

These things are all quite clearly investments. These things are exactly what banks should be involved in.

Non-productive “investments” (pseudo-investments)

Consider a loan to someone for them to buy a holiday or some new furniture. Is that investment? Maybe it’s a matter of definition. Maybe according to some economic dictionary somewhere it is classed as an “investment”. After all, so long as the borrower pays the money back with interest, the lender will have made a profit. So from the lender’s perspective it looks just the same as any other type of investment. You lend money out, you get a greater sum back. But clearly there is a difference. The true investments in the last section are designed to lead directly to an increase in productivity, whereas lending for a holiday or new furniture is clearly non-productive. One may argue that perhaps a holiday, or some more comfortable furniture, would lead to the recipient being able to work just that little bit more efficiently in their job, but the effect is very much secondary and is likely to be on a lesser order of magnitude than a true investment. Perhaps it could be said that a loan for a holiday was 5% productive, 95% non-productive. Even so, compared to a true productive investment, loans for holidays are extremely inefficient for increasing production.

It is interesting to note that in most countries there is nothing contained within banking regulations or the tax system that distinguishes productive from non-productive investments. Indeed there isn’t even a separate word for non-productive investments in the standard economics textbooks! The books make almost no effort to distinguish between the two phenomena. We’ve even had to invent our own word for non-productive investments: we’ve called them pseudo-investments.

Governments around the world perceive investments as a) good for the economy and b) involving the lenders risking their money. Because of this they often take steps to encourage investment by giving tax breaks on profits made by the lenders. Governments will rarely distinguish investments from pseudo-investments in this regard.

The bankers choice

There are many economists and politicians who insist that the “free market” is always best for an economy. Whatever people (or banks, or businesses) choose to do, based purely on their own selfish interests, is always perfectly aligned with what is best for society as a whole – this is Adam Smith’s “invisible hand”. The basis of laissez-faire economics. Margaret Thatcher, Ronald Reagan and George Bush were all keen advocates of this philosophy.

In this section we will analyse the process of a bank choosing between two loans to see whether it is deciding between them in society’s best interests. For the sake of simplicity, let’s imagine a fixed money supply system of banking, i.e. full reserve banking, as introduced in chapter 1 and to be discussed in detail in chapter ?. With this type of banking, a bank cannot create money, and so will have strictly limited supplies. Imagine the bank is down to its last $10,000 of lendable funds for that day, and two competing borrowers enter the bank, both of whom wish to borrow the full $10,000 and both of whom are respected and trusted individuals whom the banker has every faith will pay back the loan plus interest.

Comparing two productive loans

First of all let’s consider the case where both potential customers want the money for productive purposes.

Just to make the explanation simpler, imagine that the idea in both cases is for the borrower to buy new, faster, more efficient machines for their factories that will produce whatever it is they manufacture more efficiently than ever before (they are not necessarily manufacturing the same items).

So long as the banker has confidence that the loans will be repaid, the only consideration in determining who gets the loan is who is willing to pay the highest level of interest. Now assume that both potential borrowers have equally good advisors who have made equally accurate (or equally inaccurate) forecasts about the improved profitability that will be brought about by the loans. The man whose investment leads to the greatest rise in profitability will be able to afford the highest interest rate. This man will “win” the contest and get the loan.

Now we need to look at the benefits to all concerned in this lending process. The main benefits of a productive loan are made up from two parts, A and B, defined below:

Benefit A	The benefit to the borrower in increased profits after the new machine is purchased.
Benefit B	The benefit to the community from having cheaper goods available to purchase as a result of the completed investment.

Benefit A is pretty obvious to anyone, but B may need a little explanation. You may suspect that when a company invests in new improved machinery that it may decide to simply keep its prices unchanged and enjoy the greater profits. This is indeed possible but in practice is rare. As long as the company is in competition with others it will usually be more profitable for it to lower its prices (as it is now more able to do) and take market share from its rivals. Additionally if the new, faster, more efficient machinery is available to all, then its rivals may also be purchasing it and so the forces of competition will surely drive the prices lower. Indeed the amount that the prices drop will in general be proportional to, or at least correlate with, A.

Now back to the banker’s choice. We have seen that the banker is most likely to choose the borrower that can make the greatest increase in profits for themselves, i.e. the banker will choose the one with the highest value of component A. But we have also seen that the B component is likely to be proportional to A. Therefore we can conclude that the banker is indirectly going to select the investment with the highest value of B; the banker will be maximising the benefit to the community.

When comparing two productive loans, a banker will choose the one that gives the greatest benefit to society.

This result looks like confirmation of the principle of free market fundamentalism. Letting people act in their own selfish interests by a happy accident simultaneously results in the maximum benefit to society as a whole. A victory for the invisible hand!

Comparing a productive loan to a non-productive one

Let’s now imagine a scenario in which two potential borrowers come into the bank, both wanting the bank’s remaining $10,000. Both are well-respected, reliable people who, the banker is confident, will repay the loan plus interest. But now this time, one is after a productive loan like buying new machinery for his factory, and the other wants to build an extension to his house so that he can install a pool table. Again we must consider the major potential benefits to everyone affected by the transactions:

For the productive loan we have benefits A and B as before.

For the non-productive loan we have only the benefits to the borrower. A bit like A, except that the benefits are in terms of the enjoyment of the house extension rather than in terms of profits. Benefit B is far smaller than is the case for a productive loan.

Now let’s consider what this looks like from the bank’s perspective. Again the bank will give the loan to the person willing to pay the highest interest rate. This will be the one who perceives that the benefit to them personally will be greatest.

Now we can see that there is a fundamental difference between this choice and the one where both loans were productive. Imagine that the two borrowers’ perceived benefits (to themselves) are rather similar. In this case what they are willing to pay in terms of interest would be a close run thing. Imagine that the man asking for the productive loan is willing to pay 9% and the man wanting the non-productive loan is willing to pay 9.001%. The banker, acting in his own selfish interests, will give the loan to the man asking for the non-productive loan. The banker has no reason to consider B, the benefit to society of the cheaper goods.

So in answer to the original question, “Real investments v. pseudo-investments: Which do banks prefer?”, the answer is that they don’t care. They will simply end up selecting the borrower who perceives the greatest benefit to themselves. The invisible hand fails to work in this scenario.

When comparing a productive loan to a non-productive loan, a banker will not necessarily choose the one that gives the greatest benefit to society.

Is a productive loan always better than a non-productive one?

A productive loan is usually better for society as a whole than a non-productive one, though it is not guaranteed to always be so. If the benefit to a borrower for a non-productive purpose is very large compared to the size of the loan then this may be a “better” thing to do than arrange for a poor-quality productive loan which gives only a small benefit to society as a whole. Don’t forget that the borrower is part of society too and we must not discount the personal benefit to them when we attempt to tot-up the total benefit of the loan.

Productive v. non-productive loans in a fractional reserve system

So we’ve seen that bankers do not take into account the total benefit to society of potential loans. So far the simplified scenarios used to demonstrate this result have been rather artificial and have involved a fixed money supply system of banking. When we come to translate this result to the real world we have to consider a fractional reserve system where it is perfectly possible for banks to lend out a greater sum of money than people have saved. It all depends on the interest rate that gets charged; this is at least partially controlled by the actions of a central bank.

Imagine the collection of all the people in society that would want to take out a loan, given a low enough rate of interest. Some might want the loans for a productive purpose; some may want them for something non-productive. Now imagine lining them all up, ranked in order of who is willing to pay the highest level of interest. Then imagine the assorted levels of interest that the banks could charge. If the rate was very high then only a small fraction of those people at the front of the line would end up taking out loans. If the rate was set lower then a greater fraction of these people in the line would end up taking out loans. Under most circumstances (except in the aftermath of an asset bubble bursting) the government, in cooperation with the central banks, will usually not want everyone who wants a loan to get one because that would inflate the money supply too quickly and lead to a level of CPI inflation above their “target” level. So they will take actions to ensure that the interest rate is such that only a limited amount of money gets lent out. This results in there being a limited number from the line of potential borrowers that will want to take out loans.

The problem with this scenario is that the people wanting non-productive loans and the people wanting productive ones are all mixed in together. When a interest rate is chosen, and therefore a cut-off in the sorted line is made, there will be people who wanted productive loans who will have lost out to people who wanted non-productive ones. Had the line instead been sorted according to the loans of greatest benefit to society then there would have been a strong tendency for the productive loans to be ahead in the line.

To summarise the situation:

Non-productive loans lessen society’s ability to lend for productive purposes.

Sadly politicians and economists around the world appear blissfully unaware of this fact. They certainly do almost nothing to suppress non-productive lending, which is especially sad because it would be relatively simple to address.

A very easy fix

All that would be required is a tax on non-productive loans. If someone is really so desperate to have that summer holiday without saving up for it first then they should pay compensation to the rest of society for the fact that they are hampering the progress of the nation’s productivity.

Perhaps borrowing for non-productive purposes should be considered a social evil like smoking. Maybe advertising for such loans should be banned. Personal credit cards should be banned outright. All loans should be arranged person to person with bank managers – like the old days.

What you will see time and time again around the world is politicians proclaiming, “We must get interest rates lower so that we can have lots of investment.” They may even add things like, “Yes, I know the lower interest rates will cause some inflation, but that’s the price we have to pay for economic growth.” If only they knew about all the harmful effects of non-productive loans. If we could discourage non-productive loans then with the same amount of total lending (i.e. have the same level of inflation) we could have more productive investments.

Some counter-arguments (and their refutations)

Some free market fundamentalists are horrified when they hear suggestions of suppressing non-productive loans. They are liable to retort with several possible counter-arguments. We shall consider these in turn:

Counter argument: A loan for consumption is beneficial to people other than the borrower. If the borrower wants to buy a new television, for example, then this will be of benefit to the television manufacturer.

Refutation: This is indeed true. We do not dispute this. The problem is with the size of the benefit. The benefit to the television manufacturer is in the profit it can make from the purchase of the television. The profit, however, is liable to be only a fraction of the purchase price. So the benefit is small. Consider the following scenario: Imagine that you live in a town opposite a shirt-making factory. The factory uses inefficient machinery and its shirts are expensive. You like the design and quality but wish the shirts were cheaper. Let us say that a new, efficient shirt-making machine costs $5,000 and the factory owner would like to get one but doesn’t have the money. One day a rich man comes to town with $5,000. Let’s say that at this point one of two things could happen:

The rich man buys $5,000 worth of shirts.

OR

The rich man lends the factory owner $5,000 to buy the new machine.

Consider which action is most likely to bring about cheaper shirts. If the rich man buys $5000 worth of shirts, then the profit is bound to be less than $5000, perhaps only a small fraction of $5000. This undoubtedly will help towards saving up $5000 for a new machine, but there may still be some way to go before this can be achieved. However, if the rich man offers to lend the factory owner $5000, then the machine can be purchased immediately.

Counter argument: “How dare you let some government bureaucrat decide who gets loans! That’s communism!”

Refutation: This argument presupposes that we are suggesting that government bureaucrats are in charge of the entire loan selection process. This is not the case at all.

A government bureaucrat would indeed need to draft a set of rules to define the most blatant forms of non-productive loans, thereby dividing all loan applications into two classes, but the choice about which loans are made within those classes could be made by the free market.

Counter argument: It is too difficult to distinguish between productive and non-productive loans.

Refutation: It is certainly true that with complex and creative accounting methods there may well be grey areas in this regard. But given the many harmful effects of lending for non-productive purposes, it is still beneficial to attempt to suppress clear-cut cases. To suggest otherwise is rather like suggesting that all crime should be allowed to go unpunished because there are some activities where it is not obvious whether they are criminal or not.

On a final note, please keep in mind that such widespread and ubiquitous borrowing for consumption (i.e. non-productive purposes) is a very modern invention. Discouraging it, is merely going back to how society has always worked in the past.

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